The latest stamp of approval for the role equity derivatives can play in maturing financial markets has come from the most conservative and cautious of marketplaces: China. Regulations published in the China Securities Journal outline the trade in financial futures contracts and options on Shanghai’s seven-month-old derivatives exchange from the middle of April.
While it has been appreciated by the investment cognoscenti that equity derivatives have long been brought in from the cold, it is only more recently that the more conservative asset managers and pension fund trustees have embraced them in any meaningful way.
In the simplest terms, observers say they are seeing a convergence of investment styles between the more sophisticated asset manager and the hedge fund investor, at the core of which are equity derivatives. Ever more complex exchange-traded products and tailor-made over-the-counter (OTC) structures are emerging for an enthusiastic elite, boosted by an investment banking sector’s never-ending search to transfer risk and make money.
Following a three-year bear market, asset managers have become more active. “There’s a market trend towards absolute return strategies, a blurring of the differences between asset managers and hedge funds,” observes Brendan Bradley, global head of product strategy with Eurex.
“As more traditional investors seek absolute returns, asset managers are responding with what I call ‘hedge fund lite’ while hedge funds will create products engaging their normal strategies but on a lower geared basis,” agrees William Kennedy, managing director of equities at UBS Investment Bank.
Even so, controversy is never that far away. The International Swaps and Derivatives Association (ISDA) has hired consultants to study new futures contracts on credit derivatives which it says ‘may’ adversely influence the prices traders set on defaulted bonds. Eurex became the first bourse to open a market for credit derivatives, a business tipped to grow as investment banks produce ever-more liberal leveraged loans for thriving private equity deals, while desperate to lay off risk.
But whatever the ins and outs of these new credit products, the equity side of the equation currently has no such scrutiny. “There’s certainly growth and while people in 2003 questioned whether we’d ever be able to sustain the growth in the market of the late-1990s, it’s surpassed expectations,” says Mr Kennedy.
Figures for the full equity derivatives market remain murky, not least because of the increasing numbers of OTC deals. However, the ISDA’s most recent figures for equity derivative trading (including equity swaps, options, and forwards) in the first half of 2006, showed year-on-year growth from mid-2005 of a whopping 32 per cent, up from $4800bn (€3576bn) to $6400bn.
And while the European market may remain a little behind the US in terms of derivatives usage, a report from research firm Greenwich Associates late last year showed that all the institutions participating in its study used liquid flow equity derivatives: 81 per cent trading single-stock options, 75 per cent trading index options and two-thirds using index futures.
Figures from Eurex, the international derivatives exchange, give some perspective on the European market. The equity index derivatives segment set a new record with volumes of 87.4m contracts, up 44 per cent compared to the previous record of June 2006, while 31.6m equity derivatives contracts were traded during March 2007 (March 2006: 26.9m). The growth was substantially driven by single stock futures, where volumes more than doubled to 5.2m contracts year-on-year.
While figures are up, markets are not homogeneous. “Most European markets are thriving but they're not doing the same thing in terms of using equity derivatives,” observes Hassan Houari, managing director of derivative products at Barclays Capital.
 | “Use across Europe is not 100 per cent uniform,” agrees Shaun Wainstein, head of equity and derivatives at BNP Paribas UK. “For example, insurance companies and asset managers in France, Italy and Germany have long sought new forms of asset class hidden within equity trading books and have expertise in use of derivatives with stocks and volatility.” |
Derivative players point out that the relatively limited number of quoted equities in these markets compared to the US or UK accounts for the higher historical interest in such instruments and is illustrated by the national indices – Dax 30 or the FTSE 100.
“Northern Europe is mainly focused on macro hedging and view plain vanilla products as ‘simple is beautiful’ and there is plenty of liquidity in the secondary market to support put options for portfolio protection and both call and puts for yield,” points out Mr Houari.
One element of the French market and a sizeable one, is the banks use of hybrid protection products linked to equity derivatives that offer an enhanced return rate linked to Libor for the retail market. These are usually based upon variance and correlation products which are considered popular as a base for structured instruments.
Variance swaps allow investors to trade volatility by buying or selling the variance of stocks or indices (variance being the square of volatility), where investors can buy or sell stock correlation rather than outright volatility. Correlation positions can be synthesised by trading index against single stock volatility.
“One shouldn’t under-estimate the importance of the retail market in driving derivative liquidity,” says Mr Bradley.
