Stock responses - 01 Oct 2008 - Risk print v iew

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Stock responses
/risk-magazine/feature/1526571/stock-responses 01 Oct 2008, Mark Pengelly, Risk magazine

Equity markets have recently allowed derivatives desks little pause for thought. Global stocks toppled quickly in the days following the bankruptcy of Lehman Brothers. From September 12 to September 17, closing day prices on the S&P 500 and Dow Jones Eurostoxx 50 indexes dropped by 7.6% and 7.9%, respectively. The markets plunged again on September 29, after the US Congress voted against a $700 billion rescue fund proposed by the US Treasury, with the S&P 500 falling 8.78% in a day to close at 1,106.42. This caps a frenetic year-to-date for dealers, which has seen persistently high levels of correlation and volatility cause carnage for exotic equity derivatives books. "Since the beginning of this year, there have been some big moves with increasing volatility and increasing correlation, leading some structured books to realise what their real risk is," says Richard Quessette, Parisbased head of exotic trading at Societe Generale Corporate and Investment Banking (SG CIB). Volatility and correlation on the Dow Jones Eurostoxx 50 index moved up quickly in January. From 14.4% on January 14, 90-day realised volatility reached 27.47% on January 24, later peaking at 34.08% on April 10. It subsequently dropped to 25.7% by September 17, according to data from Citi (see figure 1). Meanwhile, 90-day realised correlation rose from 32.9% on January 14 to 59% by January 24. Spiking at 65.5% on April 15, it was at 47% by September 17 (see figure 2). Dealers are typically short correlation and volatility as a result of popular structured products sold to retail and private banking clients, including auto-callables, reverse convertibles and worst-of baskets. As a result, a number of banks were left nursing sizeable losses earlier this year. Among those having confessed to being hit are BNP Paribas, Deutsche Bank and Societe Generale, while
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many other major dealers are reported to have been affected. Market sources say Lehman Brothers had been unwinding its exotic exposures prior to its bankruptcy filing, while others are said to have unwound their correlation books in the wake of the tumult. "We have seen some aggressive unwinding of some banks that decided to stop their correlation businesses. Others have moderated their flows, but will probably carry their position," says Quessette. In their favour, correlation is not realising as high as market-implied levels, meaning actual losses suffered by some players may not be as bad as their mark-to-market valuations currently suggest, adds Quessette. For instance, 90-day implied correlation on the Dow Jones Eurostoxx 50 was trading at 57.1% on September 17, while 90-day realised correlation was just 47%. Nevertheless, the risk appetite of dealers has been dented, particularly in the context of ongoing bank losses in the subprime market. A common thread running through all the parameters that moved against exotic books is they were not a top priority for hedging. In some cases, it is suggested this was deliberate. That appears to be the case with notes referenced to the Nikkei 225 index and quantoed into local currencies, a considerable volume of which was sold by banks. Correlation between the Nikkei 225 index and euro/yen exchange rate typically realised much lower than the level implied in the market. For banks with short correlation positions, this proved to be extremely profitable. However, implied correlation between the Nikkei 225 and the euro/yen exchange rate spiked sharply earlier this year. Having typically traded at below 20% in recent years, it had risen to 45% by June 2008, forcing many dealers to re-mark their exposures. "Banks suffered quite a bit from remarking correlations earlier in the year - not just equity correlations but quanto correlations, which were not really perceived to be a source of exotic risk," says Moritz Seibert, London-based head of exotic equity pricing at Royal Bank of Scotland (RBS). Many exotic desks were also long dividends through products such as reverse convertibles. In these structures, the investor implicitly sells an out-of-the-money put option, creating a long dividend exposure for the dealer that increases as stock prices fall. With corporates delivering strong earnings in recent years, this exposure was not seen as a problem. But faltering expectations for corporate profits and a steep decline in dividend expectations have turned the tables against dealers (Risk April 2008, pages 48-49). In light of the battering taken by exotic books, dealers say complacency in managing these risks is no longer an option. "That's not the way banks are going to view this business going forward. You need to have a plan to get out of this risk - you cannot just warehouse it," says Nick Nassuphis, head of exotics trading at Barclays Capital in London. This means keeping a far closer eye on correlation and dividends. In particular, dealers say they are becoming much more scrupulous with their correlation assumptions, which is partly being reflected in more conservative pricing for some exotic structures. "Some banks are starting to observe correlations more precisely than in the past, looking at realised correlations to find better proxies for future realised correlation," says RBS's Seibert. RBS is also seeking to make improvements to its pricing models by using faster and more precise stochastic volatility calibrations, as well as updating volatility surfaces for equity underlyings more than once a day to reflect a rise in intra-day market volatility. In addition, the bank is working on creating vega surfaces, which show the amount of volatility that desks are long or short at various strikes. While some banks are looking to improve the way they price exotic risk, others have pulled back from
