Low volatility means challenges for Spanish structuring desks

The latest challenge for Spanish structurers of equity-linked investments is to come up with products that offer the potential for superior returns if future equity-implied volatility increases, say Spanish dealers.

“We are recommending to our clients that they buy volatility rather than sell it,” says José Antonio López Jiménez, head of Spanish equity derivatives, structured products and warrants at SG, the investment banking arm of French bank Société Générale, in Madrid. “That’s why we’re working to structure products that are vega plus,” he adds.

One product that dealers report renewed interest in is known as ‘swing’, a structure that first appeared in 2002. It offers investors the minimum absolute performance of any one stock in a basket of shares. So if the minimum movement of any one share since launch is, say, –10%, the investor gets a 10% return. With a structure like this, if equity market volatility increases after launch, the minimum absolute performance should also go up, and the investor should get that higher return. It is an effective way to take a bet on a future increase in volatility.

But swing structures are expensive, says Emilio Sainz de Baranda, head of equity derivatives sales at Banco Bilbao Vizcaya Argentaria (BBVA) in Madrid: “Customers usually look for short-term options when buying volatility, because if the maturity is longer then it’s usually much more expensive.”

Sainz de Baranda adds that interest in this type of investment is coming mainly from institutions rather than the retail market. On the retail side, the last major investment product to hit the market was BBVA’s Extra 5, the concept for which originated with SG. Spanish investors have bought into it to the tune of e3.5 billion.

Extra 5 was structured as a mutual fund with a full guarantee on invested capital. It has an initial maturity of three years but a maximum maturity of six years, being callable from years three to six. The pay-out is linked to a basket of 25 global stocks and the investor gets a 5% return upfront. Then, after three years, if a ‘core’ basket comprising the five worst-performing stocks is more than zero, the investor redeems 100% of the basket’s performance, with a minimum return of 15%. So, for example, if the market performance is 10%, then the investor gets a 15% return. If it is 25%, the return is 25%.

But if the core basket is not positive after three years, the life of the investment is extended for another year. The investor still receives a minimum coupon of 5% per year. Finally, at maturity, if the core basket is less than zero, the investor gets a coupon of 30% minus the decrease of the core basket, with a floor set at zero.

Exposure hedging

As well as proposing the idea for the investment, SG also hedged a proportion of BBVA’s subsequent exposure. BBVA says it used eight other counterparties to hedge the rest – another major counterparty was Deutsche Bank, which says it hedged almost a third of the deal.

SG hedged the product by putting in place a digital option on each core basket at the end of each year when the investment is callable, plus a separate call for the rebate that the investor gets at the end of year six. “It’s a multi-callable worst-of basket,” says López Jiménez.

Another product seeing renewed interest is a type of reverse convertible but with added flexibility – the investor can step out under certain conditions. Reverse convertibles, which allow investors to buy a bond that converts to stock while selling a put option on the underlying – thereby gaining the option premium – were very popular in Spain during the equity market bubble of the late 1990s. But they do not come with a capital guarantee, and a lot of them were sold with technology companies as the underlying during the technology boom. When the bubble burst, so did the investments.

Most of the current offerings have a three-year maturity and are callable at the end of each year if the underlying hits a certain level. If the investment runs right through to maturity, then the investor gets a put option on the underlying.

“We’ve hedged many types of this kind of structure: on a single stock or index, a basket of indexes or stocks, using a call spread, capital guaranteed and not guaranteed, long and short maturities,” says Sainz de Baranda at BBVA.

So are Spanish retail investors, still weary from past reverse convertible losses, willing once more to forgo capital protection? Pilar de la Garza Valle, vice-president of global equity derivatives, structured and investment products at Deutsche Bank in London, says her bank has structured these reverse convertible-type products for the Spanish retail investor in the past few months. “We issued them from October to December linked to the Eurostoxx 50,” she says.

If this trend continues, then Spanish retail investors might be willing to broaden their horizons and take on more risk for a potentially larger upside.