Macro Tourist

The Macro Tourist Finds A Large Mispricing…

"I love trades where I understand the mechanics of a large mispricing".

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Imagine you a trader sitting on a structured products desk.  The Great Financial Crisis hits. Suddenly clients are keenly aware of the downside risks in the market.  How do they respond? By demanding products that limit their potential loss.

So what do you do?

Well, when the ducks quack, you feed ’em. And feed them, they did.

Over the past decade, dealers have issued a monstrous whack of Equity Index Linked Notes.

From a Reuters article earlier this year:

Sales of risky equity products boom despite recent bank losses

Sales of structured products are booming again in a key region for these complex, equity-linked securities, just months after banks reported hefty losses from this kind of activity when markets slumped in late 2018.

Investment banks make hundreds of millions of dollars in revenues every year selling structured equity products to retail investors throughout the world.

Building complex equity-linked products and selling them to retail investors through wealth management networks forms a cornerstone of most large banks’ equity trading operations. The top 12 investment banks made US$14.4bn in equity derivatives revenues in 2018, according to analytics firm Coalition, with roughly US$2bn of that coming from structured issuance.

But what the heck are Equity Linked Notes anyway?

They are products that typically have a maturity of between 2 and 10 years and allow investors to participate in the upside of an equity index while offering safety of principal.  There are many flavours, but at the end of the day, it comes down to this; the dealer slaps together a fixed-income product along with a long-term equity index call option and sells it to retail.

The nice thing about this product (at least from the dealer’s perspective) is that it is difficult for end-buyers to understand how much they are overpaying for the custom structure.

I am not here to judge.  As Bob Dylan noted – we all gotta serve somebody.  Rather, I would like to talk about potential investment opportunities related to this massive issuance.

How to hedge a structured product book

Often these structured products are made more complicated to obscure pricing, but fundamentally, there are two risks that need to be hedged; the fixed-income component – which is a relatively straightforward affair, and the equity index option.  It’s the equity index option where the opportunity lies for us.

I could talk about the effects these products have on longer-dated option pricing.  There is no doubt Equity Linked Note hedging pushes up implied vols for long-dated equity index options.

But what interests me more are the opportunities that lie in an oft forgotten part of the option pricing model.

We all know how changes in the price of the underlying index affect option pricing.  And a lot of us understand how forward volatility determines the profitability of a hedging dealer’s short position.

Dealers try to hedge as many of these risks as much as they can.  Sometimes they do so by buying other options whose “greeks” are similar to the option they shorted through the Equity Linked Note.  However, that’s not usually the case.  More often than not, the dealer is forced to maintain a hedge for the life of the note.

Chasing around gamma or hedging interest rate exposure is old hat.  Nothing new to talk about there.

Yet what fewer market participants realize is that these dealers have massive epsilon risk.

I can hear you already – “Epsilon risk?  C’mon Kev, you are just trying to be a quant nerd and it’s coming across more like that finance-bro-that-needs-to-be-ditched-at-the-next-bar.

Yeah, ok.  I have to admit I needed to look it up.  So instead of talking Greek (geek), let’s translate that into English.

The dealers have gobs of exposure to the future dividend streams of the indices that the options they sold are based on – epsilon risk.  

To illustrate this point, let’s make up an option – something that approximates the typical Equity Linked Note option that dealers have sold to retail.

The S&P 500 closed yesterday at 3120.  Let’s price out a 5-year at-the-money call option.

Using the default values that Bloomberg spits out, the option is worth 430.

Now, what happens if the forecasted dividend yield is not 2.243% but instead sinks to 1.00%?

If the dividend yield declines, then the forward rises, and this has the effect of causing the price of the option to also rise.  But don’t forget the dealer is short that option, so this decline in dividend yield causes a loss.

Now to some extent, dealers can handle this risk.  There is a lot of juice in the Equity Linked Note deal, so letting dividend risk (or your epsilon exposure) ride is not uncommon.

The problem occurs when you sell so much of this stuff that your risk manager starts getting nervous.  The first $10 million of epsilon risk is fine.  Crap, even $100 million is acceptable – after all dividends usually increase over time.  But when it gets to levels that make Nick Leeson blush, even Jamie Dimon says it’s time to hedge.

However, how do you hedge dividend exposure?  You could attempt to quantify the relationship between dividends and the underlying index to put on an approximate delta hedge, but that makes your risk manager even more nervous.  No, if you want to sell more of your Equity Linked Note, the manager says you need to get off your dividend risk clean.

So you find a counterparty willing to take that dividend risk off your hands.  But let’s be honest – who wants dividend exposure out five years?  That’s not an attractive asset class for many.

Therefore, to hedge this dividend risk, dealers are forced to offer it at rates that entice natural longs.  The dealers end up giving away dividend swaps at levels they know are stupidly-low priced, but they don’t care because they are making so much money selling Equity Linked Notes they don’t want the gravy train to end.

The opportunity

I don’t know if this pricing occurs in all markets, but Canadian equity dividend swaps are offered at levels that are extremely attractive to market participants willing to accept exposure to the future dividend stream of the S&P TSX Index.  My guess is that any market where a lot of Equity Linked Notes have been sold against it is suffering from this anomaly.

I am still waiting for my MacroTourist ISDA approval, but oddly the dealers don’t seem to be banging down my door to trade with me.  Unfortunately, this opportunity in the Canadian dividend swap market is passing me by.

But don’t fret – there is a listed market that trades dividend futures.  Those Europeans seem to love to list all sorts of long-dated derivatives on their indices.  Lucky for us, they have a dividend futures contract, and even more fortunate is the fact that they have active contracts all the way out to December 2027!

Look at the shape of that curve!  The December 2019 contract trades at 122.00 and apart from the next year’s contract, the rest of the curve is progressively lower.

In a regular market it would make sense to assume that since dividends increase over time, the forward dividend future should be higher, not lower.  Yet with the peculiarity of negative rates in Europe, combined with the hedging from dealers already overweight too much dividend exposure, you get a steeply discounted price in forward levels.

I wish I could buy Canadian dividend swaps at a discount, but absent an ISDA, this European dividend future is my next best option.  I know everyone is convinced European stocks will never rise again.   No sense sending me a note about the inevitability of a European collapse – I know all the ominous terrible facts.  But that’s the point.  Everyone knows that argument.

I love trades where I understand the mechanics of a large mispricing.  I especially love them when they are positive carry.  And even better when everyone thinks you are an idiot for even contemplating going long…


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