Sie sind auf Seite 1von 9

39-47_SD_DRV_2011

23/5/11

09:39

Page 39

Trends in the use of exotic OTC


derivatives
by David Collins, SuperDerivatives

It is late 2008 and the world of finance is about to change forever.


Until then, most people had no idea what an exotic derivative or option
was. Then the financial crisis hit and derivative became a dirty word as
confusion reigned as to the cause of the crisis.

Fast-forward three years and the bonfire of the options has

One of the recurring themes over the last 18 months or

not transpired. Over-the-counter (OTC) derivatives continue

so was the strengthening of well-performing emerging

to be used and serve a useful purpose in managing risk,

economies at the expense of the USD. Local exporters find

portfolio construction, market efficiency, price discovery,

their operational margin squeezed as they receive lower

capital raising and in balance sheet management.


Now we sit in the post-Lehmans world and the reality has

amounts of local currency in exchange for their dollar


receivables. This was of course the main drive for hedging.

sunk in, that it was the poorly executed use of some of


these instruments, and not the instruments themselves,

To give an example, a Brazilian exporter will purchase a


strip of put dollar call Brazilian real (BRL) options and then

which were at fault.

finance that hedge by selling some exotic risk (in other


But what for the future? In this chapter we examine how

words receive premium that they would use to purchase

exotic OTC instruments are being used today, based on


the vanilla option).
each asset class, and how we anticipate their use evolving
in the new paradigm.

They will sell instruments like partial barrier knock-ins

By its very nature, there are different levels of

(PBKIs) or sell European knock-in options in the opposite

sophistication within the derivatives space and in part the

direction. Typically this trader likes selling these options

best definition of exotic is by defining what it is not. For

as they are activated only if a certain level is met and only

our terms of reference, we take an exotic derivative to be

during a specific period (partial barriers) or only on expiry

anything which is not a vanilla hedge or a vanilla strategy.

date (European knock-in options).


As local currencies have strengthened, some people are

Foreign exchange

purchasing back the options they sold because they are so

In FX we are seeing a lot of activity from the classic hedger

out of the money and therefore much cheaper than when

who wants to protect against adverse movements in their

initially sold. If you put that hedge on six months ago, you

FX exposure by purchasing a strip and financing this

would be in very good shape now. Buying back these

purchase by selling some exotic risk.

options would also free credit exposure limits.

CHAPTER 2 I EUROMONEY HANDBOOKS

39

39-47_SD_DRV_2011

23/5/11

09:39

Page 40

Then we still see people looking at basket options as well

We believe the main driver in the market at present is in

as target redemption notes (TARNs). From the investors

fear of inflation and the deficit in the US and people will

side we see people using correlation products to cheapen

continue to invest their money in places perceived as

the initial cost of investments they make.

inflation safe-havens such as the Swiss franc (CHF),

If an investor thinks that both the BRL and the JPY are going
to strengthen against the USD, they can choose to buy a call

Investors will be looking to emerging markets for value and

options on these currencies.

growth. We have experienced unprecedented volatility in

A cheaper and more elegant approach would be to use a

silver trading over the last couple of weeks. The best trade
was to buy gamma at any level as the spot rate moved up

Dual European Digital option. As long as the correlation


between USD/JPY and USD/BRL is less than one (i.e., they
are not fully correlated), this strategy could offer appealing

to US$49 an ounce before crashing to US$33 a couple of


days later, and is now trading at US$37.60 (at time of
going to press).

risk/reward ratios. These types of transactions are


common with hedge funds in London or Singapore,

The CNY and BRL will continue to strengthen. There is

for example.

also event risk floating around, not least triggered by the


ongoing turmoil in the Arab states.

In a similar way, one could construct a basket with

40

gold, and silver.

currencies. This type of multi currency-pair basket can be

More investors will look to more fat tail investment

made up with as many currency pairs as required and

strategies, following the lead set by people like

introduces exposure to implied correlation. These

Naseem Taleb. It will also be important for users of

transactions are being driven by the investors rather than

exotics to be aware of the affect of Black Swan events

the hedgers a new breed of participants in the FX markets.

on existing positions.

