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Kokou Agbo-Bloua
Managing Director, Financial Engineering, Société Générale
Natasha Sibley
Portfolio Manager, Janus Henderson Investors
How to Hedge Cross-Asset
Portfolios with Risk Transfer Tuesday 12 September 2017
This document is solely for the use of professionals and is not for general public distribution.
The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
1
• Société Générale: Equity/FX correlation distortions
• Janus Henderson: Equity/FX correlation risk management
• Société Générale: Supply and demand of equity/rates correlation
• Janus Henderson: Equity/rates correlation as a hedge
• Société Générale: Alternative risk transfer opportunities in fixed income
• Janus Henderson: Alternative risk transfer opportunities in equities
• Conclusion
• Q&A
Agenda
EQUITY/FX CORRELATION DISTORTIONS
Hedging Solution around macro events
Cross-Asset Correlation – Harvesting distortions with hybrids
Source: SG CIB Financial Engineering
Correlation drives the discount
“Worst-of” options provide the most
discount.
Discount in % vs vanilla assuming
cross-asset correlation of 0%:
Worst-of option: 70%,
Contingent option: 50%
Basket option: 30%
Investment case for hybrids :
A melting pot of derivative parameters
(correlation, volatility, forwards)
Isolate specific outcome in joint probability
distribution
Leveraged, yet with limited risk
Exotics book supply & demand distortion
Covariance vs Correlation Exposure
CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY **PLEASE SEE IMPORTANT LEGAL NOTICE AT THE END OF THE DOCUMENT**
THE VALUE OF YOUR INVESTMENT MAY FLUCTUATE. THE FIGURES RELATING TO SIMULATED PAST PERFORMANCES REFER TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES
TO HISTORICAL MARKET DATA.
Hybrid Pricing: Equity puts contingent to EURUSD < 1.04
June 17
Options Current Forward
Correl
Offered 95% Put
Disc to
Vanilla
SX5E 3,241 3,157 -15 1.05% 69%
CAC40 4,751 4,615 -15 1.03% 71%
DAX 11,535 11,567 -15 0.75% 70%
SPX 2,268 2,259 -8 0.65% 64%
Demand: ECB QE & Negative Interest Rates Policy (NIRP) triggered a change in regime for SX5E/EUR correlation, which created an
opportunity to buy correlation via hybrid products around Political event risks for hedge funds and asset managers looking to hedges.
Supply: Natural flows by US investors buying European equities and ETFs quanto-ed in USD and structured products issuance quanto-ed in
USD.
Equity/FX Supply & Demand Context
Source: SG CIB Financial Engineering, Bloomberg
Equity/Fx Correlation – Efficient Macro Hedges
Equity/FX correlation risk
management
6
Equity / FX correlation
Case study: Nikkei vs. USDJPY
Source: Janus Henderson Investors, Bloomberg, as at August 2017
Note: Returns from exposure to Nikkei, rebalanced to 100 at January 2012
Past performance is not a guide to future performance
Yen and U.S. Dollar return of Nikkei 225
0
50
100
150
200
250
300
350
30
35
40
45
50
55
60
Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17
Price ($)Average creationAverage redemptionUnits (millions)
Hedged exposure increasingly popular
Source: Janus Henderson Investors, Bloomberg, as at August 2017
Note: ETF is WisdomTree Japan Hedged Equity fund
Past performance is not a guide to future performance
7
Equity / FX correlation
Case study: Nikkei vs. USDJPY – opportunities in covariance
Historical Nikkei/USDJPY covariance
Source: Janus Henderson Investors, Bloomberg, as at August 2017
Historical premium (discount) of implied covariance
8
No bound to covariance:
limitless losses
No bound to covariance:
limitless losses
Equity / FX correlation
Case study: Nikkei vs. USDJPY – correlation more attractive profile
Source: Janus Henderson Investors, Bloomberg, as at August 2017
Note: Data shown is from February 2007 to August 2017. Covariance is normalised to have same mean and standard deviation as correlation.
