Saturday, May 21, 2005

Preparing for pressure

Preparing for pressure

Christopher Jeffery

“Once in a while, we do trade options that are very out-of-the-money puts with hedge funds acting as reinsurers” Thomas Mennicken, BNP Paribas

“In the event of a crash, certain sectors are more affected than others, and this is what tends to save correlation books” Richard Carson, Deutsche Bank

A jump in credit and equity market volatility last month could signal the end of a sustained period of market calm. How are dealers positioned to deal with severe market stress? Christopher Jeffery reports

Investment banks have not faced any major stress in the financial markets for more than 18 months. The last jump in equity volatility was sparked by the Madrid bombings in March 2004 and it was barely noticeable. While some dealers suffered losses from the interest rate spike in the third quarter of 2003, overall losses to the financial community were limited. Meanwhile, credit spreads have contracted sharply since the slew of defaults in 2000/01.

This lack of volatility in the three largest asset classes has presented dealers with a number of challenges, most notably how to make money from their proprietary trading desks – their value-at-risk levels have already risen dramatically. At the same time, banks are faced with an almost insatiable demand from pension plans and insurance firms seeking high-yielding investments to cover their gaping funding holes. These investors are buying hedge funds and structured multi-asset-class products, and are increasingly looking at emerging markets and high-yield investments. Some are even buying dealer book axes on relatively new assets such as correlation and variance.

Although this risk appetite has pushed down spreads, banks still appear well capitalised and are hedging a wider variety of their risks – most notably using credit default swaps and synthetic credit indexes. But there is a fear that this relatively benign market environment may have caused a degree of complacency among dealers and investors at a time when complexity is growing. “As a risk management person you have to ask yourself, ‘isn’t it at times like this that the problems tend to crop up, when people push too far?’ You have to be sure that people don’t rely too much on liquidity or complex hedges that work today, but might come back to bite you in a stressed environment,” says Wilson Ervin, head of strategic risk management at Credit Suisse First Boston (CSFB) in New York.

Perhaps ominously, both credit and equity markets have witnessed an increase in volatility in the past few weeks – albeit relatively small. Credit spreads in the European Dow Jones iTraxx index widened by more than 1% last month, while the Chicago Board Options Exchange’s volatility index, which represents the implied volatility on an S&P index option, hit a high of 18.59% compared with a level of 11.28 points on February 14.

These jumps in volatility might be the early warning that banks need to assess the consequences of dramatic market shocks on their trading books. In fact, dealers say they have significantly increased their focus on stress testing. “In limit monitoring we have both sensitivity limits as well as stress triggers, which vary in nature across different asset classes,” says Eduardo Epperlein, global head of market and counterparty credit risk analytics at Citigroup in London.

Senior management focus on the matter has also increased dramatically. “We do spend a lot more effort and time doing stress tests at the firm level as well as down at the trading-books level these days,” says CSFB’s Ervin.

Some dealers have taken matters to the next level and started laying off risks presented by market shocks through the use of what they call ‘stress test’ or ‘gap risk’ hedges – trades that act to counter the behaviour of derivatives positions placed under extreme market events, such as a 20% or 30% fall in the price of an underlying asset.

“Once in a while, we do trade options that are very out-of-the-money puts with hedge funds acting as reinsurers,” says Thomas Mennicken, head of market and counterparty risk analytics in the group risk management department at BNP Paribas in London. “They do have the appetite. But these deals are confined to a general exposure to the market, as hedging more specific exposures linked to one counterparty is usually more difficult,” he adds.

Such transactions are typically based on quotes provided on the interbank market for 20% or 25% cliquet puts on baskets of equities or equity indexes. Maturities for these deals are normally two years, with durations lasting for one day, two days or even one week, according to one major dealer. Some major equity derivatives houses have conducted such transactions – notably to cover their capital-guaranteed business – although these instruments are not yet regularly quoted on the interbank market.

And a number of banks have also used hedge funds as well as reinsurers to lay off some of their more esoteric risks, such as correlation, which they say acts as a partial hedge against a stress event. “One way to reduce exposure in, say, equity correlation is to sell some of it as a correlation swap,” says Paris-based Laurent Dignat, head of alternative risk transfer at SG, the investment banking arm of Société Générale. “As a result, when you look at your exposure and you do the stress test, as your limit is lower, so your exposure on your stress test will be lower,” he adds.

Correlation swaps usually have a maturity of between one to three years and price between e250,000 to e1 million per point of correlation. Dealers need to structure bespoke baskets of 10 to 35 individual names where they have significant risks. “A reinsurer’s job is to take risk and carry positions to maturity, which is what we want to finance as a counterparty,” says Dignat. “Alternative risk transfer can provide reinsurers with a new profile that they don’t have in their portfolio. Those risks are not correlated to traditional property and casualty risks, and therefore can represent a huge diversification element.”

While reinsurers such as Swiss Re have taken on some of these risks, the alternative risk transfer units at other leading insurance companies such as Chubb, Zurich Financial and AIG have suffered notable cutbacks or closures in the past three years. With business returns in the mainstream reinsurance sector hitting levels of 17–20%, it is unlikely that senior management at these institutions will concentrate on non-core activities, despite the seemingly endless cyclical boom-and-bust nature of reinsurance returns.

But does hedging correlation really help a bank in a stress scenario? Richard Carson, Deutsche Bank’s London-based global head of structured products trading for Europe, says they are far from perfect. “In the event of a crash, certain sectors are more affected than others, and this is what tends to save correlation books,” he says. “For example, the insurance and airline sectors were hit particularly badly after 9/11, whereas oil, gold and defence stocks outperformed,” he says. “The other sectors moved in line, so you saw a decoupling at the same time as the market was selling off.” Carson says the only recent case he’s seen when the market moved in a highly correlated manner was when Federal Reserve chairman Alan Greenspan cut interest rates in 2001 and virtually every segment of the equity markets rallied by around 10%.

