In part three of a series of articles on the impact of volatility on structured products, Daniel Danon, senior vice-president volatility portfolio management at asset manager Assénagon, speaks to SRP about selling option premium, pressure on the volatility curve and why the risk can appear under-priced.

“What do people try to get with equity-linked structured products? Yield with a certain type of exposure to the equity markets. That’s the rather simple view.

“Then you look at which ways can yield be enhanced? Selling option premium is standard. In essence, when structuring a product, an option premium is sold and passed on to the investor until the product matures. As long as the option expires worthless, the investor will get the full premium and it will help enhance the initial yield of the product. As long as the option expires worthless, that is.

“Let’s take a very simple example. An investor wants to track the S&P 500 performance with protection down to a 70% level. By protection, it means that, if the S&P 500 corrects less than 30%, the investor preserves value. In case the market goes up, the investor participates in the performance of the S&P 500. In the worst case, with a market correcting by more than 30%, the barrier knocks out and the investor loses the protection.

“In order to structure such a product, the investor needs to ‘sell option premium’ at the barrier level. In essence, such a product would look nice if option premiums on puts are elevated (the volatility used to give a price to these puts is elevated).

“Let’s imagine the bank sold such a product to an investor. The bank has now the opposite position: indeed, the client sold volatility (by means of options at the barrier level), hence the bank is long volatility. Therefore, the bank needs to hedge and make its volatility exposure neutral. For this purpose, the bank will try to sell this volatility (again by means of options) to the market.

“If many of these products are sold, it will create a lot of pressure on the implied volatility curve (especially on downside strikes in the above example). The bottom line is, if investors want to capture yield, a good way to do this is to sell option premiums. The sellers of these products (banks) become long these premiums (more technically, they become long volatility) while hedging and covering its risk, putting the volatility curve under pressure.

“What are the consequences on risk premiums? The implied volatility used to give a price to options is a good measure of what the market judges as a risk for the underlying to move in the future. If there is a lot of issuance of structured products, as in the example above, the market will eventually crush the risk premium, especially on the barrier level. Not because banks think the market will not move, but because they simply need to hedge. It will create a distortion where the risk can appear ‘under-priced’. For example, right now, these types of products are very popular in Asia and this creates a situation where the volatility is lower on puts compared with calls on some major Asian indices. It means that the market expects Asian indices to be less volatile on the way down than on the way up. Why not? Because usually it happens the opposite way.

“In a situation where interest rates are close to zero everywhere, investors have jumped in these sorts of products in order to capture premiums that exist in option prices. This has created distortions, sometimes even more extreme than pre-2007 levels.

“The problem is, if markets correct heavily, wiping out all the barriers of the above example, banks will need to buy their hedges back. Like in 2008/2009, this could create a huge squeeze in the volatility market. The volatility used to price equity options is currently very, very low; you have to be careful when writing premium and taking risk on historically low levels.”

Related stories:
How does volatility affect structured products? Part 1
How does volatility affect structured products? Part 2: Clock patterns, fat tails and cones