Drop in volatility prompts move to exotics

The drop in equity implied volatility levels is making it harder to offer yield enhancement products, says Harold Kim, Hong Kong-based Citigroup managing director, speaking at a structured products forum in the Special Administrative Region.

The use of exotic options has been a feature of the structured products market since volatility levels on global equity indexes started falling dramatically in July 2003 to the current 10-year lows.

“The biggest issue facing traditional product structures is the fall in volatility. The implication is that yield enhancement products are harder and harder to do. The seller of the option, which is the investor in the structured product, has to sell more exotic options,” says Kim.

So far, most structured products have either principal- or non-principal protected features that incorporate vanilla put or call barrier options. However, the use of exotic options, such as quantos and barrier knock-in and knock-outs, is becoming a norm.

“A few days ago, we transacted a Hong Kong and Malaysian stock basket quantoed into Australian dollars,” says Kim. Other examples of exotic structures that Citigroup has conducted include a daily accumulator knock-out swap and a 70% knock-in at-the-money put note, according to Kim, who adds: “These days, these products are almost vanilla trades.”

There are two reasons why volatility is low, namely perceived low macro risk and the surplus of sellers of volatility in the market. “It’s kind of odd. When we talk to our research people and there are all these gripes that you can throw out on macro risks, but yet none of the asset classes are pricing these in,” says Kim. “Retail investors are constantly selling volatility and there’s a shortage of buyers, even though it feels there’s risk in the world.”