Derivatives 2005 - Pushing the boundaries
Equity options volatility has held close to decade-long lows for most of this year, challenging equity derivatives houses to become more creative in their structuring. Greater competition in the equity derivatives space is further accelerating the pace at which the industry’s cycle of products and ideas reaches the mainstream. Jean Haggerty reports.
Through 2007, 12% per annum growth is anticipated in global equity derivatives business, according to Boston Consulting Group (see graphic). Product innovation, increased demand for equity derivatives products from institutional investors, hedge funds and high-net-worth investors will play key roles in the global equity derivatives industry’s growth story. Lower trading costs, due to greater liquidity, and further equity market improvements will also factor into the business line’s positive outlook.
Among investors the hunt for yield and increased demand for portfolio diversification are fuelling interest in new underlyings and pay-out features. For investors who anticipate continued range bound equity markets, the current volatility setting is a boon. It facilitates creating structured trades in which they can benefit from the upside and downside of the equity market through straddles, swings linked to a basket of stocks, ladder options and look-back options.
The current mix of low volatility and high correlation in equity underlyings is also piquing high-net-worth investors' interest in what are commonly called dispersion trades, in which payouts are based on the relative performance of different economic sectors versus a benchmark, such as the Eurostoxx 50, said Hassan Houari, head of equity derivatives structuring at Barclays Capital in London.
In the past investors were involved in products with significant sensitivities to volatility and correlation, but historically their exposure was less explicit than with the new generation of structures in the market. “In the dispersion-based investment instruments, one can easily understand that the higher volatilities and the lower correlations realise in the future, the higher the payout will be,” he added.
“The really interesting and innovative trends this year are those new indices based on innovative and systematic alpha generating strategies that add a lot of value to institutional investors - lower costs than active asset management, total transparency and liquidity and no risk of style drift,” said David Escoffier, head of equity derivatives at SG CIB in London.
"If we identify a strategy that we think has potential - like a hedge fund strategy - then we create a derivative on that," said Areski Iberrakene, head of equity derivatives at Dresdner Kleinwort Wasserstein in London, noting that DrKW is creating custom-made underlyings for distribution in its network.
According to Deutsche Bank’s Johan Groothaert, global head of the investment products group, among the innovations that clients are looking for are tailored indices that are delivering higher returns than the traditional equity indices.
Against this backdrop, Deutsche Bank has created the CROCI, which stands for cash return on capital invested index. CROCI is an investable index that only contains stocks that seem the most undervalued, according to the bank’s equity research division’s quantitative models.
“CROCI turns Deutsche Bank’s research into an investable index,” Groothaert said. In the last 12 months Deutsche Bank has sold more than €2bn in products based on the CROCI family of indices, he said, noting that investors have been buying the index outright and in structured products and constant proportion portfolio insurance (CPPI) form.
In a similar vein, SG has had success in the institutional market creating systematic investment strategies aimed at replicating alpha generating market neutral investment style in a transparent fashion. In its Palladium product, investors receive the return of an index composed of international blue chip stocks. The Palladium index automatically goes long the best performers and short the worst performers for a given period of time.
“This creates a very interesting investment which is linked to the dispersion of the returns of each stocks and thus their individual volatility versus the market volatility; as a result the Palladium shows very low correlation to traditional asset classes, moreover it is a totally transparent investment that is typically structured with various levels of leverage or guarantee of principal to precisely answer an institutional investor’s specific needs. Last, because it is systematic there are no management or performance fees and no restriction on liquidity,” Escoffier said.
Products designed to play the rebound of the equity market while having the opportunity of securing a high spread over current fixed income returns have also been attracting attention this year. Since the start of the year, SG’s ‘Click-Oblig’ product has collected several billion euros, mostly in continental Europe. Click-Oblig is a guaranteed note that is linked to the performance of a diversified basket of blue chip international stocks and to the level of a constant maturity swap (CMS). “When the basket of stocks reaches +15% performance you secure a fixed coupon based on the value of the Libor rates on the day plus a fixed spread of say 1%,” Escofier said.
Dealer willingness to innovate is also manifesting itself in the form of more structured products linked to implicit assets such as volatility, dividends and correlation. For example, with dividends, the massive issuance of structured products on the Eurostoxx 50 in Europe meant that investment banks were forced to buy long-dated forwards, thus driving down the implicit yields of dividends at a time of heightened dividend payout expectations. "If you can structure notes [linked to the future dividends of a basket of equities] for high-net-worths, you are effectively passing on that arbitrage opportunity," Barclays Capital's Houari said.
Despite recent squeezing of arbitrage from major index dividend swaps, the backdrop for the instrument remains positive. “Right now, what we are looking at is bigger, better and more dividends," said Howard Sliverblatt, equity market analyst at Standard & Poor’s in New York. The number of S&P 500 companies paying dividends has increased 17% so far this year and the dollar amount of dividends has risen 18%.
In the volatility space, dealers are watching how the market for listed volatility futures develops. Eurex last month followed the CBOE Futures Exchange (CFE)’s lead and launched its own suite of European volatility contracts. By some estimates nearly half of the volume in the CFE’s volatility index (VIX) futures contracts is generated from European market participants.
If Eurex’s contracts become liquid, any derivatives on volatility indexes could be hedged with its futures, dealers in London note.
"Market participants need [these contracts] because everyone is short volatility, short vega," Axel Vischer, a product design official at Eurex said, noting that he expects hedge funds, asset managers, pension funds and
institutional investors to find the contracts particularly useful. Issuers and issuers of warrants might use the new contacts as an informational tool.
Market participants continue to look at volatility as an asset class despite today's relatively low implied volatility levels, because volatility futures can be used to generate additional performance at a time when returns are small in many markets. It remains to be seen whether European institutional investors, who have traditionally shied away from trading volatility in the over-the-counter (OTC) market, will warm to the volatility products in listed form.
Dealers say that hedge fund clients trading volatility view the development of derivatives on volatility as a top priority. Increasingly, hedge funds are implementing views they were unable to in the past, such as trades that enable them to benefit from a view that volatility would not rise beyond some fixed level. Hedge funds are also keen to use volatility derivatives to fine-tune their risks, dealers note.
Eurex’s volatility futures are based on the VSTOXX indices for volatility in the euro area, the VSMI index for volatility in the Swiss equity market, and the VDAX-NEW index for volatility in the German equity market. The indices underpinning Eurex's new contracts are intentionally similar to the Chicago Board Options Exchange’s (CBOE) new VIX index, to open up arbitrage opportunities between US and European volatility levels. Similarity of design should also help market participants get used to the new contracts quickly, Eurex said.
The main difference between Eurex's index methodology and the VIX methodology is that the VIX uses all options down to one tick in value and Eurex's indices cut out all options with a value of less than five ticks. Eurex's decision to throw out worthless options at the end of out-of-the-money options is based on the idea that the smaller the price of an option, the less information about volatility the option actually contains. Optiver and Merrill Lynch are acting as market makers for Eurex’s contracts.
Other European exchanges, such as Euronext.liffe, are sizing up opportunities in volatility contracts. There are many major European indices without volatility indices, which suggests that there is room for other exchanges to get involved, dealers say.
Amid all of the change occurring in the equity derivatives product space equity-linked CPPI is emerging as a noteworthy casualty. By some dealer estimates business in traditional equity-linked CPPI business has contracted by at least 30% this year. “Quite a few distributors have burnt their fingers on it because they did not explain the product adequately to clients,” Deutsche Bank’s Groothaert said.
Deutsche Bank’s asset management unit DWS has backed away from the product, he said.