Asia exotics desks eye forward vol as corridor variance wilts

Forward-starting options offer discounted vol to hedge funds as dealers recycle autocall risk

Asia risk recycling

With demand for one of the primary hedging instruments for Asian exotics desks abating, dealers are turning to an alternative in a bid to reduce risk in their structured products books.

Volumes of so-called corridor variance swaps, which allow dealers to pass to investors large volatility risks built up by their structured products desks, were running at just a third of 2018 levels by the end of the first quarter, according to data from Societe Generale. 

Desks are resorting to forward volatility agreements (FVAs) to try and hedge their vega – the sensitivity to a one basis point move in volatility – traders say. The banks accumulate vega exposure from their equity-linked or autocallable securities issuance.

“Earlier, desks could position themselves better with the help of instruments such as corridor variance swaps, but there is very little appetite for such instruments from hedge funds,” says a head of investment strategies at a global bank.

FVAs are forward-starting options with a fixed strike, interest rate, dividend and volatility, which are all set at inception. For instance, an investor in December 2018 might enter a straddle – buying a put and a call at the same strike on a given index – which starts in December 2020 using the agreed parameters and ends a year later.

The investor is essentially taking advantage of a structural distortion in the volatility curve, which sees dealer hedging of structured products push down volatility at the two-year point at the trade’s inception, but which should naturally revert higher by the time the trade goes live.

For example, if at inception the volatility agreed was 10%, and when the one-year straddle comes into existence in December 2020 implied volatility is at 12%, the investor has locked in a straddle at a discounted volatility rate.

One European investor says he bought Nikkei FVAs that de-risked dealers’ Japanese structured product issuances earlier in the year.

In terms of sizes traded, it has doubled so far compared to the 2018 average but is still nowhere close to cross-corridor volumes
Bharat Sachanandani, Societe Generale

“We saw that the vol was extremely well priced at the point we bought. The term structure of vol was inverted a bit, so we were buying extremely cheap vol that actually rolled positively. So unless vol is getting even cheaper than it is today, which is at the lows, then we would also just roll positively as the contract gets shorter,” he says.

Bharat Sachanandani, head of Asia-Pacific equity flow strategy at Societe Generale, says this is a way for investors to own this illiquid and compressed volatility on lower strikes.

“We’ve seen increase in volumes over the past two months,” he says. “In terms of sizes traded, it has doubled so far compared to the 2018 average but is still nowhere close to cross-corridor volumes.”

The FVAs are being lapped up by investors as an alternative source of carry in the absence of corridor variance swaps, which have lost their appeal since 2018 when upended volatility dynamics triggered mark-to-market losses of more than $300 million on the instruments.

The rise and fall of corridor variance

For banks, FVAs help shift vega accumulated from selling autocallable notes – yield enhancement products whose popularity has mushroomed against a backdrop of low rates. Structured as zero-coupon bonds with upside and downside barriers, autocalls leave issuers long volatility. As spot heads south, increasing the probability of downside barriers being breached, dealers’ vega exposure increases.

“This is clearly one avenue to recycle the risk,” the structurer says of FVAs. “For investors it replicates the corridor variance swap idea in some form.”

Corridor variance swaps have been one of the go-to tools for recycling autocall risks in recent years. In exchange for a fixed payment, the swaps give hedge fund investors exposure to the realised variance of an index, but only while the underlying moves between two barriers. Accrual points in the swaps tend to match upside and downside barriers in the autocall.

This allows dealers to efficiently offload vega exposure stemming from autocalls outside of the regular options market, where dynamic hedging of the products sees the Street chase volatility up and down as spot moves around.

To cheapen the trade for investors, dealers offered so-called cross-corridor variance trades. This sees an investor enter a corridor variance swap on an Asia index while shorting a variance swap on a historically less volatile index such as the S&P 500.

Cross-corridor variance volumes peaked in the final quarter of 2017 when perfect conditions lured investors. Realised volatility on the US index was compressed and the instruments became an attractive source of carry, with investors selling sleepy S&P 500 variance to fund the long legs of the cross-corridor variance swap. The most popular long Asia index was Korea’s Kospi, according to a market strategist at a global investment bank.

But the instruments fell out of favour thanks to a combination of market moves. It began with the February 5, 2018 surge in the Vix – Wall Street’s so-called fear gauge, which tracks options volatility on the S&P benchmark. After languishing at an average of 11.1 for the previous year, the index level more than doubled its opening level of 18.44 to close at 37.32 on the day.

October 2018 saw another dramatic move, with the benchmark moving sharply from 11.61 on October 3 to 24.98 on October 11. In addition, the Vix rose steadily from 21 on December 13 to 29.29 on the December 24 open, before jumping to 36.07 by close that day.

With investors generally selling S&P 500 volatility as part of the cross-corridor swap, these moves in volatility have resulted in mark-to-market hits. More than $25 million of vega was printed across the Street on these structures in October 2018, says a structuring head at a global bank, but interest from investors has since tailed off.

Loss of a hedging tool

Corridor variance swaps may have been a victim of their own success. As the product gained traction as a risk recycling tool, bank salespeople looked to sell the product as a trade in its own right, unconnected to autocallable risk. When the products didn’t perform as expected after 2018 market moves, investors quickly soured and refused to buy trades when banks were looking to recycle tangible risks.

“The trouble began last year when corridor variance swaps were being regarded as a flow product, moving beyond their role as a perfect hedge for autocall issuance,” says the structuring head at the global bank.

“That led to some exuberance, so when conditions deteriorated we probably lost an effective hedging tool.”

The trouble began last year when corridor variance swaps were being regarded as a flow product, moving beyond their role as a perfect hedge for autocall issuance
Structuring head at a global bank

While the FVA trades haven’t completely covered the effective disappearance of the cross-corridor swap as a risk recycling tool, traders say there is no immediate risk to issuers, as rallying spot levels on indexes mean products are heading toward their upside knockouts, as they’re designed to do.

Problems will only occur if spot levels drop sharply, traders say. Markets in Asia are not immune to this, however, with the 2015 Black Friday crash seeing a 40% fall in the Hang Seng China Enterprises Index, which translated into a large hedging losses across the Street.

For the time being, the volatility market remains stable and desks have so far been able to manage the loss of cross-corridor activity, says the head of cross-asset structuring at an international bank.

In addition, some swap trades entered into last year were forward starting, which meant the instruments were valid until the end of 2019, which has given desks access to stable buyers of outstanding vega, traders say.

Editing by Lukas Becker and Helen Bartholomew

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