Equity derivatives house of the year: Societe Generale

Risk Awards 2018: From geometric dispersion to fund derivatives, the French bank combines popular products with risk recycling strategies

Peter McGahan

The winds of change blew through world equity markets this year. The acceleration of the bull run across all regions, coupled with some choice volatility events, provided favourable conditions for an upswing in retail and institutional demand that Societe Generale Corporate and Investment Banking (SG CIB) took full advantage of.

Evidence the French bank has enjoyed a banner year is reflected in a welter of performance measures. Sales of light exotics, such as variance and correlation, have increased 20% year-on-year, structured note issuance by 25%, and Societe Generale Index (SGI) assets under management by 25%.

Clients testify to the bank’s continued excellence in the asset class: “What I’m used to saying is there are Tier 3, Tier 2, Tier 1 banks, and then there’s SG – they are in their own league. You expect the best from the leader, and they do get better year after year,” says the portfolio manager at one large European investment firm.

Yet it is the story behind the numbers, and the platitudes, that explains why SG CIB is a worthy winner. The equity derivatives business is becoming ever more commoditised. Structured product issuers cluster around the same narrow selection of trades popular with retail investors, while innovative exotic structures cooked up by one investment bank are quickly copied, packaged and sold by their rivals to the same pool of sophisticated funds.

In such an environment, a “me too” approach will not distinguish a bank from the field. Nor will being first to a trade, especially if an issuer fails to sustain attractive pricing, or fails to match the trade to the appropriate client base.

SG CIB has charted a different course. This year, the bank identified the same popular market trends as other dealers, but instead of piling in with copycat products, crafted superior trades that added value above and beyond that offered by the competition. It has also made a conscious effort to expand the market for its range of structured exotic trades away from the usual suspects, creating new outlets for the flow of complex risks it accrues through the sale of directional products to retail investors.

“We have had more success with new client types than historically. Asset managers and pension funds, among others, are expressing interest in risk premia and risk recycling product types – that has been a factor of our business growth for 2017,” says Peter McGahan, global co-head of sales for equities and derivatives at SG CIB.

Take one of the blockbuster trades this year: dispersion. The election of President Donald Trump in November last year fired the starting gun for a sector rotation in equities, with institutional investors ploughing into financials, industrials and defence stocks, among others. As cash sloshed from one group of stocks to another, the volatility profile of individual shares started to deviate wildly from the index average, opening up attractive opportunities for fast money firms to juice returns from this disconnection.

Our inventory of covariance risk on single stocks has increased and given us greater appetite to recycle these risks

Kokou Agbo Bloua, SG CIB

Several banks pounced on the opportunity, packaging trades that put clients long single-stock volatility and short index volatility. SG CIB, however, went to the market with a more sophisticated refinement, offering long exposure to a selection of single names coupled with short exposure to the geometric mean of this selection.

This tweak removes the basis risk that adds noise to the traditional trade. Instead of a bundle of single stocks being traded against the index, here the buyer is axed long volatility on the single stocks and short volatility on the geometric mean of the same names. Extraneous stocks are excluded, sparing the client volatility exposure unrelated to their chosen names.

The geometric basket is also equally weighted throughout the life of the trade, again providing a more attractive payoff versus the traditional product, where the short volatility exposure references a market-cap weighted index and therefore understates the volatility contribution of certain names and overstates others.  

This structure also allowed the firm to transfer covariance risk – the risk that returns of two assets move in tandem – that perfectly mirrored the risk the bank has in its structured product book.

Kokou Agbo Bloua, global head of flow strategy and solutions at SG CIB, says there has been a greater issuance of retail autocallable products referencing single stocks relative to those referencing indexes in 2017. This is a function of shrinking coupons afflicting the latter, in response to selling pressure on long-term index volatility caused by the mass issuance of these products in prior years.

While the single stock versions are popular with clients, they pose a headache to dealers that often find it harder to hedge these positions. Offsetting exposures to single-name volatility can be difficult to source in bulk, and a traditional dispersion product can force a dealer to give away more than they bargained for through the short index leg. However the geometric dispersion products gave the bank a risk recycling avenue.

“Our inventory of covariance risk on single stocks has increased and given us greater appetite to recycle these risks. We’ve been actively promoting the payoff to new clients. In the past, it used to be the vol-savvy hedge funds that were the only ones in this trade, but this year we’ve expanded that market,” says Bloua.

We distribute part of the hedging portfolio to banks that don’t cover the same clients we do, meaning we get to control our global notional under management, and they get access to an exposure they didn’t have before

Richard Quessette, SG CIB

SG CIB shifted around $10 million of vega, or sensitivity to volatility, of geometric dispersion throughout 2017. It was typically done with a handful of hedge funds in Europe and US in clips of $500,000–$750,000 of vega, building up large concentrated positions at the bank as the year wore on.

