The last three months of 2018 saw severe losses in all major indices and many stocks. This type of market cycle has a significant effect on the structured product market. It will affect demand for future issuance but also can cause challenges and risks for traders managing existing positions.
S&P falls last year
The S&P-500 index suffered major falls in the last quarter of the year. Although it is normally less volatile than other mainstream regional indices on 16 different days in 2018 it suffered falls of 2% or more. By comparison the Eurostoxx-50 only had 6 such days. Large falls cause more problems because of the need to rebalance hedges quickly as the market moves. Any product barrier levels that are approached have the potential to cause losses if the market suddenly gaps down and the trader is unable to take the hedge off at the required index level. Many traders price products with a barrier adjustment to help reduce risk in such circumstances however these adjustments may have not been enough in recent months. Both indices suffered a one day fall in excess of 4%, which would result in big changes in required hedges.
Most structured product markets are dominated by the Auto-call product type which brings a concentration of risk around potential Auto-call events. The falls in the market in 2018 brought index levels back down past where the market had been for the previous twelve months. Most Auto-calls have at least the first level set at 100% of the strike price and given a continuous stream of products would have been issued in the previous year with a six or twelve month Auto-call cycle many products during 2018 would come up to their call dates with the market trading near to the required levels. This creates uncertainty as to whether calling will actually occur. Such circumstances increase the chance of trading losses because the hedges change rapidly reacting to the likelihood of the product calling and must be regularly rebalanced successfully. In general once a call point has been missed the fair value of a product falls below the value that is paid out if calling occurs. Thus when the market is near the call level as the call date is approached the sensitivity of the product to market moves is similar to a digital option with the risks that such discontinuity in the payoff poses.
Increasing volatility and correlations
The falls in equity markets last year were accompanied by fluctuating and generally increasing volatility levels (as demonstrated by the VIX values for example – averaging 17% in the first three months of 2018 and 21% in the last three months). This also makes hedging more difficult when trying to manage volatility levels as marking and hedging positions with longer dated options in the broker market suffer reduced liquidity and wider bid-offer spreads.
The other major factor that tends to play out in bear markets is an increase in correlations of indices and stocks. This affects “worst-of” products for which a rise in implied correlation will increase the mark to market value of the product and this will have to be marked accordingly against the issuer, showing a secondary market loss.
In conclusion the bear market conditions of late 2018 would have been very challenging for issuing banks in retail structured product markets and the ability to manage risks and minimise losses is essential for any desk wishing to stay profitable and viable for the long term.