“The French market digests these notes regularly, they’re effectively a structured note in a wrapper. In Germany, they’re different with alternative wrappers for similar exposure,” explains Mr Houari.
These retail products may be considered as a vital element in supporting both liquidity and product diversity available to the institutional players. As banks continue to take risks in lending (such as leveraged loans to private equity players) and stock portfolios, they are increasingly developing products to pass on elements of this risk to hedge funds and other institutional investors.
However, this approach can produce a self-fulfilling prophesy. “If you end up delivering a lot of exotic options into the market which may mitigate one type of risk, they may throw up another risk profile and they start feeding from one transaction into another,” explains Mr Kennedy.
“Traditionally, you could sell calls to enhance returns on indices but now you can design a product to specifically extract value out of your view on stocks or volatility or dividends and the growth has been significant here and it’s a significant source of revenues for lending banks,” observes Mr Wainstein.
While hedge funds have long been interested in any liquid derivative that can reflect their view, pension funds have been slower in take up. Most players accept that UK pension funds have been slower in their acceptance of the instruments than elsewhere in Europe. “There’s beginning to be a material change of view in UK pensions, usually using index options to mitigate downside risk but there's also an interest in variance and correlation tools,” observes Serkan Bektas, head of pensions with Barclays Capital.
“We’ve seen them go directly to investment banks rather asset managers for products, sometimes because it's cheaper with larger Dutch and Nordic pension funds particularly keen,” agrees Mr Kennedy.
“There is increased use but in the UK pensions are more dependent on consultants and asset managers but derivatives can give a more accurate reflection of their risks and liabilities,” says Mr Wainstein.
Smaller pensions particularly benefit from being able to access indices, especially in emerging markets where costs like custody can be prohibitive, through a derivative product. The popularity of such strategies can be seen from March’s record Eurex figures of 5.5m EuroStoxx50 futures and 2.5m options traded in a single day.
According to Mr Bradley the market demand in exchange-traded derivatives has been for single stock options, emerging market products and pan-European sector futures.
But while he accepts the interest from UK continues to grow, there are issues. “While there are exceptions to the rule, UK asset managers struggle with using options [but not futures] because of underlying systemic problems such as attribution and performance measurement,” says Mr Bradley.
Both exchange traded derivatives and OTC products are expected to continue to grow in volumes and product variations.
SOPHISTICATED INVESTORS SHUN OTC PRODUCTS FOR SOMETHING TAILOR-MADE
Provision of derivative products has become an ever-increasing area of profitability for investment banks in Europe. As they seek to lay off their loan and portfolio risk to other investors, they are able to produce more complex structured products.
In addition, there is a definite use of over-the-counter (OTC) products. “There are several reasons for institutional interest in tailor-made derivatives; seeking to specifically find something to reflect their view or not having the whole market see their strategy,” outlines William Kennedy, managing director of equities at UBS Investment Bank.
Typical of the sort of tailor-made products being offered is BNP Paribas’ Vivalto.
In order to produce a profile to match a client’s asset liability management objective, which were constrained by the need for regular returns that were also de-correlated from the rest of its assets (to lower the volatility of its global portfolio), an alternative strategy was required.
Because it was to have non-correlation to market exposure (beta) a conventional absolute return strategy could not be used but had to produce alpha returns in all market conditions.
What was suggested was an asset based on upside volatility, which only takes into account the price movement of the underlying asset when the price is trading above its initial level. While swap structures can offer upside volatility and are not uncommon, BNP Paribas offered it through option-based products.
“Due to structuring skills and the risk exposure we're able to bear on our trading books, we remain the sole player capable of writing options on this hidden asset,” says Mr Wainstein.
Along the same lines, Barclays Capital produced Voltaire Notes which were launched in March 2007. For insurance companies, in particular, these guaranteed products produce a return reflecting a more risk averse strategy but capturing some upside.
These are capital guaranteed structured notes which exploit the differential between implied (estimated volatility of a security's price) and realised volatility. It is based on a variance swap (variance being the square of volatility) which is a liquid OTC derivative product whose payout directly depends on implied and subsequently realised volatility.
The three-year maturity guarantees principal protection at maturity. Each month the strategy identifies the market exhibiting the largest differential between implied and realised volatility from among the major market indices in Europe, US, UK and Japan.
Products reflecting points of view on how markets, sectors or individual stocks might perform, while balanced by regulatory issues and fund liabilities, are acting as a catalyst for ever-increasingly complex solutions.
