Deutsche Bank's S&P plus tracker notes on S&P, Emerald to offer hedge, arbitrage on volatility

By Emma Trincal

New York, Aug. 12 - Deutsche Bank AG, London Branch's planned 0% S&P plus tracker notes due Sept. 19, 2011 linked to the S&P 500 Total Return index and the Deutsche Bank Equity Mean Reversion Alpha index (Emerald) may appeal to investors who want to profit from a volatility arbitrage between daily and weekly moves while capturing extra gains if the market is up, sources said.

The basket level on any day equals 100 plus the return of the S&P 500 Total Return plus triple the return of the Emerald index, according to an FWP filing with the Securities and Exchange Commission.

The return of each index is reduced by an adjustment factor, which is a flat 0.67% for the S&P 500 Total Return and 1% per year for the Emerald index.

The payout at maturity will be par plus the basket return, which could be positive or negative.

The notes will be called at par plus the basket return if the basket level falls below 35.

Volatility arbitrage

Deutsche Bank introduced the Emerald index for the first time in a structured note late last year, according to data compiled by Prospect News. A larger deal of $64.69 million priced in February with similar terms. Other versions of the deal offered slight variations such as double the gains of the S&P 500, instead of a leverage factor of three, or a different floor.

The Emerald index developed by Deutsche Bank implements a strategy that aims to capture the spread between the daily and weekly variance of the S&P 500 on a rolling weekly basis, the prospectus stated.

As such, it is an arbitrage strategy based on the idea that discrepancies between daily and weekly volatility levels can be monetized. To achieve arbitrage gains, the model buys daily volatility and sells weekly volatility on the S&P 500 in equal notional amounts, according to the prospectus. The Emerald index will rise if the daily realized volatility exceeds weekly realized volatility over a given week, which is the premise of the underlying strategy.

Hedging tool

Steve Doucette, financial adviser at Proctor Financial, said that he likes the product because it can be used as a hedging tool when the market falls.

"We bought this note in February, and we've had good returns with it," he said.

"The beautiful part of this note is the underlying. Emerald offers a way to generate returns in volatile markets. If the market is ugly, you still make money on the volatility because by definition, volatility is up, so you'll capture returns on the Emerald position. And if the market is up, you get the S&P returns and to some extent, some of the Emerald return too because chances are the arbitrage play between the weekly and the daily volatilities would still work," he said.

Doucette explained that the Emerald index offers investors a way to generate alpha in any market environment.

"As long as the daily volatility is higher than the weekly volatility, regardless of the direction of the market, you're getting positive returns out of the index. Emerald is a great underlying," Doucette said.

Intraday roller coaster

Several market participants agreed that the arbitrage between daily and weekly volatilities can generate attractive returns. But the explanations vary.

According to the prospectus, the daily returns of the S&P tend to be followed by daily returns in the opposite direction, which as a result reduces the net level of the weekly change.

"The arbitrage between daily and weekly volatility makes sense in this market," said Ryan Detrick, senior equity analyst at Schaeffer's Investment Research.

He said that the market can be flat on a week yet marked by strong intraday moves, which is characteristic of what traders and investors are noticing in the current environment.

One explanation for the difference could be the short investment horizon of "smart money" in contrast with retail, he said.

"Big hedge funds are looking for very short-term trades to make money, and in the midst of things, nothing happens. Traders are so short-term focused in this environment, weekly isn't that short-term for them," Detrick said.

A bull market would not be the best environment for this strategy, he explained, as volatility would be down. A bear market may be better, although investors would lose on the S&P component of the basket, he said. In addition, a bear market "would eventually end," making the trade more risky, he noted.

"A flattish market like the one we're having today is probably the most favorable for that type of arbitrage. We have a flat market because there's just too much uncertainty. No one is expecting a meaningful rally, and no one is really anticipating a severe bear market either. Meanwhile, daily moves are just very sharp," he said.

News-driven market

James White, founder of Excelsior Capital Management, a volatility arbitrage hedge fund, saw the same pattern. He noted the role played by correlation between assets as well as trading volume in the arbitrage.

"We're stuck in the trading band. Weekly volatility doesn't pick up as fast as the daily because it's a news-driven market," he said.

White noticed that the correlation between the stocks that compose the S&P 500 index is at levels that are unusually high compared to the past.

"Another factor is that stocks are moving together. Correlation has been rising, and that can cause daily volatility to go up," he said.

"The other thing is that we don't have much volume right now, which leads daily moves to be exaggerated. There's a lot of uncertainty out there with the tax situation, the elections coming up, the regulatory environment," he added.

On the sidelines

Another factor reducing trading volume is the fact that some market participants have decided to stay on the sidelines, he explained.

"A lot of long/short hedge funds have decided not to play because correlation is just too high. With the S&P bouncing around on a daily basis, all over the map, what incentive do they have to put on any positions? They feel they have to back off," he said.

All those factors help smooth the weekly volatility while daily levels continue to be high, White said, making the Emerald strategy relevant in today's market.

But others stressed the risks involved in the volatility trade.

Risky business

"These kinds of strategies are particularly risky in the current environment because the amount of 'volatility of volatility' we've seen is extremely high," said Andrew Lo, director of the Laboratory for Financial Engineering at the Massachusetts Institute of Technology.

"We're in a period of extraordinary uncertainty. It's breathtaking the speed with which volatility can change because of the market environment and the general uncertainty."

Lo said that trying to take advantage of short-term volatility moves is "certainly of interest in this environment," but he stressed that the strategy also represents "greater risks."

"The arbitrage between daily and weekly is tied to the correlation between today and tomorrow, today and the next day," Lo said. "You can try to effectively arbitrage these types of correlation, but it's risky because we've seen in August 1998, August 2007 and the flash crash of May 2010 examples of recent dislocations due to rapidly changing correlation. So there is a significant opportunity to generate returns but also significant risks if one doesn't manage risk carefully. And that would be a concern," he said.

The notes (Cusip: 2515A06J7) were expected to price Thursday and settle Tuesday.

Deutsche Bank Securities Inc. is the agent.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.