Correlation
mathematically bounded
by +/-1
Historically
correlation remained
below this limit
Histogram of realised covariance (normalised) Histogram of realised correlation
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝐶𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 × 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦1 × 𝑣𝑜𝑙𝑎𝑡𝑖𝑙𝑖𝑡𝑦2
SUPPLY AND DEMAND OF EQUITY/RATES CORRELATION
DIVERGING HEDGING NEEDS
FOR PORTFOLIO PROTECTION
RATES / Equity Correlation – A convex function of yield itself
Source: Bloomberg, SG CIB Flow Strategy & Solutions
1yr Equity vs. US 10yr rates Correlation on Weekly returns since 1962
High inflation 70s/80s
QE distortions
Taper Tantrum
Challenges for multi-
asset portfolios as Efficient
Frontier shifts due to
correlation shifts (Harry
Markowitz).
Multi-asset portfolios are
now more volatile and
subject to correlation
shocks.
Need for new assets with
more stable correlation
against risky assets.
RATES / Equity correlation – Supply & Demand Dynamics
Insurance companies have to manage their asset/liability duration gap by
constructing an asset mix that will both generate enough income to meet the
long-term guarantees commitment to their policyholders while preserving and
growing their assets. One of the least desirable market scenarios is when
both equities and bond yields fall simultaneously. This is because the
value of their assets fall while the net present value of future liabilities rises,
worsening the duration gap. They are therefore short equity/rates correlation.
Hedge Solution = Buy rates/equity correlation.
Conversely, multi-Asset managers have the opposite issue. They dread a
scenario where bond yields rise and equities fall. They have the opposite
correlation risk exposure and are therefore willing sellers of that correlation
to hedge a breakdown in equity/rates correlation.
Hedge Solution = Sell rates/equity correlation
PRODUCT PRICING EXAMPLE: 30Y CMS Receiver Contingent to SPX Down [ For Illustration purposes only ]
Past performance is not a reliable indicator of future returns.
1Y Correlation 30Y Rate/SPX
Source: Bloomberg, SG CIB Flow Strategy & Solutions
Maturity Index Option Rate Strike Strike Level Equity Barrier Price Vanilla Price Discount
1Y CMS 30Y FLOORLET ATMF 2.72% SPX 95% 3.47% 6.10% 43%
1Y CMS 30Y FLOORLET ATMF 2.72% SPX 90% 2.69% 6.10% 56%
1Y CMS 30Y FLOORLET ATMF-0.20% 2.52% SPX 90% 2.05% 4.20% 51%
2Y CMS 30Y FLOORLET ATMF 2.75% SPX 95% 5.42% 8.60% 37%
2Y CMS 30Y FLOORLET ATMF 2.75% SPX 90% 4.68% 8.60% 46%
2Y CMS 30Y FLOORLET ATMF-0.20% 2.55% SPX 90% 3.83% 6.70% 43%
Source: SG CIB Financial Engineering
Equity/rates correlation as a hedge
13
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
1962 1970 1978 1986 1994 2002 2010
1 year rollingcorrelation
5 year rollingcorrelation
Equity / interest rate correlation
Implications of correlation regime change are far-reaching
Source: Janus Henderson Investors, Bloomberg, as at May 2017
Correlation of S&P 500 with US 10yr government yield
Regime
change
Efficient frontier of equity and bond portfolio
Source: Janus Henderson Investors, Bloomberg, as at May 2017
Note: Equity and bond portfolio consist of S&P 500 and Bloomberg Barclays
US Treasury Index
7.2%
7.3%
7.4%
7.5%
7.6%
7.7%
7.8%
7.9%
8.0%
8.1%
8.2%
4.0% 4.5% 5.0% 5.5% 6.0% 6.5% 7.0% 7.5% 8.0%
Recent environment (correlation: 40%)
Historical environment (correlation: -40%)
Volatility parity
Target volatility = 10
Recent
correlation
Historical
correlation
Leverage 2.33 1.52
Sharpe 0.58 0.38
14
Equity / interest rate correlation
Market returns poorly modelled by Normal distribution
Histogram of realised correlation: 2010 – present day Correlation of Monte Carlo simulated returns
Source: Janus Henderson Investors, Bloomberg, as at May 2017. Simulated performance is for illustrative purposes only.
