Sky-high volatility may be under control, but the business may be concentrating into fewer hands.

By Andrew Webb

Don’t be alarmed. That strange noise you hear coming from the other side of the big ditch is the sound of equity derivatives dealers exhaling in relief. During the latter part of the decade, dramatic increases in equity volatility left many of their books dangerously unbalanced. But now it appears that dealers have gotten their volatility books under control. At the same time, European retail investors are looking beyond their national boundaries, and snapping up equity derivatives products in a number of new forms. Corporate business associated with acquisitions and corporate restructurings is also expanding. But there is evidence of large fundamental and structural changes that are altering the market for good.

One of the biggest drivers of change has been Europe’s new common currency. The birth of euro has forced many investment banking areas to restructure their operations—and equity derivatives have been no exception. European investors have increasingly started looking at the markets with a sectoral rather than national approach, and both the products and the providers have had to adapt. “We’ve seen a lot more stock, as opposed to index, over-the-counter business,” says Ian Martin, global head of equity derivatives at HSBC. “There’s plenty of evidence that people are using OTC equity derivatives to balance their portfolios after the creation of the euro, with the trend away from domestic equity benchmarks and toward more pan-European ones.”

All this plays conveniently to the strengths of the OTC market and opens up a number of possibilities to create relatively simple products for investors looking beyond their own borders for the first time.

Italian retail investors are a good example. Traditionally heavy investors in domestic bonds, they have increasingly branched out into domestic and now European stocks. Since they are traditional bond investors and, as a result, principally interested in yield, they have been willing buyers of products such as reverse convertibles (see box, Page 28). These products are attractive to dealers in another way: They allow equity derivatives desks buy to volatility relatively cheaply and redress their shortages.

European retail investors have also become increasinglyactive in the pan-European cash equity markets, as well as in notes linked to baskets of European equities—mainly as sector plays. The move toward sectors and away from indices has been fueled by a feeling that many European indices are top-heavy, with a few big companies dominating the weighting.

“Having derivatives people positioned in the equity capital markets area makes a broader range of solutions available.” Paul Calello CSFB

Many investors interested in sector strategies have been drawn to basket options. “Basing the call on a basket of stocks rather than on individual ones is a convenient way of lowering the overall volatility and option cost, and obtaining better gearing when you are looking for a participating structure,” says Amine Belhadj, head of European equity derivatives trading at Paribas. “Typically, they have been guaranteed on the downside with principal protection and based on a basket of higher-volatility stocks such as technology that have low correlation with each other.” Apart from retail investors buying via other banks, Belhadj has noted significant interest from institutional investors. Paribas has also sold one slightly unusual variation in the form of a resettable Asian basket option, which locks in returns when (if) the basket reaches certain predetermined levels.

In the U.S. market, similar products have been appearing—with a predictable emphasis on Internet stocks. According to Maroun Edde at derivatives software vendor Murex, there has been a clear distinction between basket products intended for more-sophisticated and less-sophisticated participants. “There have been lots of exotic basket options with upside exposure, capped at a certain level by a barrier or another mechanism, but with no downside protection, which is something you would have to take care of yourself,” he says. “For the less sophisticated investors, there are plenty of prepackaged alternatives, such as principal-protected notes indexed to, say, 80 percent of the performance of an Internet basket, but capped to perhaps a maximum return of 30 percent in the first year, with 22 percent in the following year.”

The 35 percent fall in Internet stocks between July and August has made principal-protected issues easier to sell, but not any easier to hedge. “The shares may be strong performers, but derivatives based on them are not necessarily very liquid, and you’re selling options anywhere from one to maybe five years out,” says Edde. “You can’t hope to hedge that instantly in the market with a perfect match. You are left with complex vega and gamma books to manage.”

The increasing emphasis on sectors and baskets could help concentrate the OTC equity derivatives business into ever fewer hands. Until recently, a number of players in the market have been offering index-guaranteed products. That business has a relatively low barrier to entry, and requires little understanding of equity markets per se or even much ability to execute. It’s also a business that’s not particularly sensitive to transaction costs. Dealers in baskets and sectors, by contrast, are highly reliant on their ability to execute efficiently and cheaply. The net result: many smaller providers of pure index products are less able to play effectively in the new equity derivatives market.