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certain products, recognising their models simply aren't good enough. For instance, a number of dealers have stopped providing quotes on structures containing forward skew, says Seibert. Skew reflects the fact that implied volatilities vary with strike levels, and is driven by supply and demand dynamics in the equity derivatives market. Historically, investors have purchased out-of-the-money puts to hedge their equity positions and sold out-of-the-money calls for premium. As a result, volatility for low strikes has increased, while volatility for high strikes has decreased. "Structures that contain forward skew exposure are now priced far more conservatively, if at all," says Seibert. In particular, some dealers have stopped quoting on reverse cliquets and Napoleon options, he adds. Reverse cliquets start out with a maximum return, and any negative performance over the life of the option is deducted from the payout. Napoleon options typically pay the worst return of an index over a given period of time. Both products involve complex path-dependent risks, which have caused many hedging problems in the past (Risk February 2004, pages 20-22). The recent losses have underlined the need to take a more holistic approach towards the exotic equity derivatives business, say dealers. "People have realised they need to think much more carefully about the amount of risk they take on their books," says one London-based equity exotics head at a large US dealer. Seibert says structurers are a lot more focused on finding trades to lay off book axe positions incurred by selling traditional exotic structures. RBS is making renewed efforts to put on book axe trades, with the aim of matching risk profiles and maturities more appropriately and avoiding the need to rebalance hedges where possible. Dealers say the rebalancing of hedges has been tricky at many points during the year, thanks to market illiquidity and the fact dealers were positioned the same way. "Typical exotic trades create very dynamic exposures on dealer books to volatility, dividends and correlation and those positions are very crowded," says the London-based equity exotics head. "You have a snowball effect, whereby everybody is getting long vol and short vol at the same time. They are pushed into the same positions and find there is no liquidity." The shortage of liquidity meant increased costs for those dealers forced to rebalance hedges, reflects Barclays Capital's Nassuphis: "The fact liquidity is sometimes a big problem means you have not put hedges in place when you could have." Some banks had thought they had hedged at least part of their correlation exposures with tailored products, but many dealer hedges were found wanting. For example, the short correlation exposures built up through the sale of worst-of baskets mean dealers are long single-stock event risk. Prior to the recent fallout, some banks sought to monetise this via selling single-stock variance swaps to clients, says Nassuphis. Many popular worst-of underlyings, such as financial stocks, have been extremely volatile over the past year. In such cases, a substantial fall in the stock of a single company can lead it to become the worst performer and effectively removes the dealer's exposure to the rest of the basket. However, the bank would continue to be exposed to the short variance swaps. "People have been very creative with payouts to get rid of correlation, but sometimes people were left short single-stock variance swaps as part of programmes to hedge correlation," notes Nassuphis. "Some banks were quite unhappy with the performance of these hedges." Dealers are also thought to have been caught out by using correlation swaps for hedging purposes over the past year. These products pay out a fixed strike per percentage point of realised correlation on a given
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portfolio. However, they are not a perfect hedge for the risks incurred by selling products on baskets of stocks or indexes, which leave dealers exposed to both correlation and volatility. This can result in dealers being short cross-gamma, which has reportedly led to spiralling losses for some banks. Cross-gamma is the effect a change in the value of one underlying has on the delta of another. One lesson learned over the past year, say dealers, is that exotic books are better off as part of a broader business. Banks that expanded aggressively into retail and private-banking orientated products over the past few years are said to have paid the price for having undiversified trading books. "You cannot have 80% of your business in competitive trades that are highly concentrated and highly directional. But those kinds of things can make sense in a broader portfolio," says Nassuphis. Dealers say they remain eager to build markets in hidden assets such as skew, correlation and volatility in order to recycle these risks with more sophisticated clients such as hedge funds. But due to a paucity of counterparties willing to consider such trades, it is accepted this can only be a limited part of the solution. A structural shift Pricing on products linked to bespoke baskets and indexes has suffered from rising correlation. Dealers estimate a 10% flat rise in correlation across a basket of four indexes would increase the price of a call option by 5-10%. Combined with limited dealer appetite and a mood of risk aversion by retail and private banking clients, this has contributed to a 20-50% fall in structured product take-up this year compared with 2007 levels, say bankers. That's not to mention client losses on a range of products, from worst-of products referencing baskets of European financials to accumulators sold in Asia. In the former case, the payout is referenced to the worstperforming share in a basket of stocks. If the worst performer drops below a predetermined barrier, the product terminates and pays out in the shares of that underlying (Risk April 2008, pages 44-45). In the latter, clients were left buying increasing amounts of underperforming shares at above-market rates (Risk July 2008, pages 36-37). "Extracting yield from a belief the market is going to recover is something people played at the end of the year but got burned. Now, people are reconsidering where they want to invest and how they want to invest in structured products," says Yan Assoun, head of European equity derivatives trading at Credit Suisse in London. Dealers report many private banking and retail clients are sitting on the sidelines waiting for the market to recover. For those traditional investors that remain, banks are marketing less directional trades, such as those linked to quantitative algorithms. At Credit Suisse, for instance, Assoun says the bank is conducting more trades for private and retail banking clients using a proprietary market- neutral index. It uses the bank's Holt valuation and analytics framework to go long and short stocks from a selection encompassing more than 55 countries. While Lehman Brothers was by no means a powerhouse in exotic equity structured products, its demise will certainly not speed the return of investors to the market, bankers assert. Private banks, in particular, are increasingly concerned about the creditworthiness of dealers they do business with. This, like many other developments witnessed in 2008, represents a major change for the exotic equity derivatives market. "This has been one of the most challenging years for the exotics platform. That's why some people have
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closed their business. Whether it's that or looking much more closely at counterparty risk, the entire landscape is totally changing," says Assoun. Print | Close Incisive Media Investments Limited 2012, Published by Incisive Financial Publishing Limited, Haymarket House, 28-29 Haymarket, London SW1Y 4RX, are companies registered in England and Wales with company registration numbers 04252091 & 04252093

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