Autocall differences

Disparities between autocall headline coupon rates Introduction Credit in context Autocall components Funding Estimating the Zero-Coupon Bond Funding methods and assumptions Cost of coupons Optionality What is ‘pin-risk’? Delta Volatility Explanation of disparities between trading desks / issuers Appendix – full methodology of different funding assumptions

Introduction

Autocall market - size Over two-fifth of Catley Lakeman business Summary: Talking to us is like talking to the bank – we are outsourced sales for the structured investments

FTSE 100/EuroStoxx (worst-of) Autocall market – payoffs Market participants comfortable with the many autocall iterations Step-down autocall barriers Flat autocall barriers Summary: Talking to us is like talking to the bank – we are outsourced sales for the structured investments Counterparty Credit Suisse Underlying Indices Multi-index Currency GBP FTSE 100/EuroStoxx (worst-of)

Credit since financial crisis Since the financial crisis the credit spreads of banks have compressed. Summary: Talking to us is like talking to the bank – we are outsourced sales for the structured investments

Autocall component parts

FIRST STEP Buy Zero Coupon Bond from Bank Component 1: Long a zero coupon bond, the duration of which is dependent on when or if the structure autocalls. Component 2: Long a strip of escalating coupons, payment of which are contingent on the FTSE 100 index being above pre-defined levels. Component 3: Short a knock-in put which gives the investor some downside risk. This downside risk disappears in the event of an autocall. As with all Structured Notes, the Zero-coupon Bond [ZCB] will be the important component when considering funding.

100.0 Index 108.2 100% Yr 1 95% 116.4 Yr 2 124.6 90% Yr 3 132.8 85% Yr 4 141.0 80% Yr 5 59.99 60% 149.2 75% Yr 6 As with all Structured Notes, the Zero-coupon Bond [ZCB] will be the important component when considering funding

Funding

Estimating the Zero-Coupon Bond Breaking down the Autocall components and revealing the ZCB leads us nicely to the implication of funding to the terms of an autocall. How much of an investor’s 100p investment goes into a variable maturity Zero-coupon bond? Depends on the Autocall! Example: The important factor is when is the ZCB expected to mature Expected Life! Only the barrier levels are important for the maturity date (in conjuction with which underlying’s are used of course!) – it will either autocall early or go to it’s full 6 year term. Underlying indices FTSE 100 / EuroStoxx 50 (worse-of) Snowball return [X] snowball coupon Autocall barriers 1st anniversary 100% 2nd anniversary 95% 3rd anniversary 90% 4th anniversary 85% 5th anniversary 80% 6th anniversary 75% Soft capital protection 65% of initial (observed at maturity only) Currency GBP Maturity 6 year maximum

Estimating the Zero-Coupon Bond ‘Expected life’ or average life/maturity of the autocall 3.23 years in the case of our example, as of July 2015 pricing What if we estimate our ZCB element as being 3.23 years in maturity?... Underlying indices FTSE 100 / EuroStoxx 50 (worse-of) Snowball return [X] snowball coupon Autocall barriers 1st anniversary 100% 2nd anniversary 95% 3rd anniversary 90% 4th anniversary 85% 5th anniversary 80% 6th anniversary 75% Soft capital protection 65% of initial (observed at maturity only) Currency GBP Maturity 6 year maximum Zero-Coupon Bond Expected maturity 3.23 years No. of days 1180 Start 30th July 2015 End 22nd October 2018 Capital/ZCB 95.46% The question now is how do we discount the ZCB to ascertain funding pickup from the various Issuer’s? Present Value of receiving 100p invested

Funding methods & assumptions To put funding and CDS levels into context, this graph show the 2 year CDS reference levels for our main issuers (RBC excluded here as it does not have a Bloomberg listed CDS reference). 2 year CDS as an approximation of shorter term credit (remember our autocall does not have an expected life of years at inception)

Funding methods & assumptions Let’s consider two hypothetical banks, one that funds near to a high average CDS and one that funds near to a low average CDS as measured by the CDS graph. Hypothetical Bank 1 – funding at 0.60% 2 years Hypothetical Bank 2 – funding at 0.30% 2 years

Funding methods & assumptions Funding levels and probabilities of maturities of an autocall described above. These are inferred from the Autocall pricing models

