00:05:08 · Joe Weisenthal
[00:05:08] S1: Fantastic. I always think, and I've mentioned a couple of times on the show that I love Emanuel Derman. We've had uses this analogy of the wall street bank as a kitchen and they give, they sell fruit salad. They buy a bunch of fruit in wholesale. apple. They buy a bunch of fruit in wholesale, but then they can chop it up in any different way possible to create any instrument that me, the customer wants. And then they sell it to me and then they charge a little margin. And because they're capable of chopping up the fruit in some way, any view that I want to express or any concern or any risk that I want to hedge with those raw ingredients, you can give me anything. Now, who is the natural buyer? Because if I'm interested in AI, I could buy SPY, I could buy QQQ, I could buy a memory ETF. If I'm nervous, I could sell whatever. Who are some of the natural buyers of structured products from the bank?
00:06:07 · Alex Micalizzi, Tracy Alloway, Tracy Alloway
[00:06:07] S2: Predominantly high net worth individuals through the private bank channels. I would say that why they want this is people understand a yield, right? And people understand what that means relative to owning a linear stock and the type of protection I can get. And so they can't, in a lot of ways, they can't structure this themselves. They can't go into the market. And we'll get into some of the more popular types of trades, which involve worst ofs and correlations and things like that and order callables. You can't physically do that in a listed market space. And so this product offers that ability to enhance yield that you just can't. get by selling, say, a particular stock downside. And with that comes, I think, what you initially said, some of the complications and some of the things that end up driving some of these market factors as well, because how we end up hedging this and the residual of what's left creates a very interesting dynamic that we're starting to see in the market. [00:07:08] S3: So you mentioned this particular moment in markets. Talk to us about what we're seeing in terms of issuance or what we have been seeing in terms of issuance. [00:07:16] S0: I'm used to thinking. [00:07:17] S3: about a lot of these things as single stock calls, right? So again, something that's tied to a core weave, and if the stock collapses by a certain amount before the note actually matures, then you either get all your money back with the interest or you lose out completely. But I know that we've seen a lot more index products as well.
00:07:38 · Alex Micalizzi
[00:07:38] S2: Yeah. So there's a multitude of things going on. We can start with index. So The stuff you're predominantly seeing on the index, which is creating interesting market dynamics in the longer dated option market is related to a US issued type product. So if we look at the structured product business in the US, it's got larger and larger. I think SEC registered notes this year are on track to hit about 300 billion versus approximately 200 billion last year. And a large change has been, the biggest contributor is S & P, but the greatest growth has been worst of order callables, which generally have S & P, NASDAQ, and Russell. And why that's the case is you look at something like the Russell Index, and for many years it was basically sideways. And from Liberation Day last year, it's effectively been in a straight line. So it's meant that these auto-callables that have been issued on this have knocked out, which is a whole topic we should talk about in and of itself. So let's just step back a second. An auto-callable, why is it different? Why is it giving you a larger yield than just a plain structured product? So- An auto callable is a product that can knock out earlier than its effective maturity date. Generally, if the stock is above its initial performance and it's periodically looked at. So we generally will put on a trade and let's start with a simple S & P. Yeah. Three year trade or five year trade that we observe every three or six months. If after six months, this S & P is higher than when you initially put it on, the product disappears and knocks out. And so that yield is the last time you're going to get the yield on this product. Then you have to reset. Why does that give you a higher yield than just selling a three-year put on S & P? Well, a put is worth more as an index or stock goes down. So from my point of view, if S & P has rallied, this put in and of itself is worth less. So I don't have to worry about it anymore and it's got less value. So you're taking a contingent bet now. And that increases the yield of the product. I don't need to put S & Ps up 30% if its value is a lot less than where it was beforehand. But it also creates a risk for an investor. If markets are volatile and you enter this product, it means implied volatility is higher.
00:10:14 · Alex Micalizzi, Tracy Alloway, Joe Weisenthal, Tracy Alloway
The premium that I get to be able to invest in a coupon is higher. But if we rally and volatility falls, my reinvestment risk now is that the coupon yield I get the next time around is lower. [00:10:28] S0: It's like convexity in mortgages, I guess. [00:10:30] S2: Yeah, it's a relationship between the direction of the market and volatility. We generally think that as markets go up, volatility goes down. To some extent, as markets go down, volatility goes up. And so that dynamic is important in this product. So an auto callable gives you a higher yield because of that feature. [00:10:50] S1: Why is it called an auto callable? [00:10:52] S2: Because. [00:10:53] S1: Let's talk about this word. [00:10:54] S2: Yeah. Auto on day one, once we put the initial, once we know where the initial spot price is. [00:11:00] S1: Yeah. [00:11:02] S2: We will periodically look at its value. [00:11:05] S1: Yeah. [00:11:05] S2: And it will auto knockout if the value. [00:11:08] S1: What does knockout mean? [00:11:09] S2: Knockout means the product. I'll give you a hundred dollars back. [00:11:12] S1: Yeah. [00:11:12] S2: I'll give you a coupon. [00:11:13] S3: Yeah. [00:11:14] S2: We're out. So we started with a three-year product. We have sold it every three months. Stock has gone up or the index has gone up. It's knocked out. Basically, the trade terminates. [00:11:24] S1: Oh, I see. [00:11:24] S2: As opposed to having a three-year termination, it's now a three-month termination.
00:11:24 · Alex Micalizzi, Joe Weisenthal
[00:11:24] S2: As opposed to having a three-year termination, it's now a three-month termination. [00:11:28] S1: Actually, let's stick with this because we really need to understand this in detail. I entered this trade. Let's just say, let's keep it super vanilla. Let's just say it was one index. S & P 500 or NASDAQ or something like that. I entered it a year ago. I gave you $ 100. What are you telling me I get back for that? For $ 100, what am I getting? [00:11:51] S2: You're going to get a coupon when it will pay whatever periodically, and you will get down. [00:11:58] S1: Presumably higher than what I would get on the treasury? [00:12:01] S2: Yes. Okay. Well, it depends on other factors as well, because you may want to have some participation. Some equity exposure. Yeah, exactly. Participation. Got it. But generally, that's the sort of benchmark where people are not very interested if they're getting less than the risk-free rate. But in order to give you a higher level than the risk-free rate, you're also selling some sort of put option to me. [00:12:23] S1: I see. [00:12:23] S2: And there's variations on that put option. We've been in an upward market for a long time, so we haven't... Sorry. [00:12:30] S1: No, no. So this is great. So I give you $ 100. You are going to give me some coupon that is presumably higher than I could get just by paying a treasury. And in return, essentially what I am giving up is some participation in this upward move of the stock market.
00:12:30 · Joe Weisenthal, Alex Micalizzi, Tracy Alloway
[00:12:30] S1: No, no. So this is great. So I give you $ 100. You are going to give me some coupon that is presumably higher than I could get just by paying a treasury. And in return, essentially what I am giving up is some participation in this upward move of the stock market. [00:12:47] S2: Some participation. And in a lot of cases, you are taking a downside risk, which isn't linear to the S & P performance. There's generally a buffer, some protection. And there's variations of what that protection is. So if we say, we'll take a typical example of a knock input and we'll put a 60% strike. All right. [00:13:08] S1: Let's talk about what that means. [00:13:09] S2: So that means that if S & P, you start day one at a hundred dollars and it's a one year, say it's a one year trade and we observe it every three months on the auto call ability. If S & P is down 20%, you still have protection until you hit down 40%. [00:13:27] S3: Okay.