At the beginning of 2017, Credit Suisse’s traders asked the performance optimisation working group, an internal committee, for the expansion of their global farm to speed up the calculation of prices and Greeks for their derivatives portfolio. Instead of more hardware, what they got in return from their quant team was an innovative and much faster pricing model for one of the most computationally demanding of their products, the two-underlying corridor variance swap.
Calculating prices and sensitivities of a global portfolio is as quick as the calculation of its slowest component. Reactiveness to price requests from clients is key to success in a market as fast paced as the structured products one in Asia. George Hong, head of Asia-Pacific quantitative strategies and global product head for equities modelling in Hong Kong, came up with a closed form solution that is between 80 and 120 times faster than the Monte Carlo simulation method – the standard pricing tool for exotic products.
The traders have welcomed the new tool, according to Jean-Baptiste Patois, head of Asia-Pacific indexes trading at the bank: “The new proposal from George is really great. The Monte Carlo method takes a lot of time to achieve high precision in risk output. Your theta and other Greeks can swing a lot. The first test results I saw were really fast and accurate, a big improvement from the existing method. The book is going to be much more stable.”
Hong says that, while there have been closed-form solutions available for single-underlying corridor variance swaps for some time, it has taken awhile for the market to move beyond this.
“Despite the interest in the market in the past four to five years and the prominence of the new product variant, there hasn’t been a single paper on two-underlying corridor variance swaps. What we were able to devise is a new valuation approach that has a number of advantages, the headline being its speed and risk stability,” explains Hong.
The pricing model is speeding through the internal testing and validation process and there are plans to integrate it into Credit Suisse’s pricing and risk management systems in October.
This achievement is an example of the fruitful interaction between the quant team and the traders, facilitated by the bank’s structure. “The unusual part for us is the core role our Asia quant team plays within the global setup. Both our global head quants for equities and foreign exchange are based here. This reflects our strength in structured derivatives in Asia-Pacific markets, where having our quants work closely with trading and structuring on product development gives us a real edge,” says Brian Chan, head of Asia-Pacific markets solutions and head of platform management at Credit Suisse in Hong Kong.
The team headed by Hong is well equipped for promptly providing solutions to the business. “Credit Suisse has a very deep bench of modelling and technology quant talent in Asia, one of the biggest on the street. The team has a unique mix of senior quants who have worked in the past in US or London with 10 to 20 years of experience, combined with strong juniors that we were fortunate to build up by tapping into the Chinese talent pool in recent years,” he says.
The structure of the two-underlying corridor variance swap is similar to that of a standard single-underlying one, with the difference being the realised variance of one underlying is accrued only when the level of the other underlying is within a predefined range, or corridor. Typically the first underlying is the liquid SPX and the other is an Asian or European index. The product, pioneered by Credit Suisse and launched in 2012, received wide recognition and created a new market, which most major banks joined. It is now so popular that some players say it is overcrowded and margins are too small to be attractive.
It is widely used because it is seen as a win-win trade between dealers and investors. On the dealer side of the business it constitutes a natural hedge for the vega exposure of its structured products business – primarily autocall notes and uridashi. “With the corridor variance swaps one can recycle vega exposure in quite specific ranges of markets levels, which fit much better with the profile of the vega imbalance coming from structured products desks in general. From a risk management point of view, this is a key product to enable us to maintain client service in the retail business,” says Chan.
On the investor side, it allows clients to build profitable positions across different markets. “The main attractiveness of the switch corridor variance product is that investors can trade the relative premium/discount of volatility between indexes, on specific parts of the surfaces. That provides attractive trading opportunities bridging two distinct volatility markets,” says Hong. In practice, a client would enter a value trade by taking a long position on the variance of a market with a low spread between implied and realised volatility – such as Asian or European indexes – while taking a short position on the variance with high realised versus implied volatility, typically the SPX.
This view is shared by clients. “Credit Suisse was frontrunner in that trade; they have produced a new payoff to hedge their underlying structured products risk and at the same time provided value to us,” says a quant portfolio manager at a hedge fund in Hong Kong.