Back with a bang

IFR Derivatives 2009
10 min read

It has been a wild 12 months in the equities market. In march, volatility peaked as market values reached their nadir, heralding the start of a Lazarus-like recovery, in turn giving the equity derivatives market renewed confidence. Investors are taking more risk, betting on a prolonged bull market and even returning to the exotic transactions they spurned in the midst of the crisis. Dan Taylor reports.

Since the market bottomed in March, global equity markets have bounced back impressively. The Eurostoxx 50 is up 60% from its lows, the S&P 500 is up 58% and the FTSE 100 has surged 47%.

“The cash equity market is definitely out of crisis mode,” said Simon Yates, co-head of EMEA equities with Credit Suisse in London. “It’s always the last asset class out, because it’s the furthest end of the risk spectrum, and it needs three big things to happen before you can say you’re out of the woods. On two of those three, we’re there.”

The first precondition is a normalisation of volatility – no pension fund will leap into a market where values are moving 10% on a single day. This condition has been met: from peaks in the 90s, the VIX volatility index had dropped into the low 20s by mid September. There needs to be a return of confidence among companies and a belief in their forecasts. Again, that is happening, said Yates. Even chief executives are feeling bolder – look at Kraft Foods’ US$16bn bid for UK confectioner, Cadbury.

And finally there needs to be a recovery in volumes. That’s the missing piece of the jigsaw. Volumes are still well below the levels seen pre-Lehman. But Yates is confident they will grow: “We had higher volumes in August than we did in July which is very unusual. We are starting to see some of the big accounts coming back into the market, buying dips – that is gradually coming back. So, I would say that the crisis is certainly over for equities. We are not yet into full-on bull market territory, but we are certainly going through the right steps.”

With crisis seemingly averted, the debate now centres on the trajectory the equity markets will take over the coming months. “People are convinced that the various stimulus packages have taken hold,” said Alan Rifkin, head of structured solutions in the equity capital markets group with Citigroup in London. “We have all stepped back from the abyss. But the debate that is going on now with respect to equity markets is whether they have gotten ahead of themselves.”

The depths of the crisis in the equity marked choked volumes in the equity derivatives market. As investors sold out of shares, they needed fewer derivatives. According to the International Swaps and Derivatives Association, the size of the market in notional outstanding dropped from US$11.9trn at the end of June 2008 to US$8.7trn at year end – the first fall recorded by ISDA’s twice-yearly surveys. In the first half of this year, volumes improved marginally, to US$8.82trn.

Haunted by your hedges

There was plenty of demand for hedging in the second half of 2008 and the first quarter of 2009, but those hedges proved a double-edged sword. Yates said many Credit Suisse clients bought a put on an index – an expensive play when markets are volatile and sliding – and reduced the cost by simultaneously selling a call option. For example, a client could sell a call of 105 or 110 (meaning a strike at 5% or 10% over the market’s current levels) and buy a put of 90 or 85, a transaction with zero cost. The resulting collar limited downside risk but sacrificed the potential upside. The rally from March forced many hedgers to reconsider their strategies in recent months, either unwinding or restructuring their trades.

“The theme through most of the year has been index option hedging,” said Yates. “Large insurance companies in particular have been trading collars on the Eurostoxx, with a lot of action happening around the lows in March this year. But the market has since moved to levels where people are largely short their call strikes, meaning they are not participating in the rally. So there has been a lot of business restructuring those – either simply having the insurers unwind the calls that they have sold or having them roll up to higher strikes or out to longer maturities.” Clients which put in place the largest hedges – individual trades with a notional size of €1bn-€2bn were not uncommon – were the first to come back. SocGen has done restructuring for around 15 different hedgers this year.

It hasn’t just been institutional hedgers who have been caught out. Dealers have also misjudged some of the more exotic risks on their books, forcing them to sell out of positions at crushingly low levels, or put on expensive hedges. For investors on the other side of these trades, the rewards have been huge, said Escoffier: “It’s been a feature of the year: highly distressed levels of some assets are creating tremendous opportunities. The problem was that these trades can be long-term and – by definition – they’re illiquid, so convincing people to try it at the start of this year was tough. A few did, and their profits have been handsome. But month after month, we’ve seen an increase in the risk appetite of our clients, to the point now where people are happy to put on the kind of exotic trades we saw last year, before the crisis. We were not expecting the market to recover this quickly.”

Caught out by correlation

One opportunity came in so-called dispersion trades on equity indices. Thanks to their business in retail structured products, dealers built up net short positions in correlation, assuming volatility would be driven by local factors and that stocks would largely move independently of each other. Many had opted not to hedge against the possibility that stocks would become highly correlated for a long period, which is what happened when the crisis hit. Banks were then forced to buy back expensive correlation they had sold cheaply, a dynamic investors can still exploit today, said Escoffier.

“A lot of dealers had to cut their position at distressed levels, losing a lot of money. In the first quarter this year, some banks were booking losses for their equity division as a result of this and levels are still a bit distressed today,” said Escoffier. “Meanwhile, in the market, the realised correlation that we can see is going down as markets recover, so clients have been capitalising on the fact that they can sell correlation high to the banks and at the same time carry that correlation position at a lower level than the price where they sold. They’re realising money every day.”

The same dynamic has also played out in dividends, the levels of which were cut by the crisis, leaving banks needing to unwind positions or hedge. Again, some investors have taken advantage, with dividends in some markets rallying by 50% since the market lows. SocGen’s strategists estimated there could be a further 30% of upside here.

But for every investor that is willing to look at an exotic trade on volatility or implied dividends, there are ten who want something simple, said Chris Lee, head of structured products with UBS in Hong Kong: “A lot of people just want something easy to understand, transparent and liquid.”

This demand is behind the popularity of exchange-traded funds. There are opportunities here for equity derivatives desks, too. For example, retail investors are still hungry for exposure to Chinese stocks – but many fund managers are locked out of the market. To get round the problem, ETF providers like Barclays Global Investors buy structured notes or call warrants on Chinese stocks from the derivatives desks at dealers with access to China’s markets – which has helped to make BGI’s A50 China Tracker one of the biggest ETF’s listed in Hong Kong, with over US$4bn in assets under management, said Lee.

In addition, dealers can also create fresh ETF units for investors or even use the ETF as an underlying for separate derivatives transactions – structured notes, warrants or certificates, said Lee: “If there are more structured notes done on a particular ETF then it improves its liquidity and popularity. We do a range of work with ETF providers and this whole ecosystem of trades has become a critical part of the equity derivatives business.”

Amounts outstanding of OTC equity-linked derivatives (US$bn)
Instrument/market Jun 07Dec 07Jun 08Dec 08
Total contracts8,5908,46910,1776,494
US equities1,9071,7662,0641,505
European equities6,0595,0036,1344,036
Japanese equities788543628403
Other Asian equities267553514185
Latin American equities22821228299
Other equities340391556266
Forwards and swaps2,4702,2332,6571,632
US equities795719764519
European equities1,2891,1041,384875
Japanese equities35497048
Other Asian equities72746236
Latin American equities14712613540
Other equities133166242113
US equities1,1121,0471,300986
European equities3,7693,8994,7503,161
Japanese equities753501558354
Other Asian equities196479452148
Latin American equities818614660
Other equities207225314153
Source: BIS