Derivatives move to funds
John Godden explains the benefits for investors
Options on single stocks or on indices have been around for a long time and are firmly established instruments for gaining exposure to, or protection against, the underlying share or share index in highly liquid, efficient form.
The high level of correlation that historically exists between indices and related discretionary portfolios within insurance companies or pension funds, has made index derivatives a highly useable investment tool. ALM managers have been able to protect gains, or provide catastrophe risk through instruments such as zero cost collars with ease by using baskets of options on various indices to replicate, as closely as possible, the asset allocation of their own portfolio. Shorter-term trades have also been used to good effect to facilitate efficient transition management.
The insurer/pension company is, however, still left carrying the basis risk between the index return and that of their own position, which is becoming an increasingly important issue as options are used in more highly structured formats, and a wider array of bespoke, non-index related benchmarks are being used.
Index derivatives have also proved extremely popular for structuring guaranteed retail products providing equity exposure to low-risk investors using the name recognition that the dominant global indices now enjoy. It is this success that has produced the supply/demand imbalance in derivative markets causing implied volatility, a key component when pricing an option, to rise particularly relative to historical volatility. This large spread between implied and historical volatility is a major factor in driving the price of such index options higher.
While index derivatives will continue to provide solutions for ALM and retail products in ever-evolving ways, there is a clear need to provide more accurate hedging instruments for the ever-more diverse range of discretionary portfolios.
The development of fund derivatives has provided the solution to the problem of growing basis risk between indices and portfolios, and has enabled option writers to circumvent the high levels of implied volatility that exists on the liquid index option markets.
The key has been to develop non-synthetic hedging systems that provide exact exposure to a given portfolio without affecting the discretion of the fund/portfolio manager. Being able to create short as well as long positions enables the construction of both put and call options together with an extensive range of exotic options similar to those available on indices (cliquets, straddles, Asian, American and so on).
In general, funds have lower levels of historical volatility than an equivalent index due to their ability to be selective and the need to hold cash with a small part of the principle. The careful selection of funds allied to the use of volatility limitation mechanisms can enable traders to close the gap between historical and implied volatility on funds and thus reduce the price of options.
For example, many portfolio managers are using options on Nikkei-bench-marked funds to provide cheaper exposure/protection than the equivalent options on the Nikkei itself. The basis risk between the fund and the index is a less costly exposure than the saving made on the option.
Structured derivatives are now providing exposure to the growth of many different asset classes with downside protection on principle using calls on funds, or baskets of funds, invested in the underlying required. ALM managers searching for diversification are using such instruments to obtain exposure to a wide range of minority asset classes while enjoying the low risk characteristics obtained through full principle protection or a floor linked to a zero.
European ALM managers are using this technology to invest as follows:
q Hedge funds
q Baskets of CTAs
q Property funds
q Global equity
q Market-neutral funds.
The instruments on offer provide participation rates of between 70% and 90% depending on the floor construction and the fund volatility. The Sharpe ratios of the resultant instruments make a very strong case for their inclusion in a portfolio.
Put options on funds have the potential to solve many problems faced by insurers and pension funds who face regulatory or taxation restrictions on the type of assets that can be held. The purchase of call options embedded in, say, an MTN will often not qualify as an admissible asset. However, where the insurer/pension company holds the required fund on its balance sheet, a put can provide the appropriate protection without removing it. The put should be justifiable on the grounds of efficient portfolio management, as it will alter the investment’s risk profile.
Offering a put on a fund is also bringing a wider range of fund management companies into the highly lucrative field of offering guaranteed products, predominantly through life insurance contracts. The powerful marketing story of offering access to funds with strong performance history and demonstrable added value, allied to a guarantee of full capital protection, has opened the market to risk averse investors seeking an alternative to low yielding deposits.
The flexibility achieved by using puts on funds enables more effective hedging of specific, multi-asset risks such as annuities backed by equity assets. The use of a put allied to fixed income options can produce some very efficient hedging scenarios. It is also easy to spread the charges for a put over the full maturity, which alleviates the problem, particularly in retail products, of high up-front charges/lower participation rates.
John Godden is head of structured insurance product at Paribas in London