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The cost of volatility: How volatility influences structured product pricing

By Robbie Briginshaw, Managing Director of Focus Structured Solutions

Robbie Briginshaw of Focus Structured Solutions discusses recent stock market volatility and its effect on structured product pricing

We are often asked by our IFA clients to explain in detail the effects of volatility on the pricing of our structured products. These queries have become more frequent over the past few months, which was a snapshot in time during which global stock markets have been unstable, to say the least; with the impact of potential US interest rate hikes for the first time in a decade and the issues of China looming large. Here, we attempt to de-mystify this topic, which may be of particular use for newcomers to the structured products arena.

Volatility is one of the greatest pricing factors for structured products. It is a measure of the uncertainty about future price trends. Rising volatility leads to a greater likelihood that the price for an asset could potentially change considerably in the future.

It refers to the amount of uncertainty, or risk, about the size of changes. Higher volatility means that a security's value can potentially be spread out over a large range of values. This means that the price of the security could potentially alter dramatically over a short time period in either direction (often referred to as a "spike"). Lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

One of the principal strengths of structured products is flexibility of design, which allows for the utilisation of a multitude of underlying and payoff strategies. Product providers and issuers alike are able to create timely and relevant investment propositions in almost any market environment. People have varying levels of knowledge when it comes to the effect of volatility within a structure. Many IFA clients question how volatility affects a particular structured product’s costs and margins, its infrastructure, and also its headline rate.

When discussing product pricing volatility effects, an index we encourage our clients to look at is the VIX; calculated on the implied volatility of S&P 500 index options. This index reflects the market estimate of short-term volatility and is often referred to as the "fear index" or "fear gauge". Studying this index can potentially provide advisers with an insight into the likely effects on forthcoming product terms from providers. From sitting above a figure of 40 (the VIX is quoted in percentage points) during the August slump, the index has been below 20 for the past two weeks, which suggests that volatility is returning to more stable levels.

This drop in volatility is interesting because the combination of lower market volatility and lower interest rates will generally tend to result in lower structured product coupons. This is particularly noticeable in the more popular, publicly available, product shapes.

Conversely, back in August, increased market volatility was utilised, not only to enhance investment structured product returns, but was also to improve the risk profile of asset allocation. A volatile market can produce a pricing environment able to provide exceptional structured product terms, often resulting in higher coupons or greater defensive triggers and capital barriers being offered within the structured product framework and infrastructure.

This is a particularly relevant subject, as structured products also tend to outperform many other asset classes during both volatile and steady periods. In fact, the most recent 1,000 capital-at-risk structured products to mature made an average annualised return of over 8%, and every one delivered as per the stated terms, according to figures from Lowes Financial Management.

Bearing in mind that many of these products were in force through the credit crisis, this data is surely finally providing the hard facts that will make it very difficult for the wider market not to take notice of the clear risk/reward scenario of a structured product and their ability to navigate through both the most turbulent and steady market conditions and still return impressive investment results.