Hidden assets, previously an obscure investment area dealt with by niche traders, have become increasingly accessible. Natasha de Terán investigates the developments.
The importance of equity derivatives franchises is mounting as their remit gets ever broader and associated revenues mount. More and more investors are using the instruments, turning to the market to solve investment problems and improve portfolio performance. At the same time, equity derivatives engineers have not stood still; they have been applying their technologies to new areas, including so-called ‘hidden assets’.
Hidden assets – only recently the darkest and most confusing province of the equity derivatives realm – will soon have to adopt a new moniker. The seemingly obscure investment area is becoming increasingly mainstream. Originally limited to the niche provinces of sophisticated proprietary trading desks and deft hedge fund managers, hidden assets have become increasingly accessible. But with names such as correlation, volatility, variance and dispersion, it is still not immediately obvious why these should be considered assets at all, much less how they can be usefully deployed to complement traditional investment products.
Arnaud Sarfati, head of equity-linked structured products at Société Générale (SG), says: “Equity investors will typically ‘suffer’ from volatility most of the time. But if one turns things around and considers volatility not as an unwanted risk but as an investment, it is one of the most perfect asset classes. It is a perfect hedge and the most uncorrelated asset in the sense that if the markets go down, volatility goes up, and if the market goes up, volatility can go either up or down. So on the downside it’s a hedge, on the upside it’s diversification. The same can broadly be said for dividends, correlation and so forth.”
Shaun Wainstein, head of BNP Paribas’ London Equity Derivatives platform, says: “If you think about dispersion, it can seem very technical and hedge fund-like as a strategy. But if you think about the strategy in a more basic way – about, say, a basket of stocks that you believe will have a varied or dispersed performance – you can see that you can use the same strategy to express a very fundamental view, and that a dispersion trade can be used as an alternative to a long-short strategy.”
A gradual evolution
Although these products and strategies were so complex and required so much ongoing management that only the most sophisticated could think of investing in them, financial engineers have recently worked them into more suitable formats for a wider range of investors.
“Many of these trading strategies were ‘born’ in the hedge fund and proprietary trading desk areas, but institutional investors have been looking at them actively as a way of introducing more alpha into their portfolios,” says Jessica Houtepen-Jaeger, head of the global equity derivatives structuring team for investors at Credit Suisse. “Their involvement has required a lot of education and these investors typically often require us to wrap the strategies into a simpler form and do a lot of back-testing before they become involved in the strategies.”
From 2002 to 2004, banks started proposing indirect investments in hidden assets. SG, for instance, suggested that investors buy zero-coupon plus call products. This strategy gave a partial solution to volatility – but not a perfect one – as it offered a form of volatility protection, combined with an equity exposure. Structurers quickly came to the conclusion that it would be better to give investors surer bets on volatility without equity exposures and began engineering much more exact solutions around hidden assets.
Limited players
During that first stage, only hedge funds and other very sophisticated investors were involved in the market, but since 2004 banks have been offering purer hidden asset exposure through tools that make it easier to isolate the assets and that broadened the user base.
“We developed a series of products that are now quite liquid and actively traded: variance swaps and dividend swaps, for instance. These are much easier to trade than the original strategies, which used options and required delta and gamma hedging, and were thus quite costly and demanding to manage,” says Mr Sarfati.
As hidden assets attracted increasing levels of interest, so things evolved from variance and dividend swap trades toward a range of more complex strategies and trading tools. For instance, some investors have used OBBOs (options on a basket against a basket of options) to get exposure to correlation. In these trades, investors can buy or sell options on a basket or index, and then buy or sell options on the individual components of that basket (going long or short correlation respectively).
Pete Clarke, equity derivatives strategist at Citi, says: “If investors have, for example, sold a call option on the basket and bought call options on each of the individual stocks, then they will be short correlation. If realised correlation were to be zero over the life of the trade, with half of the stocks going up by a certain amount and the others going down by the same amount, then the average move (that experienced by the basket itself) would be zero, leading to no liability at expiry on the short call. However, some of the long single stock calls would expire in the money, generating a profit for the trade.”
