For example, an equity investor concerned that an increase in oil prices will increase inflation and hence real interest rates at the expense of equity performance, and aware that low oil prices would have the opposite effect, can take advantage of both situations.
In order to exploit this market view, the investor could purchase a hybrid structure that pays a fixed coupon when oil prices are up, and an equity-weighted coupon when oil prices are down, providing an efficient response to either macro-economic environment. Similarly, the Orion structure (see figure six download file) pays a high fixed coupon until the level of the EUR/USD rate decreases below a pre-defined barrier, at which point the product automatically provides exposure to equity market, with capital protection. This product is designed to benefit from equity yields as soon as pressure on the EUR/USD rate begins to ease off. The mechanism allows the investor to benefit from a higher yield than that offered by a traditional bond asset for as long as EUR/USD levels keep threatening a European equity market uptrend.
Protection
The traditional hedging approach for investors facing multi-asset risk exposures is to hedge each of these risks separately. For instance, an investor long both bonds and equities may purchase two separate puts on both assets to hedge his exposures. The hybrid approach to this case, however, would be to buy one put option covering both bond and equity exposures. For assets with less than a 100 per cent correlation, this is the cheaper option, as it protects the total value of the portfolio, and not the individual components, avoiding over-hedging.
All investments carry one or more primary risks, but also other adjacent risks. For example, long bond or equity positions can be exposed to additional foreign exchange or inflation risks.
Hybrid products can offer a combined approach to hedge against foreign exchange risk, or can combine equity and inflation indices to protect real returns during a period of economic growth. An annual best of product based on inflation for instance, pays the better performance between an inflation index and an equity option. In this way the investment is protected against inflation, while retaining its capacity for growth. This cross-asset risk hedging can also be used to further boost portfolio returns as described earlier.
Over the last two years, hybrids have seen an explosive growth in demand. This phenomenon has been largely due to the versatility offered by hybrids, and their considerable scope for offering comprehensive solutions to a wide array of investment issues. The ubiquity of hybrid variants provides a specific, non-traditional and innovative response to any investor’s needs, from enhancement of the portfolio return to diversification and protection.
With structured products this can be achieved within the framework of a secure and/or tailor-made structured product.
Guillaume Picot is a senior hybrid trader at BNP Paribas.