The variation of USD/BRL and the 10-year USD swap

Exhibit 1

4.00

2.00

3.50
1.80
3.00
1.60

2.50
2.00

1.40
Jul

Oct

2010

Apr

2010

Jul

l S1: USD/BRL spot, close 1.6201

Jul

Oct

Jul

l S3: USD 10Y swap rate

Source: SuperDerivatives SDX platform

CHAPTER 2 I EUROMONEY HANDBOOKS

2011
2011

Apr

39-47_SD_DRV_2011

23/5/11

09:39

Page 41

After the earthquake, the CNY to USD level went down to

the system and requirements, in addition to a pickup in

mid-76. Many felt that one of the reasons for the break

volume, contributed to a healthy return in participants

was that digital barriers were hit on the way down which

to the market.

triggered changes in exposure. People were expecting


Japan to repatriate money for the rebuilding efforts as

This in turn led to increased liquidity back into the single


name, index and tranche trading space. Risk appetite

well as households looking for cash.

picked up for sovereign names, particularly in the Eurozone


It was at this point that the central banks intervened.

with a focus on PIIGS (Portugal, Ireland, Italy, Greece and

One way to benefit from this sharp move was to buy a


Spain). More recently, with continued unrest in the Middle
three-month no-touch USD/JPY option struck at 75 when
the exchange rate hovered around the 77 CNY to USD level,
betting on an intervention and that 76.50 would be the
bottom for a while.

East the number of contracts traded on sovereign and


corporate names have reached an all-time high.
However, we can see that the one size fits all notion for
the Euro sovereign crisis no longer holds true, with a clear

Credit derivatives

divergence appearing from March 2011 between Greece/

Since 2008, and the subsequent liquidity rush on the

Portugal and the other countries of the EU.

banks which amplified the issues in credit markets,

We have also seen continued innovation in the

we have seen a return in the use of credit instruments.

development of alternative credit instruments with the

2010 was a relatively good year for credit investors and the

recent launch of credit event binary options (CEBOs),

credit default swap (CDS) market in general. Less stress on

as well as Chinas credit risk mitigation warrants (CRMW).

Historical analysis of the PIIG countries: Jan 10 May 2011

Exhibit 2

1500.00

1000.00

400.00

500.00

200.00

0
2010

Mar

May

Jul

2010

Sep

Nov

Jul

l S1: Portugal, senior, restructuring, USD, 5Y


l S3: Italy, senior, restructuring, USD, 5Y

2011

Mar

2011

l S2: Ireland, senior, restructuring, USD, 5Y

l S4: Greece, senior, restructuring, USD, 5Y

l S5: Spain, senior, restructuring, USD, 5Y

Source: SuperDerivatives SDX platform

CHAPTER 2 I EUROMONEY HANDBOOKS

At-the-money volatility

At-the-money volatility

500.00

41

39-47_SD_DRV_2011

23/5/11

09:39

Page 42

supermodel

superderivatives.com

39-47_SD_DRV_2011

23/5/11

09:39

Page 43

ROBUSTA
CALL
makes morning
latte possible

SOYBEAN
COLLAR
makes soy milk
in morning latte
possible

COTTON
OPTION
makes
fashionably
grungy
t-shirt
possible

JET FUEL
STRIP
makes shopping
trip to Milan
possible

GOLD
ACCUMULATOR
makes
wrist
bling
possible

PLATINUM
CONTRACT
makes ring
bling possible

ENERGY
SPREAD
makes
limo ride
from airport possible

superderivatives

superderivatives
pricing | analysis | structuring | trading | risk management

39-47_SD_DRV_2011

23/5/11

09:39

Page 44

Taking positions in CDS is expensive and requires a

of being a cyclical market and are heading for the heavens.

significant level of investment and both CEBOs and CRMWs

Then came the events of the start of May 2011 when

have created an avenue allowing investors to gain

commodities across the board experienced the biggest

exposure to a more simplistic and affordable way of

weekly slump since 2008.

participating in the credit markets.

The commodities rout knocked US$99bn off-market

These are just some of the more recent exotic structures

value, driving out speculators. Some of the biggest

that have been introduced to the market and one expects

commodities-focused hedge funds and exchange traded

more to follow.

funds (ETFs) racked up huge losses in just over 24 hours.

From the structured finance perspective, weve seen core


stability take place over the last 12-18 months, which has
brought an increased appetite for both asset-backed

savviest of investors in commodities were wrong-footed


by one of the sharpest one-day falls on record.

securities (ABSs) and commercial mortgage-backed

Given the flood of investors funds into commodities during

securities (CMBSs) although residential mortgage-backed

the boom, and the growing use of commodities as

securities (RMBSs) will seldom see any new issuance over

collateral to finance speculation, the May 2011 slide was

the near term.

evidently a self-inflated bubble deflating a little, in line

So far for 2011, the US growth outlook has brightened with


macro indicators coming in stronger than expected and a

44

The scale of the losses demonstrated that even the

pickup in both earnings and the market as a whole.


