In Part 2 of this three-part product briefing, experienced market practitioners explain some of the ways that the equity derivatives market works – including key developments in Asia, the role of product manufacturers, factors affecting option pricing, and risks and issues to consider when buying options.
Date: Sept 2010
Tags: Derivatives, Structured products, Options, Warrants, Hedging, Volatility, Strike price, Mark-to-market, Issuer risk, Suitability
Asian market developments
According to Adam Cowperthwaite, managing director, head of equity derivatives sales for Daiwa Capital Markets in Asia ex-Japan, it is possible to identify three particular stages of the development of Asia’s equity derivatives market.
The first stage, he explained, was prior to the significant increase in volumes in the highly-commoditised flow exotic-type products such as accumulators in the height of the bull market in 2006 and 2007. Before that time saw the development of structured funds, creating large markets in Hong Kong and Singapore in particular. There was also the use, broadly across the private banking sector, of simple vanilla equity-linked note (ELN) structures, mainly for yield. This first stage also saw the development of the warrants market.
The second stage, said Cowperthwaite, saw large growth in the use by private banking clients of flow exotic products.
The low-volatility environment before the crisis led investors to take on more and more risk, fuelled by the high success ratios which investors experienced through exposure to equity derivatives, explained Werner Schlossmacher, head of structured derivatives for Credit Suisse Private Banking in Asia Pacific.
This led to a small range of products which were very well-known being competitively-offered to the private banks by a large number of intermediaries, added Cowperthwaite.
The second stage of the development of Asia’s equity derivative markets also saw a transition in the retail space from structured funds to structured notes, he said, both with equity and credit underlyings. Plus, there was continued growth in the warrants market.
The third stage of development, said Cowperthwaite, is the current post-crisis environment, where interest in flow exotic products has waned, interest in warrants has remained, and interest in structured funds has appears to an extent to have grown stronger again.
Schlossmacher added that the recent higher volatility in the equity markets has made a lot of clients more aware about the risks embedded in exposing themselves to certain equity derivatives – and these are now much better understood.
In terms of capital protected structures, Arif Mansuri, co-head of equity structured solutions and third-party distribution for Bank of America Merrill Lynch in Asia Pacific, said interest has always been there in the region.
However, he added that it has been noticeable in the Asian market that the maturity of the products is relatively short, in turn making it difficult to create capital protected structures for the time being. Yet he said he expects to see an increasing number of investors buying protected products.
The role of product manufacturers
When it comes to investment banks providing products, they provide several functions.
According to Cowperthwaite, the first and most important of these is to be the client’s conduit to a range of product which the client might want or be able to use.
This involves the intermediary showing clients what they might be able to do and giving them access to a range of products to do that.
He said this requires the bank to understand the client, their aspirations and risk appetite, and their knowledge of the underlying products. Until they have this understanding, Cowperthwaite said they are unlikely to buy the product, plus it wouldn’t be appropriate for the intermediary to sell it to them.
Garry Frenklah, managing director and head of PIP and equity derivative sales for RBS Global Banking & Markets in South Asia, explained that in his role he speaks to existing and potential clients to initially find out their views and preferences.
He then tells them what trends are happening in the market. And at the end of this dialogue, the bank has a good idea of what type of product is most suitable for the client. The bank then creates, structures and prices the product before pitching it to the client – and hopefully winning and executing the deal, explained Frenklah.
According to Mansuri, one of the key aspects of product manufacturing includes deciding what wrapper is to be used.
For example, he explained, whether the product is being sold over-the-counter (OTC), in note format, or as a warrant, determines a product manufacturer’s operational set-up, the amount of risk they are taking, and even what level of taxation they will incur.
In addition to selling product to third-party distributors, a lot of intermediaries run their own proprietary business in the equity derivatives space, explained Mark Wightman, head of strategy, alternative investments for SunGard in Asia Pacific.
However, he added, while historically the banks have made a lot of money from directly trading either the underlying or the volatility itself for their own book, the market is seeing a shift – led by regulations – towards more client business.