Corporate business

Equity derivatives associated with corporate restructurings, which have become a staple of the U.S. equity derivatives market, are expanding their role in Europe. Credit Suisse First Boston, for example, has placed a number of its derivatives personnel in its equity capital market area. The general objective for most firms making this kind of shift has been to be able to offer clients a broader range of solutions. “For example, if someone acquired a block of shares through an acquisition and wished to monetize them, the traditional solution would have been to use a convertible bond,” says Paul Calello, global head of equity derivatives at CSFB. “However, by having derivatives people positioned in the equity capital markets area, a broader range of solutions is available.” Technology companies have been frequent clients in this more-homogenous marketplace, with many using mandatory convertibles and quite a few dabbling in equity forward contracts that have specific conditions attached as to when they can be exercised.

Securing a steady stream of profitable corporate business in this fashion has the added advantage of lining up an ongoing supply of volatility. With quite a few equity derivatives operations still bearing the scars of the late 1998 and early 1999 volatility squeeze, there’s nothing like planning for the future.

Treasury stock management is one area of mutual benefit that has particular promise in this respect—clients gain a more cost-effective solution and the banks get a source of volatility. While this is common practice in the United States, in certain parts of Europe it is much less evident. The traditional method of buying back shares in the market and then holding them on the balance sheet for possible later reissue is currently practiced in France, Germany, Spain and Italy. (In the United Kingdom, however, the concept of treasury stock does not exist at all—any of its own shares repurchased in the market by a company are cancelled.)

“Morgan Stanley’s flexible collar allowed you to fund the calls and be able to readjust your position more effectively because the calls were short-dated.” Stanley Choung Savvysoft

“The approach in Europe is very much oriented to on-market transactions,” says John Staddon, executive director of equity risk management at Warburg Dillon Read. “This can be explained in terms of a regulatory framework that shows a strong leaning toward the transparency and openness of the markets and also in terms of a corporate psychology that still prefers the simplicity of cash transactions.”

A simple, but effective alternative is to sell OTC puts (typically with a strike set at 90 percent to 95 percent of the current price) to capture at least some premium. If the equity price falls to the strike, the company has to pick up the shares (which was its intention anyway), but it obviously still retains the premium. “I don’t think that this will take off immediately in Europe, but as the regulation of treasury stock management relaxes and corporates become more accustomed to the idea of using derivatives in this context, we’ll see a move toward the U.S. model,” says Staddon.

“There’s certainly evidence to suggest that people are looking at their equity derivatives books in a much more generic fashion,” says Alex Puaca, chairman of derivatives and risk management software vendor DART. “It’s gone beyond simply putting together fixed-income products with equity option kickers. People are now also looking for the ability to price a mixture of components from various previously separate markets as one item, rather than individually.”

The return of vanilla

One overall theme about which there seems to be little dispute is that OTC equity derivatives are if anything getting less—not more—complex. “In the past year or so, I haven’t seen any type of structure that wasn’t originally designed or traded in the early to mid 1990s,” says Mark Richardson, head of global equity derivatives at Commerzbank. “I don’t think you’re seeing product innovation for its own sake anymore.” Instead, much of the value in these transactions comes from the fundamental and quantitative research used to select the underlying assets.

The general move to vanilla was caused by a number of factors. First, much of the innovation in equity derivatives in the late 1980s and early 1990s was driven by intellectual curiosity rather than actual demand. Second, many houses were producing complex products but pricing them using margins associated with vanilla products—with embarrassing consequences when they went awry. Third, senior management in investment banking operations are now taking a far more cautious view as vol levels over the past two years have ballooned and the lack of supply has inflicted significant damage.

“There’s also been a tendency for people to move away from the exotic or even the semi-exotic, because they have frequently discovered that they don’t get enough bang for their buck,” says HSBC’s Martin. “In the early days, people used vanilla products since volatility was low and interest rates were high. As volatility started to rise and interest rates fell, they looked at different ways of increasing the participation—typically by resorting to increasingly exotic products. However, when it came to expiry, investors found that they didn’t get such a great payout after all, which has accelerated the move back to a more vanilla approach.” One aspect of this has been an increase in OTC activity and the use of customized options—but in a securitized form. Participants who would traditionally use an exchange product have instead been requesting securitized OTC products as a halfway house between the listed and OTC markets.

