The credit crunch is affecting every segment of the financial markets, including equity derivatives. Interpreting the repercussions, however, is no easy task.
Dissecting the side-effects of the credit crunch is going to provide sport for many a pundit for many years to come. The most visible effects will naturally be found in the credit sector but even the most cursory inspection will reveal that the impact has been felt, to a greater or lesser degree, in almost every corner of the financial markets. The equity derivatives market is no exception. The difficulty lies in interpreting the repercussions.
JPMorgan banking analyst Kian Abouhossein posted a decidedly downbeat estimation of the market in a report published in May ahead of first quarter results. He said he expected structured retail product volumes to fall by between 5% and 10% during 2008, alongside a reduction in demand for structured investments from the institutional sector. Overall, he warned of a “declining environment” for equity derivatives groups, which could expect an annual revenue fall of as much as 27%, taking the business back to levels not seen since 2005.
Banks’ revenue figures have since been published but they fail to provide an exact picture of equity derivatives revenues. And many firms’ results were complicated by changes in correlation and dividend yields such that it makes it difficult, if not impossible, to decipher the extent to which new business flows were affected.
Hedging difficulties
The correlation and dividend problems are substantial. Most banks will run short correlation positions resulting from their structured products business. The reason is that many structured products are based on baskets of underlying assets, with non-linear pay-off profiles.
The products cannot be directly hedged, so instead issuing banks need to hedge using the individual constituents of the portfolio. This is not only expensive but also imprecise: even if they do hedge the individual assets, the hedges will not perfectly match the portfolio because they will not account for the correlation of the assets in the portfolio. This can materially affect a bank’s profit and loss (P&L) when correlation increases as it did in the first quarter of this year, depending on how much risk the bank hedged or sold.
Equity derivatives players also tend to be long dividend risk as a result of their structured retail products business. In Mr Abouhossein’s view, the dividend exposure will have been a consensus long position among banks for some time, leading to losses when the shape of expected dividends took a material plunge in January, falling 15% from an index level of about 170 to 145.
Results reflect fallout
Several banks attested to these difficulties in their first quarter results presentation. Calyon made a nod towards the issue when it said that valuation of positions in equity derivatives had been “severely affected” by market conditions.
The BNP Paribas (BNPP) and Deutsche Bank statements gave more detailed insight. In its first quarter disclosure, BNPP reported: “The equity derivatives businesses revenues were adversely affected by the unexpected fall in certain dividends, the erratic variations in volatility and very strong correlation between market indices and between underlying components.” And Deutsche Bank said: “Performance in equity derivatives was negatively impacted by the increased correlation between equity markets, which led to a deterioration in the value of residual derivative positions arising from activities in European retail structured products.”
Correlation and dividend risks can, however, be ‘recycled’ – sold on to hedge funds and proprietary trading desks. Although Société Générale (SG) also referred to “an environment marked by difficult market conditions” with “very high volatility and correlation”, it did not appear to have been as severely affected. This can perhaps be put down to the bank’s broad franchise, which allowed it to achieve flows across the full equity derivatives spectrum, to repackage the risks and sell them on to interested clients. The bank also succeeded in reassuring clients after the discovery of Jerome Kerviel's rogue trading in equity derivatives.
Mixed picture for hedge funds
Hedge funds naturally account for a good proportion of equity derivatives turnover and they, too, were affected by market events. And there, too, the evidence has been mixed.
Global hedge fund assets under management rose 27% to $2650bn last year, according to HedgeFund Intelligence. But while assets continued to flow in after the summer, the pace of growth decelerated quite markedly; the second half accounted for only six percentage points of the total growth for the year, with the other 19 percentage points of new assets all added in the first half.
Like banks, hedge fund investors will have been affected by the increase in correlation between, and within, asset classes. But David Herzberg, global head of equity derivatives at JPMorgan, says that although this might have led to some distressed levels in implied correlation and dividend positions, many of the stronger funds chose to sit things out or restructure their positions rather than exit the market altogether. “Others have stepped in to exploit the opportunities”, he adds.