In this part of the business, explained Cowperthwaite, to the extent that one client wants a position in one direction and another wants a position in another direction, then the banks will match these two positions, otherwise the intermediary takes on the risk and hedges it through active hedging with the market.
It is therefore not just the case that banks can create and sell product, added Wightman – they also have an ongoing duty to manage the relevant risk profile and make sure the bank itself is fully hedged.
Aside from being client-specific, equity derivative usage is also market-specific, added Cowperthwaite. Therefore, an intermediary’s role is also to develop specific products for the circumstances which exist in different markets for various investors, as well as to cross-fertilise those ideas across different markets.
In addition, intermediaries also play an important role in after-sales service, said Mansuri. This might require, for example, showing a daily mark-to-market price if there is expected to be any buy-back for a particular product.
When it comes to fees, Cowperthwaite explained that these are a necessary part of any structured product – in the same way they are necessary as part of any managed investment.
Those parties involved in building and managing structured products need to pay various fixed costs, as well as make the business worthwhile for themselves, he said.
At the same time, he added that it is has been interesting to see fees becoming more transparent since the financial crisis, with overall fee levels for the same types of structured products coming down. Investors should therefore be seeing more value being put into the structured product.
Factors affecting option pricing
According to Mansuri, there are various key factors which affect option pricing. First is the movement of the underlying stock price. So if investors are buying a call option and the underlying stock price goes up, the option gets more in-the-money, and vice versa for put options, he explained.
Secondly, he said, the strike price is an important factor in determining the option pricing. If the underlying is priced at 100 and investors are buying at-the-money, it is likely to be more expensive than if they were buying it out-of-the-money at 90.
Thirdly, time to maturity is an important factor affecting option pricing, said Mansuri. For example, three-year options are more expensive than one-year options as investors have more chance of making more money as an option-buyer with a longer maturity product.
Fourthly, he added, volatility is a key parameter in option pricing.
When volatility is high, explain Wightman, then someone selling options will get a much higher yield; when volatility comes down, the yields get lower.
Fifthly, said Mansuri, the risk-free rate plays a role in option pricing. So if interest rates are higher, the forward is likely to be higher, so call options will be more expensive.
In general, he added, people only understand the strike or movement in underlying price – they don’t understand the impact of things like volatility and the risk-free rate, which are important factors when pricing any options.
Mansuri said that another important element to understand when pricing options relates to the intrinsic value and time value.
For example, if the underlying stock price is at 100 and the strike is at 90, then there is intrinsic value of 10. The option price will then be 10 plus the time value, he explained. So if there are three years to maturity, the value of the option will be that much greater, perhaps 15 or 16.
Risks and issues when buying options
If investors are selling an option they need to understand the risks they are taking, said Schlossmacher. If they buy a structured product with a sold put option embedded then they also need to understand the additional risks like mark-to-market behaviour and issuer risk, he explained, which are added complexities that investors and advisers need to understand to ensure suitability.
Typically there is always a credit risk with an OTC option, added Mansuri. As a result, he advised investors to be aware of who the counterparty is, and whether it is financially sound, rated correctly and well-capitalised.
When Lehman Brothers went bankrupt with a number of structured products either sold by the issuer or which used the bank as the underlying, Mansuri said that a lot of advisers and banks got into trouble as investors didn’t know they were taking the credit risk on that issuer.
With longer-dated options, and also options which are essentially sitting in levered portfolios, the mark-to-market becomes a lot more important, said Anurag Mahesh, head of global investment services for Deutsche Bank Private Wealth Management in Asia Pacific.
As a result, he said advisers need to understand how the mark-to-market would behave under different market scenarios.
The other important thing, he added, is to explain things like path-dependency to clients. In some portfolios this is important, in others less so, so Mahesh said advisers need to have these discussions at an individual level.
Mansuri added that it is important to be aware that it costs individuals to buy options, meaning they effectively end up paying a premium – which is a cost investors need to be aware of.
It is also typically better, he said, to ask two or three counterparties for a quote, especially if the underlying is less liquid. It is important to get a range of prices, he explained, to ensure the final price is robust and efficient.
