Interplay between derivatives and structured products

Derivatives and structured products are very closely related and have overlapping uses and purposes within the world of financial instruments. Derivatives markets have been around for many decades, beginning with exchange traded call and put options in equities, and then onto fixed income swaps and beyond. This development came out of traders want to either hedge away risk or to gain exposure and leverage.

In finance it is the coming together of agents with different views and objectives that makes for a liquid and active market. Because equity options ae traded directly they only need enough liquidity and the presence of market makers to make them viable. Options then quickly provided a popular and reliable way for traders and investors to gain access to risk management and targeted exposure.

From exchanges to OTC

However while an exchange is a great basis for a market such as derivatives to grow it tends to be limited in scope because the emphasis is to make sure that the instruments it carries are liquid and traded enough. This principle remains true despite advances in technology in the last twenty years. Demand for instruments that went beyond what exchanges could offer rapidly increased. This has been addressed by the Over the Counter (OTC) markets from the 1990s onwards, and the idea of an informal but active broker driven interbank and bank to asset manager market.

This development allowed for options with longer maturities, different underlyings (and combinations of them) as well as more complex product payoffs. Many different variations started to become popular as institutional business picked up. Different investment ideas were then explored - the concept of options added to initial capital to provide investments with equity upside or providing yield generation by selling covered calls on top of a portfolio. This naturally expanded into the structured product markets that we recognise today.

Hedging and investment themes

Structured products markets are now a significant investment class in their own right and while they grew out of the first use of derivatives they now depend on them to make them function. Investment banks are the main manufacturers of such products and will use various risk management techniques to run their businesses prudently. The most common strategy is that even for more complex structured products the issuing bank will use simpler derivatives to risk manage the resulting exposure. This includes trading baskets and futures to hedge the underlying asset itself for the delta risk. In addition, buying or selling options to manage volatility and hedging dividend exposure through futures is very common.

ETFs enter the fray

While index linked structured products remain popular, the explosive growth of the ETF market means that in some cases ETFs that track a certain index can be more useful than the index itself and as a result the ETF finds itself as the underlying asset for a structured product. The EEM iShares ETF which tracks the MSCI Emerging Markets index is a good example and has many billions of dollars under management. In turn, because the ETF is such a convenient, cheap and liquid way to access exposure (particularly in less liquid or more expensive cases such as emerging markets) options also become liquid driven by demand and the existence of the ETF to facilitate hedging.

Other uses of ETFs include defined risk strategies which combine an underlying with a call and put strategy to generate yield and reduce risk. These seek to combine the efficiency of the ETF and their options to provide lower risk investment solutions and have been successfully developed by the exchanges such as the CBOE.

Use of other instruments

Meanwhile, development in quantitative indices continues as banks and other index sponsors seek to test and market new strategies including volatility control, asset switching and dividend plays. Such indices can either be launched by index providers working with investment banks or used to create an ETF. Often these more sophisticated indices use various risk management techniques such as options to define their characteristics which are typically to seek performance at lower volatility. Such indices are generally then developed as delta one investments to allow exposure and liquidity in an open-ended fashion.

In the fixed income market structured products that link to Constant Maturity Swaps (CMS) have been popular in many market conditions and in the world of commodities it is routinely necessary to use futures to obtain exposure in an efficient manner.

The use of derivatives in structured products and all the related and competing disciplines goes to make up a rich marketplace of risk controlled investment solutions. Innovation is happening all the time as product providers seek to provide new answers to age old problems such as protecting capital and providing yield in low rate environments.