15
Equity / interest rate correlation
Outliers matter
Source: Janus Henderson Investors, Bloomberg, as at August 2017
Scatter of daily returns, with correlation influence Case study: S&P 500 vs. 10yr U.S. yield through 1987
Realised below strike:
trade returns a loss
Realised above strike: trade
is profitable
Black
Monday
𝑃𝑎𝑦𝑜𝑢𝑡 = $ 𝑛𝑜𝑡𝑖𝑜𝑛𝑎𝑙 × 𝑐𝑜𝑟𝑟𝑒𝑙𝑟𝑒𝑎𝑙𝑖𝑠𝑒𝑑 − 𝑐𝑜𝑟𝑟𝑒𝑙𝑠𝑡𝑟𝑖𝑘𝑒
ALTERNATIVE RISK TRANSFER OPPORTUNITIES IN FIXED INCOME
A long history of product innovation
& evolution across asset classes
CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY **PLEASE SEE IMPORTANT LEGAL NOTICE AT THE END OF THE DOCUMENT**
THE VALUE OF YOUR INVESTMENT MAY FLUCTUATE. THE FIGURES RELATING TO SIMULATED PAST PERFORMANCES REFER TO PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO
HISTORICAL MARKET DATA.
Innovations where SG was the first bank to trade
Alternative Risk Transfer – A long history of product innovation
Source: SG CIB Flow Strategy & Solutions, Bloomberg
Traded between
SG and Janus
Henderson
Long a 0% Digital Floor and short a 0% Linear Floor creates an attractive
opportunity whether the curve remains steep or inverts
Target Investors:
Volatility HFs and asset managers.
Trade Implementation:
Buy 1% Payout Digital 5x10 Expiry, Quarterly-Look 30Y-2Y Curve Floor, K= 0% vs.
Sell Linear 5x10 Expiry, Quarterly-Look, 30Y-2Y Curve Floor, K= 0% @ Indicative
level @ 25 bps initial premium credit.
If the 30Y-2Y curve is above zero at quarterly expirations, beginning in 5 years for
the following 5 years, there is no payment on either the Digital or Linear and one
profits by the initial premium credit.
If the 30Y-2Y curve is at or below zero, then the Digital will pay the long a full 1% *
Notional at each expiration while the Linear short will pay out 1 bp * Notional per
basis point of inversion at each expiration, both adjusted for number of days on a
30/360 basis (figure 1).
The cumulative P&L of the trade will be sum of the 20 quarterly sets on both the
Digital and Linear over the 5 year period plus the 25 bps of initial premium.
Risks If the 2Y-30Y swap curve were to invert below -100 bps at any single
quarterly expiration, such as to the extremes in UST curve in the period toward
the end of the 1970’s, losses could ‘theoretically’ be unlimited.
CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY **PLEASE SEE IMPORTANT LEGAL NOTICE AT THE END OF THE DOCUMENT**
Source : SG Flow Strategy & Solutions, Bloomberg as of 3rd March 2017. THE VALUE OF YOUR INVESTMENT MAY FLUCTUATE. THE
FIGURES RELATING TO PAST PERFORMANCES AND/OR SIMULATED PAST PERFORMANCES REFER OR RELATE TO PAST PERIODS
AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO HISTORICAL MARKET DATA.
Solution
Dual-Range Accruals are typically structured into notes that pay retail investors a high
USD coupon rate if 30y-2y or 10y-2Y stay above zero and 10y USD swap rates remain
below 4-5%.
Banks issuing these instruments cannot warehouse the 0% curve digital risks on
their books because of risk limits constraints.
Combining a digital puts with a linear puts allows banks to create a profile that is
attractive for an investor looking to earn carry and/or protect against a mild inversion of
the yield curve.
Supply & Demand Context
-$2,500,000
-$2,000,000
-$1,500,000
-$1,000,000
-$500,000
$0
$500,000
$1,000,000
$1,500,000
$2,000,000
$2,500,000
$3,000,000
-190 -170 -150 -130 -110 -90 -70 -50 -30 -10 10 30 50 70 90
2Y-30Y Swap Curve
Digital vs Linear Put Payoff
-1.00
0.00
1.00
2.00
3.00
4.00
1/1/99 1/1/01 1/1/03 1/1/05 1/1/07 1/1/09 1/1/11 1/1/13 1/1/15 1/1/17
- FOMC Tightening Cycles
0% line
US 30y-2y Swap Curve since 1999
Rates Risk Transfer 1 – digital vs linear 0% put on us 30y-2y curve
1Y expiry, single-look floor spread on 5CMS
with strikes of 0.60% and 0%
Target Investors:
Volatility HFs and asset managers.
Trade Implementation:
The investor buys 1Y expiry, single-look floor spread on 5CMS
with strikes of 0.60% and 0%. The client pays 2.6bps with max
payout of 60bps or 23:1.
There is historical precedence for a USD 5Y swap move of a
magnitude to make the structure in-the-money within 1Y.
