Structured products with all their complex underlyings and payoffs are in many cases a way for investors to sell volatility in a packaged product.
As we saw in our recent article about risk control, investors continue to face significant challenges when managing market volatility - for many, volatility shocks often result in large drawdowns and negative equity market returns. However, a change in the volatility regime may present opportunities to investors and other players in the structured products market.
As the volatility gets higher, the sale of a put option generates more premium, funding higher coupons and therefore higher potential returns - Jean-Victor Demaison, Cacib
Most of the structured products in the market are capital-at-risk that offer enhanced yield or participation in exchange for a conditional repayment of capital at maturity – usually when the underlying is above a pre-determined barrier level, according to Jean-Victor Demaison (below-right), head of equity solutions sales, Emea (ex FraBeLux) and Americas, Crédit Agricole CIB (Cacib).
“Those products embed a short put position. This means that investors have to bear the mark-to-market of that short option position during the life of product - as the market falls and/or becomes more volatile, capital-at-risk products see their value falling,” he said, adding that volatility can also benefit prospective investors who want to buy new products.
“As the volatility gets higher, the sale of a put option generates more premium, funding higher coupons and therefore higher potential returns. Volatility can magnify returns or losses. It is therefore important for investors to understand the risks and benefits of each individual product and seek financial advice when necessary.”
In many cases these short volatility structured products also take on a correlation exposure too.
“Many equity structured products sell a worst-of put on the downside in order to increase the coupon, and this means that they are also long correlation between the associated underlyings,” said Pete Clarke (pictured), head of multi-asset derivatives strategy at UBS.
This is because in a very high vol environment, if the correlation between the stocks in the basket is very low, with names moving in opposite directions, then the product is more likely to hit the knock-in barriers on the downside, and also less likely to be able to autocall to the upside.
“The standard worst-of reverse convertible or worst-of autocallable is short volatility and long correlation, and also tends to carry a short dividend exposure as well, because the higher the dividend versus what was implied, the more the ending spot level will be dragged lower, taking the payoff towards the knock-in barriers and away from the autocall level,” said Clarke.
From a structured product risk recycling perspective, the issuer ends up with the opposite position.
“The dealer effectively ends up long vol, short correlation and long dividends, all of which they ideally want to recycle in order to reduce risks and enable further primary issuance,” said Clarke.
The relationship between volatility and correlation is very important as seen earlier this year – in very volatile environments correlation tends to jump at the same time as the biggest spikes in volatility.
“You see that in terms of cross-asset correlation, ie bonds and equities selling off together which is what we've had year to date,” said Clarke. “Yields have moved higher, and equities have sold off.”
This has also triggered higher internal correlation within indices like the Eurostoxx50, with constituent stocks selling off together or rallying together on any given day, driven by the same market dynamics. This makes options on an index particularly expensive versus the weighted average cost of options on the constituents within the index.
“When the cost of options on an overall index is high versus the weighted average cost of options on the individual constituents, then the internal implied correlation within the index is high,” said Clarke. “If there is a very steep index skew relative to the stocks, this means that implied correlation is also expected to rise sharply on market drawdowns.”
In a very steep skew situation, a relatively small spot decline can often create a meaningful spike in the VStoxx or the VIX, which is in line with what the market has experienced at times in recent years.
“We've had very steep skews on global equity indices for much of the last two years coming out of Covid because markets have been consistently rallying and uncertainty has remained high. This has encouraged investors to spend some of their positive equity returns on mitigating downside risks via long put options,” said Clarke.
These dynamics have been driving the products that investors are trading today and the risk recycling activities from manufacturers.
One of the main functions of market makers is to be able to recycle the risk that is generated from structured products, and the last two and a half years have been action-packed as far as volatility is concerned.
According to Sumit Kendurkar (right), senior equity trader at Optiver, the focus is on two specific sets of products - the mono underlying structures linked to one asset and basket-linked structures, mostly worst ofs.
“This is a critical function for us, to be there and offer product issuers room to manoeuvre,” he said during the volatility panel discussion at SRP Europe 2022. “This is what has kept the market so dynamic even in 2020 when Covid first hit. We saw the Asia markets going first then came Europe and finally the US, when everything just went down together.
“This meant that at different points in time there were different underlyings that were basically the worst-of on those baskets. Consequently, you would see that the whole exposure switched from Hang Seng to Eurostoxx50 and then to the S&P500. Then 2021 was all about rates, inflation expectations, etc. which has led to a massive rotation within sectors and stocks in 2022.”
Since the beginning of the year, we have seen a large divergence in broad sector performances, with energy, materials, utilities and staples outperforming vs discretionary, banks and technology. This dispersion has resulted in significant rebalancing of volatility and derivatives exposures.
“These huge underlying sector rotations have meant that dispersion trades have been very popular and generally quite profitable in realised terms year-to-date, even as implied marks have been moving higher,” said Clarke. “The volatile rates environment has helped to keep realised correlation at the stock level much lower than you might naturally expect for such a high implied vol backdrop.”
This is particularly the case in Europe where implied vols have been comparable to the levels of 2015 - 2016 over parts of the last couple of years, although the absolute level of realised correlation has been significantly lower.
The problem with correlation is that there is no basket which you can use to wager your vision on any index and is difficult to measure because there are no direct listed products to recreate correlation in a basket, according to Kendurkar.
“You can use calls versus calls - so calls on the basket versus the basket of the individual calls, but these are very illiquid OTC products,” he said. “We are helping issuers by getting access to dispersion packages which consists of listed underlyings.
“One of the OTC products that has really taken off over the last few years are symmetric dispersion structures which are traded with hedge funds and allow you to literally pick the exact correlation on the stocks on your exact position exposures.”