Derivative hedging techniques examined

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Derivative hedging techniques examined

When a structured product is brought to market it needs an investment bank to hedge it and to pay out the contracted returns to the investor at maturity. This asset creation is what makes a structured product a tangible investment.

Hedging needs to take account of whatever market scenarios occur during the product lifetime and risk managing structured products and derivatives is a complex and multi-faceted task to conduct long term.

How hedging works

There are many risks to deal with including volatility, correlation, dividends, currencies and interest rates. However the most important hedge of all is the “delta” which must be put on to make sure that changes in the value of the underlying asset are properly managed. The delta hedge is calculated by the sensitivity of the product payoff to the underlying asset. Changes in the underlying asset clearly has the scope to affect valuations most significantly. The size of the delta hedge changes continuously through the product lifetime and reflects the product’s current valuation and future prospects. Delta hedging is also directly affected by key events in the product lifetime, such as initial and final hedge, coupon and capital barrier events and singularities such as digital payments.

Delta hedge examined

There are several different ways that an issuer can put on the delta hedge and they have different implications and advantages and disadvantages.

For single stock linked structured products direct investment in the underlying equity is the simplest way to effect a hedge, however liquidity effects and transaction costs can be significant. While transaction costs are generally manageable it is possible for them to eat into product profitability if trading due to changes in the hedge size is undertaken frequently. Liquidity can potentially be more of an issue for a structured product with a large notional on a single stock of moderate capitalisation since in practice the free float available of an equity can be quite small.

How to hedge indices

For index linked products the situation is rather different. Here there is a choice between a taking a position in the index future if it is traded or trying to replicate the index through the stocks directly. The future is the simpler and cleaner route since hedging through a basket of stocks may necessitate approximations and taking a small residual risk between the basket invested in and the actual composition of the index. The resulting tracking error is generally as likely to be positive as negative, however for structured products that operate on quite narrow profit margins anything that introduces a risk of profitability is generally to be avoided as much as possible. Index futures remove this problem because they track the index perfectly by definition and are therefore very convenient. They are generally very low cost but the main risk is that the traded value does not stay perfectly at fair value and can command a premium depending on supply and demand. Traders therefore need to be aware of calendars of futures and options expiries, busy times of issuance, market events affecting demand and market knowledge or rumour of large size deals maturing. While the mainstream indices have the most liquidity and choice some of the newer indices (for example decrement versions) are gaining traction. The index business has been one of the major investing growth stories in the last twenty years with hundreds of choices from multiple providers. Since these indices are intended to be investable a key component of their success is the viability of hedging otherwise they have limited commercial importance. As a result of recent consolidation, many index companies are now part of an exchange therefore the development in indices can be paired with encouraging liquidity in futures and options.

The index business has also grown hand in hand with the ETF market and ETFs are the main way that indices make it to market as investable vehicles. Here various market makers will create liquidity in the ETF but some tracking error is always accepted particularly for more esoteric indices. This error is effectively passed on to the investor and not a risk borne by the market maker as the ETF is not contractually obliged to perfectly match the index. Therefore ETFs have proven increasingly popular as direct structured product underlyings which means that the delta hedge can be executed with respect to the tradable ETF.

Managing the book

For any choice of hedging instrument a favourite way to mitigate risk is to run an active book of offsetting positions wherever possible. This might be from buying and selling in the interbank market or offering retail products with different characteristics such as long and short volatility trades (capital protected and at-risk respectively).

The different ways to manage a delta hedge are well understood but remains a critical part of efficient and cost-effective structured product issuance.

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