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.
00:13:27 · Tracy Alloway, Alex Micalizzi, Tracy Alloway
[00:13:27] S3: Okay. [00:13:28] S2: At which this will treat, in this example of a knock input, you will get the same equity participation as of earning S & P. So you get all the downside as if from $ 100, but it has to be below 60. That's a general structure. Other structures are you just sell a vanilla put there. So your put payoff comes in at that 60% point. But there's a lot of variations, bells and whistles on that. And that creates a digital exposure, which we'll talk about because that drives a lot of what we're seeing in the market. And the more... risk you take, for example, take the example of the 60% knock-in at a hundred from 60% down to zero, I basically have a hundred percent risk. So basically if I go down to zero, I've lost a hundred dollars. And so I can expect to get more premium for that as opposed to just selling a vanilla put where the most I can lose is 40%. And that changes the coupon as well. [00:14:41] S3: You mentioned worst of auto callables before. When did those become a thing? Because the idea of like tying a product to the single worst performing stock seems kind of risky to me. [00:14:53] S0: And yet they seem to have become more popular.
00:14:55 · Alex Micalizzi
[00:14:55] S2: Yeah, I'd say they've, so historically they've always been there. Like I can't remember a time not having a worst of. It comes down to the yield factor. So what is a worst of? Instead, in the example we just had now, We had S & P and it's down 40%. We take a typical structure in the market that has S & P, NASDAQ and Russell and the worst of, we now observe the worst performer. So you could have two of these indices up 20% and you could have, you know, the main street, wall street sort of trade. And one of these indices really underperform, you could end up with that put. And so it's, going to derive more premium, more premium from just selling a one index, which gives you a high yield. And it's also going to create additional risk factors for us because we have to model how these three things are moving together. And also it means that there are cases where what's the best, what's a great outcome for someone who has this yield and say it was done during a time of turbulence and the yield is very high. The best sort of outcome is two of these stocks rally and one of the stocks is marginally down and just stays there and the volatility on this thing does nothing and it goes sideways. You have now, I wouldn't say locked in, but you now have a relatively higher yield than just doing S & P that's gone up, right? That complexity of trying to monitor the worst one and being able to hedge it, is, I think, a segue to what's trading in the market and why it's creating this market dynamic, or why it's grown, sorry. And so you look at the three assets, the Russell, S & P, and NASDAQ trade, you basically have had all three of these indices and Russell over the last year. Russell was effectively sideways for many years. It's now performed a lot better. And so think about this. What drives volumes in an order call is a knockout. I can have a five-year trade, but if these three indices or three stocks or whatever go up every three months, I can do a five-year trade now has the same notion of every three months. So that volume goes up considerably.