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Low volatility: How does it affect the terms offered by structured products?

CompareStructuredProducts.com - 12/02/2020

Blair Carmichael, Lowes Financial Management

In late 2018, global markets experienced what some may describe as a market correction, and others may describe as a short blip. Regardless of your opinion, a continuous swing in the market which sustains itself for more than a few days can have an impact upon market volatility. Given that the majority of structured products utilise major equity market indices as the underlying to their performance; when volatility increases in these markets, this thereby affects the potential return of the products for the better. The opposite can be said when volatility in the underlying is low.

For example, see the difference in the returns offered by the following plans which use the FTSE 100 Index as the underlying, and launched a year apart, in January 2019 and January 2020:

The 2019 issues were launched following a period of high volatility for the FTSE 100 Index. In recent months however, implied volatility has been lower, resulting in lower potential returns being offered by otherwise identical structured products.

All three options of the Mariana Capital 10:10 Plan offered differences in return of more than 1.25% for each year held, despite utilising the same counterparty, and the contract terms being the same.

The same can be said for both the Investec/Lowes 8:8 plans, and the Walker Crips UK Kick-out Plans which launched a year apart, with a 1.5% difference in the potential return for each year held between respective issues.

The Investec FTSE 100 Kick-Out Deposit Plan has the lowest difference in returns offered, but this is, to a large extent a function of it being structured as a bank deposit rather than a capital at risk note.

Of course, there are other factors at play. Whilst volatility affects the pricing of the options utilised to create the contract pay-off, the bank’s demand for funding and as such, the rate which it is prepared to pay to borrow money can also be a significant variable. Furthermore, whilst the charges that are applied to each contract can vary and have historically been as low as 0.15% and as high as 3.2%, they can certainly play a significant role.

Thankfully, there is enough competition between plan providers at present, which helps to ensure that plans are mostly, competitively priced, so we can point to volatility as being the fundamental factor in the differing coupons. Whilst the lower volatility has led to lower potential returns currently being on offer; at current rates of 10% or more for an auto-call that requires the FTSE 100 to be at or above its initial index level on any given annual maturity date; it is less a case of the current plans in issue being unattractive but more a case of last January’s plans offering comparably exceptional terms.