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DrKW Derivatives research

Derivatives | Europe
Head of Derivatives Research 28 April 2005
Colin Bennett
+44 (0)20 7475 7474
colin.bennett@drkw.com Structured products vicious circle
How structured products exaggerate long-dated implied volume moves

The issuance of structured products causes investment banks to be short long-dated


skew and convexity. The recent collapse of equity markets has led to a sharp uptick in
the amount of long-dated volatility that banks are short, as strikes move along the
skew. By covering these shorts long-dated implied volatility is lifted, which leads to a
greater short volatility position due to convexity. This creates a structured products
vicious circle which exaggerates any move in long-term implied volatility.

► All banks are short skew and convexity: The sale of capital guaranteed structured
products has caused investment banks to be short long-dated skew and convexity. As
similar products are sold by all banks, all participants have the same position causing an
imbalance in the market due to the lack of natural buyers. Although hedge funds are
comfortable removing any imbalance in short maturity implieds, they are more reluctant
to do so for maturities longer than two or three years due to the lack of visibility and
hence greater risk.

► Recent equity market collapse has caused hedging problems: If an investor is short
skew then when equity markets decline they become short vega, even if implied volatility
surfaces do not move. Since the recent collapse in equity markets the hedging of structured
products appears to be lifting longer-dated implieds, as banks cover their short vega
positions. This rise in long-term volatility has also caused an uptick in term structure.

► Convexity is greater when volatility is low: An option has approximately constant vega
only if it is ATM, for OTM options the vega increases as volatility increases and this is
known as vega convexity. Vega convexity is greater for lower implieds than for higher
implieds, and hence is more important in the current low volatility environment.

► Short convexity leads to vicious circle: As volatility rises, the vega of banks’ short
positions increases due to vega convexity. This increase in their short positions
prompts structured product sellers to buy volatility again, starting a vicious circle of
increasing implieds.

► Structured products cause long-dated implied volatility overshoot: The principal


protection feature present in most structured products ensures their vendors are short
skew and convexity. We believe that for long-dated volatilities the large amount of capital
Research Analysts associated with hedging structured products leads to an implied volatility overshoot to the
Colin Bennett upside when markets collapse, and an implied volatility undershoot to the downside when
+44 (0)207 47 57474
markets soar. Such an effect was seen in early 2003 when the bear market ended, and
colin.bennett@drkw.com
we believe the same effect has caused the sharp rise in long-dated implieds and term
Simon Carter
+44 (0)207 47 57280
structure that we have seen over the past fortnight.
simon.carter@drkw.com
Pete Clarke
+44 (0)207 47 59588
pete.clarke@drkw.com
Chris Banks
+44 (0)207 47 52477
chris.banks@drkw.com

Please refer to the Disclosure Appendix at the end of this report for all relevant
disclosures and our disclaimer. In respect of any compendium report covering six
Online research: or more companies, all relevant disclosures are available on our website
www.drkwresearch.com www.drkwresearch.com/disclosures or by contacting the DrKW Research
Department at the address below.
Bloomberg: Dresdner Kleinwort Wasserstein Securities Limited, Authorised and regulated by the Financial Services Authority and a Member Firm of the
London Stock Exchange PO Box 560, 20 Fenchurch Street, London EC3P 3DB. Telephone: +44 20 7623 8000 Telex: 916486 Registered in
England No. 1767419 Registered Office: 20 Fenchurch Street, London EC3P 3DB. A Member of the Dresdner Bank Group.
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Structured products vicious circle 28 April 2005

All banks are short skew and convexity


The sale of capital guaranteed structured products has caused investment banks to be
short long-dated skew and convexity. The description of why their sale causes
investment banks to be short skew and convexity is detailed later. As similar products are
sold by all banks, all participants have the same position, causing an imbalance in the
market due to the lack of natural buyers. The maturity of these products can be up to 10
years, but they tend to be concentrated around the five-year mark.

Hedge funds reluctant to eliminate long-dated imbalance


Longer-dated end of volatility Although hedge funds are comfortable removing any imbalance in short maturity
surfaces suffer from the technical
pressures of structured products implieds, they are more reluctant to do so for maturities longer than two or three years
due to the lack of visibility and hence greater risk. We believe that the longer-dated end
of volatility surfaces suffer more from the technical pressures of structured products,
whereas the shorter-dated end is driven by fundamentals. As we understand that
increasing amounts of structured products are being sold, this effect is likely to be
exaggerated going forward.

