Low interest rates and stagnant equity markets have seen an increasing number of equity portfolios using derivatives to boost yield. Michael Marray looks at the changes in this field, as the trading of volatility as an asset class increases in popularity. 

Marc El Asmar embedded

The use of derivatives to boost yield on equity portfolios is growing rapidly, as insurance companies, pension funds and asset managers across the world face the challenges posed by the low interest rate environment and flat equity markets.

A growing number of real money accounts are also trading volatility as an asset class, arbitraging implied versus realised volatility via options on either the Vix or VStoxx indices. Access to volatility arbitrage has been made easier by products such as exchange traded variance futures.

Alongside traditional hedging of equity exposures, these trends are generating heavy flows of business for the major global derivatives banks.

“We see our clients shifting not so much towards complex payoffs, but towards market timing and trading ideas,” says Marc El Asmar, head of global markets sales at Société Générale Corporate & Investment Banking (SG CIB). “We can offer them derivatives building blocks, for example, to combine equities and foreign exchange, or equities and commodities, or single stock related to event-driven circumstances.”

Entering the mainstream 

What were once regarded as sophisticated strategies mainly followed by hedge funds have become much more mainstream, as real money accounts such as asset managers and pension funds with alternative investment buckets use option strategies to combine themes. “In recent months we have seen some large notional hybrid trades such as Euro Stoxx versus euro/dollar, S&P 500 versus gold, in addition to regular index outperformance such as MCX versus FTSE, SX5E versus S&P 50, and FTSE versus Dax,” says Daniel Petherick, head of Europe, the Middle East and Africa equity derivatives flow sales at SG CIB.

“Investors with a cross-asset mandate have become very comfortable with such products, and some of them move on to new ideas even quicker than certain hedge funds,” he adds. “If there is a hybrid trade that fits in with their market view, they are willing to trade it."

Other major derivatives banks such as BNP Paribas are also encountering rapid growth in their derivatives activities. “We have seen fast-growing business in hybrid options, which are usually structures helping express macro views leveraging on a certain implied correlation price embedded in the structure,” says Walid Maaouni, head of equity derivatives sales to hedge funds at BNP Paribas.

“One idea BNP Paribas was pitching early in the year to our hedge fund client base was a trade paying a minimum of one put option on the Dax struck at 95%, and a 2.5 leveraged at-the-money call on the Bund with August expiry,” he adds. “This is a ‘worst of’ option, where the investor pays an upfront premium to receive at expiry the worst of two payouts.

“In the early days of quantitative easing [QE] launched by the European Central Bank [ECB], equities and Bunds were positively correlated, based on expectations that easing by the ECB would improve financial conditions, help spark growth as well as inflation, and push equity valuations higher. But in the traditional risk-on, risk-off environment, equities and Bunds should be negatively correlated – so this is an optimal way to play the exit of the correlation regime under QE, which is what we have been observing on markets this year.”

Insurance portfolio hedging

Institutional investors such as insurance companies are also using equity derivatives in order to limit the downside risk of stock holdings, and so reduce their capital charges. In February, Swiss Life Asset Managers and Natixis teamed up to launch Swiss Life Funds (Lux) Equity Global NXS Protect, which uses a hedging system from the Natixis equity derivatives division to limit the impact of a market decline on the portfolio, via the systematic and optimised execution of options. 

The fund is aimed at institutional investors, and meets regulatory requirements for insurance companies under Solvency II. The capital charges for holding equities are high under Solvency II. Modelling for standard shocks might result in a potential 40% drop in the value of the portfolio. But by buying protection (for example, via one-year put options), the solvency capital requirement (SCR) can be reduced, often to reflect only a 20% drop in the portfolio value. 

An insurer with a very large equities portfolio would be unlikely to hedge their entire portfolio. Banks are offering solutions, which are bespoke to client requirements, on parts of their equity portfolios.

The Solvency II regulatory regime was introduced on January 1, 2016, and the market risk module now accounts for a large percentage of their capital charges. The optimisation of Solvency II capital requirements via the use of derivatives is currently a major area of business for the big derivatives houses.

In the case of insurers investing in funds, they are required to adopt a so-called ‘look-through approach’ when calculating their SCR, meaning that the SCR will need to be calculated on the basis of the underlying assets in a fund structure. Law firm Clifford Chance says that where the look-through approach is not possible, an insurer may be able to calculate its SCR on the basis of the investment policy of the fund. 

“Insurers would therefore look to invest in funds where the investment policy is sufficiently clear and specific (and may insist on writing their own investment policy) in order to apply the look-through approach and understand the underlying material risks,” the firm notes.

Volatility as an asset class

In addition to using equity derivatives to enhance equity portfolio returns, or for hedging purposes, the number of investors seeking to generate returns from volatility arbitrage has grown rapidly in recent years.

Volatility strategies have a role to play in the alternative investment bucket of many institutional investment portfolios. Volatility as an asset class has become fairly mainstream for real money accounts looking to diversify their portfolios.

“So far during 2016, bonds have been a good diversifier for investors that are long equity, but in 2015 this was less the case, especially in Europe, nor in the US in 2013 around the time of the taper tantrum,” says Alastair Davidson, head of equity derivatives sales to institutional investors at BNP Paribas.

“Another obvious diversifier to a long equity position is a long volatility position, but the issue is the carry cost, since buying insurance is not cheap,” he adds.

