An over-the-counter contract that would protect against the maximum loss on an underlying has started to appear on Street structurers' radar. The instrument would reference the so-called maximum drawdown which measures the difference between the peak and trough of an asset's price. The idea is users could buy a hedge linked to the maximum loss of their own investments or against the maximum loss of an equity index like the Standard & Poor's 500, for example.
The idea is being plugged by Jan Vecer, an associate professor in statistics at Columbia University in New York, who recently published a research paper on maximum drawdown and its possible applications.
Methods of measuring the maximum drawdown of an index or portfolio have been around for some time and hedge funds are increasingly using the measurement to give investors an indication of the risks of investing in their funds. The latest idea, however, is that the measurement itself could be used as a reference for derivatives.
A handful of officials said they have heard of the measurement. One risk manager at a U.S. firm said he has started looking at using maximum drawdown contracts. "It's expensive, but less expensive than a lookback option," he said. He also noted his firm would be able to offer such a contract to clients, if requested.
Lookback options and out-of-the-money put options are commonly used as so-called crash protection by portfolio managers. There are some downsides to these strategies. For example, with put protection, the put may not be in-the-money even if the reference entity loses, say, 30% of its value, if it has already gone up by 50% from its strike level. A lookback option will pay the investor the difference between the reference entity's value at the end of the contract and the entity's highest level--but this means investors may not receive compensation for the maximum loss over the life of the contract.
Vecer said he envisions an over-the-counter contract structured like a future, with the exchanges between counterparties based upon the difference between an expected maximum drawdown and the actual measurement over the life of the contract.
