A Proposal to study
Imbalances Created Because Of Structured Products in India Equity Markets
National Stock Exchange
Executive Summary
We propose to look at effect of hedging of structured products by dealers on equity and equity derivative markets HNIs and corporates are increasingly taking exposure to structured products as opposed to underlying stock themselves This would create an imbalance where the dealers would have to hedge their exposure in the underlying market We propose to look at the effect of this hedging and make an educated guess about the hedging behavior The outcome of the analysis is to give a clear picture of systemic risks embedded in hedging of structured products and possible liquidity measures to ease these tension points
National Stock Exchange
Imbalances Created Because Of Structured Products in India Equity Markets
Emergence of Structured Products
As a result of global integration, the widening and intensifying of links between developed and developing countries Indian equity markets have become considerably global with numerous new participants in various formats investing in the markets. Of the nonpromoter stock institutional participation is about 50% and retail participation about 30%. EXHIBIT 1: Shareholding pattern for various categories of investors as on March 2007
Promoters Non Promoters Institutional 1 48.08 2 6.87 3 5.85 4 10.78 5 3.23 6 0.63 7 0.42 Non Institutional 8 5.6 9 13.7 10 2.76 Shares held by Custodians (against depository receipts) 2.01
1 Indian Promoter 2 - Foreign Promoter 3 Financial Institutions /Banks/ Central & State Government/ Insurance Companies 4 - Foreign Institutional Investors 5 Mutual Funds 6- Venture Capital Funds including foreign venture capital investors 7- Others 8- Corporate 9 Individuals 10 - Others * Source- ISMR- 2007 www.nseindia.com
Higher participation of retail and corporate accounts in the market would imply a weak risk management in the system as a whole. As a result the market volatility would affect the end user more. To reduce the mark to market exposure increasingly retail (especially HNI and corporates) are moving towards buying structured products mostly in principal protected from or otherwise. Principal protection is being obtained in three formats: 1. Option based principal protection where the clients capital is locked in for certain time and a minimum return (could be zero) and an upside participation (typically less then 100% or with a cap) in an equity index or a set of stocks is guaranteed. 3
National Stock Exchange 2. CPPI Constant proportion portfolio insurance. The client is not guaranteed a participation in the index but principal protection is achieved by dynamically reducing risk as we approach the floor. 3. Range accruals/digitals In these products instead of guaranteeing and upside participation the clients gets a constant coupon if the underlying index or stock basket is above certain level. There are other structures as well prevalent in the market. Some of the structures also take leveraged bets on rally/sell-off without providing guarantee on investment, but the above structures have been more popular because of their simplicity and limited downside risk.
Effect of the structured products on equity markets
Most of the structures are manufactured by dealing banks or broker dealers. Because of the nature of the investment the clients invest in them for the terminal payoff and will not typically hedge/unwind mid-term. Where as the dealer who manufactures the product would not be willing to take exposure to the other side of the terminal payoff, he typically hedges the exposure with other market instruments. As a result of the asymmetry in hedging there could be supply/demand mismatches in the market putting pressure on both underlying and derivatives market. We propose to research the effect of the above mentioned and other structured products on equity markets in detail. At the first cut as most of these structures have been bullish in nature the dealer would have to go long in the underlying/derivatives market to hedge the exposure. This would create an additional bid in the market. Also, as these products have typically bounded down side, the dealer ends up shorting an option (though the exposure could be different for different structures). This will create a bid in the option market especially in the low strike put options. That being said, these structures cannot be completely hedgable using exchange traded derivatives because of their long term and exotic nature. Hence the dealer is required to dynamically change/ rehedege his exposure as the market moves. This could create some imbalance if all the dealers go in one direction and their hedging could increase/dampen market volatility. We look at various structures prevalent in the market and see the impact of dynamic hedging of these structures.
National Stock Exchange
Proposed study
We propose to split the study in the following steps: 1. Data collection: Collect data about popular structures in terms of trade details and market sizes by looking at popular structures from various dealers. 2. Categorization: We can categorize the most of the notes into typical structures with stylized coupon, exposure and tenure. 3. Modeling: Most of the structured products can be modeled using theoretical models similar to Block-Scholes option pricing formula. As an example the chart below shows the terminal payoff of a simple principal protected note and a range accrual. We note that the exposure is similar to a call option for principal protected note with participation and to a digital option for a range accrual. EXHIBIT 2: Payoff of two structured products
130
Payoff of diff s tructures
125 P rincipal P rotected N ote 120 D igital/R ange Accrual
115
110
105 100
95 80 90 100 110 U nderlying 120 130
4. Risk Analysis: The risk exposure of the dealer changes as the underlying moves. Once we model the structured note using a theoretical model we can come up with the exposure as the underlying moves. For example the chart below shows the delta of the above two structures for different underlying movements. Change delta would mean the dealer has to rehedge his exposure by buying/selling the underlying.
National Stock Exchange EXHIBIT 3: Delta of dealer for different rate moves for principal protected note
90% 80% 70%
Hedge notional for the dealer
P rincipal P rotected N ote
Buy
60% 50% 40% 30% 20% 10% 0% 80 90 100 110 120 130 U nderlying
Sell
*Assuming Black-Scholes model
It is worth while to note that as market rallies the dealer is forced to buy more of the underlying to hedge his exposure and market sells off the dealer would sell some of his hedge. Thus hedging of principal protected note would accentuate the market volatility as the dealer buys in a rally and sells in a selloff. The profile of hedging would be different for range accruals.
National Stock Exchange EXHIBIT 4: Delta of dealer for different rate moves for range accrual note
Hedge notional for the dealer
35% D igital/R ange Accrual 30% 25% 20% 15% 10% 5% 0% 80 90 100 110 120 130 U nderlying
Sell
Sell
*Assuming Black-Scholes model
In the case of range accrual the dealer is forced to sell the hedge either in a huge rally or sell off, he would hold to his initial hedge only if the underlying remained close to the barrier. Thus hedging of a range accrual would dampen volatility in a rally and increase volatility in a selloff. 5. Hedging behavior: Given the knowledge of risks of the dealer and how they change with underlying movement we can come up with educated guess on hedging behavior of the aggregated dealer community. Even though this may not be extremely accurate (because of difference in modeling across dealers and presence of OTC market) we think this analysis would give more insights into the supply demand dynamic of the derivatives market.
Conclusion
The first outcome of the analysis would be to give a clear picture of what risks the structured product hedging would present to the market. Some of the recent volatility in international financial markets has been because of concentrated exposure to structured products. In this light it becomes essential to closely monitor the exposure of dealers as all 7
National Stock Exchange dealers typically tend to take the same side of the trade thus accentuating the problem further. Secondly and more importantly the study could suggest measures that could ease certain pressure points. The measures could be in terms of introducing new derivative instruments or better monitoring systems. Because of the complex nature of the structure products the liquidity measures are not obvious unless a detailed study is performed.
