Structured Products & Current Volatility Environment

Mumbai 24 Jan 2007

Arom Pathammavong Director, Head of Asia Pacific Structuring

Agenda
Current volatility environment Yield and volatility relationship Structural reasons for current volatility state Case studies Reverse convertibles Knock-in put, worst-of puts Autocalls Call overwriting Conclusion

10%

15%

20%

25%

30%

35%

40%

45%

50%

10%

15%

20%

25%

30%

35%

40%

45%

0%

5%

Oct-99 Jan-00

NKY AES

SPX AES

Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06

0%
Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 SPX 3 Months ATM
NKY 3 Months ATM

5%
Source: Citigroup
Source: Citigroup

Source: Citigroup

Nikkei 225

S&P 500

Global: Recent Trends In Volatility

2
10% 20%
Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06

10%

20%

30%

40%

50%

60%

70%

30%

40%

50%

60%

0%
Source: Citigroup

Oct-99 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06
KOSPI2 AES KOSPI2 3 Months ATM

0%
Source: Citigroup

STOXX5OE AES

STOXX5OE 3 Months ATM

EUROSTOXX

KOSPI 200

Global: Very Long Term Equity Volatility Trends

Globally, equity market realised volatility declined last year, returning to pre-1990s levels.
50% 45% 40% 1 Year Daily Realised Volatility. 35% 30% 25% 20% 15% 10% 5% 0%
Jan-28 Jan-34 Jan-40 Jan-46 Jan-52 Jan-58 Jan-64 Jan-70 Jan-76 Jan-82 Jan-88 Jan-94 Jan-00 Jan-06
1929: Market Crash 1939: World War II 1973/79: Oil Crisis 1987: Market Crash 1990: Global Recession 1991: First Gulf War 1991-97: Recovery 1997: Asian Crisis 1998: Russian Debt Default and LTCM 1999-2001: Technology Boom/Bust 2001- September 11 2002- Enron / World Com 2003- Second Gulf War, Large-Cap Crisis

S&P 500

Nikkei 225

FTSE 30

Source: Citigroup

Source: Citigroup

Global: Short-term Volatility Trends

70
S&P 500 Volatility (VIX)

60 50 40 30 20 10

DJ Euro Stoxx 50 Volatility (V2X)

Source: Bloomberg

0 Jan-90

Sep-92

Jun-95

Mar-98

Dec-00

Sep-03

Jun-06

5-yr US swap rates 10 3 4 5 6 7 8 9 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00

1500 1250 1000 750 500 250 0

Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96

Source: Citigroup

Participation

SPX Index Level

Rates vs vols drive structured products demand

Interest Rates and Structured Products Demand

5
Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06

Dec-97

Yield

Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 10% 15% 20% 25% 30% 5-yr implied vols

5-yr rates (LHS) 5-yr vol (RHS) 35%

Structured Products Demand Pendulum

Participation demand High interest rates Low option prices (implied volatility) Strong market trend
Yield demand Low interest rates High option prices (implied volatility) Weak market trend

Warrants Participation Notes Twin-Win Demand for options increases implied vols

Overwriting Autocallables Soft Protection Demand for options decreases implied vols

Structural Reasons for Low Volatility

Structured products: Worst of feature: investors sell covariance between stocks to subsidize going long underlyings Auto-callable: investors get yield and called away if market higher, sell volatility. Vega convexity: complex structures cause vol selling on the way down CPPI: principal protected structures created without buying option/vol Low interest rates: demand for yield, growth products not attractive Overwriting: mutual funds and others sell calls for yields Range trading: buying options unhedged fails, selling strangles works End of the tech bubble: tech volatility lower and lower index weights Capital structure/credit: tighter credit, cleaner balance sheets lower volatility Hedge fund & private equity flows: strategies monetizing volatility, Spread trading: long short as opposed to outright Lack of macro events: after one per year 1997-2003, none for 3 years

Case Study: Reverse Convertibles

Most yield products are based on same concept: Sell downside risk and volatility to create yield Reverse convertibles became increasingly popular from 2001 onwards Investor is short a Put. Premium raised is paid at maturity as a coupon Structure is not capital protected At maturity if stock above strike price, investor receive the coupon and his principal Otherwise investor receives shares

