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Technical: How volatility can affect returns offered by structured products

13 August 2017

Ian Lowes, founder of StructuredProductReview.com, explains how volatility and other factors in the market can result in headline rates changing from one issue to the next and how structured products can be used in client portfolios.

Those of you who use UK structured products within your portfolio construction will know that providers launch new investment products on a regular but discrete basis, mostly for a limited period only.

More often than not, each launch remains the same in all facets but one, the headline rate. The change in headline rate is best summarised as being the effect of net changes in the pricing environment from one issue to the next.

So, what drives the difference in returns offered from one launch to the next? Why would a product launched in June have better or worse terms than the similar product launched in January?

There is a plethora of factors at play here – the level of the underlying index, anticipated dividends, the credit quality of the issuer / its funding rate – but by and large it is two main factors, the change in interest rates and volatility.

Interest rates

Interest rates continue to remain relatively benign and can probably be discounted for the present time except where a provider moves a kick-out event in terms of timing, meaning a potential change in maturity date and therefore the portion of the overall investment needed to defend capital preservation would change.

Since the collapse of interest rates following the financial crises, the major driver in the pricing of structured products has been around changes in volatility.

So, what is volatility and how does it affect the pricing of structured products? Is volatility a good or bad thing in pricing?

Volatility impact

Volatility measures the rate of change in the value of an underlying asset (such as the FTSE 100 Index). Low volatility means the change in price movements is relatively low, whereas high volatility means prices are changing considerably, regardless of direction. Importantly volatility measures captures both positive and negative price movements, i.e. it looks at absolute price changes.

Volatility itself is also a tradeable investment as measured by the VIX, vStoxx and

vFTSE; all tend to behave in a similar manner and are highly correlated; the VIX is the best known one and often quoted by the media when there is market turbulence, it is based on the performance of the S&P 500 Index. Currently it is measuring around 9.5, having been under 20 since February 2016 and having reached almost 59 during the 2008 financial crisis. The absolute numbers will mean little as it is their relative difference that is perhaps more relevant. It’s worth keeping an eye on the performance of the VIX not only as an investment barometer, but also to understand why structured products change over time.

Historically there have been three styles of structured product prevalent in the UK market since its inception more than 25 years ago. These are:

  • Fixed term capital protected investment where the return is dependent upon the positive performance of an index, usually the FTSE 100 Index;
  • A fixed term regular income based investment where the capital return is dependent upon observing the performance of the index either during or at maturity, almost always with a large contingency buffer built in before capital is lost;
  • A variable term investment where a product may mature at observed points conditional upon the performance of an index, with a return based on pre-defined fixed amounts.

It is this last style that has dominated the current market and one that we will dwell upon later. However, it is worth setting the scene by highlighting why the first two styles are rarely seen now.

Change in the market

With the capital protected product, the majority of the investment is used to defend the ultimate capital return, so if interest rates are say 1%, that only leaves 5% (assuming a five- year product) to gain investment exposure (excluding the providers manufacturing costs).

During periods of low volatility, the price of gaining this exposure is lower than when volatility is high because the market expectation for strong growth is lower, so ideally with volatility fairly low at present one would think that we should see more of these products. Sadly, this is not the case because with only 5% to allocate, any exposure to an index would be low, as little as 25%! That doesn’t make the product proposition very appealing.

The income product works slightly differently, the risk is put on the capital side of the equation and here the value of putting capital at risk is reflected in a higher than otherwise income rate being offered.

Again, volatility plays a role, if there is little expectation that capital will be lost, e.g. the risk to the capital preservation buffer is deemed to be high, then with low volatility, little premium is gained by risking capital resulting in little income pick- up.

That’s where we are at presently, hence why there are few products and those that are out there are typically from providers who perhaps have higher funding demands than say banks with a higher credit rating.

Another feature here is also to make income conditional, i.e. introduce an element of uncertainty of payment in the income, however unlikely.

Autocall or kick-out

That leaves the final style of product which most of us will recognise as being the ‘kick-out’ or ‘autocall’ product. The pricing of this product is almost entirely centred on volatility; if volatility is high then the risk of an event happening is considered higher than if volatility is lower.

You may recall the days when regular style kick-out products, yielded potential for returns around 10-12%p.a.? Today it might be 8%p.a., so what has happened?

Yes, the fall in interest rates has had an impact, but the main driver has been the lowering of volatility meaning that the premium you can earn for putting capital or the return at risk, is less.

What is perhaps unusual about the current environment is that not only is volatility relatively low across the board, but the desire for capital protection is very high, perhaps driven by pension freedoms and IHT planning.

Arguably, low volatility is most often seen during bull markets and is generally suggestive of modestly predictable markets and relative calm. Clearly that can change and change quickly, particularly in sentiment-driven markets marked by geopolitical events and 24-hour streaming news.

Using structured products in client portfolios

Whlist returns on structured products vary from tranche to tranche, it seems apparent that structured products can add additional diversification to portfolio construction. The ability to structure products with payoff profiles, to generate returns in both bull and bear markets means that investors have the opportunity to achieve positive returns even if the market performance is negative.

Equally, if the market merely moves sideways, a structured product may produce a positive return where, other investments, such as a tracker fund would only achieve growth through dividends.

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