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Benoit Rauly, UBS, Global Head, Complex Equity and Hybrid Trading 04/04/2013 ESCP Europe

Introduction

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Autocallable : a range of payoffs which can mature prior to the scheduled maturity date if certain predetermined market conditions are achieved It has become very popular across a wide range of clients (retail, private banks, institutions) across the globe (Japan, Korea, Europe, US) Over USD 25bn is being traded every year in any type of wrapper (note, swap, structured fund etc...) This payoff offers an interesting alternative to traditional equity investments as they generate attractive yields and allow the investor to express a specific view with flexible features The high volume of trade can lead to concentrated risks on the books of hedge providers Some of the second order risks can lead to significant P&L volatility for the investment banks in certain market environments

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**Example : Autocallable on Emerging Markets Index
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Rationale

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I am an investor who has a preference for emerging markets (EM) equities

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**I am looking for a product which would offer
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An opportunity to gain from any positive performance of these markets A product with high coupons A product with limited downside risk but without full capital protection A product with an early redemption feature

Bank A issues a Step-Down Autocall on Emerging Markets (MSCI EM Index) in note format

Let’s take a concrete example

Indicative Terms

Currency Underlyings Maturity Autocall Barrier Autocall coupon Kick-In Barrier (Maturity) Redemption on Autocall Redemption at maturity USD MSCI EM Index 3 years 100% 10% after 1 year, 20% after 2 years, 30% after 3 years 50% 100% + Step-Up coupon 1) If MSCI EM Index > 100% the structure redeems at 130% x Notional 2) if MSCI EM Index < 100% and a) No Kick-In occurred, the structure redeems at 100% x Notional b) A Kick-In occurred, the structure redeems at MSCI EM Index x Notional

**What are the scenarios ?
**

MSCI Emerging Markets Index

130% C 120% 110% A B

Scenario A : auto-called in year 1 Payoff = 100% + 10% coupon Scenario B : auto-called in year 2 Payoff = 100% + 20% coupon Scenario C : redemption at maturity / No Kick-In occured Payoff = 100% + 30% coupon Scenario D : redemption at maturity / A Kick-In occured Payoff = MSCI EM Index * 100%

100%

T

Obs 1 Obs 2 Obs 3

50% 45% D

At T=0 I pay 100% to Bank A

**Sensitivity to vol and skew
**

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3 years Bank A bond pays a fixed coupon of 10% How can I get such a coupon with the autocallable when 3 year US swap rates are ? 1. The coupon is financed by an ATM put with a down and in barrier at 50% 2. Hence, the investor sells the down and in put to Bank A 0.5%

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As a result :

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Bank A is long vol (if vol increases, so does the probability of the put hitting KI barrier, which reduces the product value) Bank A is long skew (if skew increases, so does the probability of the put hitting KI barrier, which reduces the product value) In the above example, Vega = -0.60% (as a comparison, a 3Y atm put vega is 0.60%), i.e. the client who bought the product is short vol, Bank A is long

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Assuming we had a flat vol, we would only be able to offer a coupon of 6.5% p.a. (instead of the 10% p.a.). Given this is skew sensitive, the bank cannot price the product with a flat vol Bank A will use a local vol model to price and hedge the autocall.

**Delta hedging the structure
**

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If the forward increases, then the probability of hitting the KI decreases and the product value increases. In other words, once I have bought the underlying to hedge the delta, I will expect a certain amount of dividend in the futures that will help deliver the coupon. As a result,

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the autocall is long forward, so Bank A is short spot and long dividends Bank A needs to buy the underlying index to hedge the spot

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In our example, the initial delta is quite high = 60% The Bank still needs to hedge the long dividend exposure later…

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**Gamma hedging the structure
**

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At day 1, Bank A is long gamma Bank A shorts a put D&I Æ Bank A is short theta and long gamma

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If spot goes down, Bank A becomes longer gamma

Gamma profile

Spot 100%

**Hedging of vol and skew on day 1
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Given Bank A is long vol and long skew, both of these need to be sold to be flat sells vega and skew by selling OTM puts on each of the 3 underlyings Which maturity has to be used for the hedge ?

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Bank A can choose to do everything to the expected life of the trade from the model if it is a small trade Else Bank A might do a portfolio of hedges with a portfolio of OTM puts to each probability of KI

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In this example, if the bank hedges, the expected maturity is 2Y

Bank A will for instance sell 50% put with maturity 2Y

**What do I do with my dividend exposure ?
**

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As seen before, Bank A needs to sell dividends to hedge the exposure coming from the short autocallable Meanwhile, Bank A has sold puts to hedge skew/vol. This actually is a hedge as it gives it the opposite position. However, there is more delta on the autocallable than the OTM put, so this in not enough… Bank A can hedge the rest with a synthetic forward

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How does it work/get quoted ? Bank A buys Dec ATM call / sells Dec ATM Put, cross with the nearest to deliver future Note : this is a static hedge which need to be updated through the life with relative and absolute performance of the underlying

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**Hedging rho and funding rho
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At Day 1, Bank A is long funding rho Bank A enters a swap rate of maturity “expected maturity”

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At Day 1, Bank A is long rho Bank A deposits cash to the Bank’s Treasury for “expected maturity”

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But what is the “expected maturity” ? Expected maturity can be defined as : (probability to exit in year i)

**Nearly all done ?
**

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A bit of effort, but spot, dividends, vol, and skew exposure are now hedged. I need to rebalance delta based on gamma.

