Thursday, January 24, 2008

Risk 2008 Equity Derivatives House of the Year - Société Générale

Newspaper headlines in August were dominated by the credit markets - the rise in US subprime mortgage delinquencies, the nasty losses reported by banks, hedge funds and structured investment vehicles, and the sharp squeeze in liquidity. However, the equity markets also had a rough ride. Most notable was the plight of quantitative hedge fund strategies, many of which racked up sizeable mark-to-market losses in just a few days in early August. But the sharp rise in correlation and volatility also caused some pain for dealers.

With one of the largest exotics books on the Street, one would imagine that Société Générale Corporate and Investment Banking (SG CIB) would be licking its wounds and coping with hundreds of millions of euros in losses. There was some impact, but the losses have been relatively minor and entirely manageable, says Christophe Mianne, SG CIB's head of market activities, covering equity, derivatives, fixed income, currency and commodities in Paris.

"We managed the existing book very well because we decided some time before the crisis to be long volatility and be less sensitive to correlation, so the losses were minimal. We suffered on our statistical arbitrage trading activity, but that was just for one month, and minimal compared to some hedge funds or other banks. Overall, our trading activities will be approximately flat compared to last year, which is a good performance," remarks Mianne.

Third quarter figures appear to bear this out. Net banking income for equities increased to EUR679 million from EUR609 million in the third quarter of 2006. Trading revenues fell from EUR264 million in the third quarter of 2006 to EUR112 million over the same period of 2007, but revenues from client-driven activities (flow, structured products and cash equities) were up 65.4%.

"We always quoted to clients and we were always present. For me, it was more important to be there for clients rather than worry about any mark-to-market losses on a few trading positions. Our reputational franchise is worth far more than any loss during one month," adds Mianne.

Indeed, many clients praise SG CIB not only for consistently providing liquidity during the market turmoil, but for coming up with innovative structures that helped them benefit from the leap in volatility in August and September. One such structure is Symphony, a product designed to extract value from the implied volatility smile on a basket of stocks.

"Symphony is the most innovative thing we've seen in the derivatives markets this year. In terms of performance, it's been phenomenal given the volatility of the market," says one head of trading at a New York-based hedge fund.

The volatility smile - which reflects the fact that the volatility implied from the market price of vanilla options varies with maturity and strike - is driven by supply and demand dynamics in the equity derivatives market. In effect, the relative smile implies that high-performing stocks are less volatile than low-performing shares. However, this is often not realised in the short term - mainly because investors are quick to buy en masse following rumours of takeovers or unexpected good news on a stock, but are not as quick to sell. By incorporating a payoff that is sensitive to skew, Symphony enables the investor to benefit if this implied smile is not realised.

The product is based on a basket of 30 stocks (although Symphony structures referenced to a basket of 12 or so indexes have also emerged). The underlyings are ranked in order of performance based on a three-month observation period, and the portfolio is split into three groups - the best-performing stocks, the average performers and the worst-performing stocks. The relative smile can then be observed by calculating the difference between upside and downside performance (the best-performing portfolio minus median on the upside, and the median minus the worst-performing portfolio on the downside). In essence, investors are systematically going long the upside performance of the best-performing stocks and short the downside performance of the worst performers. So long as the best-performing stocks' volatility is greater than that implied by the smile, and volatility on the downside is less than what is implied, investors will make money.

To benefit from this non-realisation of the implied smile in the short term, the product comprises a series of swaps with three-month maturities. So, a two-year structure would incorporate 22 swaps of three-month maturities launched each month. The two-year structure also has a global floor of -25%. "What we saw is that it was a payoff that is very robust and makes money statistically whatever the basket," explains Stephane Mattatia, head of engineering for hedge funds business in Paris. "The payoff is very skew sensitive and has a very interesting characteristic - it is short skew and long volatility."

This meant the product performed well during the spike in volatility in August, with a number of hedge fund investors buying the structure as a hedge for their portfolios, adds Mattatia: "Some of our clients realised this is the perfect hedge because it is a long vol product with positive carry. And it worked very well - it proved to be negatively correlated to the market." SG CIB has traded more than EUR1.5 billion of Symphony so far, primarily with hedge funds.

Another innovation this year was the timer option. These products allow buyers to specify the level of volatility used to price a call or put option, rather than relying on implied volatility. As implied volatility is often higher than realised volatility, this means investors are not overpaying for options.