Denis Frances, global head of flow sales at BNP Paribas, points out that a sizable segment of the hedge fund community has emerged largely unscathed from the credit crunch. “In some cases these funds have even been able to exploit the arising opportunities and, as a result, flow businesses have had a very strong start to the year,” he says.
External statistical research provides another means of taking the market’s gauge – and here the evidence is far more positive. Research from the Bank for International Settlements showed that turnover of equity-linked exchange-traded derivatives rose by almost a third in 2007. The US-based Options Clearing Corporation, meanwhile, reported that in the first four months of this year equity options turnover totalled more than one billion contracts, up nearly 50% on the same period last year.
Financial consultants Arete estimated that European issuance rose from €136.9bn in 2005 to €222bn in 2007; in the first quarter of this year, the volume rose by a further 4% to €58.5bn for the quarter. According to the New York–based Structured Products Association, the US structured products market has fared no worse: it estimates that issuance grew from $64bn in 2006 to $114bn in 2007.
Evidence from those at the coalface of the market again shows signs of mixed performance.
Mr Herzberg says that the lack of a clear market direction has kept some investors on the sidelines but, on balance, the business is growing well. “Hedge funds are actively engaged on the flow side and traditional equity managers are now much more involved. This is partly down to market conditions having required that they use the instruments for hedging, but can also be attributed to greater familiarity with the market, changes in regulation, the emergence of new products and strategies and the growth of the 130/30 funds,” he says. These are partially leveraged funds that can take a short position of up to 30% of the portfolio.
Simon Yates, head of global equity derivatives at Credit Suisse, says: “Retail accounts for a large proportion of the structured product investor base and investors have naturally been quite nervous, so activity has slowed down. But there have also been positives: our flow business has really been going gangbusters compensating for the tougher business areas.”
Dixit Joshi, head of global equities at Barclays Capital, agrees. “Listed derivative and cash equity volumes have been strong and the over-the-counter (OTC) side of the business has also risen. Volumes in plain vanilla options have risen sizably, as investors have sought to hedge out their tail risk. Where we have seen a temporary slowdown is on the structured product side but momentum has again picked up strongly in the past two months.”
Counterparty risk considerations
Bankers seem to agree that one of the key changes brought about by the credit crisis is the increased consideration that is now given to credit risk.
Mr Herzberg agrees that balance sheet strength and ratings now make a big difference. “Previously, distributors and private wealth managers distinguished little between firms in the structured product market, and institutional investors and hedge funds paid little attention to ratings on the flow side. This has now changed quite dramatically,” he says.
More liquid
The market’s overall resilience, shown in the statistical research, is testament to three principal factors: liquidity, transparency and creativity.
The first two were the issues that most clouded the credit markets, but they did not affect the equity business. “There continues to be a healthy engagement in equity derivatives – because the market is liquid and transparent it has not been as affected as other less transparent, asset classes,” says Mr Herzberg.
Arnaud Sarfati, head of engineering for Europe at SG, says: “When the credit crisis started to unfold last summer, we immediately made a concerted effort to communicate with our clients to reassure them about our product transparency, pricing availability and that we would continue to provide liquidity.”
As for creativity, the equity derivatives market is nothing if not inventive – and the market’s continued performance is proof of the structurers’ ability to react, reinvent and adapt their products to the changing conditions. According to Mr Tranter, as the credit crisis peaked, there was a clear shift toward more plain vanilla products across the flow business. “If things could be done more simply, this was favoured – the clear objective being to preserve as much liquidity as possible at the same time as minimising or diversifying counterparty risk exposure,” he says.
Mr Wainstein agrees, saying: “The products that are being marketed now are relatively simple, have lower leverage and are much more liquid than they have been historically.”
Accelerated sales
Theme-based structured products sales have accelerated quite significantly, according to BarCap’s Mr Joshi, particularly formulaic investment products that are liquid, transparent and easily priceable. These include BarCap’s VAAM, Q-BES and Revolver products (see New questions, new answers for details on these strategies).
Mr Herzberg notes that while previously leveraged and high-conviction call strategies were popular, there has been a noticeable shift to a more balanced approach and more hedging activity. “We have also seen more demand for yield enhancement opportunities as interest rates have fallen.”