Put Premium => Coupon Strike Stock Price

For reverse converts, the issuer is long put options so hedges by selling these on market lowering implied vols

Case Study: Knock-in and Worst-of Puts

Knock-in Put Variation from the classic reverse convertible Benefit: Allows soft protection Short put (downside risk) only activated when a certain barrier level is breached. Selling knock-in put still provides premium to enhance yield but is less risky

31-May

31-Dec

28-Feb

Worst-Of Put Payoff based on the performance of the worst performing of a basket of underlyings. Risk is higher for seller, so provides for greater yield or participation. Option seller is short volatility and long correlation Higher correlation leads to less yield/coupon for investor. At the extreme with a correlation of 100%, the Worst-of-put becomes similar to the Put on a single underlying

Investor view of relative stock performance - high correlation 130% 120% 110% 100% 90% 80% 70% 31-Mar 31-Jan

Underlying 1 Underlying 2 Underlying 3 Underlying 4

Source: Citigroup

All above yield enhancing structures based on selling downside risk and volatility have same net effect of reducing volatility

30-Jun

30-Apr

Case Study: Auto-callables

Autocallables were developed around 2002 and have become the dominant yield product since 2003 particularly in Japan and EU (rates lowest and vols highest). Japan market ~USD 10 bn. Euro market ~USD 50 bn Most popular when: Interest rates are low making the yield generated more attractive Implied volatility is high meaning there is a greater value in the digital options Many variants traded in the market: available on single indexes, stocks and baskets of indexes/stocks Most structures involve automatic call feature, with large coupon payment if underlying is above barrier level on autocall dates If autocall condition is met, coupon is paid and structure terminates If no autocall, structure continues to following periods; coupon increases (snowballs) for following periods until autocall or maturity

At maturity, structure may/may not have principal protection More popular variants include puts or KI puts, increasing coupon

10

Case Study: Auto-callables

Example
Underlying: Maturity: Pay-off Type: KOSPI 200 Index Three years Autocall

Potential Coupon: 10% per annum (subject to the Autocall Feature) Autocall Feature: Note redeems at 100% + 10% p.a. if Index is above Autocall Barrier on Valuation Dates Autocall Barrier: 100% Valuation Dates: Annual anniversary Payout at Maturity: 100%, unless the Underlying falls by 30% or more during life of transaction (Knock-in Condition), at which point full capital is at risk

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Autocallable: Issuer Hedging Risks

Embedded options

Issuer is short strip of contingent digital options of varying maturity, 10% pa payout Issuer is long contingent ATM put, 70% knock-in level
Volatility risk Issuers are long volatility hedge is to sell volatility However, expected time to maturity is variable, affecting term structure and skew hedging Pin risk Arises from presence of autocall and knock-in put barriers Significant hedging risk if index is near barrier levels at valuation dates or maturity Bond and index correlation risk High correlation is negative for issuer Increase in index + bond rally increases value of autocall structure

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Autocallable: Volatility Risk

Issuers are generally long volatility through autocall structures If index is near (but below) autocall barrier, issuer prefers index to be volatile If index falls, increases distance to barrier If index rises through barrier, prefer large jump to profit on delta hedge If index is above barrier, issuer prefers volatility If index falls through barrier, no autocall If index rises, short coupon remains constant, but issuer profits on delta hedge If index is down, volatility increases probability of put knock-in However, expected time to maturity is variable, affecting term structure and skew hedging As a consequence, vega and gamma exposure becomes dynamic as expected time to maturity changes

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Autocallable: Volatility Risk Volatility Hedging

Volatility Term Structure Hedging -- Vanilla Option 18 17 16

Volatility (%)

15 14 13 12 11 10 0 1 2 3 Maturity (years) 4
18 17 5 16

Hedging vanilla long volatility risk Sell volatility at fixed maturity For example, if issuer is long five year vanilla option, sell matching amount of five year volatility Static hedge
Volatility Term Structure Hedging -- A utocall

Volatility (%)

15 14 13 12 11 10 0 1 2 3 Maturity (years) 4 5

Hedging autocall long volatility risk Since maturity date is unknown, hedge by selling volatility across range of maturities For example, for five year autocall, hedge may involve selling several buckets of volatility

