The equity derivatives market has displayed a high degree of innovation over the last few years, driven both by the demands of hedge funds for ever more complex products, and by the opportunities identified by investment banks themselves to capitalise on some of the risks on their own books.
One particular trend has been to provide investors with products that are more bespoke to their portfolios. Take for example a hedge fund running long short portfolios on the Eurostoxx 50. If the manager wanted to hedge out a slight beta in their portfolio, in the past they may have bought a put option on the index, but the rising cost of volatility has driven them to seek cheaper solutions. This could be in the form of a basket option, which is a more tailored approach to their requirements.
Matt Renirie, head of hedge fund derivative sales EMEA at Merrill Lynch explains: “We look at a mock-up of what the portfolio looks like, drill down, and if they have a slant to, say, an industrial book, we suggest they buy a put on a basket of industrial names. That allows us to deliver a more bespoke product. It allows the client to cheapen protection and take less of a shotgun approach.”
Adrian Valenzuela, head of equity derivatives investor sales at JPMorgan in London, says that at the simplest level of demand hedge funds have been using barrier options to suit their pay-off needs or achieve lower premiums, while the more sophisticated have chosen more complex strategies
“More sophisticated users have embraced concepts like correlation or best of or worst of optionality, where by using basket options they get relief or enhancement by
complementing a directional view with a correlation angle - out of a basket of names or indices which one do they think will pay off most and how can they minimise their initial outlay of premium.”
Another innovative product is the countdown option, which allows the user to set the volatility they want to pay. “The client determines the volatility they want to pay for the option,” says Mr Valenzuela. “Then the life of the option depends on how long it takes the underlying to realise that volatility.”
Other changes have been more mainstream demand for instruments that in the past might have been regarded as exotic. One such is a dividend swap, which allows investors to take a view on dividends from a particular stock or from a whole index, which is independent of what might happen to the direction of the stock price. Investors have the option of being long a dividend swap if they think dividends will increase, or short if they think dividends will decrease.
 | "It's a more scalpel approach rather than a broad brush approach," says Mike Ward, head of equity derivatives flow sales, EMEA, at Merrill Lynch. "The big theme that has happened over the last five years is people are much more specific on the risk they want either to take or mitigate." |
Yet another type of instrument coming into the mainstream is the variance swap which allows investors to take a view on the volatility of a stock or index.
"A variance swap is one of the cleanest ways to express a view on volatility in the equity derivative space," says Mr Renirie. "It's definitely becoming more mainstream, it is for the more sophisticated investor. The likelihood of a long short fund using a variance swap is low, the likelihood of a multi-strategy hedge fund that runs a portfolio of convertible bonds, ie with volatility expertise, is quite high."
Correlation
One particularly hot topic is correlation plays on the major indices, driven by recent turmoil. Correlation swaps are among the more innovative and exotic derivatives structures that enable investors to extract value from discrepancies between implied and realised volatility. The products most in demand have traded on volatility correlation and smile. High correlation is normally a feature of falling markets, when they all follow each other down, but is less prevalent in rising markets.
"Usually when the market trends higher there is dispersion between indices or stocks that do well and those that do less well," says Hassan Houari, head of equity derivative structuring at Barclays Capital. "Effectively there is dispersion of performance which means correlation is low. When there is a sell-off everything falls at the same time which translates into a higher realised correlation. At the same time the implied correlation that market participants use for pricing purposes will increase."
The French banks have been able to capitalise on their structured products experience to build up a particular expertise in the realm of correlation swaps. Société Générale Corporate and Investment Banking was an innovator in correlation swaps. Having accumulated large short correlation positions from its structured products business, SocGen constructed baskets of names where it was short correlation. These were then sold to hedge funds. The business gave the bank, along with others that had a strong footprint in structured products, a head start in offering these products. But now that derivatives based on correlation risks have become more mainstream the wider investment banking community has also entered the fray.
Société Générale Corporate and Investment Banking has been offering correlation swaps since 2001, but the market has changed a good deal since those early days.
Developing market
“The correlation market has developed since 2001,” says David Escoffier, global head of flow sales in the Global Equity Derivatives division of SGCIB. “Since then it has become more liquid; before it was a one-off transaction and now it is almost a flow business.”
From correlation swaps SGCIB has moved on a step further to develop products based on volatility risk. Symphony for example is based on the "smile" a.k.a "volatility skew": the fact that volatility varies depending on options different exercise price.
“The concept is to systematically use the discount in volatility induced by the smile generated in the options market on certain stocks and indices.” says Mr Escoffier. “With Symphony we recycle our skew risk into one transaction summarizing the smile arbitrage in a one-off trade that we customize on different underlyings depending on client anticipations, markets relative skewness levels and trying to match our warehoused risks generated via our retail structured products sales globally. Typically the Symphony will reset the arbitrage every 3 months to create a statistical arbitrage largely market neutral that plays implied smiles and realised volatilities over a term of two to three years".
For investment banks high volume of business in short time frames, which is a feature of hedge fund business, presents a challenge. Banks have to be able to respond to their demands quickly and efficiently. Good communication between bank and client is key.
"It's important to have an efficient operation to communicate daily with hedge funds about for example margin calls on these instruments, how we derive our valuation of that instrument, making sure they understand the inputs we're using, how one type of instrument offsets the risk of another type of instrument. It's also about bodies on the ground to communicate with their back office,” says Mr Ward at Merrill Lynch.
Scaleability is necessary in systems and procedures to deal with an ever increasing number of clients with more varied and complex demands. A bespoke sophisticated technology system is key, to create processes that can cope with the varied demands from a range of different clients. "Technology is one of our biggest spends," says Mr Ward. "In time gone by, you might have done a transaction once a month, with one sales person dealing with one individual account. Once you use these complex products in high volume across a number of customers you need to transfer information efficiently."
FUND ADMINISTRATION BECOMING INCREASINGLY SPECIALIST
The increasing complexity of derivatives has had a profound impact on the business of fund administration. There are two aspects to this: first is the kind of skills required in staff, and second is the quality of valuations.
New style derivatives with a more quantitative structure require mathematical skills from those who are validating prices. In the past staff with an accountancy background were well equipped to deal with valuations that relied on exchange prices and company news to fix pricing levels, but not any more.
For Citi this has resulted in the creation of a specialist team, the Complex Pricing Group and recruitment of specialist staff. “We hire people with a mathematics or quantitative background, with financial or mathematical engineering PhDs, who see a derivative as a mathematical formula, and can break down the instrument into models and understand the drivers of what makes those instruments sensitive to changes in price that would substantiate differences in valuation,” says Hugh Hanna, head of Citi’s Complex Pricing Team.
The second area of change is the range of data sources used to gather pricing information. Administrators need to draw on data from specialist providers such as Mark-it Partners and SuperDerivatives, as a means of checking and validating prices from counterparties, whose accuracy could be questionable.
“Everybody in the industry is starting to question the validity of counterparty valuations - how accurate they are, how often they’re updated, what quality control there is around the creation of that counterparty mark,” says Mr Hanna. “If the administrator takes a price from a counterparty and has no other means of verification there is a risk they could be using a stale valuation.”
The new generation of derivatives present greater challenges to valuation, in comparison to something like a credit default swap, which is a cash flow model with sensitivity to the credit spread. Valuing a correlation swap or a variance swap is different.
“Something more structured is harder to value and you need a specialist vendor to do that, somebody with access to good data and who can model the instrument to provide a price,” says Mr Hanna. “If you have poor market data going into a good model you’ll get a bad price; if you have good market data going into a bad model you’ll get a bad price.”
