Deal of the year: Credit Suisse

Addition of knock-outs to corridor variance swaps keeps investors happy and helps with risk recycling

Arnaud Leteissier, Credit Suisse

Structured Products Asia Awards 2016

When Credit Suisse came out with the corridor variance swap in 2013, it provided a much-needed hedging alternative for flows of Japanese retail structured products that had cost dealers hundreds of millions of dollars. But for some clients, there was one problem: when the underlying indexes moved out of the corridor, the structure became useless and potentially expensive for clients and dealers.

Credit Suisse wins deal of the year for taking its ground-breaking innovation to the next level by adding knock-outs that allow the structure to end when the underlying Asian index moves out of the accrual range.

"We did some of the first trades with Credit Suisse on the corridor variance swap. We've been trading that product from the very beginning and been very active in it. But one of the issues that arose is that the trade consumes a lot of margin during its lifespan, even though we bear no risk. That can be pretty bad for return on equity, so we requested the knock-out feature," says a strategist at one hedge fund in Hong Kong.

The original corridor variance swap, introduced into Japanese markets in 2013, sees the investor going long the Asian index volatility between two strikes, and short the S&P 500 volatility between the same strikes. The investor only receives payments based on realised variance if spot is between these strikes. The structure is an important risk-recycling trade for Credit Suisse, because it allows the bank to offset large vega positions - the sensitivity of the underlying to volatility - from structured retail products, boosting its capacity to provide retail products.

We are able to hedge more products successfully compared to other market participants, so we can have a higher market share and a safer book
Charles Firth, Credit Suisse

"If you look at the Nikkei-linked private placement market, Credit Suisse is number one. This comes down to more sophisticated ways of recycling risk," says Charles Firth, head of the equity derivatives structuring for the Asia-Pacific region at Credit Suisse in Hong Kong.

"We are able to hedge our products more successfully compared to other market participants, so we can maintain a higher market share and a safer book. If you look at the market dynamics that caused so much pain last August, we've had a much smoother ride because of our hedging strategy. This means we are able to do larger trades and manage them more ably than our competitors."

However, some clients had an issue: if the underlying Asian index moves out of the range between the two strikes, then there will be no more accrual. To address that, knock-outs were added to end the structure when the Asian index moves more than 5% outside the strikes, paying the client the volatility spread accrued up to that date.

"The problem with the non-knock-out corridor variance swap is that, in the event of a big rally, the client will sometimes be locking up margin against the trade even though it isn't making them any carry any more, because the index is now way out of range. We put the first trades on with clients when the Nikkei was trading [within] a relatively narrow range. Then when it rallied to 16,000 the next year, clients were very far out of the money. Now, the knock-out feature allows clients in that situation to unwind naturally without facing any unwind costs," says Arnaud Leteissier, head of Asia index trading, Japan single stocks and quant trading at Credit Suisse in Hong Kong.

From the bank's perspective, adding the knock-outs allows dealers to escape the problem where a dealer could end up continuing to have to pay for their hedge even after their autocallable positions - which the corridor variance swaps are hedging - are wiped out.

If spot fell below the lower barrier, then rallied back into the corridor between the two strikes, the dealer's put option embedded in the autocallable would be triggered and the volatility exposure would be gone, but the bank would have to continue paying fixed payments to the buyer of the corridor variance swap, which means paying for a hedge that is no longer required.

"The knock-out allows the trade to disappear naturally at the same time as the bank's trade - the retail autocallable - disappears, which makes sense because the hedge should disappear when the trade disappears," says Leteissier, who designed the original corridor variance swap structure.

The knock-out isn't fit for all clients, as some benefit from holding onto the corridor and can handle keeping it on balance sheet even when it is not generating any carry. Those clients opt to stick with the original structure, which was launched by Credit Suisse in 2013 to recycle the risk from Uridashi autocallable knock-in, knock-out (Kiko) structures sold to retail investors in Japan.

The banks providing the Kikos are buyers of volatility, and then hedge by selling it via vanilla options as spot falls - but have to buy it back again if spot subsequently rises. Because in that situation the largely one-way market is illiquid, rehedging can cost a lot of money - for example, in 2013 UBS reported a loss of Sfr177 million ($180.6 million) linked to hedging Uridashi flows.

The corridor variance swap provides an alternative way to shift the vega without crowding into the same options trade as other banks - allowing the bank to write more retail business as a result.

How much more retail business this has allowed the bank to do is difficult to quantify, but Credit Suisse says it has been enough to more than hedge its autocallable business.

There have been times where the vega we did on corridors was bigger than what we did on autocallables - it was more than the hedge, so it was actually okay to go the other way to pre-position or pre-hedge for future supply
Arnaud Leteissier, Credit Suisse

"There have been times where the vega we did on corridors was bigger than what we did on autocallables - it was more than the hedge, so it was actually okay to go the other way to pre-position or pre-hedge for future supply," says Leteissier.

In 2014, the concept of the corridor variance swap was extended to South Korea and Hong Kong, and Credit Suisse added on the Min-Max variance swap concept. This goes long whichever of the two indexes has lower realised volatility, and on the second leg, goes short which of another two indexes has higher realised volatility.

While the corridor variance swap trade opens the door for more retail business, it's also a boon for sophisticated investors, as it allows them a lucrative play on expectations that realised volatility of Asian indexes like the Nikkei 225, Kospi 200 and HSCEI will exceed S&P volatility.

"I don't think we have ever traded a Nikkei corridor variance swap that lost money. I'm pretty sure everyone has made money - it's just a function of S&P realised volatility, which is complete garbage, and Nikkei, which is doing really well. So it's pretty hard to have a bad year. When Nikkei had an 8% move one day and that was in the band, it was just spectacular, and the S&P did nothing," says the hedge fund strategist.

The major downside for clients is that although they may make money in the end, the volatility of the indexes can make for heavy mark-to-market moves in the meantime.

"For hedge funds, it is a trade they carry to maturity. Mark-to-market will go up and down, but the point is because there is a very low entry level, there is no time in the past where they wouldn't have made money on the actual realised volatility, because the Nikkei is more volatile than the S&P. But it isn't free money: they have to be happy and ready to say: ‘I will make money on this trade, but I need to be able to handle the mark-to-market that can be against me for a while,'" says Leteissier.

Year to date, Credit Suisse has traded tens of millions in vega notional in corridor variance swaps of all types and since launching the original product in 2012, Leteissier estimates the bank has traded between $50 million and $100 million in vega notional with around 30 different counterparties.

Credit Suisse has also quoted a "weighted" version of the product where returns are given a weight that varies with spot, and a barrier where the knock-out is triggered on a basket of the two underlying indexes, not just the Asian index.

Other dealers entered the market in the meantime, and so when clients first requested the knock-out feature, it wasn't just Credit Suisse they approached, and Credit Suisse was not first to market. However, clients that have been on the corridor variance swap since the beginning say they still see Credit Suisse as a leading counterparty on the trade.

"Credit Suisse is great - in the vol space, I would say they are probably one of the single best houses on the Street. They are quite innovative - everyone knows they came up with the corridor variance structure, which has been very successful - and they continue to be quite innovative," says the hedge fund strategist. "I wouldn't say anything but good things."