Equity-Based Insurance Guarantees Conference

November 18-19, 2013

Atlanta, GA

Equities/Rates Hybrid Derivatives: New Ways to

Manage VA Risks and Opportunities in the
Current Market
Mohamed El-Hioum

Equities/Rates Hybrid
Deri ati es
Derivatives
New ways to manage VA risks and
opportunities
t iti iin th
the currentt market
k t
Mohamed El Hioum, CFA
Director Equities Structuring Group
Director,
Deutsche Bank Securities
Equity Based Insurance Guarantee Conference (Atlanta)
18 No
November
ember 2013 (0925 1010 Ho
Hours)
rs)

Contents
Rates-Equity Hybrids Market Overview
Products, New
New Risks
New Products
Long-Term View on Rates-Equities Correlation Regimes
Regimes Implication on Hedging and New Products

Rates-Equity Hybrids
Market Overview

Rates-Equity Hybrids Market Overview

M k P
Market
Participants
i i
and
d Transactions
T
i

The hybrids market allows participants to efficiently express views or hedge exposure related to both equities
and rates positions

Transactions typically entail the purchase of conditional swaps, forwards or options, such as:

Receiver swaps where notionals scale up as Equities fall

SPX puts where notionals scale up as rates fall to hedge insurance liabilities

SPX calls contingent on lower rates to express a risk-on mode supported by the Fed QE program

SPX puts contingent on higher rates / payer swaptions contingent on lower SPX as tail risk protection

The hybrids market has grown substantially since 2008, as asset classes have become more inter-related and
attention to downside protection has increased. Market participants include:

Insurance companies variable annuity hedging

Asset managers multi

multi-asset
asset portfolio tail-risk
tail risk protection

Hedge funds leveraged market expressions, trading of correlation

Pensions multi-asset risk factor allocations

Equities-Rates Correlation Market

Hi t i l Rates
Historical
R t / Equities
E iti Levels
L
l

Hi t i l Equities
Historical
E iti / Rates
R t Correlation
C
l ti

SPX vs 10y Swap Rate Correlation

Pricing Considerations

Correl Swap Market

Realized Correl

Expiry

Bid

Offer

Term

Correl

1y

15

30

1m

-35%

2y

18

33

3m

6%

3y

20

35

6m

23%

5y

22

37

1y

40%

10y

25

41

Taking advantage of high correlations

Long-term correlation is quite elevated compared to

recent realized volatility.
y

Term structure of correlation is relatively steep,

reflecting the cost of the premia

Correlation skew

As the correlation market gets more and more liquid the

sensitivity to strike becomes more apparent

Equity
E
it d
downside
id strikes
t ik would
ld command
d hi
higher
h iimplied
li d
correlation than ATMs

Source: Deutsche Bank

Past performance, simulated or actual, is not a reliable indicator of future results

Rates Exposure in Equity Puts

Equities Puts carry interest sensitivity through:

Forward: Lower terminal interest rates lower the forward - e.g. a 1% decrease in interest rates increases
the option premium by approximately Delta * Tenor * 1%

Discounting : The higher the interest rate, the lower the premium paid the duration of the premium is
equal to the tenor of the option

Balance sheet and CSA considerations add additional rates and currencies correlation exposures to even the
simplest put payoff

CSA/Discount

Eq/Ir
Covar
Rates
Volatility

Net Put
Price

Equity
Volatility

Rates Slider Equity Put Current Environment

We consider 10-year S&P at-the-money put options with a notional sliding from 0 if 10y USD swaps at maturity
are at least 100bps greater than current 10y USD swaps to 100% if swaps at maturity are at least 100bps less
than current 10y USD swaps

Equity volatility has revisited pre-crisis lows, lowering prices for both vanilla and slider options

USD rates duration premium has increased substantially recently, cheapening slider strikes that reference spot
swap levels by pushing them further out-of-the-money

This has lowered the ratio of the price of a slider option to the price of its underlying vanilla option

Tenor 10years

40%

Underlyings SPXIndex

35%

10yearUSDSwapRate(ISDAFIX3)
Payoff Scaler xMax[0,(1 SPXFinal/SPXInitial)]

30%

SPXInitial 1765

25%

Scaler

Min[Leverage,Max{0,Leveragex(HighStrike 10yUSD
swaprateatexpiry)/(HighStrike LowStrike)}]

Leverage 200.0%

20%

LowStrike 1.72%

15%

HighStrike 3.72%

Vanilla

IndicativeOffer 16.0%

Slider

10%
Jan12

Apr12

Jul12

Oct12

Jan13

Apr13

Jul13

References

SPXIndex:1765;Vanilla1765S&PPut:23.7%;10yUSD
swap:2.72%;10yforward10yUSDswap:4.74%

Historical pricing of an at-the-money S&P put option with notional sliding from 0 if 10-year USD swaps at maturity are at least100bps greater than spot 10year USD swaps to 100% if 10-year USD swaps at maturity are at least 100bps less than spot 10-year USD swaps. The notional is linearly interpolated for
intermediate swap levels. Pricing assumes a constant S&P-rates correlation. Source: DB. Historical pricing as of 05-Novermber-2013
7

Slider vs. Vanilla Ratio

R ti S
Ratio
Sensitivity
iti it to
t Implied
I li d Volatility
V l tilit

S
Sensitivities
iti iti

30%

120%

25%

100%

20%

80%

15%

60%

10%

40%

Slidervs.Vanilla

All else held constant,

lower volatility
increases the ratio with
an inflexion point at
about .75. Yet the ratio
has been decreasing
while volatility was
dropping.

