There's lot of activity to extract value from [autocall] risk

Volatility knock-out (VoKo) products were deployed in 2022 to extract value from the low volatility downwards trajectory of the markets. SRP spoke to Kris Sidial, co-CIO at Ambrus Group, about the market dynamics around risk repackaging and transferring over the last 10 years, and how volatility strategies are looking at ways to extract value from the risk coming from the structured products market.

The Ambrus Group offers a tail risk strategy that specialises in trading volatility and aims at capturing big returns when markets are crashing and a lot of intraday order flow trading if markets are not crashing to run a carry neutral book which has significant convexity to it.

The tail risk fund is designed to provide protection against extreme market events, such as a sudden market crash - this type of fund is intended to be a core holding in an investment portfolio to diversify and hedge against extreme events.

Looking Back

When you look at the derivatives ecosystem, risk can never be eliminated - It's only transferred, according to Sidial. “If you look back at the environment in 2015 - 2017, there was a narrative around volatility selling - it was almost like if you were buying volatility, you were the crazy guy,” he says. “Nobody thought buying volatility could provide a source of returns.”

At that time, many hedge funds but also certain bank desks sold variance swaps - outside hedge funds and market makers there are certain international arms of certain investment banks that can take on this kind of risk via their prop desks.

“Issuers of structured products engage in this as well and we saw this a lot when Covid hit and a lot of the deleveraging came from these desks selling variance swaps, and some of these issuers got wiped out,” says Sidial.

Then, in 2020, the market saw the huge growth of autocalls in South Korea which brought new risk to the market.

“A lot of that flow came over to the US as well with many hedge funds and vol traders taking interest in the risk brought to the market by these autocalls,” says Sidial. “In 2020-2021, there was a lot of risk in the market from those products and a lot of activity to extract value from that risk.”

According to Sidial, some things have changed in the variance swap market now. “One, you cannot get uncapped single name variance swaps anywhere, and that's a really big thing - you can only get uncapped on indexes, so people do not sell uncapped single name variance swaps,” he says.

“When you look at these variance swaps, they are done OTC which means the market is even more illiquid now because nobody wants to sell those.”

NOW, FAST FORWARD TO 2022

The dynamic in 2022 was that new issuances of autocallables kept increasing despite the spot down / vol down dynamic.

“One thing we noticed during this time was that some of the insurance companies and pension funds that would run these overlays - the OTC risk of knock in and knock out notesturned their attention to the equity market and to other ways to implement strategies to capture the tail risk,” says Sidial.

These firms are now trading significant amounts of knock in and knock out notes because they have become much more cost effective on their books. However, on the other side, banks that are issuing these knock out notes are not equally hedging their exposure.

“If they were hedging these notes with whatever neutrality you want to look at it, the skew profile of the S&P complex would not be as flat as it is, specifically in the six month/oneyear timeline where you'd see more of a beating if issuers were selling those VoKos and then going right into the S&P complex and hedging their exposure, but that's not the case,” says Sidial.

“There's a certain amount of Vega that's going through on the retail side and that risk is not being transferred.”

According to Sidial, here is another situation where “this sort of risk is ballooning a little bit more for some of these banks because the hedges are being done equivalently in the way most people think that they're being hedged”.

Hedging Mismatch

The problems with the mismatch are really the reflexive implications that could occur if the market starts to crash, because if banks are not hedging that exposure the way it should be and are completely tied up on that exposure.

“If the market crashes and vol is really going through the roof, they will be hit,” says Sidial. “Our research shows a very weak spot vol beta relationship when the VIX was in the 20s to 30s - it is as it has a spring attached to it and if it gets to the 60s then it could move to the 80s within a day because of this sort of hedging that could take place during a time of distress. It is really important to be aware of these risks.”

The Ambrus Group’s view is that the mispricing of the tails, when you're faced with a market crash, will be much more extreme going forward because of the way how the US derivatives ecosystem is changing and some of the risk dynamics coming from the structured products market.

Playing The Market

When you think of 2008, there were two big changes that came about during the GFC that changed the entire spectrum of the US market - Dodd Frank and Basel III, notes Sidial.

“The reason why they implemented this was because they didn't want a situation where you had everybody rushing to the exit door at points of market distress and amplify the damage,” he says, adding that those two implementations changed the market because banks can no longer inventory some types of risk.

“We could see back into play that sort of all at once type of dynamic, especially if banks are not hedging properly.”

Sidial concluded that these dynamics provide opportunities to play that tail risk “to extract value and offer a more appealing payoff profile for our clients from dynamics happening on the back of the structured products market”.

“We're playing the value that we see in the tails where banks are not hedging that exposure,” says Sidial. “We think that there's a repricing of risk that could happen in the tails and we want to be buyers of some of those tails that could increase substantially during a crash.”