Source: Citigroup

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Autocallables: Volatility hedging

Hedging implications Hedges the digital options (coupon payment) with tiny call spreads As the market rallies, Autocall becomes more probable. Predicted term shortens. Longer dated short vega hedges are bought back and more shorter dated vega hedges are sold (steepens term structure) As the market rallies, the auto-call payment becomes more certain so more call spreads are required to generate the coupon value (flattens skew) This constant hedge adjustment makes volatility hedging difficult

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Autocallable: Delta and Pin Risk

Delta at Trade Initiation and Expiration Delta is smooth on trade Initiation, but can be very large if the index is near autocall barriers or the knock-in barrier on valuation dates Large delta near barriers near valuation dates due to jumps in payoffs Significant risk to issuers
60.0% 70.0% 70%
Delta at trade initiation

60%
Delta Hedge

50% 40% 30% 20%

Trade Initiation

Close to Expiry
80.0% 90.0% 0% 100.0% -10% -20% 110.0%

10%

Source: Citigroup

120.0% 130.0% % strike level

140.0%

Example
Assume autocall close to expiry Index at 99 If Index increases 1, autocall payout changes from 100 to 130 increase cost to issuer of 30 To be delta-hedged, issuer must have delta long index position of 3000 (= 30x notional), so 1% increase = 30! For $100 mm notional, delta = $3 billion
60% 70% 80%

1000%
Delta at expiry

800%
Delta hedge

600%

Close to Expiry
400%

200%
Source: Citigroup

90%

0% 100% -200%

110%

120%

130%

140%

% strike level

Chart from Auto-Callables, European Equity Derivative Strategy, Citigroup Global Markets, Dec 2004

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Structured Products / Funds: Call Overwrite

Popularity Initially most popular in Europe. Predominantly stock options with OTM strikes and 1 to 3 months maturity. Insurers and asset managers actively managing stock and option portfolios Structured Products followed (global) Income Plus etc Total of ~EUR 25 bn in FUM that sell stock call options BXM (tot rtn) index and associated funds brought trend to US Predominantly sells index options with ATM strike and 1 month maturity Total of ~USD 30 bn in FUM Total of ~USD 18 mn in vega

Source: IbbotsonAssociates

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Structured Products / Funds: Call Overwrite

Hedging implications Starting 2005, USD 30 bn of closed-end income funds were sold. Funds overwrite by selling individual and index options, shorted dated, with a total annual vega of USD 18m. Downward pressure on index volatility Issuer is long call options so hedges by selling these out on market If willing to hold long call position due to attractive pricing (low volatility) then position is long gamma (buys dips and sells rallies) and delta hedging reduces market realised volatility.
Effect of significant long gamma hedging on stock price (low er volatility)

101.0% 100.5%
Stock Price

100.0% 99.5% 99.0% 0

Unhedged Delta hedged

2 4 Days 6

Source: Citigroup

10

Source: Citigroup

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New Structured Product Developments: Twin-win

Product Similar to participation but to both upside and downside movements. Reason for inclusion in Structured Products Participation but no view on market direction (higher rates, low vols but not bullish) Implications Essentially the same vol demand as participation (just split across upside and downside) Takes advantage of current low volatility to buy cheap KO puts
Expiry payoffs of simple Tw in-w in
140 120 100 80 60 40 20 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130
Value at expiry

1x zero-strike call

2x long 100% strike 75% KO puts

Source: Citigroup

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Conclusion
Evolution and possible change in trends
Because the US was up only moderately last year, and Europe and Asia were up significantly in local terms last year, the behaviour of retail investors changed. Investors in Europe and Asia, having seen 20 to 30% return in one year, started believing in growth as opposed to yield and had started to buy participation products (eg Twin win), causing less pressure on volatility. As a sign of this, European investors had started buying access to BRIC and other emerging markets as well as thematic plays (infrastructure, water) Overwriting strategies still remain - keeping short-dated vols subdued In Japan Autocallable dominant in the medium term. Still yield focused and use long maturities. 2-5yr vol remains under significant pressure from issuance. In Asia: Until June 2006, we estimated net notional of short volatility products on Asian underlyings increased by 20%+. However, if high interest rate environment persists, demand for yield enhancing structured products may start to wane.

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