Popular options
Outperformance options, variance swap options and one-touch options have also been popular. Outperformance options are options in which pay-offs are linked to the amount by which one underlying outperforms the other. For example, investors can buy or sell calls or call spreads on the outperformance (the outperformance itself effectively becoming the underlying), and the trade can generate a profit irrespective of market direction.
Variance swap options, meanwhile, enable investors to obtain an option-based pay-off on levels of realised variance. “Bearish investors often buy call options on variance in the anticipation of market turbulence (leading to a spike in realised variance), whereas investors expecting the status quo to be maintained might choose to sell straddles on variance,” says Mr Clarke.
One-touch options are binary structures that result in a payout if the underlying asset reaches or surpasses a predetermined barrier during the life of the trade. They can be used as an alternative to call-overwriting strategies on names involved in potential takeover situations. “Call overwriting often prices attractively on takeover names owing to the elevated call option implied volatility that arises,” Mr Clarke explains. “However, if the stocks do get taken out, investors miss out on all of the upside.” If investors buy the stock and sell a one-touch option on the upside instead, they can receive an attractive premium from the short option position and still participate in the upside if there is a significant move, he says. “In the current trading environment (with a number of names having high implied volatilities due to takeover speculation), this can appear particularly attractive.”
Exotic trading desks are often asked to trade one-touch options, as a way of shedding some of the risk accumulated through their retail structured products business. Hedge funds have typically taken the other side of these trades, but institutional investors have shown increasing interest in them as well, according to Mr Clarke.
Structured solutions
In a next step – and aware of the complexity of some of the above propositions as well as the fast-growing media coverage of the success of hidden asset-based strategies – banks started developing more packaged structured solutions or products. Lionel Fournier, head of equity derivatives structuring at Credit Suisse, for instance, says that a popular strategy on the relative value between realised and implied volatility used to involve selling monthly variance swaps on a rolling basis to capture the spread between implied and realised volatility. Initially taken up in unstructured form by hedge funds, he says that Credit Suisse has recently sold products based on this strategy to institutional investors in both capital protected and certificate form.
Similarly, Barclays Capital launched a new volatility product, Voltaire, earlier this year, which seeks to profit from the structural imbalance of supply and demand in options markets. Each month, the strategy invests a portion of trading capital in a short variance swap against whichever of the major global market indices exhibits the largest volatility risk premium. Profit generated by the strategy in any month is then added to the trading capital and is available for reinvestment the subsequent month.
Voltaire can be provided in total or partial principal protected form, and it can also be delivered as a Delta1 structure for investors who are willing to take on more risk. “As such, it gives clients an opportunity to deploy what is quite a complex investment strategy traditionally employed by hedge funds with much lower trading risk, increased transparency and daily liquidity,” says Hassan Houari, head of equity derivatives structuring at Barclays Capital.
Other bank-originated structured products have been written on a less well-known hidden asset, gap risk, which is the risk that an investment’s price will change from one level to another with no trading in between. Dealers often end up being exposed to gap risk and have recently found a means of hedging it out by issuing so-called gap risk notes.
BNP Paribas, which is naturally exposed to gap risk from its structured products activity, decided to sell a small part of its gap exposure to clients for risk management reasons. Last year it structured the Argento Note, a one-year structured note on its gap risk, which it sold to institutional investors across Europe. Argento is exposed to the down gap risk on the DJ Eurostoxx 50 index, with a gap event set at -6.5%. At maturity, Argento will pay a yield of Libor 12M + 150 basis points (bp), provided the gap event has never occurred, so that investors effectively take on the unwanted gap risk in exchange for receiving a high money market yield. A Swiss insurance company bought a version of the product that paid out a coupon equal to Swiss franc 12-month Libor + 150bp, the return being reduced by applying seven times leverage to the negative spread between -6.5% and the worst daily performance of the Dow Jones Eurostoxx 50 index over the duration of the trade
Dispersion strategy
Another example of a structured solution can be found in SG’s Palladium product. Dan Fields, head of flow and listed product sales at SG, describes Palladium as being, in essence, a dispersion strategy that works like an investment in a long-short equity hedge fund in which the customer is systematically long on the best performing shares and short on the worst performing shares, relative to the average performance of the basket.
