Derivatives houses including Citigroup, Deutsche Bank and Merrill Lynch have started structuring capital guaranteed products on individual hedge funds and some are moving on to options on single funds. Most of the early structures have used a threshold technique known as Constant Proportional Portfolio Insurance (CPPI), but more firms are now starting to look at non-path dependent option trades, according to bankers. Options on single hedge funds are much harder to price and risk manage because there is not a pool of diversified managers and strategies to lower the volatility, notedMike Fullalove, head of origination for the structured solutions group at Merrill in London.
Often the structure of the options means they are essentially a hybrid between a CPPI structure and an option. Jean-Marie Barreau, managing director in global alternative investments at Deutsche Bank in London, said the options on hedge funds usually use Asian averaging and volatility caps. Asian averaging determines the final price of the option over a defined period and vol caps mean the option will knock-out if the volatility gets too high. Both of these help to reduce risk.
Citigroup and SG Corporate and Investment Banking both offer CPPI and options on single hedge funds. Deutsche Bank has already structured CPPI products and will likely offer options on certain types of funds in the coming months. Merrill has offered CPPIs on single strategies but has no plans to offer options.
Bankers emphasized the need for strict criteria in choosing the hedge fund. Erwin Parviz, director of global hybrid trading at Citigroup in London, said Citigroup scrutinizes management track records and ensures the funds have sufficient liquidity. He stressed that liquidity is the most important assessment factor and as a result would not offer options on certain types of hedge fund strategies such as mortgage arbitrage.