However, the German bank does use stress-test hedges to cover its constant proportion portfolio insurance (CPPI) business. “The main area where we talk about stress risk is hedging CPPIs, which only really kicks in when the market is down 20% to 30%, and then the market would have a large exposure if we didn’t buy this risk,” says Carson. Like other dealers, Deutsche Bank buys deep out-of-the-money puts from hedge funds in the interbank market to cover its equity derivatives positions.

Dealers seek protection in this area, as they know their modelling of market crashes is far from perfect. “As crashes occur infrequently, there is not enough statistical evidence to properly model crash events. You can’t draw a particularly strong idea of the probability of a 20% fall tomorrow based on a crash in 1987, for example,” says the head of derivatives trading at a leading bank. “An even better example of this is in the hedge fund arena, where very few funds of funds have experienced a downward move of about 5–6%. So how do you value selling the 20% out-of-the-money put?”

In response, Deutsche Bank, SG and UBS have devised new methods of stress-test hedging their capital-protected structured hedge funds business. “We have issued a large number of bonds that will redeem early if specific funds of funds drop by more than 20%,” says Carson. These two-year bonds resemble reverse convertibles – which are similar to convertibles, but rather than buying a call option on a stock, the investor sells a put on the stock or index – and are effectively a 20% out-of-the-money put on a fund of hedge funds, except the strike rebalances every month. Investors receive around 50 basis points against the possible risk that they lose a proportion of their principal should the value of the underlying fund of hedge funds fall by more than 20%. This hedges Deutsche Bank against an adverse downward move. “There is a huge demand for these bonds, which we push through distributors,” Carson adds.

SG and UBS have also sold ‘stability notes’ to hedge themselves against a drastic drop in the market. “These are products that are going around at the moment where banks basically buy back some of the gap risk protection,” says the head of equity derivatives trading. “An example might be on the Eurostoxx, where you buy the 85/70 put spread from a client geared up 6.5 times, with the price being agreed up front. The client buys a coupon-paying bond and the extra yield above Libor is provided by these put spreads. So in any one day, if the market falls more than 30%, then the client could lose all their capital. If that doesn’t happen they’ll receive a coupon that could be 2% above base rates,” he adds.

However, some dealers warn about the dangers associated with shedding risk. BNP’s Mennicken cites JP Morgan’s lawsuit against a group of insurance companies in 2001, where the US dealer claimed the insurers failed to pay on surety bonds used to back $1 billion of prepaid forward natural gas and crude oil contracts for now-bankrupt oil company Enron. The same year it sued WestLB for failing to make payment on a $165 million letter of credit backing an Enron-related swap. “In that particular case, the insurers claimed JP Morgan was much better informed,” says Mennicken.

But Mennicken says it is harder for counterparties to make this a convincing argument if the hedge is related to a wider number of participants or to the overall market level – it is less likely that a dealer would be privy to information about a lot of companies compared with a single company.

“You do need to be careful,” adds CSFB’s Ervin. “When, say, you are hedging, you are clearly reducing your primary risk. However, you may be adding some second-order elements such as documentation risk, legal risk and implementation risk. While ‘second-order’ sounds small, it can sometimes be a big number as the scale of hedging and its complexity grows,” he says.

Mennicken says BNP Paribas’ risk management team is validating its risk systems by testing its entire equity derivatives book using new models – effectively, a stress test on the bank’s models. And it is also working on developing a consistent approach across asset classes, as the bank is increasingly forced to offer multi-asset-class structured products to yield-hungry investors.

Of course, these efforts could be largely in vain. A contrary theory to the ‘sudden market shock’ is the concept of a ‘death-by-boredom’ scenario, says CSFB’s Ervin. The developed world has large pension plan and insurance issues, with investors needing assets that provide yield, and investment banks and hedge funds need volatility. “If rates, prices and spreads continue to trade in fairly tight bands, and volatility continues to grind lower, you reduce normal trading opportunities. This hurts P&L – albeit in a different way – which can put different pressures on the system,” says Ervin. “It could be like watching the decline of the US steel industry: no sudden shocks but rather a terrible, slow-moving process.”

Wednesday, May 18, 2005

Cisco puts a spin on options

Cisco puts a spin on options
Manufacturer of computer-networking equipment proposes new way to value employee stock options.
May 12, 2005: 8:27 AM EDT

NEW YORK (CNN/Money) - Cisco Systems is seeking regulatory approval for a financial instrument that could allow the company to assign a lower value to the stock options than under current valuation models, according to media reports Thursday.

A Cisco (Research) spokesman confirmed that the big San Jose, Calif.-based company had recently proposed to the Securities and Exchange Commission creating a "market instrument" that would parallel employee options. The spokesman said Cisco is waiting to hear from the SEC.

Buyers of the new instruments, called employee stock option reference securities, or Esors, would not be able to transfer them and would have options that would vest over five years. Both provisions are similar to those in employee stock options, according to reports.

Cisco would use the new securities to value employee options on its books.

The Financial Accounting Standards Board adopted a rule last year requiring publicly traded companies to record the value of employee options as expenses in their financial statements.

Cisco will have to begin implementing the new rule in its fiscal year that begins July 31.

A lower value for the options would reduce the impact expensing will have on Cisco's profits and could lead other companies to follow suit.

Options give employees the right to buy stock for as long as 10 years at a price set when the option is issued, and thus can become very valuable if the stock rises over that period.