Funding methods & assumptions Funding levels and probabilities of maturities of an autocall described above. 1.1 year funding rate across the entire life of the trade – most conservative. 2.“Step-up” funding – more aggressive. 3.Fund to “Expected Life” – more aggressive. **see appendix for full details of funding calculations**

Funding methods & assumptions Summary Funding method ‘Higher’ CDS Bank pick-up ‘Lower CDS Bank pick-up Difference 1st Autocall 1.48% 0.59% 0.89% Step-Up 1.99% 1.10% Expected life 2.34% 1.37% 0.97% What can we take from this summary of funding methods? Whilst credit does indeed appear tight, the varying methods of applying funding levels by an issuer make more of an impact to the discount of the ZCB than you may initially assume. Taking the difference between our hypothetical banks – the difference between them is as much as 1.75% (2.34 – 0.59%)

Cost of coupons We have quantified a difference in funding as an “up-front” equivalent. We can quantify what this means in extra autocall coupon. Our example 5% dropping FTSE/EuroStoxx dual index autocall: 1% extra UF discount to the ZCB will buy an extra 0.67% autocall coupon. Funding method ‘Higher’ CDS Bank pick-up ‘Lower CDS Bank pick-up Difference 1st Autocall 1.48% 0.59% 0.89% Step-Up 1.99% 1.10% Expected life 2.34% 1.37% 0.97% >>> Our hypothetical banks have a maximum difference of 1.75% if they use different funding methods, doesn’t sound a lot, but this would translate into an extra 1.17% per annum to the autocall coupon headline rate! Not insignificant in the grand scheme of yields and market levels!

Optionality What is ‘pin-risk’? Delta Volatility ‘Pin-risk’ – best described with an example.

Optionality What is ‘pin-risk’? Delta Volatility ‘Pin-risk’ – best described with an example. On the year one autocall observation date, the FTSE was trading very close to the trigger level. As it happened, the close of business level was enough to cause an autocall event, by just 15 FTSE points!

Optionality What is ‘pin-risk’? Delta Volatility The VIX is the market’s expectation of the future 30 day rolling S&P 500 index volatility As is always the case for derivatives, volatility (both realised and implied) is quoted as an annualised volatility figure. For example, if the VIX is trading at 13, this implies roughly a 0.81% average daily move over the next 30 days of the S&P 500. ...not likely to be relevant to most Structured Notes!.. ...remember our autocall example is linked to the FTSE and the EuroStoxx, with an expected life of >3years.

Optionality What is ‘pin-risk’? Delta Volatility Investors in an Autocall are “short” volatility Bank therefore is naturally long volatility that it must sell Dynamics between spot levels and therefore differing probabilities of autocall maturity and payoffs, means that this nature of hedging volatility is also very dynamic

Optionality What is ‘pin-risk’? Delta Volatility The price of the autocall must take into account the cost of hedging the future changes in the implied volatility impact on an autocall. There is interplay between spot movements and the volatility profile that trading desks have to hedge. For example, if from strike, spots move down quickly, the expected life of the autocall increases as the larger autocall coupons in the later anniversaries become more probable to be activated (more likely to miss year one’s autocall). These larger coupons, especially if the autocall barriers are set at lower than strike levels, will exhibit a higher level of volatility hedging by virtue that they are larger coupons.

Explanation of disparities between trading desks/issuers If we consider a world in which there exists two issuers pricing an autocall: Issuer 1’s trading desk: No existing positions on the book. Issuer 2’s trading desk: Large and established autocall book that it is currently hedging. Large variation in strike levels, strike dates and differing autocall barriers. Active in a number of other derivative flow Markets Recently sold an Out-the-money Put option to a large pension fund. Has to incorporate more hedging costs. Less competitive Autocall coupon. Has overlapping Autocalls, overall book is easier to neutralise risk. More competitive Autocall coupon. Day one price of an Autocall must reflect the cost of hedging through its life. Remember the ‘discontinuities’ (e.g. Digital pin-risk) associated with hedging an Autocall Issuer 2’s trading book has less overall discontinuity due to the overlapping individual Autocalls that make up the book. >>> less discontinuity risks that need to be neutralised. Issuer 1’s trading book requires the full discontinuity to be neutralised in total.

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