The recent case of EUR 5Y rates exemplifies how the low level of
rates is not necessarily an insurmountable hurdle to such a move.
This structure compares favourably to eurodollar options for
several reasons: (1) 5CMS minimizes the LIBOR distortions that
could affect eurodollar prices if rates were to collapse due to a
financial crisis. (2) Ease of execution for a relatively large size.
Risks: Loss is limited to premium spent
CONFIDENTIAL AND FOR DISCUSSION PURPOSES ONLY **PLEASE SEE IMPORTANT LEGAL NOTICE AT THE END OF THE DOCUMENT**
Source : SG Flow Strategy & Solutions, Bloomberg as of 3rd March 2017. THE VALUE OF YOUR INVESTMENT MAY FLUCTUATE.
THE FIGURES RELATING TO PAST PERFORMANCES AND/OR SIMULATED PAST PERFORMANCES REFER OR RELATE TO
PAST PERIODS AND ARE NOT A RELIABLE INDICATOR OF FUTURE RESULTS. THIS ALSO APPLIES TO HISTORICAL MARKET
DATA.
Solution
SG is positioned to sell floor spreads on 5CMS (5Y swap) on the back of Reverse
Convertible Note issuance (RCNs). RCNs are 1Y maturity structured notes that pay a high
coupon as long as 5Y or 10Y swaps remain above a “strike” level until maturity.
If the referenced swap rate drops below the strike before maturity the holder will begin to
lose principal in proportion to the then current swap rate over the initial swap rate until the
rate hits zero.
Most of these strikes on 5CMS reside around the 0.60% and 0.65% level.
The hedging of these notes leaves SG long the aforementioned 0.60% strike and short the 0%
strike, therefore we can offer this 5CMS floor spread at attractive levels.
Supply & Demand Context
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
30/10/2013 30/04/2014 31/10/2014 30/04/2015 31/10/2015 30/04/2016 31/10/2016
USD 5Y Swap
EUR 5Y Swap
Higher Strike
USD and EUR 5Y Swap Rates
$0
$20,000,000
$40,000,000
$60,000,000
$80,000,000
-1.00% -0.80% -0.60% -0.40% -0.20% 0 0.20% 0.40% 0.60% 0.80% 1.00%
5Y Swap Rate
Payout Profile (per $10bn notional)
Rates Risk Transfer 2 – US 5yCMS floor Spread
Alternative risk transfer opportunities
in equities
21
Investment bank risk
Dodd-Frank
FSO
Vickers
EMIR
Liikanen
Basel III
CRD IV
EBA
Volker
-78% from Peak
0
100
200
300
400
500
600
700
FY 2006 FY 2008 FY 2010 FY 2012 FY 2014 Q2 2016*
$m
Supply demand imbalance driving mispricings
Regulation is leading to inefficiencies
Source: Henderson Global Investors, Bloomberg, as at 30 June 2016
Note: Summed Investment Bank Equity VaR on 99% daily basis
* Based on Q2 or H1 2016 data
Source: Henderson Global Investors, J.P. Morgan Equity Derivatives Strategy,
KSD and KIS Pricing, as at March 2017
Note: Publicly available equity linked structured product issuance out of Asia
0
4
8
12
16
20
24
Q1-11 Q1-12 Q1-13 Q1-14 Q1-15 Q1-16 Q1-17
Others NKY
SPX SX5E
HSI HSCEI
KOSPI2
Structured product issuance
Demand
up
Supply
down
$bn
22
Opportunity in equity delta one
2600
2800
3000
3200
3400
3600
3800
4000
Mar-17 Mar-19 Mar-21 Mar-23 Mar-25 Mar-27
Spot
Interest rates effect
Estimated dividend effect
Long dated forwards dislocated to underlying parameters
Source: Henderson Global Investors, Bloomberg, as at May 2017. Based on the Euro Stoxx 50 index, for illustrative purposes only.
