How does volatility affect structured products? It is very complex
As part of a new series on volatility, SRP talks to Benedict Peeters (pictured), chief executive of Brussels-based Finvex Group, about the impact of volatility on structured products.
“When you are building a structured product, choices have to be made. Is the investor long or is he short volatility? That very much depends on the type of product he is buying. There are products which will increase in value when volatility is higher, and you have products where it works the other way round.
“The classic capital-protected product which participates in the upside of an equity index, where you need to further distinguish between the moment of the primary emission and the secondary market, because the purpose is that the client buys the product at the time when the option premium is not too expensive. At that moment, you want the volatility to be low, because the client is long vega.
“In the secondary market, if volatility increases, this will have a positive effect on the value of the option and, therefore, also on the value of the product, all things being equal. But in today’s market, if you want your client to buy a structured product with full capital protection, if you buy a long option, if you buy vega, you buy volatility, then, for many products, this is no longer possible because the interest rate budget you have to spend is insufficient to pay for an option with normal volatility levels.
“For the client, in the current climate of low interest rates, and I am talking about euro-denominated issues, it is no longer possible to create an option product on standard benchmarks. For example, say the 10-year swap rate is at 1%: if you issue a zero coupon bond, in today’s market, you would buy at par at €1,000, and after 10 years you would receive €1,100; or you buy a bond today at €900, that will return €1,000. Now, if, instead of buying a bond at €1,000 which pays €1,100, you opt for a bond which pays a minimum of €1,000, you have €100 to spend on the option.
“If you buy a capital-protected product and you invest €1,000, after 10 years, you receive at least €1,000 and the €100 - the interest, the 1% per year - that is the amount you can spend on the option. That is 10% of the nominal. You have to ask yourself the question, with that 10%, can I buy an interesting option? Today, on a benchmark such as the Eurostoxx 50, such an option costs €200, so €100 gives you only 50% exposure to the markets. That’s how simple it is.
“Therefore, we are looking for products with lower volatility – I am still talking long-only – and, as an investor, I buy an upside call option with participation.
“Then, you can do different things. Either you buy an instrument with a lower volatility, or you create an instrument for which the volatility is limited by, for example, a volatility cap. So, an index which replicates the Eurostoxx 50 but with a maximum volatility of 7%, and, if the volatility is higher, then the index is partly invested in cash. Then, you actually buy an underlying instrument that is not a 100% equity instrument, but a combination of equity and bonds, equity and cash, which has a lower volatility.
“Now, I am talking about relatively straightforward long-only instruments. There are many other instruments. Take the reverse convertible, a very simple product. If an investor buys a reverse convertible, he writes a put option. He is basically saying, ‘yes, I want a high coupon, but I take the downward risk on a share’. Let’s say you buy a reverse convertible on ING shares with a term of five years, you get, for example, a coupon of 5%, but, if ING shares drops in value, you get paid those shares and you have made a loss on your investment.
“If you write a put option, you should hope that the volatility at that time is high, because the option premium which you get paid, in the shape of a coupon, will be higher when the volatility is higher. In that case, the investor gets a high coupon at the time of the initial public offer. Therefore, you are buying an underlying instrument at high volatility. For example, if you buy a reverse convertible on a very boring share with very little movement and volatility, then the coupon will be very low.
“But, of course, if you buy a reverse convertible with a high coupon, it is because you are taking a high risk. Because then you provide protection on a very volatile share and the probability that this share falls is also higher. That’s why the fee, the premium you receive is much higher, because you take a much higher risk.
“Then you have other products, such as autocallables, which also appear more attractive as a function of the degree of volatility, because, in that case, it will be more likely to exercise the call. And so you can decide for each instrument separately who is interested in what. Am I interested in a high premium? In that case, I have to take the underlying with high volatility.
“It’s hard to put it under a single heading whether a customer is better off with high or low volatility. With a structured product, it is like this: you can have a vision on volatility and express that vision on your product. You can even buy a product linked to an index which purely reflects volatility, the Vix for example.
“So, volatility can be bought as an underlying, but volatility exposure can be built in a product by buying or selling an option on a single share. In a capital-protected product, the client is normally long-volatility and he hopes he is able to buy the volatility cheap today. In the secondary market, clients want the value of the underlying to rise, but, even if the value does not increase; but if there is more volatility, with all things equal, the value will increase before maturity because the volatility has increased. It is very complex.”