SPA 2007: New products could link to VIX, housing, hurricanes, movies...

By Peter Heap

New York, March 27 - Structured products linked to the VIX volatility index could make sense for investors - and, further away, deals tied to housing indexes and possibly even hurricanes or motion pictures, according to panelists at the Structured Products Association conference in New York.

Noting that the BXM Buy-Write index is already widely used as an underlyer for structured notes, Matt Moran, vice president, business development for the Chicago Board Options Exchange, said the VIX volatility index or a closely related measure would be a logical next step.

"I think there's good possibilities for some very interesting products out there," he said during the panel on structured products with exotic underlyings.

"There appears to be evidence that this could help your risk-adjusted returns," he said.

For example, a 20% weighting of the VXD index (a counterpart of the VIX, but based on the Dow Jones Industrial Average) added to a position in the Dow itself would cut risk without taking away too much return performance, Moran noted.

But he pointed out that marketing products with unusual underlyers can be a challenge. BXM-linked deals have been much easier to sell to retail investors as a yield story rather than as something that improves the "difficult to relate to" Sharpe ratio of a portfolio.

John Blank, associate director for financial research at the Chicago Mercantile Exchange, said even more exotic products are under development - although some of them may never see the light of day because of the practical challenges.

Non-exotic products, he remarked, are focused on company balance sheets and the rate materials they use - "kind of a 19th century view."

The next stage is to reform those measures, for example, by building credit derivatives that give exposure to the single concept of a credit event, removing the issues of maturity, liquidity and subordination that entangle traditional credit instruments.

The final stage is to expand what is at the core.

One good example, Blank said, is the Case Shiller home price index.

But he cautioned that before measures in this expanded area can be used, users have to be get comfortable with issues concerning the quality and timeliness of data.

"You get into indexes that are simplistic at the top line and very complicated below that," he added.

Looking further afield, Blank said possible indexes could be tied to hurricanes or movies - although he warned that "these may or may not be products" at the end of the day.

Hurricanes are economically important, as Katrina demonstrated. But to make an index work, it is necessary to come up with a model that relates its level to the cost of insurance.

Meanwhile motion pictures are a $40 billion industry.

"If you ask studio executives, what's the price of a movie, what's the value, everyone know what the production cost," Blank said. But on the issue of the value, "the answer is uniformly, we don't know."

Because of this uncertainty, capital is deployed in "a very risk adverse way."

The right product could extract value and inform the market.

Meanwhile, Andres Vinelli, chief economist at the NASD, said that advances are welcome from a regulatory point of view.

"We view new products as part of the exciting field of financial innovation," he told the panel, adding that structured products are simply considered as new instruments and not treated differently from any other development.

As far as exotic underlyers giving exposure to new asset classes are concerned, Vinelli said: "We think that's a great think." Such products can reduce volatility and bring other benefits.

Having said that, firms need "should be cognizant of the increased risk."

And the NASD will be scrutinizing the level of fees - including costs that are not broken out separately but folded into the manufacturing of structured products - and whether people understand what they are buying and selling.

Vinelli welcomed events like the Structured Products Association meeting that improve understanding in the industry and also praised efforts to standardize naming of the different products.

But he also warned that even relatively simple securities such as a 30% coupon reverse convertible he saw recently linked to a dot.com company with a chief executive that has taken a high profile stand against naked short selling could have "problematic suitability considerations."

"There are many products like this," he noted.

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