1. Pension Funds and Capital Markets: The Latin American Experience Nathan Engelhard Director UBS Warburg LLC June 2001

2. Introduction

3. 3 Years of creation Affiliates Assets under Management & Relationship to GDP Portfolio Limits Composition of Assets under Management Evolution of Assets Under Management Returns

4. 4 Years of Creation Source: AIOS

5. 5 Introduction System Participants / Total Work Force Source: AIOS As of December 2000 the Work Force was estimated at 81 million

6. 6 Participants (millions) December 2000 Source: AIOS

7. 7 Assets Under Management (millions of USD) Assets under Management Source: AIOS

8. 8 Assets under Management/GDP Source: AIOS

9. 9 Portfolio Limits Defined by Law (a) As a percentage of the total value of the fund (b) Bonds convertible to equity maximum 15% and minimum 10% (c) Fund type 1. In Chile there are two kinds of funds. Fund type 1 admits any worker; fund 2 admits individuals next to retirement because of old age or disabled individuals. (d) Fund type 2 (e) The investment regime in Chile does not talk about derivatives. This regime only mentions instruments necessary to hedge interest and exchange risk; among them figure out credit loans and tradable securities. (f) The law just considers investments in “SOFOLES”, institutions that give mortgage loans. Source: AIOS

10. 10 Composition of Assets under Management (relative to total value of fund, December 2000, millions of USD ) Source: AIOS

11. 11 Chile 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 Dec-81Dec-82Dec-83Dec-84Dec-85Dec-86Dec-87Dec-88Dec-89Dec-90Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97Dec-98Dec-99 Total Assets under Management Source: SAFP

12. 12 Brazil Source: ABRAPP

13. 13 Mexico Source: SHCP

14. 14 Argentina Source: SAFJP

15. 15 Returns Source: AIOS

16. Derivatives

17. 17 Use of Derivatives In general terms derivatives can be divided into three groups: Risk Management Hedging strategies to limit market exposure Monetization Strategies Obtaining liquidity against stock positions Investment Strategies Risk Diversification Return Enhancement Structures Positive Carry Transactions

18. 18 Risk Management Purchase of Put Options Sale of Call Options Equity Collars

19. 19 Purchase of Put Options

20. 20 Sale of Call Option

21. 21 Equity Collar

22. 22 Monetization Strategies Equity Swaps Collared Equity Swaps Forwards Sale of Stock and Purchase of Calls/Call Spreads

23. 23 Equity Swaps

24. 24 Investment Strategies Principal Protected Notes Reverse Convertibles

25. 25 Investment Strategies

26. 26 Investment Strategies

27. 27 Principal Protected Notes (Structuring) Two main components: Zero- Coupon Instrument Option Principal Protected Note = Zero-Coupon Instrument + Option Typical Payout at maturity: Nominal Amount * [ Principal Protection Factor + Participation Factor * (Underlying Performance)] Where, Performance = Max [ 0, (Underl. final - Underl. initial) / Underl. initial ]

28. 28 Principal Protected Notes (Structuring) Example: Investor interested to invest USD 10.0 million in the Mexican market for 1 year with 100% principal protection. Step 1: Definition of Zero-Coupon instrument: Suppose issuer bank funds itself at Libor + 1.00%. 1 Year Libor = 4.1679% Discount factor = 1 / [1 + (0.051679 / 360 * 360)] = 0.950860 Step 2: Definition of Option Characteristics: 1 Year Notional USD 10.0 million Call option (to capture upside potential) Strike: At-The-Money (100% of Initial Spot Reference) European Style Cash Settlement Option Premium = 13.84% of Notional Amount

29. 29 Principal Protected Notes (Structuring) Step 3: Capital Protected Note issuer receives USD 10.0 million from Investor and distributes the cash as follows: Zero Coupon : USD 10.0 million * 0.950860 = USD 9,508,600.00 USD 10.0 Million Option: USD 10.0 - 9,508,600.00 = USD 491,400.00 Step 4: Computation of Participation Rate: How many options can you purchase with USD 491,400.00?

30. 30 Principal Protected Notes (Structuring) How many options can you purchase with USD 491,400.00? 1 option (on USD 10 million) is worth USD 10.0 * 13.84% = USD 1,384,000.00 So you can purchase: 491,400.00 = 35.50% (Participation Rate) 1,384,000.00 Step 5: Payout Formula: USD 10.0 million * [ 100% + 35.50% * Performance] Where, Performance = Max [ 0, (IPC final - IPC initial) / IPC initial ]

31. 31 Principal Protected Notes (Structuring)

32. Derivatives: Benefits & Issues

33. 33 Benefits The use of derivatives tends to increase liquidity in the local market. The use of structured notes with guaranteed capital provides diversification over different geographic regions and economic sectors. Derivatives transfer risk form one entity to another (e.g. Collars transfer downside as well as upside risk). Use of derivatives would tend to increase the learning curve of the pension fund’s managers as well as that of local banks and other local investors. Local banks could eventually compete with international banks offering a wide range of derivative products, and thus creating a more sophisticated local capital market.

34. 34 Issues Use of derivatives may lead to an increase in volatility of the fund’s Net Asset Value. The size of the derivative market depends on the size/liquidity of the whole market. Lack of derivatives knowledge could lead to an increase in risk rather than a decrease in risk if instruments not properly managed. The use of derivatives could impose challenges to the regulators in monitoring the mark- to-market of the funds (especially if complex structures are included).

35. 35 Monitoring the Mark-to-Market In Latin America the regulators use different benchmarks to monitor the use of derivative products. In Argentina for example, regulators only allow the use of those derivative instruments that the regulators themselves understand, are capable of pricing and monitoring. In Mexico, the regulators have assigned the task of monitoring the mark-to-market of pension funds to specialist companies called “Price Vendors”. Which method is better?

36. 36 The DIVA’s Story In 1996 the regulators in Argentina allowed the use of DIVA’s and “Fideicomisos”. DIVA’s and Fideicomisos are zero-coupon instruments (CDs in the case of Divas and Zero-Coupon in the case of Fideicomisos) with embedded options. The DIVA’s and Fideicomisos were indexed to a series of equity indices and bonds (i.e. the Dow Jones, Nasdaq, Nikkei, Argentina 07, etc.) The use of these structured notes allowed local banks to obtain inexpensive deposits while pension funds with “low risk” diversification products. Allowed the pension funds to diversify risk with a 100% investment protection.

37. 37 The DIVA’s Story DIVA’s and Fideicomisos were improperly valued. DIVA’s and Fideicomisos became very popular in Argentina during in 1997 that 1998 to take advantage of the valuation methodology in order to boost Net Asset Values. About USD 2,500 million were outstanding during 1997. Since the valuation methods were corrected, the use of Diva’s and Fideicomisos has been steadily declining. Currently, structured notes are used as capital protected investments aimed at diversification.

38. 38 The Diva’s Story