5%

Slider/VanillaRatio

Apr12

S&PVega

59bpsvs.89bpsper1pointincreaseinS&Pimplied
volatility

20%

Correlation

Jul12

Oct12

Jan13

Apr13

8bpsvs.5bpsper1bp dropacrosstheratescurve
7bpsper1pointincreaseinSPXUSDRates
Correlation

0%
Oct13

Jul13

Interest Rate Term Structure

Term Structure Steepness vs. Ratio

120%

4.0

The recent decrease in

the ratio between the
slider and the vanilla
has been the result of
steepening term
structure.

26%vs. 35%

Rho

SPX5yATMImpliedVol
0%
Jan12

S&PDelta

3%

01Nov13

3.5

100%

01May13

2%

30
3.0
01Nov12

80%

2.5

2%

2.0

60%
1%

1.5

40%

1.0
20%

0.5

1%

Slider/Vanilla Ratio
Slider/VanillaRatio
FrwdSpotSpread

0.0

1y

5y

10y

20y

30y

0%
Jan12

Apr12

Jul12

Oct12

Jan13

Apr13

Jul13

0%
Oct13

Source: Deutsche Bank

Past performance, simulated or actual, is not a reliable indicator of future results

Hybrid Options - Pricing Considerations

A
Assessing
i transaction
i size
i and
d risks
i k

Significant sizes for hybrid markets would be roughly 25% of significant sizes for the vanilla rates/equities
markets

The hybrid structure impacts liquidity in terms of pin risk, tail risk, replicating instruments and correlation
sensitivity

Pin risk, where the payout is either zero or one, becomes a concern if the asset trades near the strike
close to expiry, consider using smoother payoffs

The ease of replication increases the liquidity of the product; consider using zero coupon bonds payoffs
vs. rates caps and floors or even swaps

Correlation sensitivity limits the size to be traded, pure correlation swaps can not be traded in very large
size
i

Other ways to increase liquidity

Limiting the maximum payout on the digital by trading option spreads rather than outright vanilla options
helps cap the size of the digital and manage the pin risk

Spreading the risk across several expiries is another way to mitigate pin risk and improve liquidity and
pricing

Correlation Market

Correlation market transparency keeps improving; we started to see tighter pricing on correlation term
structure and smile

The improved transparency allows for competitive pricing both on the way in and on the way out

New Products, New Risks

10

10

10

Traditional Variable Annuities Products

R
Rates
and
dE
Equities
i i Sensitivities
S
ii ii

Traditional Variable Annuity riders typically increase in value as rates and equities drop

The sensitivity to rates depends on the rider elected and the level of the guarantee higher guaranteed
income or roll ups increase that sensitivity

The sensitivity to equities depends on the equity allocation, the minimum guarantees, roll ups and
ratchets
GuaranteesRisks

GuaranteesRisks
0%10%

10%20%

20%30%

30%40%

40%50%

50%60%

60%70%

0%5%

70%80%

5%10%

10%15%

15%20%

20%25%

25%30%

30%35%

35%40%

40%45%

45%50%

50%

80%

45%
40%

70%

35%

60%

30%
25%

50%

20%
40%

15%
10%

30%

5%
20%

0%
1.00%

10%

0.00%

70.0%

200.0%
220.0%

180.0%

160.0%

140.0%

120.0%

80.0%

10.00%

100.0%

5.00%

Volatility

60.0%

0.00%

40.0%

40.0%

0%
5.00%

100.0%
1.00%

130.0%
160.0%

Equities

Equities

2.00%

190.0%

Rates

220.0%

The charts above show the different forecasted values of policies with riders that include high roll ups and
ratchets vs. basic policies with no riders

Source: Deutsche Bank

11

11

11

Variable Annuities De-Risking

N
New
P
Products
d
F
Features

Since the financial crisis, insurers have had to raise fees, reduce benefits, and impose restrictions

New products include many features that control for cost of hedging; such as volatility-controlled underlying
funds, volatility indexed fees, treasury indexed benefits

VAGuaranteedBenefitsatHeightofArmsRace
RiderType

BaseGrowthLevels

FeeRanges

BaseGrowthLevels

FeeRanges

0.05%to0.85%

Mostarenowannualratchets,
onlyafewdaily,quarterly;
rollupsarenomorethan5%

0.05%to1.15%

0.40%to0.85%

Veryfewratchetsnow.

0.10%to1.20%

0.30%to1.25%

Mostrollupsare5%,justafew
at7%;limiteddailyratchet

0.70%to2.35%

0.50%to0.80%

Mosthavebeenclosed
completely;rollupsare5%(Met
recentlywentto4%);some
rollupstiedto10yearTreasury

0.50%to1.10%

0.25%to0.85%

Muchfeweroftheseriders
availableandfewratchets.