Investors are more inclined to go long in equity and short
in credit. Linked to this, the rating agencies are not
downgrading as many corporates as expected, which in
turn has led to a reduction in default probabilities.
Then there is the ongoing matter of the maturity wall due
to hit in 2013 and 2014 when a wall of issuance debt will
mature stemming from the 2008 crisis. Corporates had
originally feared they would have to refinance their debt

with mass-psychological dynamics. In a nutshell, investors


took flight and many got hurt.
Taking a position in commodities is not for the fainthearted and there are lessons to be learned from the
events of early May. Those looking to hedge against large
movements in commodity prices tend to be more creative
than submitting to a linear price lock-in.
Investors who are long should be cautious. This isnt a
one-way street and they should think about locking in
some protection. Corporates who supply commodities
need to think about locking in current prices and
lengthening the terms of their hedges.

at much higher rates.


However, the issuance of junk bonds during 2010 by many
lower-rated corporations has seen almost US$200bn of
fresh capital raised, enabling the refinancing of the
impending short-term maturities to take place.

Corporates who buy commodities are starting to transition


from linear hedges to strategies that give protection
against future price rises but also allow them to benefit
from falling prices. We believe the option premium will be
worth it over time.

To conclude, with the crisis behind us and more regulation


and transparency ahead, the focus will shift in 2011 to the
Dodd-Frank Act, which in and of itself could redefine the

According to a recent survey of manufacturers, over 80% of


senior executives said commodity price risk is important to
a companys financial performance, adding that commodity

OTC market as we see it today.

risk was not managed well during the past two years.

Commodities

Companies try with varying levels of success to apply

Market watchers would be forgiven for thinking that

solutions to help them manage commodity price risk and

commodities have broken out from the traditional wisdom

their exposures.

margin management, procurement strategies and hedging

CHAPTER 2 I EUROMONEY HANDBOOKS

39-47_SD_DRV_2011

23/5/11

09:39

Page 45

One of the most significant trends of current times is the

This means that most lines between counterparties are

use of commodities in structured products previously

going to low threshold daily posting for non-centrally

reserved only for equity investors. This is illustrated by the

cleared interest rate derivatives trades and also across

increasing sale of, for example, up and out call options on

other asset classes.

WTI, worst of knock-in puts on corn, soybean and sugar


and even cliquets based on the performance of gold by

At the same time, the regulators are pressing to have

leading investment banks.

swaps and other instruments centrally cleared through


central counterparties (CCPs) such as LCH.Clearnet and

Investing professionals and corporations need to focus on


ensuring that they have calibrated tools and pricing

the CME Group. These bodies would manage the

mechanisms to first price and then manage the exposures

collateralisation process and would run with frequent

and risk associated with handling these instruments.

posting and very low thresholds, in effect similar to the


terms of margin posting.

The key to managing commodities exposure and risk is to


employ the optimum tools, data and analytical capabilities

Financial markets are moving to a position where

to manage both the spot instruments and related hedging

institutions such as hedge funds which use interest rate

instruments, such as OTC derivatives based on commodities.

derivatives like interest rate swaps will probably have them

Customers need to correlate commodities versus

all centrally cleared, but more exotic options will remain

commodities and currencies versus commodities and use

privately cleared with the dealer or agent who sold them.

these correlations to price, analyse and re-use options on

Privately negotiated collateral agreements which will likely

baskets of commodities.
require collateral to be posted must be held in a specific
account which earns overnight interest, rather than the

Interest rates

current London Interbank Offered Rate (LIBOR) rate.

The landscape for interest rate derivatives has changed

It is also highly likely that centrally cleared instruments

beyond all recognition over the past few years since the

will use overnight interest on accounts also. Earning

financial storm of late 2008 and subsequent events.

overnight interest rather than LIBOR has an impact on how

The biggest overriding factor in interest rate markets has

institutions value an interest rate swap.

been recognition of overnight index curve swap (OIS) as a


means of discounting swaps.

As the definition of the value of an interest rate swap, is


the sum of the present values of all its future cash flows,

The legislation coming out of the various regulatory bodies

the interest rates used to determine this should be tightly

is pushing to have instruments such as swaps centrally

linked to the real cost of the derivatives user, or dealer,

cleared and this is leading to a fundamental change in how

for funding those positions.

interest rate derivatives are valued.


In the old world it was simpler to build a forward-looking
Pre-crisis, some derivatives trades were collateralised and
LIBOR yield curve to project future rates and discount
some were not. This meant that a customer of a particular
investment bank, for example, would have a line and a

cash flows.

high threshold.

Now if a counterparty posts collateral against a swap,

All counterparties be they banks, hedge funds or

then the real cost of funding that position is the overnight

corporates are all much more concerned about credit

interest rates, not LIBOR. So if an institution wishes to

risk, and non-corporate derivatives trading is now much

project LIBOR forward rates, they also have to discount

more tightly collateralised, typically with low thresholds.

them back, based on overnight interest rates.

