Emmanuel Naim, Equity manager for the cross-asset solutions group, Société Générale Corporate & Investment Banking

Emmanuel Naim, equity manager for the cross-asset solutions group at Société Générale Corporate & Investment Banking, explains how the equity derivatives business has overcome the challenges posed by the Lehman bankruptcy to continue offering investors ways to participate in the equity market. Writer Philip Alexander

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Philip Alexander, Finance editor, The Banker

Click here to view an edited video of the discussion

How have market conditions affected the equity derivatives business? For instance, the downgrade or removal of bank and hedge fund counterparties in over-the-counter transactions?

The bankruptcy of some well-known names in the industry has put a reality to something that was quite vague in the past - the risk of a major default in the industry with respect to structured products in equity derivatives. We have seen a lot of clients, from the retail side to the prime banking side, who were worried about the creditworthiness of the issuer that was issuing products into which they would invest.

So we have been involved in designing special purposes vehicles (SPVs) that allow clients to tailor the credit risk that would be embedded into the product they are buying. Société Générale Corporate & Investment Banking (SG CIB) has come up with a vehicle called Codeis, which is an SPV from which the client would select bonds - say, sovereign or supranational - as the collateral of their equity investment. Therefore the client bears only the credit risk that they have decided to input into the vehicle.

The second focus this year has been on the alternative investment industry. We have been very much involved in the managed account business at our Lyxor platform. We ask a given hedge fund manager to manage money the way he or she does normally, but through a Lyxor fund, which is a great way to have a lot more transparency and liquidity on that particular manager. The recent crisis and scandals that have been tainting the alternative investments industry have confirmed that business model and the fact that investors should focus into managed accounts rather than standalone hedge fund managers.

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In terms of what you are able to offer by way of products, does the removal of some counterparties affect, for instance, pricing and liquidity?

I would not say that we have seen a major drop in liquidity on normal assets, but obviously some parameters have been less easy to trade than in the past. Overall I would say that liquidity has been fairly good - which proves the resilience of the equity derivatives business.

On our side, I would not say that this has had any strong constraint with respect to the type of product that we could offer and the various types of underlyings that we could structure upon.

With respect to the type of structure that has been put forward this year, there has been a clear trend towards transparent structures, very simple and most of the time index-based. On both the institutional and the retail side, clients have been looking at ideas that were very easy for them to grasp from the beginning, and this has been a clear major focus of ours and of the industry in general this year.

We have seen a partial rally in equity markets - there is still some uncertainty about the economic fundamentals and the way that that is going to play out. what is the case for investing in equities at the moment? And where do structured products fit in as a way to approach that?

There is a strong case for investing into equities at the moment, and in spite of this strong market rally that we have seen. There is a need for institutional investors to be long equity. Right now the cash interest rate is close to zero, so leaving your funds in the money market is not attractive.

And since March 2009, we have seen a sharp decrease in the credit default swap spreads on corporate bonds, so therefore cash bond investment has less of a role in generating returns than it used to. At the same time, a lot of investors are worried about a return of inflation, which would have a strong negative impact on bond investments.

So what is left? Equity definitely offers a strong potential. First we are still on low valuations from a historical point of view. And the world is a bit safer than, let's say, six months ago, as can be measured by a big decrease in the implied volatility of equity markets. So all the stars are aligned in favour of equity investment right now.

So how can we enter into the equity market using structured products? Our main approach at SG CIB has been to propose to clients to use structured products as a way of diversifying, as compared to straight equity investments.

In other words, if a client really believes in a steady rise of the equity market, then there is nothing like a simple exchange-traded fund (ETF) investment to be long the equity market. However, a lot of clients have been focusing on alternative scenarios. What if, for instance, there is a J-curve evolution of the market, a further decrease and then a rebound afterwards? What if there is no clear trend in the market but a lot of volatility along the way - how do you want to play this type of scenario?

On those scenarios, holding an ETF would generate a rate of return that would be below the one you could generate on the structured product that is tailored for this type of scenario. So our approach is really to focus on alternative scenarios as a complement to a core allocation in cash equities.

Is principal protection still a key investment theme in equity structured products, or is risk appetite starting to return as well?

We've really seen a strong uptake into risk in the past three months. A lot of institutional investors switched their assets into directional equities, not necessarily involving principal protection. Structures providing diversification of risk profile with a strong sensitivity - close to one-for-one - on the equity market have been extremely popular in the recent market environment.

The second area that we've been focusing on is products that are guaranteed on the long-term basis and that offer a good alternative to bond investments. In other words, we've seen interest rates going down to a low level, so why not use the equity engine to generate return on a yearly basis as a bond would normally do.

The funding position of a lot of corporate pension schemes and life insurers has suffered as a result of the crisis, and due to demographics more generally. How have they responded to that in terms of their approach to equity derivatives - have they seen that as something that is going to be necessary to help plug that funding gap?

To protect against that there are various types of structures. First, a pure hedge on the asset side, meaning how to protect their equity portfolio from a sharp downturn, without paying too much premium upfront which is one strong challenge. Usually when you need to be hedged, that is exactly when the cost of hedging is very expensive for reasons such as volatility. So our main challenge was to design options that are as effective as plain vanilla hedging but that will cost a bit less.

The second aspect was essentially how we could help a client cover its funding ratio globally. So now it is an asset and liability management issue, in the sense that we have to model the liabilities of the pension fund and model their assets, then create a derivative that will allow them to be hedged against the downside of their funding ratio without having to spend too big a premium upfront. I would call these hybrid transaction structures, because on one side you have interest rate sensitivity, and on the other side equity sensitivity. We have been very active in tailoring those for large pension funds on the European scale.

In SG CIB itself, the global markets division has gone through an organisational change that has brought together the equity business with the currencies, commodities and rates business under one head. Are cross-asset solutions an increasing trend in hedging and in derivatives activity for your clients?

In addition to the pension fund hybrid structures I just talked about, we have seen some interest from asset managers recently, looking at cheap ways to play the rebound of the equity market. It made a lot of sense for them to have something that would be taking benefit from the decorrelation of asset classes, therefore being exposed to several asset classes at the same time. And for us, it made a lot of sense also from a client coverage point of view to have all market activities put together - a one-stop shop where you could have coverage on every asset class that the client may be interested in.

The issues

- How the economy is affecting equity derivatives

- The effect of removing some counterparties

- structured products

- principal protection versus risk

- How life insurers and pension schemes are responding

- the trend for cross-asset solutions

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