SG had started marketing Palladium in 2005 to both hedge funds and institutional investors but with different approaches and different structures. “We sold it as a fully structured systematic long/short to institutional investors – sometimes even in note and or capital guaranteed form. Meanwhile, our hedge fund clients wanted leveraged volatility and correlation bets, so we offered the strategy to them in more direct form, and as a shorter-term trade with higher leverage,” says Mr Fields. The bank has also been able to sell Palladium to fundamental cash investors who do not usually have a great appetite for equity derivatives, and who see it as a more statistical and fundamental play.
In one instance, SG sold the Palladium concept to a continental institutional investor who wanted to allocate more assets to hedge fund strategies, but who was restricted from doing so. The investor was, however, able to invest in equity-linked capital guaranteed products linked to equity, and through Palladium SG were able to provide him with exposure to the desired hedge fund-type strategy with the necessary equity type wrapper and underlying.
Palladium is particularly interesting, according to Mr Fields, because it cannot be deconstructed: “Palladium is very difficult – if not impossible – to replicate. You can’t take it apart or decompose it and say that the end result is the x correlation and x volatility. So we have, in effect, created a hidden asset on a hidden asset.”
Fund-based solutions
In a more recent step, banks have begun developing fund-based solutions for the growing market for hidden assets. A pioneer in this is SG, which has developed and recently sold such products through its Lyxor Asset Management arm. Lyxor’s Hidden Asset range of funds includes the mono strategy quantitative Generis funds and the multi-strategy, actively managed Quantic funds.
Christophe Baurand, head of sales and marketing, alternative investments, at Lyxor, explains the rationale behind the move to fund-based solutions: “We saw there was a strong demand for hidden assets from institutional investors, but for many of them the market was still difficult to access and trade. We adopted the fund format because it is ideally suited to funds of funds, insurance companies, banks and other institutional investors who find it easier to invest in a fund than in the typical swaps and options trades or structured solutions otherwise on offer.”
Olivier Cornuot, head of investment management, Lyxor structured and index management, says the move was also a logical extension of SG’s existing business. The bank was aware that it had developed significant internal expertise and realised it made sense to export this to a new range of clients.
“In this case, our idea was to exploit Lyxor sophisticated derivatives risk management expertise in the hidden assets area by giving its managers access to our trading ideas and latest pay-off structures. There are still lots of inefficiencies, growing liquidity and tight bid-offer spreads in the hidden asset market, so it is a great time to be doing this,” he says.
Lyxor’s Quantic range includes three different funds targeting different risk/return profiles. The Quantic 150 is a money-market plus fund that aims to return Euribor + 150; the Quantic 300 has a target of Euribor + 300; and the Quantic Dynamic fund aims to return 600bp-800bp over Euribor.
The Generis range includes the GVolt fund, which focuses on a dispersion strategy; the GSquare fund, which engages in systematic arbitrage between the main equity indices’ implied volatility; and the Gsphere fund, which plays on the systemic risk premium between implied and realised volatility.
Lyxor plans to continue adding further strategies to the range as new possibilities emerge and, similarly, to close down funds when strategies are no longer as interesting. “We are confident there will be a good supply of new strategies as new inefficiencies and opportunities are emerging all the time,” says Mr Cornuot.
Collectively, the funds aim to reconcile the demand for hidden assets, with the complexity of the asset class and a lack of knowledge and systems capabilities to trade and manage them among parts of the investment community. SG believes this type of investment will be the biggest, or one of the biggest, growth areas in the increasingly voguish hidden asset market and marks the beginning of a growing convergence between the capital markets and asset management worlds.