Recent equity market collapse has caused hedging problems


Hedging of structured products The recent collapse in equity markets, the largest two-day fall for two years, has caused
appears to be lifting longer-dated
implieds and hence term structure significant hedging problems for investment banks. As the short skew and convexity
positions have to be hedged dynamically, such sudden movements can leave traders
exposed. The subsequent hedging of these products appears to be lifting longer-dated
implieds and hence term structure.
Structured products have previously participated in implied volatility decline
We believe part of the sudden collapse of implied volatilities in early 2003 can be
attributed to structured products reacting to the impressive rise in stock markets at that
time. Although implieds subsequently continued their fall, the magnitude of the initial
steep decline is more likely to have been caused by technicals rather than fundamentals,
in our view.
Eurostoxx50 Index implied volatility
Implied volatility (%)
60

50 Structured products helped


contribute to sudden implied
40 volatility collapse in early 2003

30

20

10

0
May-03

May-04
Mar-04
Mar-03

Sep-03

Sep-04

Mar-05
Nov-03

Nov-04
Jan-04

Jan-05
Jan-03

Jul-03

Jul-04

Source: DrKW Derivatives research

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Structured products vicious circle 28 April 2005

Falling markets + short skew = short vol


Vega is the sensitivity of an option price to volatility. If a trader is long €1m vega at the
110% strike and short €1m vega at the 90% strike, then the position is short skew. The
position has no sensitivity to the overall level of volatility, as shown by the chart below.
Implied volatility against strike

Implied volatility (%)


24

23
If you are short €1m vega at
90% strike and long €1m vega
22 at 110% strike then you are
short skew but flat vol
21

20 €1m vega

€1m vega
19

18
70 80 90 100 110 120 130
Strike (% of spot)
Source: DrKW Derivatives research

Should markets decline 10% then the original short €1m vega at 90% position is now
ATM. As the vega of ATM options is greater than for OTM options, the short position will
increase in vega. Similarly, the original long €1m vega at 110% position declines in vega
as it is now approximately a 120% strike option. The chart below shows how the
originally vega neutral position is now short 160,000 vega due to the 10% stock price
decline.
Vega of option for €100 and €90 stock price
Vega (%)
50

45 €1m vega short


€1m vega long
position has
position has
40 increased 5%
decreased 11%

35

30
Previously flat vol position
25 now short 160K vega

20

15
70 80 90 100 110 120 130
Strike (% of spot)
Vega stock at €100 Vega stock at €90

Source: DrKW Derivatives research

Rise in markets leads to long volatility position due to short skew


Should equity markets rise, then We have shown that being short skew leads to a short volatility position if equity markets
being short skew would lead to a
long volatility position fall, but the reverse is also true, ie, should equity markets rise, then being short skew
would lead to a long volatility position.
Rate of change of vega sensitivity measured by vanna, not skew
The rate of change in vega for a given change in spot (dVega/dSpot) is measured by
vanna. The effect of a short skew position leading to a short volatility position as equity
markets decline is due to the change in value of an option due to a moving equity price, not
due to the fact lower strike options tend to have a greater implied than higher strike options.

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Structured products vicious circle 28 April 2005

Convexity greater when volatility is low


The vega of options is sensitive to the absolute level of volatility. An option has
approximately constant vega only if it is ATM, for OTM options the vega increases as
volatility increases, and this is known as vega convexity. Vega convexity is measured by
the rate of change of Vega for a given change in volatility (dVega/dVol) and is called
volga (or vomma). As shown in the chart below vega convexity is greater for lower
implieds than for higher implieds, and hence is more important in the current low volatility
environment.
Vega for 90% and ATM options against implied volatility

Vega (%)
45
40
35

30
25
Vega convexity is greater for lower implied
20
volatility than higher implied volatility
15
10
As vega for OTM options increases
5 as implied volatility increases it has
vega convexity.
0
0 5 10 15 20 25 30 35 40
-5
Implied volatility (%)
90% strike ATM strike

