Credit Lyonnais is preparing to offer by year-end structured equity products that pay the performance of baskets of hedge funds. Eric Debray, equity derivatives salesman in London, said the recent downturn in the U.S. equity markets is driving demand for hedge fund-like returns. However, insurance companies and pension funds are still haunted by the Long-Term Capital Management debacle in 1998, and as a result Lyonnais is pitching products featuring principal protection.
The note can be structured either as a zero-coupon bond with a call option on the basket of funds or by investing in the basket and moving capital into secure assets, such as bonds, if the value of the basket of hedge funds falls to a threshold level, Debray explained. Credit Lyonnais likely will use both structures.
In the current falling interest-rate environment the cost of capital protection with zero-coupon bonds is rising, leaving Lyonnais with less capital to put into the hedge fund component, Debray explained. The problem with the second method is if the basket of hedge funds performs badly at the start capital will have to be moved into bonds for most of the duration of the fund, which will also shrink clients' exposure to the basket of hedge funds.
It will take Lyonnais until year-end to offer these products because it has to work out ways around the lack of liquidity in the hedge fund market in order to delta hedge the options it plans to write, according to Debray. The hedge fund market is illiquid with the possible exception of the end of each quarter. But Debray said banks need to hedge their delta more often than this.
It has not been finalized whether the fund of hedge funds, which Credit Lyonnais plans to write the options on, will be managed by the bank or by an external manager. Debray declined comment on the criteria on which it will decide. The hedge funds that make up the basket will be chosen by the fund manager. The funds will cover all aspects of the hedge fund industry, Debray noted, adding that it aims to reduce volatility and risk through diversification.