Regulatory issues have also played a part here—particularly in London, where capital charges have been determined largely by the quality of valuation and whether products were SFA approved. A number of equity derivatives operations found that doing longer-dated and more convoluted equity structured products was simply uneconomic. The attractive profits associated with the deal soon paled into insignificance compared with the prospect of tying up several million in capital and depressing the bank’s return on equity.

The new products that have emerged owe more to market pragmatism than exotic financial engineering. Morgan Stanley’s flexible collar of early this year was a case in point. Rather than buying long-dated puts and selling calls with the same expiry as a regular collar, the equity derivatives team started pushing the idea of funding the long-dated OTC puts in a collar by selling near-dated calls. Most of the activity in flexible collars was in indices—particularly the Standard & Poor’s 500—with typical versions of the flexible collar consisting of one- to two-year puts with call adjustments made every three months.

“The logic behind it was that you could fund the calls and be able to readjust your position much more effectively, given that the calls were short-dated,” says Stanley Choung, director of product development at Savvysoft and former vice president in equity derivatives at Morgan Stanley. “You could tweak the position should the market move up—you’d lose money on the calls, but then you could readjust your strike higher as the market moved.” The obvious advantage of the strategy was that it enabled the client to easily adjust the financing of the protection and participation on the upside. (Capping the underlying portfolio’s return at 10 percent for one quarter was clearly more attractive than receiving 10 percent annually.) During periods of extreme market moves to the upside, clients could also opt not to sell another call after three months—a choice unavailable under the traditional collar strategy.

Foreign & Colonial’s Volatility Strategy

Equity derivatives desks that suffered volatility starvation last year must be hoping that more fund houses will follow the lead of the United Kingdom’s Foreign and Colonial. The firm has become a substantial player in the volatility market—especially when compared with its peers. F&C treats volatility as an asset class in its own right—ranking equally alongside equity, bonds and foreign exchange in its portfolios (commodities are outside its mandate). The major volatility traded is equity—at one time on individual equities, but now only on indices. F&C was in the forefront of designing volatility contracts with both caps and floors, and has been active here for nearly five years. “These [contracts] are a particularly useful tool for us for a couple of reasons,” says Steve Dolbear, head of derivatives at F&C. “First, they allow us to buy and sell volatility in a limited-risk manner because of the cap and floor, which is ideal to have in a fund situation where most fund owners are risk-averse pensioners. Second, because we don’t have a global book we are spared from having to sit up all night delta-hedging positions on overseas markets.” Although F&C could transact in the bilateral over-the-counter market, fund regulations make that tricky. Instead, the norm is for it to have the volatility trade structured into a listed security, such as a volatility swap embedded in a bond or in warrant form. In addition to selling normal calls and puts within bonds, F&C trades volatility on certain European indices using a strategy it calls “one over k squared.” “When we want the freedom of delta-hedging the contract ourselves, we won’t sell a mechanical contract that ties us into, say, daily or weekly volatility readings of the underlying,” says Dolbear. “Instead, we sell a portfolio of European options in a size related to one over the square of the strike price. We then have a variance exposure, which we deltahedge with futures as we see fit. In effect, we are creating our own in-house-manufactured variance swap.” —A.W.

Missing Volatility

The search for volatility remains as important a quest as ever. Although most firms have managed to dig out from the worst of the great volatility crunch of the late 1990s, there are signs that the market has changed—perhaps permanently. The longer end is traditionally a one-way market—plenty of buyers of volatility through retail-structured products but few natural sellers. The biggest sellers of volatility have historically been hedge funds—but apart from a few niche players, that’s not so much the case these days.

“Obviously, there’s clear evidence of a lack of supply of products at the longer end of the market,” says HSBC’s Martin. “The supply dynamics of OTC equity derivatives products have fundamentally changed as a direct result of the experience a lot of firms have endured at the longer end.” The net result is that the volatility market is quite liquid out to around three years, but dries up extremely quickly thereafter, as participants become reluctant to quote.

“After the turbulence in the markets last summer, investment banks are reluctant to take naked volatility risk, because they are unwilling to tolerate the P&L swings on their books,” says Vanessa Gilbert, head of European equity derivative sales in London at Dresdner Kleinwort Benson. “Before, investment banks were primarily concerned with hedging their market [delta and gamma] and interest rate [rho] risk and taking a view on volatility. Now, they are far more inclined to hedge volatility, and that obviously constrains liquidity, because there’s no other asset class that provides a supply of volatility other than options themselves.”

