Deutsche Bank's alpha overlay notes linked to Emerald, Fed Funds are for range-bound market

By Emma Trincal

New York, June 13 - A Deutsche Bank AG, London Branch note linked to a strategy that sells weekly volatility while buying daily volatility may be well adapted to a "choppy" or sideways market, a volatility arbitrage hedge fund trader said.

But a change in volatility trends could make the play more risky, he noted.

Deutsche Bank plans to price Tuesday 0% alpha overlay securities due June 18, 2014 linked to a basket holding the Deutsche Bank Fed Funds Total Return index and the Deutsche Bank Equity Mean Reversion Alpha index (Emerald), according to an FWP filing with the Securities and Exchange Commission.

The basket level on any day equals 100 plus the DB Fed Funds index return on that day and three times the Emerald index return. The return of the Emerald index is reduced by an adjustment factor of 1.3333% per year.

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

The notes will be called if the basket level falls below 40. The payout will be par plus the basket return.

Emerald

The Emerald index, created by Deutsche Bank on Oct. 12, 2009, reflects a strategy hypothesizing that daily realized volatility will exceed weekly realized volatility over a given week, according to the prospectus.

This hypothesis itself is based on what is known as "negative serial correlation," meaning that daily returns of an index tend to be followed by moves in the opposite direction.

The index strategy "aims to monetize any negative serial correlation exhibited by the S&P 500 index by periodically buying daily volatility and selling weekly volatility on the S&P 500 index in equal notional amounts," according to the prospectus.

Emerald will appreciate if daily realized volatility is less than weekly realized volatility over a given week, the prospectus explained.

Range-bound is best

"If the daily moves in volatility go up when the weekly levels decline, then it works" the trader said.

"As long as the weekly vol is less than the daily vol, it makes sense to be long the daily and short the weekly."

The strategy is more relevant in a sideways market, he noted.

"In a choppy market, the daily volatility will be greater than the weekly because it's going to go up and down and up and down. The daily will mean revert," he said.

But if volatility stops trading range-bound, he cautioned, the strategy could be risky.

"If we break out in a trading range, the weekly volatility will pick up relative to the daily and the strategy may not work anymore," he said.

So the investor in a three-year note based on such strategy should have a view on how volatility is going to move, he explained, something that is difficult to predict in general, especially for a three-year horizon, the trader said.

No crystal ball

"It's kind of long term to be making that bet," he said.

"I'm a hedge fund guy, and I don't know what's going to happen in three years. I don't know what's going to happen in a month!

"It's more of a hedge fund product, something a trader would use for short-term trades.

"But with the fees and the lack of liquidity that you get with those structured notes, I wouldn't commit to that investment."

The notes are putable on June 22, 2012 and June 27, 2013, according to the prospectus.

But the notes are not listed on any securities exchange, and the bank is not required to offer to purchase the securities in the secondary market, the prospectus also warned in its risk factors section, a risk commonly disclosed in prospectuses of structured products.

Hard to explain

Carl Kunhardt, director of investment management and research at Quest Capital Management, said that he would not be showing that product to his clients but for different reasons.

"It would take more than five minutes to explain it to an unsophisticated investor, and it's a struggle. I wouldn't have the comfort that my clients would understand it," he said.

A second objection was the "technical analysis and market timing" aspect of the underlying strategy embedded in the Emerald index, he said.

"One of our clients said she became our client after walking in our office one day when volatility was all over the place and it was quiet and calm, she said. Nobody was panicking. Nobody was overly concerned. We just don't focus on the day-to-day. We focus on the long term," he said.

"I don't do technical analysis. I am not a trader. I want steady, boring growth. And that's why this note wouldn't make it in any of my portfolios."

Alpha

Other financial advisers were open to the product assuming that the structure and pricing were fair to their clients.

Robert Russell, president at financial planning firm Russell & Co., for instance, said that the volatility element of the index was worth being explored as an asset class.

"Investors should be interested in asset classes that are not correlated to the market. We're always looking at things that are different," he said.

"This could be one of those asset classes that may or may not make sense to clients.

"We would use alternative investments like those. But they are not all created equal."

The fact that investors are exposed to a three-times leveraged decline in the Emerald index with no downside protection is a concern, he added.

The notes (Cusip: 2515A17M7) are expected to price Tuesday and settle Friday.

Deutsche Bank Securities Inc. and Deutsche Bank Trust Co. Americas are the agents.

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