Source: DrKW Derivatives research

Short skew and short convexity leads to vicious circle


Vega of their short positions Let us assume sellers of structured products are short long-dated skew and convexity
increases due to vega convexity
and want to remain implied volatility neutral. A decline in equity markets causes them to
be short volatility or vega, due to their short skew position. They begin to cover their short
vega position, causing an uptick in volatility as everyone has similar positions and is
attempting to buy volatility. Due to increasing volatility, the vega of their short positions
increases due to vega convexity. This increase in their short positions prompts structured
product sellers to buy volatility again, starting a vicious circle of increasing implieds.
How declining markets cause increasing implied volatility

1. Market declines 2. Traders are short vol


as they are short skew
Price Implied vol

3. Traders buy vol

Time 80% 90% 100% 110% Strike Vicious


(% of spot) Circle

4. Convexity
means traders are
short vol again

Source: DrKW Derivatives research

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Structured products vicious circle 28 April 2005

OTM put similar to capital protection


As structured products are often capital guaranteed, the seller can be thought of as
effectively short an OTM put as this provides similar downside protection. Being short an
OTM put has the features listed below:

► Short skew: An increase in skew without a change in ATM volatilities causes the value of
an OTM put to increase, hence being short an OTM put means one is short skew.

► Short convexity: As OTM puts have positive convexity, being short an OTM put is a
short convexity position.

We recognise that the above description is simplified. In practice, structured products


leave the seller to be long ATM volatility and short OTM volatility at both wings, and
hence short convexity as OTM options are more convex than ATM. As the embedded
option in structured products is floored, this leaves the seller short skew in a similar way
to being short an OTM put.

Equity market collapse caused long-term implieds to rise


We believe that the large amount of The principal protection feature present in most structured products ensures their
capital associated with hedging
structured products leads to an vendors are short skew and convexity. We believe that for long-dated volatilities the large
implied volatility overshoot amount of capital associated with hedging structured products leads to an implied
volatility overshoot to the upside when markets collapse, and an implied volatility
undershoot to the downside when markets soar. Such an effect was seen in early 2003
when the bear market ended, and we believe the same effect has caused the sharp rise
in long-dated implieds and term structure that we have seen over the past fortnight.

Term structure increases as long-dated implieds rise


The vicious circle of increasing implieds tends to only affect long-dated volatilities due to
the long duration of structured products and the participation of hedge funds towards the
shorter-dated end. As a consequence of relatively stable short-dated implieds and
increasing longer-dated volatilities, term structure has recently increased.

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Structured products vicious circle 28 April 2005

Notes

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Structured products vicious circle 28 April 2005

Disclosure appendix
Disclosures under US regulations

The relevant research analyst(s), as named on the front cover of this report, certify that (a) all of the views expressed in
this research report accurately reflect their personal views about the securities and companies mentioned in this report;
and (b) no part of their compensation was, is, or will be directly or indirectly related to the specific recommendation(s) or
views expressed by them contained in this report.
Any forecasts or price targets shown for companies discussed in this report may not be achieved due to multiple risk
factors including without limitation market volatility, sector volatility, corporate actions, the unavailability of complete and
accurate information and/or the subsequent transpiration that underlying assumptions made by DrKW or by other sources
relied upon in the report were inapposite.

Recommendation history charts


Past performance is not an indicator of future performance.

Dresdner Kleinwort Wasserstein Research – Recommendation definition


(Except as otherwise noted, expected performance over next 12 months)
Buy: 10% or greater increase in share price Sell: 10% or more decrease in share price
Add: 5-10% increase in share price Reduce: 5-10% decrease in share price
Hold: +5%/-5% variation in share price

Distribution of DrKW equity recommendations as of 31 Mar 2005


All covered companies Companies where a DrKW company has provided
investment banking services (in the last 12 months)

Buy/Add 274 47% 39 48%


Hold 208 36% 32 39%
Sell/Reduce 99 17% 11 13%
Total 581 82
Source: DrKW

Additional disclosures under other non-US regulations


The disclosures under US regulations above should be read together with these additional disclosures.

In respect of any compendium report covering six or more listed companies, please refer to the following website for all
relevant Italian disclosures: www.drkwresearch.com/disclosures/

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Structured products vicious circle 28 April 2005

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