That has had considerable impact in the retail financial products market—with the virtual disappearance of volume flexibility options. Over the launch period (usually about six weeks) of a new retail product, issuers often start selling with their hedge already in place. Although they lock in a price for the product with one of the OTC derivatives desk, they have little way of knowing exactly how much they are going to sell and therefore how much to hedge. As a result, common practice has been to lock in the price for a certain amount of product, but then enter into a volume flexibility option for an additional amount at the same price, which can be exercised should retail demand justify it. There’s obviously a hedging cost for the derivatives desk involved in that, because the issuer may walk away—while they lock in the price, they aren’t committed to taking it up.

“The fee for these options was based on the cost of the product price changing as a result of yield curve shifts,” says Gilbert. “In other words, the fee equated to the price of a swaption covering the selling period. Typically, longer-dated volatility was relatively stable in those days, and banks therefore didn’t charge for the potential cost arising from the product price movement as a result of volatility moves over the selling period. However, that’s definitely not the case anymore. We have seen dramatic moves in longer-dated volatility over very short periods in the last 18 months.” The lack of liquidity in longer-term volatility has made it difficult or impossible for derivatives desks to make a price on volume flexibility options—much to the inconvenience of the issuers. How the issuers will react to that remains to be seen—but a rash of “limited, hurry, hurry, hurry, special offers” with less-attractive returns looks a pretty good bet.

While the dearth of volatility has encouraged some dealers to look at the exit doors, others are seeing a big part of the solution to their problems in e-commerce. There are already signs of tangible (and successful) activity at the retail end of the OTC equity derivatives market.

E-commerce may enable banks to expand their distribution of securitized retail products. “By using it for some of the projects we’ve run in Germany in relation to the warrant business, we’ve seen a dramatic increase in volumes,” says Warburg Dillon Read’s Staddon. “That’s simply a result of having an on-line facility, finding bridges with local banks, and tapping into their client base. I think there’s little doubt that it will quickly become an integral part of the securitized retail business.”

While the prognosis for those with the global reach to cope with the new cross-frontier demands in equity derivatives is rosy, others may not be so fortunate. Those left to compete in the more commoditized area of index products are likely to see margins trimmed further by competition. There are also those who see credit issues making things even tougher. “Lower-grade credits are going to find it harder to transact in OTC equity derivatives,” says HSBC’s Martin. “There’s already more of a tendency for them to use the OTC market as a process of price discovery, but actually cross the business through the exchange clearinghouse.” Although the exchanges have been trying to push the credit risk benefits of their clearinghouses for some time, now could be a good moment to push a bit harder. In the long run, if they get their acts together they could absorb a substantial amount of vanilla business from an OTC equity derivatives market increasingly dominated by a few leviathans competing among themselves for the more lucrative customized solutions.

The Appetite for Synthetic Convertibles

The over-the-counter equity derivatives market has been predictably quick in seizing on the opportunities presented by the flush of Internet IPOs hitting the market. Synthetic convertibles may be nothing new, but issuance has been climbing fast. “There’s an obvious demand as some of the strongest sectors of the market are high-tech, and typically the common stocks for these companies don’t pay dividends,” says Ed McCartin, managing director of equity derivatives at BancBoston Robertson Stephens. “As a result, there’s a willing audience of investors in equity income funds or convertible bond funds looking for exposure to these companies, who perhaps by charter cannot hold the common stocks since they aren’t getting an income return.” The popularity of these synthetic convertibles has seen commercial as well as investment banks actively writing business. The structure is typically simple, usually consisting of a note with an attached call option. The tenor of the instruments has varied according to the volatility of the underlying stock, with up to five years being fairly typical. In some cases, the actual underlying company is not issuing its own convertibles, so institutional investors in general have had to turn to the synthetic alternative. On the other hand, many technology companies have noted the investor enthusiasm and have come forward with their own convertibles issues (usually callable) in order to reduce their borrowing costs. Some see this as a potential problem further down the line, given many investors’ propensity for treating convertibles as straight equity plays and ignoring the credit implications. While tool kits for pricing the most convoluted convertibles can be bought off the shelf, calculating and hedging the risk of a collapsing theoretical bond floor on a zero-cash-flow Internet stock presents a different kind of challenge. —A.W.

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