New developments
The French bank is not pinning all its hopes on the fund-based solutions, though, having come up with yet another sophisticated option product: the Timer Call. This product seeks to address some shortcomings in options behaviour and, by doing so, to offer improved exposure to the variance of stocks involved in leveraged buyout and other speculative situations.
Stéphane Mattatia, head of the hedge funds engineering team at SG, says: “The pricing of call options relies on implied volatility, which is fine so long as implied volatility and realised volatility are closely aligned. But when implied volatility is higher than realised volatility – as often occurs in takeover situations – it’s a problem, because the options become too expensive. The Timer Call gets around this.”
Mr Mattatia says that this mismatch between implied and realised volatility also occurs with other stocks: for instance, the realised volatility of HSBC is typically about 10, but its implied volatility is about 15. “That means that, statistically, you will overpay for a vanilla call on the stock. Similarly, if you look at the historical prices of three-month vanilla calls on the Eurostoxx 50 stocks, which expired in the money, in 80% of the cases you will find you would have overpaid because the implied volatility was higher than realised volatility.”
What SG has done in developing the Timer Call is to switch the fixed and variable inputs normally used in options pricing: the fixed input in vanilla options is traditionally the maturity and the variable input is usually the volatility. In a Timer Call, the fixed reference is the volatility, while the variable input is the maturity.
“The Timer Call is a redesigned equity option, in essence. We were playing around with the basic Black-Scholes assumptions that an option’s maturity is always fixed and volatility is always variable, and looked to see what would happen if we reversed these,” says Mr Mattatia.
The way it works is as follows: an investor with a forecast volatility of 10 on a particular stock over a six-month time horizon will, instead of buying a vanilla call, buy a Timer Call and SG will shape the variance budget according to the investor’s aforementioned parameters. Just after the strike each day, SG will adjust the variance consumed, adding up the square of the log of the returns. The variance budget will reduce each day and when the entire variance budget is consumed, the call expires and SG pays it off like a regular call option – a pay-off that depends on the interim performance. Crucially, however, the Timer Call’s maturity will depend on the volatility consumed, so that if the stock is very volatile the trade would mature in, say, two months but if it is very stable, it could expire in six or 12 months. To put it another way, if the investor’s budget assumptions were correct and realised variance was indeed 10, then after six months the call will expire but the investor will have bought an option with a 20% discount.
SG traded the first Timer Call in late May when it initially began rolling out the product to hedge funds. Since early June, the bank has also been marketing the call to the more traditional fund management community, where Mr Mattatia believes it will also be taken up. “So far the product has been very well received by our client base. We see it as a reference product that will have a very wide application and will appeal to all sorts of investors – even perhaps replacing traditional vanilla options in some instances,” he says.
Good news
It is perhaps too early to deliver a firm verdict on the Timer Call, but for hidden asset solutions generally, the future could hardly be brighter. This is good news for equity derivatives dealers who are keen to offload risks. The increased trade and innovation surrounding the assets has been catalysed as much by dealers’ risk transfer efforts as it has by investors’ recognition of the new alpha investment opportunities that these assets introduce.
The benefits are particularly large for the more active firms with large structured products books. Mr Sarfati, for instance, admits that the reason why SG can offer these strategies is because “it has huge positions in volatility on lots of names in our structured product books, so it can tranche those risks without impeding its position management or creating additional risks”.
Mr Wainstein agrees. “Running a large retail structured product book gives you a natural lead in these markets, because you have more of an axe and more risks to repackage and sell on. But it is not simply a repackaging process; instead we are manufacturing risks on both sides, taking new risks from hedge funds and selling old ones onto the market.
“Thus, you need the technical ability to match the residual and mismatched risk for which you need scale, modelling power, research, sales teams and so forth,” he says.
