Autocalls hit peak vega, where hedging costs mount

Eurostoxx and Nikkei losses flip structured product dealers into painful short vol territory

Jitters are growing among structured product issuers as the stock indexes underlying popular autocallable bonds plunge through a shadowy inflection point known as peak vega, where hedging costs surge and losses can mount.

This fabled territory, where issuers of the products see their volatility sensitivity flip from long to short, has already been surpassed on the Eurostoxx 50 and Japan’s Nikkei 225. In previous stress periods, this has forced dealers to buy volatility in unison, inflating the price and causing heavy mark-to-market losses.

“We’re through peak vega now on the Eurostoxx,” says one equity derivatives strategist at a European house. “The impact on dealers depends how books are positioned, but it could end up being painful for some.”

Global equity markets have plummeted in response to tumbling oil prices and growing concern over the spreading coronavirus. The Eurostoxx 50, Nikkei 225 and S&P 500 each shed more than a quarter of their value in the three weeks since February 21.

For autocall issuers, this is dangerous territory. “These are not easy days,” says a source at one European structured products house.

Structured products history is littered with hedging horror stories as sensitivity to parameters such as volatility, dividends, correlation and convexity can whip around when stocks fall. In 2015, Asian exotics desks were hammered with $300 million in losses when the HSCEI shed 40% over five months.

Three years earlier, banks lost an estimated $500 million on Uridashi bonds as the Nikkei 225 zig-zagged. In December 2018, Natixis took a €260 million ($288 million) hit on its Korean autocall book after the Kospi index shed 15% in a month. The offending positions were subsequently sold to rival banks including Bank of America, BNP Paribas and Citi.

Given the protracted nature and scale of the latest selloff, dealers say this could be another dark period for structured products desks.

“The dynamics of autocallables can be challenging, but it depends on the timing of the selloff,” says a structuring head at a US house. “The first leg is not the most painful one, but when you have a few more legs down it can be a different story. What’s more painful is when spot gets closer to knock-in put barrier levels.”

Beyond the barriers

Taking the basic form of zero-coupon bonds with upside and downside barriers, autocalls have become the dominant retail structure for these low-rate times, delivering above-market coupons while spot remains between the two barriers. The structure knocks out when spot hits the upper barrier, returning principal and an improved coupon to investors. The downside barrier is typically set 40% below the initial strike and triggers a knock-in put option, which eats into investor principal if breached.

Issuers of the instruments are long volatility. As spot falls and the chance of breaching the downside barrier increases, their sensitivity to volatility, or vega, increases. In this scenario, traders must sell puts to flatten their risk – a scenario which causes spot and vol to head down in tandem, upending the normal inverse correlation between the two.

As spot heads towards the barrier, an inflection point is reached: peak vega. Beyond this point, the issuer's vega exposure falls and dealers collectively switch to buying back volatility. The scramble for vega causes implied vol to jump, ultimately delivering losses to dealers that bought their hedges at the higher level.

Analysts say peak vega on the Eurostoxx 50 sits just below 3,000 - a level that was breached on March 10. By March 12, the blue-chip eurozone index had tumbled further to close at 2,545 – its lowest level since 2012.

The sudden switch in vega exposure is evident in a stark reversal in Eurostoxx spot/vol correlation. According to analysts at Bank of America, correlation between spot and two-year fixed strike vol on the index has fallen from 40% to -40% in recent weeks – its most negative level since 2012. The relationship hit zero in late February.

“Any further equity declines will likely see upward pressure on long-dated put vol from autocalls,” say Bank of America analysts in a report published on March 10.

 

Peak vega on the Nikkei is estimated at around 18,000 to 20,000. The index fell below this range on March 13, ending the day at 17,431 – down by more than 6%. Compared to previous selloffs, hedging turbulence has so far been contained, some say, but this could change rapidly beyond the inflection point.

“Up until now, in this selloff, it has been relatively OK. Once you go below peak vega, dealers need to buy back vol,” says one Tokyo-based analyst at a European dealer. “Once that happens at the same time – everyone else buying vol – you'll get potentially more risk in terms of vol upside.”

If spot keeps falling and eventually hits the downside barriers, vega exposure is wiped out altogether and delta exposure increases. Put simply, autocalls begin to behave as a delta-one instrument rather than a structured product. In a standard autocall, any spot fall below the barrier is only realised when the product matures. At this point, the buyer would receive the index value of the product.

Dealers’ downside barriers are generally spread over a range, reflecting spot levels at the time of issuance. For Eurostoxx 50 issuance, analysts estimate this level sits between 1,800 and 2,300. For Nikkei products, it is around 12,000–15,000.

For example, if an investor entered an autocall with initial spot at 3,600 and a 60% put barrier, an index level of 2,160 at maturity would see the investor lose 40% of the initial investment. If the product matured with the index at 1,800, the investor would lose 50% of principal. Full principal would be returned as long as the index is above the 2,160 barrier at maturity.

Hedging defences

For dealers, hedging costs could cut into first-quarter equity trading revenues, but some suggest it will be less painful than in past episodes. That's partly because a second-half 2019 and early 2020 rally in the Eurostoxx 50 helped clear out a glut of legacy instruments that had been piling up on bank balance sheets. The new crop – typically issued at spot levels of 3,600 and above – still has a cushion before investor capital is at risk.

“Had we gone down without going up first, we could be in a very dangerous place. But we’ve got a decent buffer following the 2019 rally,” says a strategist at another European house.

Some indicators of stress across structured products desks have been relatively muted. For example, moves in dividend derivatives, which have previously acted as an indicator of problems on structured products desks, have performed in line with spot.

“The gap lower in pretty much all of the div curves has followed spot – everything’s down 25%. In as far as that’s been a broader indicator of pain in autocallable books, you don’t seem to see that footprint now,” says the equity derivatives strategist.

Korea’s equity-linked securities (ELS) market is typically a hot spot for autocall hedging disarray. Dominated by ‘worst-of’ baskets of two or three underlying indexes, the instruments reference the worst-performing one at any given time. This exposes dealers to shifts in correlation between the underlyings, making hedging more complex and costly in times of stress.

According to a source at a Korean securities house, hedging of single-index ELS has been relatively calm so far. Through 2019 issuance of ELS has been at average spot levels of 3,300 for the Eurostoxx 50, 10,000 for the HSCEI and 275 for the Kospi.

Hong Kong’s HSCEI has been an outperformer, losing just over 10% over the past three weeks to end on Friday at 9,650 – but still well above peak vega estimates of 8,800. The Kospi has shed 18% over the last three weeks, hitting 240 on Friday – just 10 points above peak vega estimates.

With surging volatility and increasing correlation between underlyings, a few dealers will have suffered from more ‘cross gamma’ and trading costs

Source at a Korean securities house

“In spite of recent turmoil, dealers’ ELS hedging is stable in response,” says the source.

He warns hedging of worst-of baskets may have proved far more painful for dealers: “With surging volatility and increasing correlation between underlyings, a few dealers will have suffered from more ‘cross gamma’ and trading costs.”

Cross gamma is the rate of change in the delta of one exposure in response to a change in another underlying.

Other defences which may keep losses in check include greater product diversification, meaning products are less concentrated around given strikes.

In Asia, analysts say banks learned a lot from the 2015 crunch in Korean products.

“Banks are more proactive and dynamic with hedging than in the past. It’s not as though you sit there and hit 3,000 and all of a sudden you need to re-hedge. Banks have learned lessons and are a bit more strategic in the way they do their hedging,” says the strategist at the second European house.