Mumbai – 24 Jan 2007

Structured Products & Current Volatility Environment

Arom PathammavongDirector, Head of Asia Pacific Structuring

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AgendaAgenda

• Current volatility environment

• Yield and volatility relationship

• Structural reasons for current volatility state

• Case studiesReverse convertiblesKnock-in put, worst-of putsAutocallsCall overwriting

• Conclusion

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KOSPI2 AESKOSPI2 3 Months ATM

Source: Citigroup

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NKY AESNKY 3 Months ATM

Source: Citigroup

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STOXX5OE 3 Months ATMSTOXX5OE AES

Source: Citigroup

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SPX 3 Months ATMSPX AES

Source: Citigroup

Global: Recent Trends In VolatilityGlobal: Recent Trends In Volatility

S&P 500

Nikkei 225

EUROSTOXX

KOSPI 200

Source: Citigroup

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Global: Very Long Term Equity Volatility TrendsGlobal: Very Long Term Equity Volatility TrendsGlobally, equity market realised volatility declined last year, returning to pre-1990’s levels.

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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

1 Ye

ar D

aily

Rea

lised

Vol

atili

ty.

S&P 500 Nikkei 225 FTSE 30Source: Citigroup

1929: Market Crash1939: World War II1973/79: Oil Crisis1987: Market Crash1990: Global Recession1991: First Gulf War1991-97: Recovery1997: Asian Crisis1998: Russian Debt Default and LTCM1999-2001: Technology Boom/Bust2001- September 112002- Enron / World Com2003- Second Gulf War, Large-Cap Crisis

Source: Citigroup

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Global: ShortGlobal: Short--term Volatility Trendsterm Volatility Trends

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Jan-90 Sep-92 Jun-95 Mar-98 Dec-00 Sep-03 Jun-06

S&P 500 Volatility (VIX)

DJ Euro Stoxx 50 Volatility (V2X)

Source: Bloomberg

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Interest Rates and Structured Products DemandInterest Rates and Structured Products DemandRates vs vols drive structured products demand

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5-yr

US

swap

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5-yr

impl

ied

vols

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

SPX Index Level

0250500750

100012501500

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Participation

Yield

Source: Citigroup

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Structured Products Demand Pendulum Structured Products Demand Pendulum

Participation demandHigh interest ratesLow option prices (implied volatility)

Strong market trend

Yield demandLow interest ratesHigh option prices(implied volatility)

Weak market trend

WarrantsParticipation Notes

Twin-WinDemand for options

increases implied vols

OverwritingAutocallables

Soft ProtectionDemand for options

decreases implied vols

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Structural Reasons for Low VolatilityStructural Reasons for Low Volatility

• Structured products:“Worst of” feature: investors sell covariance between stocks to subsidize going long underlyingsAuto-callable: investors get yield and called away if market higher, sell volatility.Vega convexity: complex structures cause vol selling on the way downCPPI: principal protected structures created without buying option/volLow 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

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Case Study: Reverse ConvertiblesCase 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

Strike Stock Price

Put Premium => Coupon

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

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Case Study: KnockCase Study: Knock--in and Worstin and Worst--of Putsof 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

Source: Citigroup

Investor view of relative stock performance- high correlation -

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Underlying 1Underlying 2Underlying 3Underlying 4

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

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

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Case Study: AutoCase Study: Auto--callablescallables

• 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 attractiveImplied 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

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Case Study: AutoCase Study: Auto--callablescallables

Example

Underlying: KOSPI 200 IndexMaturity: Three yearsPay-off Type: 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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AutocallableAutocallable: Issuer Hedging Risks: 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 riskIssuers are long volatility – hedge is to sell volatilityHowever, expected time to maturity is variable, affecting term structure and skew hedging

Pin riskArises from presence of autocall and knock-in put barriersSignificant hedging risk if index is near barrier levels at valuation dates or maturity

Bond and index correlation riskHigh correlation is negative for issuerIncrease in index + bond rally increases value of autocall structure

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AutocallableAutocallable: Volatility Risk: Volatility Risk

Issuers are generally long volatility through autocall structuresIf 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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AutocallableAutocallable: Volatility Risk: Volatility Risk

Volatility HedgingVolatility Hedging

Volatility Term Structure Hedging -- Vanilla Option

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0 1 2 3 4 5Maturity (years)

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Volatility Term Structure Hedging -- Autocall

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0 1 2 3 4 5Maturity (years)

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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

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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AutocallablesAutocallables: Volatility hedging: Volatility hedgingHedging implications

Hedges the digital options (coupon payment) with tiny call spreadsAs the market rallies, Autocallbecomes more probable. Predicted term shortens. Longer dated shortvega 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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AutocallableAutocallable: Delta and Pin Risk: Delta and Pin Risk

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% strike level

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Delta at expiry

Source: Citigroup

Close to Expiry

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

ExampleAssume autocall close to expiryIndex at 99If Index increases 1, autocall payout changes from 100 to 130 – increase cost to issuer of 30To 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

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

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Delta at trade initiation

Source: Citigroup

Trade Initiation

Close to Expiry

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Structured Products / Funds: Call OverwriteStructured 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 portfoliosStructured Products followed (global) – Income Plus etcTotal 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 maturityTotal of ~USD 30 bn in FUMTotal of ~USD 18 mn in vega Source: IbbotsonAssociates

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Structured Products / Funds: Call OverwriteStructured 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.

99.0%

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101.0%

0 2 4 6 8 10Days

Stoc

k Pr

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UnhedgedDelta hedged Source: Citigroup

Effect of significant long gamma hedging on stock price (lower volatility)

Source: Citigroup

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New Structured Product Developments: TwinNew Structured Product Developments: Twin--winwin

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

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1x zero-strike call 2x long 100% strike 75% KO puts Value at expiry

Expiry payoffs of simple Twin-win

Source: Citigroup

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ConclusionConclusion

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 Asianunderlyings increased by 20%+. However, if high interest rate environment persists, demand for yield enhancing structured products may start to wane.

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23

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