The French bank’s desire to become a leader in dispersion is born out of its obsession with its risk recycling franchise: the engine that powers its huge public distribution business. Throughout 2017, the French bank directed its team of financial engineers to design products for institutional investors that would offset risks generated from the sale of freshly minted equity derivatives sold to retail investors.  

One success story concerns the bank’s sale of call options on mutual funds, popular this year in Asia. The products consist of a zero-coupon bond, which provides protection of capital upon maturity, coupled with a call option linked to the value of a fund. If the fund’s value has decreased at the time of maturity, the call option becomes worthless, but there is still a return on the initial investment from the zero-coupon bond. If the value increases, the option is triggered and usually settled with cash.

Issuers have lowered the cost of these products by creating volatility-control overlays, which cheapen the call options at the expense of some upside to the end client.

The writing of these options loaded SG CIB with a short volatility position on a select number of mutual funds. To offset this position, the bank designed a new type of variance swap that would pay it the realised volatility of the funds above a cap, mirroring the vol-control overlay.

The variance swap proved a hit, with SG CIB selling around $10 million of vega, representing 75% of the short position it had accrued from the sale of $2 billion notional on the fund-linked products.

Key to its appeal to institutional clients was the risk-return profile, with the French bank drawing on the historical performance of the fund to set an entry and cap level that would make the probability of the trade going underwater for the client remote.

“They are fast to innovate and are always trying to find the best way to hedge the risks on their massive books, while trying to find an interest for the client as well,” says the portfolio manager at the large European investment firm.

We are clearly seeing a transition from over-the-counter black boxes, where the client cannot really understand the pricing and marking of these things, to a transparent process where they can be observed

Peter McGahan, SG CIB

Beyond the sale of exotic derivatives, this year SG CIB expanded its risk recycling activities to include the wholesale syndication of autocallable vega, dividend, and correlation risks not to asset managers or hedge funds – but to other dealers.

It may sound strange for a bank to willingly give up part of its hard-won autocallable book to rival banks, but through this initiative SG CIB is playing the long game. 

“It’s a win-win for us and the partner banks. We distribute part of the hedging portfolio to banks that don’t cover the same clients we do, meaning we get to control our global notional under management, and they get access to an exposure they didn’t have before,” says Richard Quessette, global head of equities and derivatives at SG CIB.

To get to this stage, the French bank established a legal framework within which interested counterparties could bid on the hedging of autocallable portfolios originated by SG CIB. Part of the recycling was linked to specific fixed-dividend indexes, an in-vogue product. Globally, SG CIB has recycled more than $1 billion of its autocallable risk through this platform.

Geopolitics

It’s not only in the business of risk recycling that the bank has demonstrated unconventional thinking. It also departed from the herd in trading around the most fraught geopolitical event of the year: the French presidential election, which pitched the centrist Emmanuel Macron against the populist nationalist Marine Le Pen.

Market participants, anticipating a shock result in the mould of the UK’s vote to leave the European Union or the election of US President Donald Trump in 2016, rushed to purchase downside protection to guard against a Le Pen victory, causing the premium for structured puts on European stocks to soar. SG CIB offered institutional investors an alternative option: cheap access to an expected market rally in the event that Macron was elected instead.      

“The innovation we brought to the table was a bullish strategy where the client bought calls on the Euro Stoxx, contingent on the VSTOXX April futures [contract] staying above 22 vol points. The expiry of the futures occurred before the election above this level, so when markets rallied, our clients exercised their call options and gained the best return of any trade made around the election,” says Bloua.

Structuring the calls to knock-in contingent on the performance of Euro Stoxx volatility allowed SG CIB to shave 55% off the premium, and after the election, clients exercised their options for a handsome 400% return on their investment.

Structuring expertise

SG demonstrated its structuring expertise can be applied to hedging as innovatively as it is to speculation in a landmark deal with a Tier 1 UK pension fund. The fund sought an efficient, transparent derivatives overlay for both its US and European equity portfolios – with a combined notional of $1.5 billion – that would minimise future drawdowns, maintain upside and smooth trading of the hedging instruments over the course of each day.

SG CIB leveraged its risk premia capabilities to design two rule-based indexes that replicated the performance of a systematic enchanced collar strategy – one each for the US and European portfolios – and entered into a swap with the client to provide economic exposure to each.

Insight to the pricing of the options it was implicitly buying and selling through the indexes was key for the client – a demand becoming ever more common across institutional players.

“We are clearly seeing a transition from over-the-counter black boxes, where the client cannot really understand the pricing and marking of these things, to a transparent process where they can be observed. The best way of achieving this is through using listed derivatives. This is where our engineering and structuring innovation combines to distinguish ourselves against the competition,” says SG CIB’s McGahan.