Players pitching hybrid equity and interest rate-linked investment products to high-net-worth investors are upset over what they view as predatory pricing. Several European firms are complain these dealers are showing aggressive prices for structures which combine constant-maturity swaps with an equity payout, which is making it harder for others to both sell and hedge the structures.
A hybrid structurer at a European house admitted the structures are complex to model and risk manage. The investment's price should take into account correlation throughout the maturity of the product and so across the equity and interest-rate curves, he said. But some firms, which the official declined to name, are putting only one correlation point into their model, which means they can offer the structure at a better price for the investor than those using a range of correlations. This is making equity and rates hybrid products a tough market to compete in, agreed several sales officials.
Another official said the market is still young enough for firms to write hefty margins into the structures that could compensate for losses. "But when this becomes a cut-throat business, these guys will get burned," he noted. This is not a new problem, noted an equity derivatives veteran. It is common with new products for different dealers to price the structure differently, and for there to be model teething problems, he added. "Maybe these guys have made a mistake, but maybe they're just trying to compete," he said, adding often if it is a mistake, the problems don't come to light until someone new starts managing the trading book.
Hybrids have become increasingly popular as low interest rates, low volatility and tight credit spreads have squeezed dealers' margins and investors' returns. Nearly every European firm in the City is looking to get into this market. While the products can be structured with high margins and also with high headline returns for investors, firms may find themselves paying a steep price down the road if they scrimp on setting up solid models, cautioned one official.
