About 12 years ago, the typical product range on offer to private banking clients consisted of:
* Access products;
* Yield enhancement;
* Warrants;
* Capital-protected notes or CPNs; and
* Asian, capped, barrier/worst of/non-linear payouts.
Clients were looking for access to new markets where foreign investment was restricted. Long-term investors were happy with yield enhancement through selling calls or puts, while more speculative investors enjoyed the gearing and price movement in warrants. Conservative investors were looking for alternative investments to cash deposits or straight bonds, and capital protected notes--simple bond-plus-option structures--fit the demand. Some sophisticated investors would consider barrier options and other non-linear payout products but on the whole the menu was simple and life was vanilla.
These products made different contributions to the trading book:
* Access products * long inventory;
* Yield enhancement * long gamma and inventory;
* Warrants * short gamma/vega, long inventory;
* CPN * short gamma/vega, long inventory; and
* Asian, capped, barrier/worst of/non-linear payout * path dependent and feature digital risk and correlation.
As computation power gets commoditized, we Monte Carlo all day long and private banks expect a modern choice of products:
* Target Redemption Notes, or TARNs;
* Range Accrual Callables, or RACs;
*Worst-of feature
*Multi-level callable trigger
*Yield enhanced by down-and-in put
* Accumulator
*Geared up feature
* CPPI and CPN
* Variance swap/dispersion
Target redemption notes and range accrual callables gain market share with infinite mutations. An accumulator--a daily up-and-out forward--becomes a popular investment method for blue chips. CPPI and capital protection notes still see demand. Sophisticated investors are taking views on volatility as an underlying and also trade correlation.
The risk profile of these products is no longer vanilla:
* TARN * digital exposure, correlation
* RAC * digital exposure on callable dates
*Worst of feature * short correlation
*Multi-level callable trigger * skew impact
*Yield enhanced by down and in put * jump risk
* Accumulator * digital exposure, time decay
*Geared up feature
* CPPI and CPN
* Variance swap/dispersion * hedging mismatch
Costs To The Trading Book
The early-redemption features of TARNs, RACs and accumulators bring serious digital exposure to the trading book. The unwinding cost of the bond component, the coupon payment and the loss of optionality become a digital risk.
Assume the cost of early termination to the issuer is 20% of notional. If such digital risk is approximated by a 5% call spread, the notional of the call spread will be four times the note notional in order to generate a 20% payout. Imagine the note size is USD100 million, the call spread will be USD400 million notional. In the case of a worst-performing share trigger, such risk will be magnified in this particular underlying. The liquidity in the stock may not be able to support efficient delta hedging.
CPPI is a great investment methodology but it is path dependent. If the underlying happens to fall sharply after launch date, the investment will become a cash instrument with virtually no chance to profit. Bond-plus-option CPNs offer great clarity in payout at maturity. The secondary pricing, however, will not have the same transparency as CPPI products.
Variance swaps are an effective way to trade volatility without worrying about delta or gamma risks. To recycle the vega risk, we often need to use vanilla options and a mismatch happens as the underlying moves. Dispersion between index and top constituents only works on indices with the top 10-15 constituents accounting for 80-90% of the index. The liquidity of the smaller constituents often leads to slippage.
Real World
In reality, the liquidity of the underlying limits the product notional. Option pricing assumes continuous price movement and infinite liquidity, it does not work well on illiquid stock. Whether there is a liquid options market on the underlying also has strong impact on pricing and hedging. Assumptions as to how volatility skews with different strike prices are more art than science. In real life, we often see short-dated implied volatility moves in the same direction as the stock price. This observation is especially true for big blue chips where investors are keen to sell puts on the way down and buy warrants in a rally.
Digital risk is very hard to manage in a market with limit up or limit down mechanism. In extreme conditions, traders may not be able to execute the stock with >10% price movement. It is tough enough to visualize volatility as a tangible commodity. Correlation risk is even less tangible to monitor and manage. Should correlation change with strike or time? It is definite not a constant number.
Can Structured Products Survive Without A Flow Business?
When considering how many underlyings a private bank trades through structured products in a year, it becomes clear we need a large global stock universe. Understanding the competition firms face, it is not surprising to see volatility on bid/ask spreads within the over-the-counter market. A strong vanilla franchise such as listed covered warrants makes the issuer a natural buyer in volatility. The issuer has a better chance to win the deal.
In order to support a large global stock universe, traders have to maintain volatility surfaces on hundreds of underlyings. There are not too many reference points to lean on in generating a 10-year volatility surface on most Asian stocks. Coupled with that, are the dividend forecasts on every stock and also the rate curve on all the currencies. On the restricted currencies such as KRW, INR, TWD, we have to maintain a curve based on non-deliverable forwards. There is also the borrowing fee on stocks in case of short selling--where that is allowed. Traders need to focus on the correlation risk and digital risk. With so many barriers, strikes, callable dates, there is always something exciting.
The Way Forward
Multi-asset class products are important. They help to construct baskets with low correlation. Equity and commodities are generally more volatile than interest rates and fx, making them great for high-coupon non-capital-protected products. Credit products are getting more exotic everyday. The interesting point about equity and credit is the growing underlying universe as more companies become listed.
Every private bank and investment bank is seeing its number of outstanding products growing. It has become an operational challenge: scalability is a key factor in competitiveness. After-sales services and support are intense, especially for products with a daily-accrued feature or multi-variable coupon and early-redemption events.
To aim for steady revenue, distribution channels must be geographically diversified. Retail demand has high correlation with index levels or investment climate. Deposit rates control the gearbox of demand for capital-protected structured products. Rules and regulations are evolving with structured products. By distributing the products in different markets, the business will be more resilient.
Different client segments have their own investment objectives. Retail banks, private banks, insurance companies, hedge funds and listed companies can be attracted by different products. It is important to recycle the risk and this can be done much more easily with a diversified client base. Investment banks may sell volatility through capital-protected notes distributed by retail banks and then source this volatility from hedge funds through variance swaps.
Clients are learning fast and becoming more demanding. They will look for themes in products rather than for just a basket of 10 good stocks. Structurers are critical in order to compete with other firms on turnaround time and creativity. Flow products are a good bread and butter business but are highly price-sensitive. Beauty contests will be compulsory with intermediaries who have to look after the investors’ interest.
Simplicity still works. Delta-one or access products, exchange-traded funds, warrants, synthetic futures and other listed instruments will survive because of their effectiveness and transparency. At the same time, the development of electronic trading platforms will also encourage more real-time trading of high-delta structured products.
| Matthew Wong |
This week’s Learning Curve was written by Matthew Wong, head of private investor products marketing for Asia, at ABN AMRO in Hong Kong.