The traditional divisions of derivatives structuring teams into individual silos for each asset class are breaking down, as investment banks seek to offer more coordinated responses to their clients' needs. Writer Philip Alexander
Globalisation has given investors and international banks access to new markets on an unprecedented scale. But it has also expanded financial problems. One of the distinguishing features of the 2008/09 financial crisis and its aftermath was the degree of market correlation across the world: most stock markets worldwide enjoyed recoveries after March 2009, before sliding again in the first half of 2010.
"This has brought a caveat to the historic idea of portfolio theory - global allocation in one asset class does not bring meaningful risk reduction, so to control the risk in a portfolio, you need to go into implied assets and long/short, but this is not permitted for many pension or insurance funds, or you need to diversify across the asset classes," says Alain Bokobza, head of global asset allocation strategy at Société Générale Corporate & Investment Banking (SGCIB).
Structural rethink
For clients who want to take that cross-asset exposure synthetically or with options capability for hedging purposes, this has necessitated investment banks to gradually rethink the structuring of derivatives. Where the structuring teams for each asset class - equities, commodities, rates and credit - once sat separately with the flow-trading desk for each of those asset classes, banks are increasingly seeking to offer clients a more comprehensive package. This has also prompted a rethink of The Banker's equity derivatives supplement, now in its seventh year, to become a more general overview of derivatives structuring.
In 2009, SGCIB created within its global markets unit a cross-asset solutions team that could draw on the flow trading of the equity, fixed-income and currencies and commodities desks, to provide structuring and advisory services. It also works closely with the bank's alternative asset management platform, Lyxor.
Arnaud Sarfati, global co-head of engineering in the cross-asset solutions team at SGCIB, says the new approach is especially important when speaking to continental European insurance companies as institutional investors, where the maximum equity exposure tends to be no higher than 30% of assets, depending on each company's liabilities and local regulation.
"If you can talk to the institutional investor about fixed income and rates at the same time as equity, then you can talk about all the asset base, and how it links to its liabilities in rates and inflation. Being a cross-asset division enables us to have a conversation with clients at a higher level, to better understand their needs, new regulation, accounting, and come up with an adequate solution, most generally a hybrid solution," says Mr Sarfati.
Cross-asset coverage also helps a bank adjust its own business model to cope with rapid changes in market conditions. Over the past year, poor growth prospects and unpaid dividends for equities contrasted with high corporate credit spreads. This encouraged many investors to switch away from equities into corporate debt, and investment banks with separated structuring teams for each asset class find it more difficult to adapt to that change.
Mr Sarfati says credit-linked structured products with an insurance company wrapper have been one of the major product lines for SGCIB since the final quarter of 2009. The merger of engineering teams has also encouraged a more creative approach to credit derivative structuring.
Prior to the crisis, the credit derivative business had been heavily driven by US banks with vast balance sheets, which were essentially distributing baskets of default and recovery risk to the entire market - products such as collateralised debt obligations (CDOs) that have fallen out of favour.
SGCIB's equity derivative clients already expect pay-offs that are more tailored to their own needs or investment views, and these techniques have been carried into the credit business, says Mr Sarfati. One recent product involved a basket of 20 names which would pay out 160% of the initial investment if all remained performing. For each default, the return would drop by 10 percentage points, giving investors a floor of 80% of their original capital, and effectively allowing them to sell the recovery risk back to SGCIB, rather than the other way around in a traditional CDO product.
"Equity underlyings are easier to model for creative pay-offs; credit risks and curves are more complex to model. So we needed to import into the credit universe our ability to devise products that incorporate a lot of engineering knowhow, while remaining pretty straightforward for clients," says Mr Sarfati.
For BNP Paribas, extending its pricing models and trading platform for equity derivatives into commodity derivatives, which are also driven by the economic growth cycle, was a natural development that took place about four years ago. Matthew Yandle, BNP's head of global equity and commodity derivatives structured products design, says the combination is now barely regarded as a hybrid product.
"Equity and commodity derivatives are now part of the same mandate and book that we run. We would consider hybrid derivatives to be the combination of equity or commodity products with other asset classes such as credit, foreign exchange or interest rates," says Mr Yandle.
He believes that a normalisation of the extraordinary market conditions of the past two years, which were triggered by massive bank and hedge fund deleveraging and liquidity shortages, would also bring back the benefits of diversification between equities and commodities, which have been moving in tandem since the crisis.
"Historically, these two asset classes had different market cycles, although both were linked to the business cycle... In the long run, we still believe in decorrelation between equities and commodities, and even among the commodities, as softs, energy and metals should all behave differently. So there is still value in diversifying your investments between less correlated assets," says Mr Yandle.
BNP Paribas has also found the insurance industry a central client for the cross-asset hedging approach. The industry is facing the twin pressures of asset underperformance during the financial crisis, and demanding new regulation - especially in the form of Solvency 2 capital rules.
"Its portfolio is not composed only of fixed income or equity, but a combination of the two. Because of the decorrelation between the two, it is much more cost-efficient to hedge by buying a put on the whole basket of fixed income and equities, than to be tactical in hedging the two separately," says Mr Yandle.
For private investors and hedge funds, he adds that the sharp and compressed market cycles that have evolved over the past few years are changing the attitudes towards derivative products. The traditional hybrids that combined a capital guarantee with an equity or commodity performance engine to permit a fixed income-style coupon pay-off, with a premium to prevailing interest rates, may not navigate the market well enough to meet investors' needs.
Instead, there is a growing trend toward derivatives built around investable indices generated by algorithmic or fundamental indicators. These products do more than simply hedging or diversifying exposure, but instead dynamically reallocate between assets quickly and efficiently as the market turns.
Uwe Becker, the head of Europe, Middle East and Africa investor solutions for Barclay
Access all areas
One aspect of derivatives structuring that remains a constant is the demand for ways to access assets that cannot be easily reached through conventional cash markets. Uwe Becker, the head of Europe, Middle East and Africa investor solutions for Barclays Capital, says finding new ways to access commodities, for example through a basket of commodity-linked currencies such as the Brazilian real, Russian rouble, Australian dollar and South African rand, has been a growing trend.
"In most commodities, holding a straight long position results in a significant negative yield each time you roll the futures contract, and this would also have an impact on the pricing of a structured product. Holding the currency is a nice way to get exposure to the commodity price trend without having to pay the roll yield," says Mr Becker.
In addition, the uncertain outlook for corporate earnings and regulatory intervention in the financial sector (and even in the natural resources sector) has brought dividend risk into sharp focus. Research by SGCIB shows that reinvested dividends account for about 48% of total returns in equities over the medium term.
Recognising the investor need for transparent ways to price dividend risk, in 2010 SGCIB created an exchange-traded fund (ETF) giving access to rolling five-year futures on dividends of the Euro STOXX 50. Previously, the market had consisted largely of investment banks as forced sellers (to hedge their corporate equity exposure) and sophisticated hedge funds as discretionary buyers, so that dividend swaps typically traded at a discount to realised dividends.
"We realised that dividends had a different behaviour to equities; in addition to this natural discount, they are also less volatile than cash equities in normal markets," says Stéphane Mattatia, head of financial engineering and advisory in SGCIB's global equity flow team. A dividend future becomes less volatile as the dividend date approaches and uncertainty about the payout dissipates. By using an index of rolled futures, Lyxor allows investors to benefit from that reduced volatility on average over the life of the ETF.