“Long volatility has for some time been a core component of the [hedging] toolbox for institutional investors, but the question has been how to structure trades more effectively. One example of a popular long volatility trade has been buying Asian or European volatility via volatility swaps or variance swaps, and selling S&P 500 volatility as a way of reducing carry costs. In terms of fixed-strike hedges, investors often approach buying puts on a more tactical basis, but we have seen a shift in interest towards more systematic hedging programmes.”

Option flows

The price of volatility options are themselves influenced by flows through the market and, particularly in Europe, much of this flow is associated with the structured products market. This is especially the case with the VStoxx, as it is with the autocallable structured products with the Euro Stoxx 50, as the underlying are generating large volumes of business with investors in both Europe itself, and in Asia.

Many retail and high-net-worth investors currently favour products with a coupon payoff, and express certificates are particularly popular. A typical five-year certificate might be observed annually. If the underlying asset (most often the Euro Stoxx 50) is at or above a certain price on observation day, then the coupon is paid and the product is redeemed. If it is not above the predetermined price level then the product proceeds to the next observation date.

The embedded derivatives influence pricing in the VStoxx options markets is an important additional factor alongside overall market sentiment. The VStoxx spiked up to 38 in early February, but quickly settled down and was at 21 in early June.

“There has been tremendous growth in autocallable structures in Germany in recent months,” says Wolfgang Gerhardt, head of financial products, Germany, at Vontobel. “These are typically ‘buy and hold’ products, where the client is focused on receiving a high coupon, and is willing to bear the risk that the product is called prior to maturity.

“A typical express certificate would have a five- to seven-year maturity, and be structured with an annual observation date, though we do also see placement of some  shorter maturities of two to three years with quarterly observation,” adds Mr Gerhardt. “Express certificates are popular with retail clients all over Europe, including major structured products markets such as Germany, Italy and the Nordics. The most prominent underlying is the Euro Stoxx.”

Major global structured products providers are well placed to benefit from these retail flows. The Euro Stoxx 50 is not only the most popular autocallable underlying in Europe itself, but also in markets such as Canada or South Korea, since investors all over the world are faced with a similar hunt for yield. Thus the houses that generate flows in these products, including those denominated in currencies such as the Canadian dollar or South Korean won, have exposures on their own books that can be structured and offered to their institutional clients.

Structured product issuance is less of a market influence in the US. Not only is there a smaller market for autocallables, but the trading volumes on CBOE Volatility Index (Vix) options are much larger.

“The main drivers of Vix options are investors buying call options as a hedging trade to protect their portfolios, but many of those investors tend not to buy when the Vix is elevated,” says Maneesh Deshpande, New York-based head of equity derivatives strategy at Barclays. “They prefer to wait for it to come down, perhaps to below 15, before initiating a reload of their hedges.” Thus when the Vix is elevated, the open interest volume often drops.

US/Europe differences

The systematic buying of options by asset managers for hedging purposes generates an excess premium for options pricing, which creates an investment opportunity for volatility arbitrage. This used to be mainly a hedge fund trade, but is now widely used by real money accounts such as pension funds and asset managers. The growth of exchange-traded products with the Vix as the underlying has also made market access easier.

But the underlying dynamics of options pricing are different in the US versus in Europe. “In the US the dominant force is portfolio hedging, since US autocallable issuance is not big enough to impact the options market, given its huge size,” says Mr Deshpande. "But European markets such as VStoxx options are not as liquid and, for longer dated options, autocallables have a big impact on pricing.” There is also a sizeable volume of autocallable issuance in Asia, often with the Euro Stoxx 50 as the underlyling.

The Vix, an indicator of implied volatility on the S&P 500, has been at low levels for much of 2014, 2015 and into 2016. After a brief spike above 27 in January it settled down, and was 14 in early June. During the second quarter of 2016 there has been a surge of activity on volatility trades, with open interest on Vix call options at its highest level in almost two years.

There are attempts to launch new products, and challenge the overwhelming dominance of the Vix. The Chicago Board Options Exchange has exclusive rights to trade Vix options. It also has exclusive rights to S&P 500 options.

In March, Bats Global Markets and T3Index joined together to launch a volatility index based on the SPDR S&P 500 ETF (the so-called Spider), which is managed by State Street Gobal Advisors and is the world’s most actively traded security. The volatility index known as Spyix (the 'Spikes') measures 30-day volatility.

Index provider Stoxx also offers the V-Dax-New based on the Dax, and the VSMI based on the Swiss Market Index.

And in April 2015, the Eurex Exchange (a subsidiary of Deutsche Börse, which also owns the Stoxx indices) added Eurex variance futures to its volatility offerings. These contracts replicate the payoff profile of over-the-counter variance swaps on the Euro Stoxx 50 underlying, and are designed to fit the needs of investors who seek exposure to volatility but are simultaneously looking to benefit from the efficiencies of exchange trading and central clearing.

Higher trading volumes

The next period of sustained volatility is likely to see higher trading volumes on the global options markets, given the broadening investor base, and new products giving ease of access.

Over the past few years, US equity volatility has been generally low, with the occasional spike, against a background of loose monetary policy from the Federal Reserve. But the Fed is now attempting to normalise policy via a gradual series of interest rate hikes. As a result, analysts are forecasting higher levels of volatility over the next 18 months.

“In the US we have passed the peak of profit margins, and are approaching the end of the business cycle, so in the coming months and into 2017 volatility should be on the rise,” says Stephane Mattatia, head of global macro sales and head of the hedge fund sector programme at SG CIB.

“There is a strong link between the path of the business cycle and equity volatility – which is therefore much more cyclical than many people might expect, even though there can be noise and short spikes in the middle of the cycle,” he adds.


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