Product in the current market scenario

Structure for the current market scenario:
Structures that can be bought cheap in today’s market scenario are the ones which are - Short correlation (Realized correlation has been very high in the past one year in the financial markets as compared to the years of bull run), short volatility/structure having minimum Vega exposure since implied volatilities are at an all time high & more bumps are being given to volatility since in strenuous times realized volatility is greater than implied volatility, short skew – Banks are generally short skew & it’s hard to hedge skew for underlying’s which don’t have a liquid option market & long dividends - banks are generally long dividends.
Market Observations:
- Volatility term structure is inverted due to peaking short term volatilities. This implies that forward volatility would be much cheaper now.
- Downside skew for the SPX has come off sharply in recent weeks and is in contrast with the still elevated levels for skew at the single stock level. This is perhaps more consistent with the very high corporate default rates being priced in for both the high grade and high yield credit markets. Similarly emerging market underlying’s are continuing to trade at a high skew.
- Oil, a major driver for emerging markets such as Russia, Brazil & Mexico has been losing ground on fears of deep recession.
Market view: Expect markets to remain volatile & range bound till credit becomes cheaper. Economic stimulus by the government would be a major source of upward pressure on the markets & an upside down turnaround of the economy is not expected in a short period of time, hence don’t expect the economic data to show any improvements in the near future; which would cause a major downward pressure on the markets. Volatility should subside in a time frame of (6 – 12 months). In-case the pain increases dollar & yen are expected to appreciate. Long term view: Emerging markets will outperform SPX but more pain may see oil go down further & emerging markets underperform SPX
Structuring (Term: 1 year)
- Deepening crises would be accompanied by falling oil & appreciating US Dollar (a strong indicator of the crises situation). In such a scenario SPX will outperform MSCI EMEA Index (Emerging markets Index).
- Structure: Up & in outperformance call spread (SPX - MSCI EMEA Index), with up & in barrier on US Dollar (at +105%) & a participation P ranging from (120-150%)
- Incase dollar falls (-10% i.e. back to its normal levels) MSCI EMEA Index is expected to outperform SPX. Hence short a down & in outperformance put on (SPX - MSCI EMEA Index), with dollar as a down & in barrier (at -110%)
- Funding call spread through put (barrier’s can be chosen to design a zero cost structure)
- A good time to fund cheap skew since structure is long SPX skew & short MSCI EMEA Index skew
- Structure is long US dollar-SPX correlation & short US dollar-MSCI EMEA correlation
- Considering US dollar against EUR, the structure is long EUR-MSCI EMEA correlation. A lot of banks operating in emerging markets had sold Quanto EUR/GBP calls on MSCI EMEA thus making them Long EUR-MSCI EMEA/ GBP - MSCI EMEA correlation. Given that the above structure is Long EUR-MSCI EMEA correlation, it provides more incentive for the banks to trade it & offset its long correlation exposure.