Exotics enter the mainstream

"We're not quite back to the heyday of 1993 but the structured asset market is definitely back in a big way." The period this global head of derivatives is fondly recalling was characterized by highly leveraged bets on falling interest rates that culminated in the debacles at Procter & Gamble, Orange County, and elsewhere. Today the bets are less leveraged but they express views on ever more exotic currencies and assets using an ever more complex combination of non-vanilla products. This increasing fondness for the exotic has already taken its toll ­ this time not only on the buyers of the products but also their suppliers.

Range trades in the foreign exchange markets and recently, to a lesser extent, interest rate markets have been one of the most popular products in the last 18 months. In the most straightforward version, the range binary option, investors receive a payout of several times the premium paid but only if the underlying exchange or interest rate remains within a preset range. More exotic variants are often embedded in bonds. These create products that allow daily accrual of interest on days when the range conditions are satisfied. In some cases, accrual is stopped once the range is broken. In other cases, accrual is restarted after a range breach if the underlying subsequently trades back inside the range.

To give an idea of the scope for leverage in range trades, in mid-1996 products were being structured that gave 8:1, 10:1 and even 15:1 payoffs on a straightforward double knock-out structure. There were more complex versions: Bankers Trust's Quattro product gave four ranges: if an investor was correct on all four ranges, his payoff was eight times the premium. Even if only one range remained unbroken the Quattro holder received double the premium. Although these instruments are highly leveraged, they limit losses to the premium paid. This differentiates them from more conventional bets on low volatility such as the sale of straddles, which expose the holder of the position to unlimited risk. That said, holders of notes in which these options are embedded can lose significant amounts of their principal if the bonds are not accruing and are sold before maturity. Libor-indexed range floaters cost investors dear two years ago. Recently it's the dealers who have been hit hardest by range foreign exchange products.

The problem forex deals were struck when volatilities on European cross-rates were close to or at all-time highs. This pushed the price of binary range products down dramatically since it seemed likely the ranges would be broken. Subsequent sharp falls in volatility ­ for example, Deutschmark/lira volatility has fallen from around 15% to nearer 5% ­ have meant that the ranges have not been breached. In addition, the popularity of the product with both institutional investors and corporate hedgers, which used the range option in place of vanilla options to reduce hedging costs, exacerbated dealers' problems. Prices fell below the levels at which they covered hedging costs as dealers competed for business. Moreover, the scramble to hedge positions once it became clear that the downward trend in volatilities was permanent itself forced down volatility. As a consequence, option holders have made huge profits and underhedged option dealers have taken significant losses. Bank of America, NationsBank and BZW are rumoured to have suffered: these institutions have cut their exotic foreign exchange teams recently. They will not confirm that these moves are linked to losses on exotic options dealing.

However, just as the market recovered quickly from the shocks of 1993, so the range trade debacle is proving merely a momentary stumble on the path to ever increasing acceptance of exotic products throughout the investor and corporate universe.

Investors are still eager for range products despite higher pricing as a result of lower volatilities and the reduction in the number of banks in the market. "Even with present volatility levels there is still enough value to be extracted from range trades for people to be interested," says Zar Amrolia, head of global risk strategy at Deutsche Morgan Grenfell in London. "That is especially true now that people think that Emu will occur ­ volatility may only be 5% but the currency bands will be 2.5%."

Volumes have also been driven by demand from corporate treasurers who see range options as a cost-effective hedging instrument. By themselves, range options are not true directional hedges, they hedge volatility. However, in combination with vanilla options or forwards they can be used to create cheap and even self-financing hedges. "It is true that a range binary by itself is not a hedge for a long or short cash exposure," says one dealer. "However, take a corporate that is long dollars and wants insurance. It can buy a dollar put and a range option on the relevant exchange rate. If volatility falls then the value of the put will fall but the value of the range option will rise. The put may expire worthless but the range may pay out, funding the put premium."

Rumoured losses

These trades were first seen when volatilities were high and corporates were unwilling to pay the consequently hefty premiums for standard option protection. As usual it was French and Scandinavian companies that led the way in developing the market and one trade, an 18-month range option on the French franc/dollar rate for French state-owned arms manufacturer Aérospatiale, has since become notorious. It is rumoured to have caused substantial losses to the banks which were ultimately left hedging the other side of the position (the original sellers, Credit Suisse Financial Products, sold out early). No parties to the trade returned calls to Euromoney.

Range options can also be combined with forwards in a similar fashion to create what some banks call the range bonus forward. Instead of buying an outright forward, a treasurer can decide to take some of the forward points and use them to buy a range option. "Say the forward dollar/Deutschmark outright is 1.67 and spot is 1.68. You can take one pfennig of premium to buy a range position that produces say four pfennigs of windfall profit if your view is correct," says Deutsche Morgan Grenfell's Amrolia.