How has the spike in market volatility impacted the structured products market in Asia?
ItÆs no surprise that the risk appetite of Asian investors has been severely tested over the past few months. Certain long-only equity and FX carry strategies, which performed well in previous years, appear to have suffered so far in 2008. This has prompted investors to take a more diversified approach to their investments, with structured products being used to restructure existing positions.
The need to diversify has brought simple income-generating fixed income structures back into play, with steeper yield curves and high volatility in regional and global interest rate markets providing an opportunity for these kinds of products. Widening credit spreads have seen sophisticated money move into cash bonds and structured credit as this market is seen as being cheaper than equities.
So, structured products are generally becoming a lot more defensive. That said, the need to diversify has driven demand for commodity-linked products, with active asset allocation into soft commodities and precious metals. Agricultural commodities have been the biggest beneficiary as this market is being viewed as a good recession play in light of tight global supply and demand constraints. There has also been active interest in the environment and alternative energy via thematic funds.
How are structured product issuers changing their product mix?
The change in market conditions over the past six months has tested the capabilities of structured product issuers in Asia. To remain relevant to investors, issuers have had to respond quickly and efficiently to help steer their clients through the recent turmoil. This has meant providing a wider range of asset classes, rather than building an ever-larger range of equities products. Direct access to markets such as commodities, credit, alternative energy and environment are now more of a focus for structuring desks than they were previously.
Simpler products are gaining in popularity while there has been a significant decline in the level of implicit leverage in structured products. There is more focus on asset allocation products and themes with rule-based or discretionary asset allocation across various asset classes, using either indices, funds or cash products. Principal protection is also back in vogue with income-oriented products that pay high levels of fixed or minimum income.
We are also coming up with innovative ways to help investors sell equities and FX positions to reduce risk and diversify, with current high levels of volatility aiding this process. Indices to track new opportunities in markets such as agriculture, alternative investments, FX, and rates are also being developed, along with indices to track the next rung of emerging markets beyond BRIC, FX carry and other strategies.
How are structured product dealers managing correlation risk on the equity structured products they have issued?
Correlation is the residual risk arising from those structured products that have been extremely popular over the past couple of years. It is the risk that the underlying assets in a structured product simultaneously head in the same direction and is a basic assumption that goes into the pricing of basket products across stocks, indices and other asset classes.
Correlation, both implied and realised, has risen sharply from where dealers were positioned, as markets corrected simultaneously all over the world over the past few months. Correlation has no natural hedge as there is a limited market for over-the-counter correlation swaps. The dealers are trying to manage it better by adopting new approaches.
For example, dealers are coming up with new structures and payoff profiles that can help them buy back correlation sold. There has also been a tightening of internal risk management for correlation where trades have more buffer against correlation risk and room for dislocation in the marketplace. Dealers are also paying closer attention to the dynamic hedging of underlyings to help realise correlation closer to where they sold at.
To what extent has the increase in funding costs affected structured product issuers in Asia?
There are some positives out of this liquidity crisis besides just the negatives. While a decline in inter-bank and dealer liquidity has seen volumes for new debt issuance decrease, investors have benefited as funding pressure is pushing some banks to issue new debt in the form of structured products that pay generous terms. This has offset some of the decline in US interest rates, with higher funding spreads being passed on to investors in the form of various structured products. Asia is becoming a new source of long-term financing for banks and the longer the crisis persists, the more important Asia and the Middle East are going to be as a source of capital.
The need for long-term financing is also trumping the need for profitability and dealers are being more aggressive in their derivatives pricing to help secure financing for as long a tenor as possible. Duration is also getting extended on some products by virtue of them not being called back.
How extensive is the rate of de-leveraging in Asia and in what markets is this being carried out?
De-leveraging is happening across all asset classes where leverage was increased significantly over the past few years, for example in real estate, equities and FX. In FX markets, Japanese yen shorts in the carry trade are being forced to reduce dramatically. Similarly, financing against real estate and equities is also being reduced. The yen carry trade reduction has probably seen the greatest reduction of positions.
However, we have also seen investors realise the value of a more diversified approach to carry and have subsequently helped re-structure existing carry positions across a number of different currencies via be-spoke indices.
In equities, however, the increase in volatility has been far more dramatic and price declines far steeper. Investors have unwound positions where they could still take profits or lower losses û such as in precious metals or some emerging markets stocks, bonds and fixed income û and moved into cash to reduce leverage.
In addition to financial markets, there was a significant build-up of leverage in the real estate market. The equity and real estate markets were supportive of each other in the previous bull market. However the relative illiquidity of real estate has prevented investors from unwinding quickly enough, with the urgency to reduce positioning in this market becoming more acute.
How do you see AsiaÆs structured products market performing in 2008?
ItÆs been a challenging year so far for traditional structured products. InvestorsÆ enthusiasm to make major new investments and commit fresh capital is not as vigorous as last year, however issuers with broader platforms have been able to offset this by focusing on demand for more income-paying structures and greater asset diversification.
The breadth of products available across asset classes, new payoff profiles and access to a wider range of delta one products has meant investors now have far more choice in managing their assets compared to previous corrections. Also, investors have not completely given up on the Asian growth story and will still look to participate in that trend as soon as signs of stability are seen. However, for the present, risk management is the primary goal.
A focus of dealers at this point in time is to help improve and provide solutions to first de-leverage and restructure existing positions. They can then recommend investment products which are more defensive and suitable for the current market environment.
We believe there is merit in a broader asset allocation strategy, away from the overwhelming equity focus of the past few years. Strategies and products with allocation to both option-based and delta one strategies may be one way to position for the next market turnaround.
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