Some of the strongest demand in the structured note market this year has come from investors looking for an interest rate play with an inflation hedge overlay. BNP Paribas' outstanding achievements in hybrid inflation/interest rate notes, combined with its across-the-board performance in hybrids generally, makes it a worthy recipient of two awards: house of the year, hybrids and house of the year, interest rates. It's important to note that this is the first time in the two years Structured Products has been running awards that a structurer has won both these awards categories. It's also the second year in a row that BNP has picked up our hybrid award.
Toward the end of last year the bank produced the first ever 'Logic' note linked to Belgian inflation (Logic stands for lower of geared inflation and constant maturity swap (CMS) spread). "It was also the first exotic ever traded on Belgian inflation," notes Kara Lemont, the bank's London-based European head of interest rate and foreign exchange structuring. The client felt that interest rates would rise and so wanted to invest in fixed-rate paper.
The first port of call was to look at a CMS spread product, but the straight steepener did not pay enough of a gearing. Also, capping the product at the Euribor rate, which was relatively steep, did not produce as much value as the client would have liked. "One product on which we had previously executed a lot of business was a CMS spread capped at the 10-year rate plus, which was a way of getting the higher gearing on the CMS spread - by capping it at a rate that would then move up if rates moved up. Clients were quite comfortable with that. This was a spin-off of that product," Lemont says. But rather than capping the interest rate, BNP instead looked to the inflation market. Although it was generally taken as a given that a rise in interest rates would be accompanied by a rise in inflation, the Euribor curve was still much steeper than the HICP inflation curve. The bank therefore introduced a cap on the flatter inflation curve, which enabled it to pay a gearing on the CMS steepener of 10, rather than the five of a classic steepener.
However, the client did not want a product linked to European inflation rates, but rather to the more esoteric and highly illiquid Belgian rate. "The Belgian market wasn't that liquid, but we decided to take the correlation risk between Belgian and European inflation," Lemont says. Other houses may not have been comfortable warehousing the spread risk between the Belgian and European inflation rates - indeed, others may not even have been comfortable with the correlation risk between the CMS rate and the inflation rate - but BNP Paribas feels its modelling and analysis can more than cope.
"There's a lot of volatility and correlation at every point in time on that product," Lemont says. The bank sold EUR30 million (EUR20 million in swap and EUR10 million in note format) worth of the product to its client, where it paid 5.2% for the first year and thereafter 10 times to the 10-year minus the two-year CMS spread, capped at 250% of Belgian inflation.
The bank also broke new ground with a number of other inflation and rates products. Last November, for example, it executed a EUR50 million inflation-capped Euribor - Ice - note for Royal Bank of Scotland. Again, by capping at a gearing to inflation the client was able to get a large pick-up over the Euribor rate. The 10-year note pays a coupon of Euribor plus 50 basis points, capped at 150% of the annual inflation rate. BNP Paribas says that since it launched its first European Ice transaction, the market in European Ice notes has exceeded EUR3 billion. "We kicked that market off, then a big wave of these products appeared on the market in the first few months of this year," Lemont notes.
Excellence across the board
As well as producing some of the most innovative interest rate notes over the past year, which happen to be hybrids by tying in an inflation play out of necessity, BNP has also shown across-the-board dominance in all areas of the fast-developing hybrid market.
For example, before the increase in global commodity market volatility kicked off earlier this year, BNP's private banking arm asked the trading side to come up with a product that would give its wealthy clients diverse, cross-market exposure that could act as a safety net if markets started to look shaky. The bank came up with a note that consisted of a commodity basket linked to oil, gas, aluminium and zinc, and an equity basket made up of firms that would benefit from a fall in commodity prices, such as companies from the pharmaceutical, car industries and large retailers. Aluminium and zinc were chosen because of their fundamentals and forward curve backwardation (when many commodity markets were in contango), while historical analysis showed that the two underlying equity and commodity asset classes are generally negatively correlated.
The capital-guaranteed product, branded Phoenix, delivers a 4% fixed coupon in the first two years and then a 6% coupon until maturity, provided the commodity level is higher than strike. If the commodity basket falls below its initial level then a substitution takes place, where the coupon paid varies depending on the performance of the equity component. The bank says it has sold over EUR50 million of the product.
Another product based on a diverse basket of underlyings is TrendSpotter, which the bank describes as its biggest commercial success of the year. It consists of a basket of equity, commodity, real estate and interest rate exposures, overlaid with a systematic momentum-driven asset allocation process. The product offers capital protection plus 122% gearing of the performance of the TrendSpotter strategy.
Every six months, the mechanism re-weights the underlying indexes (which can be tailored to suit the client) in favour of the top performers, with 50% allocated to the best performing index, 30% and 20% to the second and third best performers respectively. The idea is to capture bullish trends in each asset category, thereby replicating mechanically active asset management. Products like this seem to be the way forward. "People want to see these slightly more managed products," Lemont says.
Among others, the bank sold TrendSpotter to a leading European insurance company. "We put under competition three different counterparties, and the service we received from BNP was pleasingly professional, and also in terms of pricing they were quite aggressive," the client says. "They are certainly innovative with these types of trades."
As well as coming up with interesting product variations, BNP Paribas' success in the hybrid market also has a lot to do with its quantitative and modeling expertise. The classic difficulty with hybrids is modelling the joint distribution between a number of underlying assets, because there are an infinite number of ways - called copulas - to join marginal distributions, and each gives a different price. BNP has developed its own proprietary copulas.
The traditional way to bring together the different asset class smiles in order to price a hybrid is to use Gaussian copulas. "But you find that you don't get the best tail dependencies with these," says Chris Hunter, one of the bank's London-based hybrid traders. "If the markets aren't moving that much then correlations are fairly low between underlying assets, but as soon as something extreme happens everything moves in the same direction at once. That type of effect is what we're able to capture in the proprietary copulas that we've developed," Hunter adds.
With its market-leading pricing technology and hybrid structuring expertise, BNP Paribas looks set to be a key player in this growing market for some time to come.
WHY BNP PARIBAS WON
BNP Paribas has executed a number of innovative interest rate transactions that tie in an inflation play to give clients superior performance. Meanwhile, its ability to price and structure complex hybrids and come up with new payout scenarios gives it unmatched dominance in the hybrid field.