15 Jul 2009, Matt Cameron, Risk magazine
The trades, also known as gap options or stability notes, allow dealers to offload gap risk (the risk the price of an asset will jump from one level to another without being able to hedge the move) accumulated on exotic books as a result of constant proportion portfolio insurance (CPPI) products and other derivatives trades. Dealers claim private banks and some institutionals are starting to enquire about the products after almost no activity at all during the financial crisis.
"There is definitely some interest in gap notes, and dealers will be consciously looking to sell these products to alleviate some of the gap risk being housed on exotic books," says one derivatives trader in London. "Dealers will get much better prices recycling the risk with investors than trying to offload the same risk in the interdealer market, where they will trade with other dealers with similar risks."
Gap trades typically pay a fixed spread above Libor as long as the underlying index does not fall by more than a given percentage in one day (from one closing price to the other; intra-day variations are not taken into account). The percentage is determined by structuring a put spread on the index and is usually leveraged. For example, if a trade is structured with a 90–80 put spread on the DJ Eurostoxx 50 index with 10 times leverage, and the index level drops below 90 to 85, the client will incur a loss of 50%. In this case the index has to gap by more than 10% for the investor to incur a loss. The most commonly used put spreads include 90–80, 85–75 and 75–65.
Gap notes were extremely popular before the financial crisis and were successfully traded by most dealers as the products paid a coupon above Libor and carried a risk that had never been realised. For example, on the Eurostoxx the worst daily move ever was –7.93% on October 19, 1987. Many of the notes were structured with a puttability feature (meaning the investor could sell the note back to the issuer at a set secondary market price).
As global equity markets started to fall steeply during the financial crisis many of these trades were not rolled over at expiry, while many investors opted to make use of the puttability features.
"Investors got out of these notes not because the trades were about to blow up but because of the exceptional intra-day trading movements witnessed in September and October last year," says the derivatives trader. "The realisation that a 10% to 20% intra-day move in some of the major indexes could be experienced scared a lot of investors. Gap notes then fell out of favour very quickly."
Meanwhile, the interdealer-broker market, another avenue through which dealers can recycle gap risk, was experiencing a severe lack of liquidity in gap options and prices soared. In 2007 the cost of a 90–80 put spread was quoted at around 30 basis points, while at the peak of the crisis, sources claim the cost was as high as 200bp.
Coupons currently priced in gap notes are still inflated compared with 2007 given the re-pricing of equities, and the trades still make sense, as most would only result in losses under far more serious circumstances than the crisis has produced, according to dealers.
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