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So after that, can Bank A just get done with it and wait until expiry except for a bit of delta/gamma hedging ?

Unfortunately, this is just the beginning and all these hedges need active rebalancing !

**Equity/Rates and Equity/Funding correlation
**

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If the underlying is up, then the autocall probability increases, meaning that the expected maturity reduces. Bank A needs to borrow back some of its long dated deposits to redepo it to shorter term

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If we assume positive equity/rate correlation, then with underlying up, rates should also be up, i.e a bond is down. z Negative P&L due to this correlation z If the autocallable is longer dated, this effect gets bigger as duration increases z Use stochastic rates/local equity vol model to capture this effect z Sensitivity to rates volatility This negative effect is compensated by the Equity / funding correlation : z When the underlying is up, it most likely correlates with the funding rate being down, which is the opposite effect to the above. z Likewise, when markets fall, Bank A becomes long dated cash when it needs it the most (mitigation of losses in 08 with banks CDS significantly up)

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**Equity/Dividends correlation
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If the underlying is down, the duration increases. In the mean time, the delta increases. z The dividend sensitivity increases significantly as the bank is expected to hold the delta for a longer period z Bank A becomes longer dividends z Most often, dividend is correlated with spot, so dividends are down P&L loss ! Note that sensitivity is to implied dividend yield, not realised. There is concentrated position in the market : z Everyone is long at the same time and dividends are very illiquid z The fall is exacerbated P&L loss is exacerbated... To take this effect into account, Bank A needs to use proportional dividend model Ex : rather than assuming that Index will pay 100 USD of dividends, assume that it will pay 50 USD + 50 USD * (spot/spot initial) (equivalent to 50% correlation ish)

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DEDZ3 Index - Eurostoxx Dividend Future December 13 expiry since June 2008 (gross cash dividend announced and paid by the constituents of the Euro Stoxx 50 Index for the calendar year 2013)

Loss expected in the market from this effect alone > $500m

Vega convexity

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When the underlying falls, Bank A becomes longer vol and skew (as KI probability increases). And vice versa, i.e when spot is up (probability of KO increases), Bank A becomes shorter vol and skew

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Very dynamic exposure to vol, which is supposed to follow the skew curve (i.e. vol down with spot up) Short convexity This can lead to significant P&L if the vol does not follow the skew curve, in particular when the street is dominated by this kind of product.

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Given significant size are issued, it is highly likely the risk gets concentrated. In addition, there is a vol cliff just above KI, i.e. :

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The closer to KI, the higher the vega BUT when KI is hit, there is no more vega in the product whilst hedges remain Bank A becomes short vol at the worst time, i.e. when markets crash and so they all need to buy vol at the worst time

**Vega convexity examples
**

A) 2008 Financial crisis

In 2008, there was high concentration in market and very violent spot move towards lower KI barriers : z Vol did not pay above the barrier as everyone gets longer at the same time and no liquidity was available z Opposite after everything KI through large moves, i.e. vol goes up significantly after KI events when everyone is short significant losses across banks at the same time

B) 2012, Japan

Most products had no KI or KO for a while. As a result, concentration increased as position did not reduce. dVega/dSpot was around USD 4m per 1% move estimated in the market There was little liquidity from other flows, low implied, call buyers to buy Japan story. As a result

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NKY vol up with spot up, i.e. inverted skews significant losses in market also if no other hedge

**Variant : Autocallable on Emerging Markets
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Rationale z I am an investor with a strong conviction for emerging market (EM) equities. I am bullish on all those 3 markets Russia, Brazil and China.