When buying a timer option, the investor would specify an expected volatility and a target investment horizon. This is then used to calculate a variance budget (target volatility squared, multiplied by the target investment horizon). Once the variance budget is consumed - in other words, once realised volatility squared multiplied by the number of expired days divided by 365 is greater than the variance budget - the option expires. If the realised volatility exactly matches the investor's expected volatility, the expiry of the option will equal the target investment horizon. If realised volatility is higher or lower, the option will expire at an earlier or later date (Risk July 2007, page 6). Since the timer calls were first launched in April, the bank has traded in excess of EUR1 billion with hedge funds and asset managers.

More recently, however, SG CIB has developed new additions to the timer option range - the timer outperformance call and the time swap. The outperformance product is similar to the timer call: the investor specifies an expected volatility for the spread between two underlyings and a target investment horizon, which is used to calculate a variance budget. Mattatia claims the timer outperformance call can be 30% cheaper than a plain vanilla outperformance option - that's because the price of an outperformance option depends on the implied volatility levels of both underlyings (meaning the investor is overpaying volatility) and implied correlation between the two (which is usually under-priced).

The time swap, on the other hand, gives investors a means to short volatility with an inverted convexity profile (meaning the downside is limited). Rather than volatility, the strike is expressed in days. In other words, if an investor wants to short volatility over a specified investment period - for instance, three months - a variance budget is calculated with a volatility level set by SG CIB. The payout is based on the number of days required to consume the variance budget minus the specified investment horizon, times the notional. So, if realised volatility is consistently lower than the specified level, it will take longer than three months for the option to expire, and the investor receives a payout.

But it's not all about innovation. The bank also set itself apart by opening one of its proprietary fund of hedge funds to external investors in January this year. Called Turquoise, the fund was up 14.5% as of the end of November. "We decided to open up one of the hedge funds within our equity derivatives group and sell it directly through Lyxor," says Laurent Seyer, Paris-based chief executive of Lyxor, the asset management arm of SG CIB. "We are now contemplating opening up a couple of other funds managed by the Turquoise team that will be focused and more concentrated on a thematic investment line, although it is not decided yet." The fund had raised $2 billion in its first five months, causing the bank to announce a soft close by the end of May. By the end of October, Turquoise had $2.4 billion in assets under management.

However, arguably the most groundbreaking shift this year is the move into active management of structured product portfolios. Called CrossRoads, the new initiative aims to combine structured products and exotic option trading know-how with active management, with the aim of winning mandates from large institutional investors. By doing so, SG CIB is competing directly with traditional asset managers - but Arnaud Sarfati, head of equity-linked structured products at SG CIB in Paris, believes the firm has a real advantage.

"A lot of these clients are used to giving mandates to asset managers. More and more are also realising the benefit of structured products as a means of improving the efficient frontier of their portfolios, but they don't consider themselves experts in the product. Therefore, if you can provide both the added value of a structured product plus an actively managed approach through a mandate, this is matching the demand of clients," he says.

Indeed, the active management approach meant clients were able to benefit from the rise in volatility last August. In one mandate, initially comprising five strategies, two vega negative strategies with high delta were redeemed in December 2006, and replaced with market neutral vega positive strategies to take advantage of a projected rise in volatility. Following the spike in volatility earlier this year, the fund took profits on the vega positive structures and invested the money into cash, enabling the firm to comfortably beat its performance objective of 10% a year.

"At the end of the day, you have much more flexibility than a traditional asset manager because both can use a traditional asset, but you can also get exposure to hidden assets on an actively managed basis. You have much more tools at your disposal than a traditional asset manager," adds Sarfati.

This has all contributed to a sharp rise in Lyxor's assets under management, from EUR61 billion at the beginning of last year to EUR73 billion as of end of October. That's not to say Lyxor was untouched by the volatility in August. Several hedge funds on its managed account platform (in particular, the statistical arbitrage funds) registered losses, while the platform was hit by some draw-downs in August - a result of delta and gamma adjustments from SG's structured products traders and some redemptions from fund managers. But Lyxor recorded net positive inflows in the third quarter of EUR530 million overall.

"It will be the best year ever, both in terms of asset gathering and performances," says Seyer. "We are aware that the environment is uncertain and there is a lot of volatility, and we don't pretend some of the hedge funds on our platform won't be hit - some were. But, on average, annual performances remain at a peak and we have been extremely pleased with the resilience of returns this year."

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