Volatility is often referred to as the “investor fear gauge” as it is generally higher in times of distress. In the last 15 years there have been several panic situations: the Asian Crisis in the late 90s, the demise of the tech bubble in the early 2000s, the SARS scare in Asia in 2003, and most recently, the global financial crisis of 2008. All these large distress events led to episodes of increased volatility (in some cases radically so). It has been a little less than five years since the last “big event” and volatility levels have reverted to near pre-crisis lows, even though there are still several macro risks and the economies of many developed and developing countries look weak. This drop in volatility can be partially attributed to the provision of liquidity by central banks around the globe to many investors who, in search of yield, have sold off options to pocket the premium, further depressing volatility.
Volatility in Asian Markets
Although volatilities are low across-the-board, we see some divergence between the major Asian markets and the rest of the world. First, the most common observation is that the volatility of volatility1 is generally higher in Asian markets than in other developed markets. Second, representing the crux of the opportunity, Asian markets typically have skews2much lower than those in the West (as seen in the graph below), and we believe a key reason for this is the plethora of structured products sold in the region. Since these are principally OTC retail products, it is difficult to gauge the exact size of the market. However, it is known to be quite significant as we will discuss later with regard to Japanese Uridashi notes.
Structured Products in Asian Markets
While there are many types of option-linked structured products, some of the most widely issued products in the region are notes designed by bankers to pay a slightly higher yield under “certain conditions.” These notes are typically linked to the performance of stock indices, currencies or even blue chip stocks, and are issued mostly in South Korea, Hong Kong and Japan.
One example is Uridashi (literally “sell-out”) notes, a popular structured product in Japan. These notes typically pay a higher coupon (which for the past few years has hovered around 2-4%) to the investor, but are “taken out” if the Nikkei either goes over or under certain pre-determined levels. The lower of these barriers is an at-the-money, down-and-in put option generally set at 50-60% of the deal spot. The higher barrier is a knock out, meaning the product matures early if it hits a set target (typically 105-110% of the deal spot).3 The dynamics of being taken out (generally called knock in/knock out) of the products are actually what create a very interesting dynamic in volatility. For these products, the investor is basically selling options to capture the premium, which provides the additional yield. The issuer has to buy these options and becomes long vega.4 To hedge the position, the issuer shorts other options to bring down vega exposure, which is how the downward pressure on implied volatilities is transmitted to the listed options market.
This position is fine as long as the issuer is within the barriers of the knock-out or knock-in. If the market moves within this range, the bank can gradually adjust its hedge as needed. The interesting dynamic occurs when markets break these barriers – suddenly the options the bank bought from investors are nullified. In this case, the bank’s long vega position disappears and banks end up holding a lot of short option positions that they initially sold as a hedge. The banks are then forced to buy any options available to re-hedge themselves which accelerates the upward movement of implied volatility. This happened during the strong rally that started in December 2012 when Prime Minister Abe’s new government announced aggressive plans for monetary easing. When the market broke the upside barrier of many of the outstanding structured products, the issuers of the Uridashis were forced to re-hedge. Nomura, the largest issuer of these products (it is estimated to issue 30-40% of the total market), estimated the total notional amount outstanding for these notes was about $15bn,5 which offers some sense of the magnitude of change in implied volatility caused by re-hedging. Additionally, the spike in implied volatility in a rising Japanese market is indicative of re-hedging given that, in general, implied volatility often falls or remains flat in strong up-markets.
Taking these factors together, it would appear that implied volatility in Japan was at artificially compressed levels before the flood-gate burst of option buying. Based on the views of market makers, the current consensus seems to be that everyone has essentially covered their short positions and that markets are near a new equilibrium. However, it follows that if another wave of these products were to be sold at current levels (which would, of course, provide more yield due to current heightened implied volatility) we could find ourselves in a similar scenario with new sets of barriers yet again. However, the counter-argument is that, for the time being, Japanese equity markets are “exciting” again so there would not be as much retail investor interest in these products as before. In any case, the volatility dynamics of Japan merit close monitoring.
Volatility Dynamics in South Korea and Hong Kong
South Korea and Hong Kong also have similar, yet also different, dynamics caused by structured products. Both markets, especially Korea, have very low implied volatility. There is evidence to suggest that the low volatilities are partially driven by structured products, as in Japan before the strong rally. One could argue that there could also be a potential acceleration of implied volatility in Korea if there is a strong market move either to the upside or downside. However, although there is an abundance of auto-callable note products similar to the Uridashi bonds in South Korea and Hong Kong, investors in these countries do not seem drawn to only these types of notes. One example is that there is also strong interest in other products such as best/worst of call notes that do not have barriers that suddenly nullify them. So while the banks may have to hedge themselves, such activity could be more gradual than, and not as dramatic as, having a certain point where the options disappear, causing banks to become short in a fast moving market and frantically purchasing options to hedge themselves.
Preparing for Volatility-Related Opportunities
Asian markets have shown unique characteristics with regard to volatility through lower skew and much larger and faster moves in volatility when markets move. We believe the search for yield in Asia via structured products has been a contributing factor to these distortions. Japan was probably the most obvious recent example as the implied volatility was at historical lows but had spot levels (barriers) that led to a burst of implied volatility when the market moved up. This meant an investor could have taken advantage of buying very cheap options with much more upside than in other markets. Of course, it’s easy to point this out in hindsight after the move happened. Going forward, being aware of these dynamics should present future opportunities to investors through absolute return or long-biased tail hedge volatility strategies.
1 Volatility of Volatility: Volatility is measured by using standard deviation of returns from the same security or market index. In a similar sense, Volatility of Volatility is measured by standard deviation of volatility.
2 Skew is the difference between the implied volatility of out-of-the money put and call options that are the same distance from the strike. For example, in this paper we used the difference between a put that is 10% out of the money (90%) and a call that is 10% out of the money (110%). Usually in developed markets such as those in the US and Europe the skew is positive as more investors want to buy puts and they are more willing to write calls. A flat skew in Asia generally means there are more sellers of puts than in markets such as the US or Europe.
3 Cameron, Matt. “Uridashi losses put at $500M after Nikkei rebounds.” Nomura: The Uridashi Market, and Risk.net (November 2011).
4 Long Vega: Vega is the measurement of an option’s sensitivity to changes in the volatility of the underlying asset. Being long vega means being long optionality – the sensitivity to volatility is positive.
5 Nomura: 2013 Jan 18 Nikkei Vol Update
David Shin is an Associate Director working in Portfolio Management based in the firm’s Singapore office. Prior to joining PAAMCO, David was a senior analyst at Audax Group, a private equity fund in Boston. He began his finance career at Merrill Lynch Private Equity Partners and prior to entering the finance industry he spent two years working for Inductis, a boutique strategy consulting firm based in New York. David holds a Bachelor of Science degree from Columbia University, and an MBA from the UCLA Anderson School of Management.
David Walter, Director in PAAMCO’s Singapore office, made significant contributions to the analysis behind the conclusions in this paper. The author very much appreciates David’s insights and assistance.
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