Asset structuring. Derivatives again

Derivatives are older than the stock market. Since we have been selling grain we have not yet harvested, to obtain some liquidity in advance and deliver it in the future, humanity has had them at hand. Recall, for example, Thales, the Greek philosopher, and the olive presses.

Derivatives allow us to hedge against negative scenarios, uncollectible loans, and fluctuations that make us lose sight of a business’s core; to isolate currency markets from exchange‑rate volatility; and, of course, to invest in volatility (or in certainty).

All derivatives carry a bet, at least implicitly, whatever the intent or reason we enter into them. When we buy a put option (the right to sell an asset at an agreed price when the contract is executed, within a specified period), we are fixing the price now, clearly acting as insurance in case the price falls. Similarly, calls (a purchase option, that is, the right, not the obligation, to buy at an agreed price when the contract comes into effect, payable in the future) bet on a price rise.

Puts and calls, together in volume, form a straddle. One example, among others, of the potential of these instruments. If the options have the same expiration, holding both a put and a call means the position profits if the price moves: if it rises the call wins, if it falls the put wins; and you lose if the price stays near the strike, because the two premiums offset each other. The buyer of the straddle bets on volatility; the seller bets on calm.

Options became very useful because of the Black‑Scholes model. From there came the VIX, which is a volatility index based on derivatives. The Cboe VIX measures expected volatility over the next 30 days based on options in the U.S. market. The VIX itself is not traded; it is simply a calculation of the price of many derivatives. But it is possible, especially for banks, to sell exposure to it, although not directly.

A pure‑volatility derivative seeks to bet on volatility itself. One example is VIX futures, popularized through ETPs. There are ETP and ETF strategies that aim to monetize rises or falls in the VIX using various financial contracts.

In a way, with the above, volatility went from being an indicator (of risk) to being the gateway into risk. This allows a factor to influence other things while at the same time being influenced by that same factor. There is the well‑known lesson from phenomena in which observing something changes the nature of what is observed (Goodhart’s Law).

Now then, when we have derivatives and volatility, the limit of the different operations that can be done is hard to perceive. There are countless opportunities.

A good example is structured products, mainly those that seek to limit exposure to sudden moves. They provide better returns precisely through options. We will now discuss covered calls. These buy an index and, simultaneously, sell a call on the same index. With this, we obtain exposure to the index and improve the return on that exposure (by selling the call we raise capital, since the premium is income), although we give up part of the upside potential if the index exceeds a certain threshold (for example, we forgo gains above 3%). The investor using this covered‑call strategy believes the upside will not exceed 3%, monetizing that view by selling the call.

Covered calls, and other similar products, are generally structured by banks.

What is interesting is that these structured products can influence volatility, but from the bank’s side. The bank, which must hedge its position as the counterparty to the client who bought the covered call (remember that within the structured product an option was sold, and the buyer of that option is the bank), must offset that option. In other words, when the bank sells the structured product, what it does in financial (legal) terms is buy the client’s option (the seller of the call). And to hedge that purchase, the bank will trade the underlying asset (the index in our example) according to the price at which the option closed (the day the option contract was perfected). Therefore, it will buy if the index falls and sell if the index rises (called dynamic hedging).

The bank is, in very pure terms, hedging the risk (neutralizing losses on the bank’s part, thereby limiting its gain). And the way it hedges is by selling short on the other side of the market (not on the client’s side, obviously). If the option’s underlying index is rising, the option’s value also rises, because recall we fixed a strike price lower than the current rising price, making the option more valuable; therefore, to hedge that position you sell the index (short). If the index falls, the option’s value also falls, because the strike price we fixed to exercise the call will be higher than the current falling market price, making the option less valuable; therefore, to hedge that position you buy, not sell, the index (long).

We mean that when we say the bank “hedges,” literally if the index price rises by $1, it will gain some money on the option and lose a compensating amount on its position in the underlying asset (index) that it sold to hedge (because in this hypothesis it is short and, when you are short, if the asset rises you lose).

And conversely, if the index price falls by $1, it will lose some money on the option and gain a compensating amount on its position in the underlying asset (the index) that it bought to hedge (because in this scenario it is long and, when you are long, if the asset rises you gain).

The index can rise or fall, but the bank is indifferent, because it is hedged in either case (whether the stock goes up or down). In our example, it will depend on whether the underlying exceeds the 3% threshold or not.

The bank tries to act in the opposite direction, effectively damping the profit/loss and the price movement on its balance sheet.

And here is the important point. The above, in systemic terms, at least theoretically, should reduce volatility and, furthermore, would also lower the cost of insuring against it. By attempting to offset the movement, the banks’ trades would be reflected in option contracts. That said, it is not clear that trading volumes support this theory, but we believe that, if they do not yet, with volumes increasing every day they could do so at some point.