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**I am looking for a product which would offer
**

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An opportunity to gain from a positive performance of my 3 preferred markets (and not from the other emerging markets) A products with high coupons but not necessarily full capital protection A product with an early redemption feature

Bank A issues for me a “worst of” Autocall on Emerging Markets in note format

Example : Worst of Autocallable on Emerging Markets

Indicative Terms

Currency Underlyings Maturity Autocall Barrier Autocall coupon Kick-In Barrier (At maturity) Redemption on Autocall Redemption at maturity USD

RDXUSD Index (Russia), EWZ US Equity (Brazil), HSCEI Index (China)

3 years 100% 18% after 1 year, 36% after 2 years, 54% after 3 years 50% 100% + Step-Up coupon 1) If WO > 100% the structure redeems at 154% x Notional 2) if WO < 100% and a) No Kick-In occurred, the structure redeems at 100% x Notional b) A Kick-In occurred, the structure redeems at WO x Notional 100%

“WO” stands for the level of the worst performing stock as a percentage of its level at the strike date

Reoffer

**Why does correlation matters ?
**

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Bank A is short correlation, i.e. if correlation is low, the likehood to hit the KI is higher, which reduces the product value, i.e. Bank A makes money How much is this effect worth ? Quite a lot ! As we see, in the first example, we could offer a coupon of 10% p.a. to client. With this worst of feature, we are now able to deliver a coupon of 18% p.a. : coupon jumps from 10% p.a. to 18% p.a.

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Implied correlation matrix between the 3 underlyings :

Russia Russia Brazil China 100.00% 78.98% 80.81%

Brazil 78.98% 100.00% 77.99%

China 80.81% 77.99% 100.00%

**How can we hedge correlation?
**

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Daily impact : cross-gammas (if index 1 is up +2%, this generate a negative delta of on index 2 and index 3. If index 2 and index 3 are up as well, I will lose money from the cross-gamma effect) P&L based on their moves It is very difficult to hedge this correlation as most products in the market are giving the same exposure, so the market is mainly one way If anything Bank A can hedge it with : a) IDB market : call vs call 50% call A + 50% call B – call basket (50% A, 50% B)

Long correlation Æ vega hedge / delta hedge / correlation exposure

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**b) trading other products giving the opposite exposure
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**Best-of (but very expensive) products Call on dispersion ( perf(A) – (perf(A) + perf(B))/2 + perf(B) – (perf(A) + perf(B))/2 - K )+
**

Note : If perf A = perf B, then the dispersion is worth 0 which is the corellary of a correlation = 1

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**Now getting on with the digitals…
**

Bank A will have to manage a digital option to be able to offer the coupon Digital call options are all-or-nothing options that settle at 100 if ITM, or at 0 if OTM

Delta tends to infinity as time to expiry (T) approaches zero

Gamma can soar and plunge as time to infinity as time to expiry (T) approaches zero

**Call spread hedging of digitals
**

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A digital option is almost always hedged as a call spread. By doing this, the bank achieves a smoother set of greeks especially the delta. long position on a call with "strike = strike of the digital - overhedge amount" and a short position on a call with "strike = strike of the digital" with each with a quantity = "the digital payoff/overhedge".

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Note that the call spread is structured that it is more expensive than the original binary option and as a result the bank will quote prices for a call spread. The maximum delta for the call spread will be “Digital payoff/Overhedge amount”

**Call spread hedging of digitals example
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Let’s take the following example :

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$10m digital notional 98-100 CS (Æ 2% overhedge)

Maximum delta = 10m / 2% = $500m !!!

We need to ensure we’ll have sufficient liquidity to trade that delta in the market. For Eurostoxx, SPX or Nikkei, this size is fine but for a stock like Peugeot for example, it would take several days to trade such a delta without moving the market…

Barrier shift

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The barrier shift is the amount by which the bank shifts the barrier while pricing so that in fact they are really pricing a new digital whose replicating call spread is the hedge of the actual binary option. The barrier shift is chosen so that the resulting shifted payoff over-replicates the payoff of the binary by the least amount, but such that the Greeks of the new payoff are manageable near the barrier. The size of the shift chosen by the bank depends on different factors :

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Discontinuity size Liquidity of the underlying (daily volume of the hedging instrument) Volatility of the underlying

**Let’s go back to our primary case…
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Assumptions : z Daily volume of the underlying : $500m z maximal volume that Bank A can trade : 30% z Autocollable notional : $100m z Remember : coupon year 1 = 10%, coupon year 2 = 20%, coupon year 3 = 30% barrier = 50%

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**“Maximum delta” = $150m (=30%*$500m) Payoff / overhedge size (%) = delta max ≤ “Maximum delta”
**

Æ overhedge size (%) = Payoff / “Maximum delta” z Autocall Year 1 : overhedge size (%) = ($100m * 10%) / $150m = 6.67% z Autocall Year 2 : overhedge size (%) = ($100m * 20%) / $150m = 13.33% z Autocall Year 3 : overhedge size (%) = ($100m * 30%) / $150m = 20% z Put Year 3 : overhedge size (%) = ($100m * 50%) / $150m = 33.33%

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Conclusion

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We didn’t get into vol of vol or quanto covariance. Maybe next year. Not such an easy life being a trader... Sales and structurers do not get fired when the product goes wrong Always beware of crowded trades. Liquidity is never there when you need it the most Having the right model to value all your risks is very important, but you cannot replace experience and a deep knowledge of your market These products are very dynamic so they require constant rebalancing. Hedging costs can add up very quickly so you need to have a macro view

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