The hedging process is one of the most important aspects of creating structured products. One of the key differences between structured products and traditional investments is that they need an investment bank to create and hedge the product by trading component parts in a way that will provide the contracted payoff to the investor.
The bank takes on the risk that the hedging process may end up being more expensive than it anticipated or that unexpected trading losses occur. As compensation the investment bank will charge a premium over what it believes will be the likely total hedging costs to run a profitable business over the long term.
Before a trade is confirmed comes the product design and pricing stage. This stage tends to be iterative as different permutations are tested. Any special considerations around hedging will affect the banks willingness to trade and if so at what levels. The hedging process starts once the product has been traded between two parties which are usually the investment bank as issuer and an asset manager or distributor as the purchaser.
The role of hedging
The main purpose of hedging is to take the net investment purchase proceeds of the structured product and manage it to be left with the final payoff amount for the investor. There are many sides to hedging and there is a great responsibility for traders to prudently risk manage a book of derivatives and structured products to cope with the many types of risks and to be prepared for any market eventuality.
We will divide hedging into first order effects associated with directly reproducing the payoff (such as Delta hedging of the underlying and Vega hedging for option positions) and what we will call carry effects (caused by factors such as interest rates and dividends).
Delta hedging is key
Most structured products involve a combination of capital, income and option components. Delta hedging to manage direct risk in the underlying is always the first risk to take care of and is usually supplemented by Vega hedging to help manage volatility risk and prevent the cost of hedging becoming prohibitive. The initial Delta hedge is made on the strike date and the higher the sensitivity of the product to the underlying the greater the initial hedge will be. How quickly the Delta hedge needs to be rebalanced is measured by the second order effect of Gamma. When markets become more volatile the trader generally needs to do more rebalancing and for products that offer optionality to the investor this hedging will get more expensive. This is not generally because of transaction costs but because the trader needs to buy when the underlying goes up and sell when it goes down making a round trip loss. Holding some suitably chosen options will see their value increase when volatility rises which helps offset the extra Delta hedging costs. The interplay between Delta and Vega hedging is quite subtle and the success of delivering product payoff without incurring trading losses primarily depends on getting it right.
For multi-asset structured products correlation risk is also very important and notoriously difficult to hedge. The overwhelming number of multi-asset products issued are either worst-of capital at risk or basket-linked capital protected. These two cases have the same direction of correlation risk position since the bank will lose money if correlation increases. Products such as those with dispersion payoffs help reduce risk but are rarely traded in a large enough size to be meaningful and the broker market in correlation dependent options is also rather limited.
The size of this problem is underlined by several cases of trading losses due to correlation in recent years as banks have competed against each other on price and then got hurt when correlation subsequently moved against them. The main defence against this risk is to mark correlations significantly higher than is expected based on realised or predictive levels. This feeds through to higher pricing and means investors will get less pick up in yield or other product terms but by definition an equilibrium will be found where banks are willing to trade and investors will still buy the product. However, this “self-insure” approach by banks against correlation risk cannot always prevent losses.
Ready for the dangers of gap risk
The other important consideration of hedging the underlying is that of “gap” (or “jump”) risk. Most pricing models assume continuous movement of the underlying asset according to a certain volatility and distribution and requires that rebalancings are made whenever dictated by the model. If an underlying suddenly jumps in value in either direction there may be insufficient time or liquidity to be able to trade. This effect can be costly at any time but is particularly important at key points and dates such as barriers, auto-calls and strike levels. When the underlying is near any of these levels as the date approaches the price and the Delta will be very sensitive and if the underlying jumps or moves wildly the hedge cannot be liquidated at the level assumed by the model and the trader will incur a loss.
A common technique to prevent this is to price the product with all such levels moved by an appropriate amount (perhaps by one day’s standard deviation of the underlying) For example the trader might price a product with a barrier level of 59% instead of the actual level of 60%. This will increase the product price (leading to questions as to whether it would remain competitive) but allows the trader to hedge as if the barrier was at this lower level. Provided the hedge can be liquidated inside this “self-insure” target then the trader will make a small windfall gain rather than risk a loss.
Subtleties of rates and dividends
Hedging the underlying is always the most important but hedging of carry effects also plays a key role. These effects include price sensitivity to interest rates and dividend yields. Most structured products have an embedded bond to provide capital payment and is purchased at a fixed interest rate. It is important for any hedging to be done at a fixed rate rather than floating rate otherwise losses would occur if rates were to rise.
A related carry effect is caused by dividends paid by the underlying. In 2020 the importance of this was suddenly brought into focus when many companies decided to cancel or reduce their dividend payments to preserve cash in the uncertain economic climate caused by the pandemic. Most equity linked structured products do not pay dividends and therefore when the stock is held as part of the Delta hedge the dividends that are earned are expected to contribute towards the hedging account. When dividends are cut this income is lost and that can be significant. Both carry types become more important for longer dated products because of the cumulative effect.
As we move into well into 2022, we will continue to see strong competition ensuring that products in the market are keenly priced and there is every likelihood of continued market volatility. Therefore, the role of the trading desk to hedge thousands of products remains critical to the smooth and viable running of the industry.
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