Exotic Derivatives Trading

March 31, 2009

Down and in puts – “An alternative to the traditional ones”

Filed under: Derivatives Strategy — Exotics Trader @ 3:17 pm

Down and in puts were the most actively traded options in the OTC derivatives market during the bull run. They were traded under a fancy name called reverse convertibles in which the buyers used to get fixed coupons and were short a down and in put or a worst of down in put. The recent market turmoil has forced the buyers of these reverse convertibles to rethink their strategy of enhancing yield, because in most of these options the puts have been activated and are deep ITM. The trading volume in the OTC derivatives market has considerably gone down and clearly the fear has gripped the structured products investors, especially in cases where the investors had to take a downside to enhance yield (down and in puts). In this post, I have suggested a structure which will help investors to diversify their risks without losing significantly on the yield. I personally think that it’s a good time to buy reverse convertibles since one can get a decent yield because of the existing high volatility scenario.

The Alternate structure: Down and in put on asset A & B, where the barrier is on the worst of but the put performance is on the other asset. For example – incase asset A hits the barrier first, the put is triggered on asset B and asset A performance becomes redundant in calculating the final payoff.

Why an investor doesn’t have to sacrifice the yield / which one is more costly – a simple down and in put / the modified down and in put?

Take a case where – volatility of asset A and asset B is 40%, A & B have similar dividend levels/forwards. Clearly the price of a simple down and in put on A is equal to the price of a simple down and in put on B.

What about the modified down and in put on A and B? In case of a +1 correlation scenario (highly positive correlation) the price of the simple down and in put on A or B is same as the price of the modified down in put on A & B. “The price of the modified down and in put decreases with decrease in correlation”.


  1. The two assets should be intelligently chosen so that there is an efficient diversification of risk
  2. Don’t have to sacrifice on the yield significantly because of the current high positive correlation scenario

Choosing A and B in light of current market conditions:

Things to keep in mind

  1. What if Mr. Geithner’s plan fails to stimulate the lending and the current rally is just a short lived one?
  2. Who is going to withstand the second tide? The ones having lower levels of leverage, sitting on just enough cash to keep them afloat in the murky waters.
  3. Whatever the result be, at the end of the day governments are printing money and there is a high risk of inflation.

Recently equities have shown high correlation due to the market turmoil and clearly everyone including gold miners has taken the hit due to the shortage of capital (The liquidity crunch).

GDM Index: AMEX Gold miners Index

Gold miners seem to be undervalued especially when economy has high inflationary tendencies in the medium term.

Comparative Returns for different sectors: Beverages, Gold miners, Tobacco stand out!

Possible combinations for asset A and asset B

  1. S&P 500 Beverage Index and AMEX Gold miners Index
  2. AMEX Gold miners Index and AMEX Tobacco Index
  3. S&P 500 Beverage Index and AMEX Tobacco Index

One would prefer a pair with higher correlation and volatilities so as to earn a higher yield on the modified down and in put option.

Historical Correlation and Volatility levels:

I would personally prefer a basket of S&P 500 Beverage Index and AMEX Gold miners Index.
Gold just seems attractive to me and trust me if the world goes worse from here, alcohol consumption is no where going down! You can mail me for indicatives 🙂



  1. Hi,
    Thanks for your answer. I am working for a UK company in HK as a sales/structurer and, as we have more time these days, I am trying to get a better knowledge of a all the structures we have been selling through the past years. Ideally, I would really like to put together a few slides where I can really describe with precision how to hedge digital/barriers/autocallables… I have found nothing very clear about it in the web. I was advised to read the Taleb for that and I did not find the book very clear… Would you be interested in working with me on such project?
    I read with great interest your previous post and was asking myself a question regarding reverse convertible. I have read that the only two hedges you need to do for this structure are a IR hedge and a vol hedge. First one is OK. For the vol hedge, I would have thought it is a little bit too expensive and I would have only done a delta hedge on my DIP. So basically, how to hedge a reverse convertible bond in the real life?
    Thx a lot for your help.

    Comment by Jean — April 15, 2009 @ 1:36 am | Reply

  2. Thx a lot for your answer….
    A few more questions.
    +++Do you always put in place the vega hedge you described for one structure only?
    +++Imagine you sell for 10M notional of reverse convertibles and that is the first deal you are going to have in your book, isn’t it better to buy vol at cheaper price and just delta hedge?
    +++As your book grows bigger, you will have a significant vega risk and do your vega risk at the book level?
    +++I asked a trader once on a different structure (ZC+call on mutual funds). The guy (still employed) was only delta hedging the structure. He agreed he had a vega risk but told me he was not going to buy a call to hedge his vega on one single call. Reasons for that were he could not find exact match on the mkt (because of funds)and, even if he could find a good proxy (ie a the fund was perfectly tracking an index), it was too expensive. So basically, he was selling the vol at a higher price and deltahedging the call (like you are proposing for illiquid underlyings). His book was not very big at that time and he was waiting for a bigger size to do a macro hedge on the book level. Is it something you were used to in practice?

    +++ B/S the hedge will introduce some delta as well, you need to delta hedge this as well. I guess this will be aggregated with the DIP delta and the delta sensitivity will be hedged for DIP+hedge.
    +++ I agree with your comment on the barrier shift…

    3/Rates: OK

    4/ No gamma hedge? Why is there no gamma hedge done?

    Thx a lot for your answers.
    Let me open my ears for the jobs.

    Comment by Jean — April 15, 2009 @ 5:26 am | Reply

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