2600
2800
3000
3200
3400
3600
3800
4000
Mar-17 Mar-19 Mar-21 Mar-23 Mar-25 Mar-27
Finance 101: Forward = Spot x e(interest rate - dividend) x time The real world: F = Se(interest rate – div – repo +basis) x time
Dividend
risk
premium
Dividend
seasonality
Repo
Basis
23
70
90
110
130
150
170
190
2016 2018 2020 2022 2024 2026
Forecast
Market price
70
90
110
130
150
170
190
2016 2018 2020 2022 2024 2026
Forecast
Market price
70
90
110
130
150
170
190
2016 2018 2020 2022 2024 2026
Forecast
Market price
Risk
premium
Opportunity in equity delta one
• Sell-side expectations (red line) are upward sloping, pricing in growth
• Dividend future prices (black line) are upward sloping in other major markets
• In the Euro Stoxx 50, investment bank hedging pressure is causing price distortion
Dividend risk premium pronounced in Europe
Source: Henderson Global Investors, Bloomberg, Goldman Sachs, as at April 2017. Charts show analyst forecasts, actual levels may differ significantly.
Note: Dividends rebased to 100 at December 2016.
Eurostoxx 50 Nikkei 225 S&P 500
CAGR: 4.4%
2.2%
CAGR: -1.8%
4.9% 4.4%
3.5%
24
-0.20
0.20
0.60
1.00
0 12 24 36 48 -0.40
-0.20
0.00
0.20
0.40
-0.20 -0.10 0.00 0.10 0.20
Up betaDown beta
-0.20
0.20
0.60
1.00
0 12 24 36 48
Opportunity in equity delta one
Complex risk management: focus on dividend beta
Pre-crisis beta Liquidity adjustment
-0.20
0.20
0.60
1.00
0 12 24 36 48Months to expiry
Source: Henderson Global Investors, Bloomberg, Goldman Sachs, as at May 2017. Charts show beta of Euro Stoxx 50 traded dividends.
0.10
0.12
0.14
0.16
0.18
Jan
Fe
b
Ma
r
Ap
r
Ma
y
Jun
Jul
Au
g
Se
p
Oct
Nov
Dec
Seasonality of constant maturity Post-crisis beta
Asymmetry
Regime variation
25
70
100
130
160
190
220
Jul-08 Jan-10 Jul-11 Jan-13 Jul-14 Jan-16
Opportunity in equity delta one
A diversifying source of return
Source: Henderson Global Investors, Bloomberg, as at 31 March 2017
Note: Please see the disclaimer slide for back-test assumptions.
Past performance is not a guide to future performance.
Back-test statistics
Return (ann.) 8.2%
Volatility (ann.) 10.7%
Sharpe 0.72
Correlation to major markets
S&P 500 total return index +0.04
US 10yr yield +0.13
US high yield index +0.05
Global hedge fund index +0.05
VIX -0.11
Source: Henderson Global Investors, Bloomberg, as at 31 March 2017
Note: Correlation is over last 5 years
Back-test of systematic forward sales
CONCLUSION
27
Conclusions
1. Risk transfer allows banks to free up balance sheet capacity to serve clients
2. Allows investors to match and hedge opposite risks (equity/rates correlation)
3. Innovative solutions in packaging and wrapping risks a key factor of success
1. Risk transfer typically has positive expected return
2. With careful selection and risk management they can be diversifying
3. Actively managed risk transfer mitigates principal/agent dilemma
SELLSIDE PERSPECTIVE
BUYSIDE PERSPECTIVE
Q&A
Disclaimers
IMPORTANT DISCLAIMER: This material is the product of Sales or Trading in the Global Markets Division of Societe Generale (“SG”). The material contains market commentary, trading
strategy, trade ideas and/or information about SG products and services. It is not a product of the Research Department and should not be regarded as a research report. It is directed only
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disclosure document and, when referencing security futures, is available only to such institutional investors who have received the proper security futures risk disclosure document. The
securities and financial instruments discussed in this material may not be suitable for all institutional investors and investors must make their own investment decisions (using their own
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(SG), SGAS, and their affiliates. All rights reserved. www.sgcib.com
31
Slide 25: The back-test shown uses Bloomberg data to simulate the performance of a delta one risk premium strategy. This strategy is simulated by
systematically selling 5-year Euro Stoxx 50 forwards on an annual basis. It uses quarterly rolled Euro Stoxx 50 futures to delta hedge, using the team’s
proprietary dividend beta model. It uses Bloomberg interest rate swap data to rho hedge. The performance shown includes estimated transaction costs but does
not include fees.
These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual
performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-
or-over compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also
subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or
losses similar to these being shown.
Disclaimer
32 G:\CS\UK\2017\!P\G17\SGJH on Risk Transfer - CBOE Sep-17.pptx
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amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law
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investor information document before investing.
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