Deal of the year: BBVA

Applying an autocallable structured product payoff to a Quantitative Investment Strategy (QIS) index carries a significant amount of continuity risk. This may be why most banks have been so far unwilling to bring them to market.But not so with BBVA. The bank chose to tackle the formidable risk-management challenge head on, developing a seven-year, principal-protected autocallable linked to its BBVA Smart Index.What began as a transaction for a Singaporean asset manager has since been replicated across the US and Europe, generating more than $100 million in sales so far, according to Charles Firth, managing director, global markets Asia.“In terms of risk management, this product really is cutting edge,” says Firth. “Our peers might be happy to do vanilla options and other access products on QIS indices, but they have so far steered clear of autocall structures. It is not a question of whether they can manage the risk, but whether they are willing to take it on.”The scale of the risk is considerable. According to Firth, the delta hedge required can be as much as 13 times that of a conventional option, reflecting the product’s unusually steep exposure around the point at which the autocall is triggered. The product designAt the core of this new type of structured product is the BBVA Smart 5% Risk Control Index. This is a multi-asset QIS that allocates dynamically across equities, bonds and gold and combines trend-following signals, market shock indicators and a volatility control mechanism designed to deliver stable returns across different market regimes.BBVA has structured the autocallable as a seven-year snowball, in which investors have six opportunities to receive the return on their principal plus a 10% step-up coupon. If the structure hasn’t autocalled by the end of year seven, then investors get all their money plus all the upside of the index. This is delivered via an out-of-the-money call.This is what has made the product so attractive and distinguishes BBVA’s snowball QIS product from some others that have appeared in Asia, most notably in China, in which investors’ capital is at risk once the index starts to under-perform.The autocall barrier is set at 1.5% above starting level in year one and rises by an additional 1.5% each year. Therefore, the index only needs to rise 1.5% in the first year for an investor to receive 100% plus 10% autocall coupon.“This has not been a difficult product to sell,” says Firth. “The 10% per annum yield is eye-catching. That’s what tends to drive the conversation, and then the fact that the index only has to rise 1.5% makes the proposition even more compelling.”A portfolio manager at the firm for whom BBVA originally did the trade confirms the appeal of the product.“BBVA has demonstrated strong innovation by packaging systematic, rules-based indices into autocall formats,” says the portfolio manager. “This provides our fund with attractive, risk-adjusted yield profiles and lower correlation to traditional equity markets, supported by clear structuring and transparent index mechanics.”In designing the product, BBVA made a deliberate effort to minimise costs and ensure that investors retained as much of the return as possible. In particular, the bank chose to avoid intraday rebalancing, which can generate significant transaction costs when implemented frequently.“Rebalancing more slowly than competitor indices means that the index’s realised volatility may well be higher than that of competitors, but in terms of performance, it more than pays for itself,” says Firth.Hedging challengesThe most demanding aspect of risk-managing the product is coping with sudden and enormous changes in delta as the index approaches the autocall trigger.For instance, if the index is up 1.5% at the first annual observation, BBVA must pay investors 110% of their principal, including a 10% coupon. If the index is flat or below the 1.5% threshold, however, the autocall is not triggered and the product continues.“This is a very difficult profile to hedge, because the implied leverage is more than six times,” says Firth.He says a static delta hedge would require BBVA to buy 650% of the underlying – which is too much to hold outright – compared with 50% for a regular call option. So, the delta needs to be hedged dynamically, and the gamma warehoused.“The gamma is very hard to manage, but having written the product, it is a risk we have to manage ourselves,” says Firth. “Most other banks aren’t prepared to take on this kind of discontinuous risk. It is both cutting-edge and technically demanding, with the potential to go wrong, and that requires a willingness to take on a level of complexity and risk that not everyone has.”Snowball 2.0This was a product that started life in Asia for a single asset manager client but has since expanded well beyond its original market. Investors in Europe and North America are now also turning to the structure, underscoring its appeal across geographies.“The index itself is already a big seller in various formats – whether options, capital-protected notes or whatever else people want – but this autocallable, principal-protected snowball product is really taking things to the next level,” says Firth.“For now, I haven’t seen anyone try to replicate it,” he adds. “Perhaps they will, but to do so they’ll have to be willing to take on the complexity and risk that comes with it. That won’t be easy.” Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe You are currently unable to print this content. Please contact info@risk.net to find out more. 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