Structured equity desks, forced to buy or sell volatility to balance books when the underlying equity market moves, are getting caught in a chicken and egg situation where their own hedging activity is beginning to drive the market. While structured book hedging is nothing new, it has had a much stronger effect in the last month, since inflation fears stirred up global equities. Since then, institutional equity players have been sitting on the sidelines, unwilling to enter new positions while volatility remains, and hedge funds have been removing risk from the table.
Limited position taking by buysiders has made dealers' hedging all the more noticeable, explained one equity derivative strategist. Brokers and traders agreed this is evident in the size and quantity of orders going through at market close: traders responsible for hedging an exotic equity book with volatility sensitivity tend to buy or sell options at the end of each day the underlying equity market moves. "The last month has been pretty labor-intensive for those guys," commented one variance-swap broker. He noted while time is spent rebalancing books, dealers have little time to spare for putting new positions on, or in finding ways to offload risk to hedge funds through new structures.
The increasing popularity of barrier-option-based equity investment products has contributed to structured traders' problems, said the strategist. These notes are popular with investors because they can pay high coupons providing five stocks, for example, stay above a certain barrier over a certain period of time. But for issuers, they are particularly sensitive to moves in volatility and correlation and tend to require day-to-day hedging. An increase in volatility means the stocks are more likely to pass through the barrier, and an increase in correlation raises the probability all five stocks will move in the same way.
"Hedge funds have reached a level where they have had an impact on the [volatility] market, and their absence is noticeable," said one volatility trader, who said the return of volatility sellers will balance the market. One broker predicted while this month may still be turbulent, the traditional summer lull across capital markets in Europe will likely restore implied volatility to pre-May levels.
