BNP Paribas’ notes tied to S&P 500 Futures 35% Defined Volatility index to use new vol index

By Emma Trincal

New York, Sept. 7 – BNP Paribas plans to price autocallable notes linked to a new volatility index.

The 0% notes due Oct. 5, 2027 tied to the S&P 500 Futures 35% Defined Volatility index (USD) ER may represent the first-time use of this underlying in a note.

The issuer in a term sheet said it has entered into a “limited exclusive” license agreement with S&P Dow Jones Indices, the creator of the index. There has not been any U.S. structured note offering based on this index since its launch in June 24, according to data compiled by Prospect News. Prospect News data encompasses offerings filed with the Securities and Exchange Commission. Deals issued by BNP Paribas are not registered with the SEC.

The S&P 500 Futures 35% Defined Volatility Index is designed to measure the performance of the S&P 500 Futures (3-Day Roll) Index, while maintaining a level of implied volatility. This is done by applying leverage, which is calculated based on the current weekly implied volatility of the S&P 500, according to S&P Dow Jones Indices.

The volatility target is 35% subject to a maximum exposure of 500%. In an effort to achieve the volatility target, the index is rebalanced weekly.

High volatility

A structurer explained that the design of the underlying index facilitated the pricing of an autocall, a structure that is typically short volatility.

The notes will be called at par plus a call premium of 12.7% if the index finishes at or above its initial level on any annual observation date, except the final one when the call level will be 60% of the initial price, according to the term sheet.

If the index finishes below the 60% barrier level, investors will be fully exposed to the index decline.

“You’re basically dealing with volatility of volatility,” the structurer said.

“Volatility of volatility is always very high. Even if you control it like they do with the 35% target, it’s still very, very high.

“That explains the terms,” he said.

Coupons and barriers are structured through net short options positions. The higher the volatility, the greater the premium obtained to enhance yields and increase protection sizes.

Leverage, control

The volatility control is done via the use of leverage, he explained.

“If volatility is at 35% your exposure is one-to-one. If it’s less, they’ll apply some leverage, so you get more. If it’s more than the target, they will downsize your exposure by reducing the leverage.

“There’s a widely-held view that volatility correlates with stock levels. Does it mean you should increase your volatility exposure when vol is low and decrease it when it’s high?

“What they’re adopting here is a mean reversion strategy.”

He pointed to some of the risks, in particular the 5x leverage, which can magnify not just gains but also losses.

“Just because you have a vol control mechanism doesn’t mean you can reduce volatility. The control is done through a three-day rolling period. Volatility in the market can jump immediately. Even with the control, when the market gaps, you may go over your target very quickly.”

The volatility target was necessary.

“They built a 35% control, so you won’t lose your shirt. But even with the control, this is an extremely volatile underlying.”

Relative return

A chart on the S&P Dow Jones Indices website showed that the S&P 500 Futures 35% Defined Volatility index outperformed the S&P 500 futures (three-day roll) index (USD) ER since 2017 especially since March 2020.

The structurer said he was skeptical.

“I won't put too much weight on back-tested results,” he said.

“Since Covid, the S&P has more than doubled. I don’t see how volatility as an asset can outperform the S&P.”

“When you hold volatility, you lose money eventually.

“Volatility is not an asset. It’s a hedge, an insurance policy. You’re guaranteed to lose your premium. The only time you win is when you get compensated for some damage.”

However, the same chart showed that the S&P 500 Futures 35% Defined Volatility index incurred severe drops.

“The volatility index even with the defined 35% has a lot more risk. From a risk-adjusted return standpoint, the vol index did not outperform the S&P.

“That said, it’s precisely because of the risk that you can get very attractive terms.”

Step-down

A market participant agreed.

“It’s an enhanced volatility product. I’m sure they designed it so you can get things like the double-digit return combined with the 60% step-down,” he said.

A “step-down” is the feature allowing investors to capture the totality of the premium at maturity at a lower strike than the initial price

“You would have a tough time getting those terms on the S&P,” he added.

“Getting a call level at the end that matches the protection level is almost a must for a snowball. You don’t want to be holding a note for five years just to get your principal back. I think most investors don’t realize the risk.

“The step-down gives you a greater certainty to receive your entire premium. I think it should be in place more often.”

The notes are guaranteed by BNP Paribas, New York Branch.

BNP Paribas Securities Corp. is the agent.

The notes are expected to price on Sept. 30 and settle on Oct. 5.

The Cusip number is 05592QAA3.

BNP has announced the pricing of three other issues of five-year autocall notes for pricing on Sept. 30 all of which linked to the S&P 500 Futures 35% Defined Volatility index (USD) ER.

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