0.45%to1.15%

Annual,quarterly,monthly,

GMDB dailyratchets,rollupsof5%to
7%

GMWB Annual,5year,3yearratchets
Annual,quarterly,monthly,

GLWB dailyratchets,rollupsof5%to
10%

Annual,quarterly,monthly,

GMIB dailyratchets,rollupsof5%to
7%

GMAB Annual,5year,3yearratchets

CurrentBenefitAttributes

Source: Soleares Research

12

12

12

Variable Annuities: Hedging the correlation risk

R
Rates-Equities
E i i Correlation
C
l i

The volatility control feature of many products reduced the vega and gamma costs of hedging these riders but
still keeps the same cross correlation sensitivity, if not increased sensitivity to equities-rates correlation

One way to source that correlation is through hybrid options on volatility controlled indices
Tenor 5years
Underlyings SPXT10UEIndex
10yearUSDSwapRate(ISDAFIX3)
Payoff Scaler xMax[0,(1 SPXFinal/SPXInitial)]
SPXInitial 1755
Scaler

Min [ Leverage Max { 0 Leverage x (High Strike 10yUSD

Min[Leverage,Max{0,Leveragex(HighStrike
10y USD
swaprateatexpiry)/(HighStrike LowStrike)}]

Leverage 200.0%
LowStrike 1.72%
HighStrike 3.72%
IndicativeOffer 9.0%
References

SPXIndex:1755;Vanilla1755S&PPut:18.65%;10yUSD
swap:2.72%;5yforward 10yUSDswap:4.35%

Vanilla

VolControlled

0.29

0.52

S&P Vega
S&PVega

59bps

None

DV01

12bps

7bps

Correlation

7bps

4bps

S&PDelta

13

13

13

Long-Term View on RatesEquities Correlation

Regimes

14

14

14

Volatility and Correlation Regimes: Framework

The framework should be able to answer the following questions:

What is the probability of being in a given regime currently?

What was the probability of being in a given regime at a historical point (say, in July 2007), leading up to
or after an event?

What is the probability that an entire stream of observed returns was produced by a given volatility
regime? A systematic regime-based strategy (hedging or asset-allocation scheme) will likely be based
on a period of observations, not just a single days snapshot of regime probabilities

Model-fitting

The calibration produces the model that would have generated the historical returns with the highest likelihood

Assumptions
3 distributions
1 transition matrix

Results
Maximum Likelihood
Estimation

Data

3 regime-specific
i
ifi
distributions
3 x 3 transition-probability
matrix

S&P 500 daily totalreturns 62 13

10-year
10
US T
Treasury rate
t
changes 62-13

15

15

15

Volatility and Correlation Regimes

The resulting historical probabilities of being in either high-, low-, or medium-volatility regimes are shown below.

highvolregime

lowvolregime

SPX(log)

Rates

1.000
0.900
0.800
0.700
500

0.600
0.500
0.400
0.300
0.200
0.100

16

Jan13

Jan10

Jan07

Jan04

Jan01

Jan98

Jan95

Jan92

Jan89

Jan86

Jan83

Jan80

Jan77

Jan74

Jan71

Jan68

Jan65

50

Jan62

0.000

16

16

Implied Volatility and Correlation Regimes

Over a third of the time period since 1960 has seen the market in a low-volatility regime, where equities rally
and long term rates trend mildly upward, while daily correlation is highly negative

Over 50% of the period has experienced a medium-volatility regime, where equities tend to sell off mildly and
rates stay relatively flat, with daily rates and equities returns staying negative

7% of the time has seen the volatility/correlation regime shift aggressively to a high-volatility regime where both
equities and rates volatility realize negative trends and positive correlation
Expectedlikelihood
low
34 87%
34.87%

medium
57 82%
57.82%

high
7 32%
7.32%

AnnualizedReturns
low
medium
high
20.95%
0.19%

2.47%
0.06%

15.79%
2.22%

CovarianceMatrices
Low
7.43%
12.86%

Medium
0.40%

High

15.73%
8.49%

1.11%

17

42.84%
6.32%

2.83%

17

17

Implication For Hedgers

And New Products

18

18

18

VA Hedging and EIA Products

VA Hedging

Volatility is contagious besides delta hedging, buy volatility to hedge against a high-volatility regime

Use conditionality to target your hedge and cheapen downside protection

Sell upside correlation to cheapen downside hedges

Consider relative value strategies between different sources of risk

Use rates, equities, credit and currencies for hedging

EIA Products

Buy volatility-controlled indices capped with vanilla calls

1Y, 1.5% premium, call spread: ATM call on SPXT5UE and cap call on SPX@110.2% cap strike

5Y, 6.0% premium, call spread: ATM call on SPXT5UE

Consider upside through timer options

Buy equity upside conditional on rates staying within a range

1y, 5% target vol budget 2.45% offer

50 to 60% discount on the vanilla prices

Consider caps relative to interest rate levels

19

19

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Important Notes
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