Major derivatives dealers, including Citigroup Global Markets, Deutsche Bank and SG Corporate and Investment Banking, started to structure more capital guaranteed equity instruments last year and this trend is expected to pick up in the following 12 months. The investment products are structured on alternative investments using a technique normally only used in Europe.
Leon Gross, global head of equity derivatives research at Citigroup in New York, said dealers came up with alternative ways of structuring capital guarantees, the most popular of which is a dynamic hedging strategy known as constant proportional portfolio insurance or CPPI, to overcome the problem of low interest rates. In a traditional principal protected instrument the investor purchases a zero-coupon bond and a call option. The low interest rates, however, have made bonds expensive, which in turn leaves less premium with which to purchase calls, he explained.
Johan Groothaert, global head of structured products in the equity derivatives group at Deutsche Bank in London, noted that although the firm has seen more U.S. interest in CPPI structures, he would have expected to see more demand from fund managers. This is especially surprising considering the extent to which they have been adopted by European asset managers. Groothaert speculated that U.S. funds may have been preoccupied over the past year by industry reorganizations and other industry problems and predicts that demand will grow.
In a CPPI structure, issuers dynamically recreate a call option for a note holder, explained Gross. Under this strategy the issuer buys more of an asset as it appreciates and sells when it depreciates. Bonds are purchased as the asset is sold and provide the principal guarantee.
The CPPI structure also allows derivatives houses to reference illiquid assets, such as hedge funds, on which they may have decided against writing options because it is hard to manage the risk against such positions. The issuer does, however, retain a 'gap risk,' meaning that if the market drops a lot, such as 20% in a day, then the issuer may not be able to sell the assets fast enough to buy bonds for the principal guarantee.
