Losing Money When There is No Volatilty

It is common knowledge that there is more risk when there is more volatility. But it is also possible to lose (a lot of) money in the absence of volatility as well. This case was illustrated in a recent article published by Financial Engineering News. It was reported that Credit Suisse recently lost $120 million in Korean Derivatives -- particularly reverse convertible bonds.

A conventional convertible bond offers lower interest rates but gives the investors an option to call a company's stock. The bondholder is effectively the owner of the option and the issuer is the option writer. A reverse convertible bond gives investors higher interest rates but gives the issuer the right to put shares to the investor. In this case, the bondholder is the seller of the option and the issuer is the option buyer. When volatility increases, option prices increase as well. This added value stems from a higher possibility of going in-the-money. Conversely, a decrease in volatility will lower the option value. So if Credit Suisse was the one who "bought" the stock options via the reverse convertible structure, a decrease in volatility will decrease option value and will result into a mark-to-market loss on their end.

Now as market makers (structurers), shouldn't Credit Suisse be hedging their exposure? The problem with this particular structure is that the option is not based on one stock. It issued reverse convertibles on a number of shares. Hedging proved to be quite difficult and luck was not on their side, as stated in the article:

The problem however came in the hedging. Credit Suisse no longer had a single put option, nor did it have a portfolio of put options, since it could exercise its put into only one share. Instead it had an option on an option, a put option under which it could choose the share on which the option would be exercised. This instrument could be reasonably hedged by an appropriate portfolio of the shares provided volatility remained approximately constant, but it was effectively unhedgeable against a sharp change in volatility. If volatility in Korean shares had increased, there would be no problem; Credit Suisse’s multiple put option would be more valuable. There was, however, no effective way to hedge against a decline in volatility, which is what happened.

The lessons that we can learn here are the following:

1) You can lose when there is less volatility -- particularly in options since volatility is explicitly included in valuation.
2) When building a structure, one should know how to hedge it properly.

Tags: derivatives financial engineering investments valuation volatility structured products options