FEATURE
Recycling risk (part 2): offloading vol The Priips saga, with its sector heroes, regulatory disputes, implementation frustrations and (even) parliamentary uprisings, has finally come full circle.
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arket players talk about the role of implied volatility in triggering the shift away from traditional equity index-linked autocallables and reverse convertibles. Issuers of structured products use several ways to offload implied volatility. The easiest way is to go into the inter-dealer broker market and see if there are any matching interest within hundreds of participants - these can be other banks but also market makers, and hedge funds, according to Pierre Roussel, head of EIS stocks trading, Crédit Agricole CIB. “Liquidity will mainly depend on underlying and maturities, but trades will always be listed derivatives,” he said. “For less liquid underlyings, it is possible to macro hedge the volatility exposure with more liquid ones - main indices in general.” Another way is to structure products that can help to mitigate the volatility risk, said Roussell. “We can think about simple payoff diversification with usual clients to more sophisticated products that can be traded with more advanced clients such as hedge funds.” Active investors like hedge funds and market makers want to see where the structured products flow is as this can affect the dealers option positioning. Trading desks look at S&P 500 index flows, for instance, to see if dealers are short or long gamma - if there's a level where dealers are short gamma, and the index goes down, issuers need to start hedging their gamma if they're short. The selling pushes the market even lower and escalates the need to sell even more which adds some volatility to the markets. When dealers are long gamma that dampens the volatility because they start buying when the market goes lower, and they start selling when the market goes higher. “Hedge funds are looking at where the flows are, what kind of products are sold, where are the strikes and the peak Vega – the level at which knocking puts are set,” said Tom Karlsson, director of volatility strategies at Dunn Capital.
“The structured products market is a very interesting space for hedge funds because it offers opportunities – the flow may be so one sided that some volatility becomes very cheap to buy and some volatility becomes very expensive to sell. It’s not only the arbitrage opportunities but also about having good trade entry points.”
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Hedge funds and market makers are always seeking opportunities to buy cheap volatility so they tend to look a the longer dated implied volatility levels of an index and “where the structured product flow is pushing the volatility down too much and there is little liquidity to hedge in longer dated maturities”. DIVIDEND RISK If there is a lot of option activity this might affect the implied volatility and dividend levels which in turn may open attractive trading opportunities for these firms as the market flows are not always balanced. “Longer dated dividends have had constant selling pressure as banks need to hedge their long dividend risk exposure. In times of risk-off market this risk can trade very attractive levels and you can earn a good yield carrying this illiquid risk,” said Karlsson. “That is what happened with the Covid crisis of 2020 when companies stopped paying dividends, and it became a real risk for the market, but also an opportunity. Issuers reacted quickly and addressed the problem with decrement or synthetic dividend indices - clearly a good way for banks to hedge that risk and pass some of that premium on to investors.” The dividend risk generated by structured products has become a key theme since 2020, according to Conor McCann (right), equity derivatives trader, Susquehanna International Group. “There was certainly a lot of stress in March 2020 and the structured products market has been an area of the marketplace where we've had to step into in a more serious manner,” said McCann, during the volatility panel discussion at SRP Europe 2022. “The introduction of decrement indices is a good example of the innovation triggered by the industry which moved fast to come up with ways to manage and reduce these risks.” According to McCann, the dividend risk has been reduced across the marketplace, on average, but there are still occasions when dividend risk is coming under stress. “I think that is still very much an important risk for us all to manage,” he said. “A lot of the work that has gone into the last two years and being more focused on this risk has also provided a better framework to manage the risk and have an orderly market in terms of the dividend risk compared to 2020.”