CHAPTER 2 I EUROMONEY HANDBOOKS

45

39-47_SD_DRV_2011

23/5/11

09:39

Page 46

This effectively creates a two curve world and is much

Prior to the collapse of Lehman Brothers, the trend led

more complicated, requiring institutions to build two

chiefly by the French banks had been to create increasingly

curves dependent on each other. Essentially this is

complex options, usually with higher margin associated.

rebuilding the LIBOR curve so that when you discount

Most of the traders were recycling these risks (volume or

overnight rates you get back to the correct market

correlation) by dealing light exotic instruments with

swap rate.

hedge funds (mainly vol-arb funds).

The sell side already has this infrastructure and systems

The financial crisis, by generating massive losses for exotic

to cope with this change but the buy side does not.

books, has revealed a deadly mismatch between the risks


created by clients trades and the hedges put in place to

So, for example, if a big insurance company which uses


derivatives and has an interest rate trade with a large mark
to market value, and their system can only discount on

cover these risks. The best example has been hedging worst
off put (embedded into reverse convertibles, auto callable,
etc) with vary swap dispersion or correlation swap.

LIBOR, then the value they get for that trade could be
significantly different from the value a dealer would ask or

46

pay to terminate that trade.

The future for exotic options

The old way of valuing swaps does not work anymore and

Exotic options are now making a comeback in popularity

the new world has been created by the need for people to

but in a different form. They are less diverse than before

insulate themselves against credit risk.

and more commoditised: banks focus on creating


variations or tweaks around a smaller family of popular

As a result, were seeing more demand from customers to


get valuations based on overnight interest rate discounting

exotic options such as auto callable, look back and worst


off options, but the risks remain the same.

and we expect this to continue.


The regulatory environment has in turn pressured
investment banks to limit the complexity of structured

Equities

products, which has led to less complex exotic options

The equity exotic options market remains by far the most

embedded in these products.

advanced one among all asset classes in term of

As the liquidity has fallen off in complex instruments,

sophistication, innovation, nature of the risks involved

traditional investors have moved away from this market

and modelisation.

and been replaced by global macro funds that trade light

Exotic options are mainly driven by the structured product

exotic options to express a directional market view.

market, with both retail and institutional clients seeking

This standardisation of the structured product market and

investment products with bespoke market view and which

the subsequent increase in exchange traded products has

offer better risk/return ratios.

led many to assume that exotic options have become

On the one hand, structurers from investment banks


are regularly tasked to deliver new and highly
sophisticated exotic options. On the other hand, managing

simple flow options: these options remain challenging to


manage and can potentially create further massive losses
for many unsophisticated (new) players.

exotic options can be extremely challenging for traders;

Going forward, the market is now moving towards

there have been many cases over the years where banks

greater transparency for end clients in order to increase

have incurred large losses on their exotic books due to

the volume of structured products, together with a

issues in pricing forward skew or just hedging correlation

broader universe of underlyings, giving better access to

risk effectively.

illiquid markets.

CHAPTER 2 I EUROMONEY HANDBOOKS

39-47_SD_DRV_2011

23/5/11

09:39

Page 47

At-the-money volatility

World Trade index

Exhibit 3

100.00

50.00

Jul

2008

Jul

2008

2009

Jul

2010

Jul

2010

2009

2011
2011

l S1: Crude Oil (WTI) nearest at-the-money implied Vol 45.45636

Source: SuperDerivatives SDX platform

47
We also expect to see more development on the hybrid

Over the last few years we have seen the emergence of

options side (effectively options with multi asset classes as

FX and commodities as investment asset classes and this

underlyings, including equity components), as it will help

gives investors greater opportunity to seek

to diversify traders risks.

outperformance. To this end, we think there will be a


continued growth in X-asset derivative products as well as

To this effect, the largest sell-side institutions have been

instruments that allow investors to play the relationships

investing and will continue to invest in the creation of

between asset classes such as equity and credit.

teams of hybrid exotic traders, structurers and sales desks


Far from being the weapons of mass-financial destruction,
to meet the increasing demand among investors and
hedgers for these instruments.

exotic derivatives have proven their ability to create


exposure and relationships that would be impossible with

Take for example an investor who believes that both

pure vanilla instruments.

the USD, gold, sugar and WTI will all simultaneously


continue to fall. The investor could increase his/her

Contact us:

leverage through the purchase of a worst off basket and

SuperDerivatives

magnify this leverage still further with the inclusion of a

St Mary Axe, 33rd Floor, London EC3A 8EP, UK

knock-in barrier.

tel: +44 (0) 20 7648 1050

The lower the intra-asset correlation and the higher the

web: www.superderivatives.com

number of constituents in the basket, the more risk and

e-mail: sales@sdgm.com

therefore return the investor can take on.

CHAPTER 2 I EUROMONEY HANDBOOKS

Das könnte Ihnen auch gefallen