He says that now that the markets have stabilised, the write-downs seem to have tapered off and the pace of hedge fund redemptions has slackened, there has been a gradual return to the more structured, bespoke product areas. “In a sense, the credit crisis has provided us with an opportunity. It has highlighted the benefits of the more transparent structured product investments and we have been able to leverage our capabilities, convincing investors to come back to the market with suitably designed product offerings,” he says.
Out of adversity
“Every part of the business has since been impacted by this credit crisis, which has required that we rethink and redesign products suitable to the new environment,” says Mr Sarfati. But he is in no way discouraged. “This has been both challenging and interesting, and the continued pace of our activity proves that we have produced some suitable products.”
Christophe Baurand, head of sales at SG’s asset management arm, Lyxor, agrees. “Although the pace of the market’s growth has moderated, structured product activity remains robust and the crisis has in many ways played to the strengths of our structured product business,” he says.
In the past few years, SG had been promoting principal-protected products on hidden assets and advising clients to take positions in volatility to hedge themselves against a potential market downturn. Lyxor’s Palladium is one example of this. It is a dispersion strategy that works like an investment in a long-short equity hedge fund – the customer is systematically long on the best performing shares and short the worst performing shares, relative to the average performance of the basket.
Another Lyxor product, Symphony, is designed to extract value from the implied volatility ‘smile’ on a basket of stocks. The so-called smile reflects the shape of the maturity and strike curve for volatility implied from the market price of vanilla options, and is driven by supply and demand dynamics. Investors will often react precipitously and systematically to good news, but less quickly to bad, leading to distortion in the implied smile. By incorporating a pay-off that is sensitive to skew, Symphony is designed to enable the investor to benefit if this implied smile is not realised.
Products such as Palladium and Symphony performed well until July last year, when volatility spiked. At that time, SG advised many clients to lock in their profits and exit the strategy, and many of them did. However, the products have since been adapted to current market conditions and remain popular among clients, says Mr Baurand.
Regulatory and accounting issues have also contributed to the continued increase of equity derivatives techniques. For example, SG used the expertise of its regulatory and accounting specialists to build out solutions and strategies that cater specifically to the new regimes, such as the International Financial Reporting Standards (IFRS), the new banking capital adequacy regime under Basel II and its equivalent for European insurers, Solvency II.
“We have been marketing products with capital guarantees to financial firms because under Basel II they need to set aside less capital for products with embedded capital guarantees; on the accounting side we have created products that can be put in the ‘available for sale’ basket, rather than in the investment or trading books, where they would need to be marked to market and would risk causing unwelcome volatility on the firms’ P&L,” says Mr Baurand.
Reverse convertibles contrast
One significant concern highlighted in JPMorgan’s report was the lacklustre performance in convertible bond strategies, which Mr Abouhessian believes will have particularly affected Swiss investors. Reverse convertibles are yield products that incorporate a put option for the issuer rather than a call option for the investor, who receives in return a coupon for accepting the risk of a fall in share prices.
In his report, Mr Abouhessian said that many of these structures will have reached the trigger point, and investors who were originally looking for a yield product, with a limited perceived risk, will be nursing material losses and be exposed to further equity market falls.
Mr Joshi admits that funds that are active in the convertible bonds sector will not have had a great first quarter, but he remains upbeat about the market’s prospects. “There is a strong pipeline of deals and those funds that have derisked or remained uninvested have capital to put to work and are waiting in readiness for the deal-flow to come through,” he says.
Despite this one trouble spot, the combination of new products and strategies to roll out, plus a relatively robust core investor base among the hedge funds, gives the equity derivatives market a better outlook than that of most financial markets. Its geographic reach is also expanding, and institutional investors, especially pension funds, are increasingly turning their attentions to the asset class.
Little wonder that market participants are not expecting structured product volumes to decrease significantly any time soon. “Provided you can be selective, the equity story remains,” says Mr Carson. “Investors that have moved away from the credit markets are looking for new areas in which to invest. Structured products should benefit from this and I expect they will see something of a rebound.”
