SIGMA CAPITAL ADVISORS LLC

The US and global economy in general, and financial markets in particular are being challenged not only by the immediate external shocks inflicted by a health crisis and subsequent government imposed restrictions around the world and across industries, but also by more profound structural shifts that defies conventional wisdom and poses significant questions to future policy making. As part of a series of consulting rounds with the aim of delivering alternative, prioritized data points that inform and enrich the decision making of stakeholders in different industries and with special relevance in the continued response to the COVID-19 crisis, we put together a small brief with some of the macro and emerging trends and dynamics that have affected financial markets in recent years, as well as the shifts that have occurred as a result of current health crisis, who is leading them and what might be the immediate and long term consequences. We also briefly discuss some of the areas that need to be addressed in the current situation and future events of similar magnitude.

The current pandemic-induced economic crisis has brought several immediate and long term financial risks for companies across all sizes, sectors and industries. CFOs and Treasurers must anticipate, assess and mitigate these contingencies and their impact along the different areas and business lines. Therefore, it is crucial to add clarity and precision into the decision making process. For this purpose, we’ve synthesized a series of relevant questions for C-suite management to address before formulating a holistic and comprehensive financial risk plan. We invite you to read on this brief questionnaire in order to take targeted and effective action.

Proper identification of the risk of default of a debt issuer in an investor’s portfolio has always been crucial for sound credit portfolio management. However, the assessment and risk mitigation at a portfolio, security/loan, issuer or even sector level remains highly ineffective and at times very costly. Therefore, investors and risk managers should try to implement, or at the very minimum remain cognizant, of alternative derivative tools available to them.

In addition to natural hedgers (e.g. banks, hedge funds, private equity funds, mortgage companies and agencies, insurance, pension funds), active investors in the credit space (e.g. market makers like banks, proprietary trading firms, hedge funds) can utilize outright or net spread position strategies to take advantage of opportunities or arbitrage away dislocations or other disruptions in the cash and derivatives market (e.g. negative basis spreads).

Recent regulation in the over-the-counter market, enforced in the US markets as part the enactment of the Dodd Frank Act, such as the utilization of swap execution facilities (SEFs) and central counterparty clearing houses (CCPs), have added liquidity and efficiency in their trading as well as transparency and strength to their risk management, by standardizing contracts, netting positions, streamlining and consolidating the whole clearing process. Consequently, extreme attention should now be placed at CCPs risk mitigation structure and their members’ initial/variation margin and guarantee fund valuations to avoid the calamity of 2008.

This product brief should serve only as an introductory snapshot into some of the more popular credit products available for market participants. But they could also be used as building blocks to other more esoteric products like synthetic CDOs and other credit linked notes and securitizations.

Given the stock market return correlation with its volatility, investors started using an option price implied volatility index (the VIX index) - first developed by CBOE in 1993 as a theoretical gauge of the overall market "fear", as a tool to diversify portfolios, trade speculatively and hedge their market volatility exposure by replicating it with a portfolio of SPX options. In 2004 and 2006, the CBOE introduced the first VIX futures and in 2006 launched the first VIX options. Subsequently, many other indices where developed around the VIX futures and options in order to replicate long/short positions in volatility, which were later used as benchmarks by wrapper products like ETFs/ETNs and other structured products.

The inflation market is relatively young in comparison with other debt markets. The earliest inflation adjusted government bond was issued by the UK treasury in 1981 and US Treasury TIPS, first issued in 1997, is now the largest and most liquid market. Today, all developed and most emerging market economies have developed an inflation adjusted bond and real yield curve. In addition, major central banks now take this market to gauge implicit levels of inflation expectation and real interest rates. The product has established itself as a separate asset class in every institutional fixed income portfolio, due to its lower volatility, longer durations, high liquidity, and growing outstanding volumes.

Participants in the inflation debt and derivatives markets use them to better match and manage their assets and liabilities, enhance diversification of market and credit risk of their portfolios and exploit relative value opportunities.

Payers of inflation can be governments and government agencies (due to their inflation correlated tax revenues), commercial and real estate property investors (given their inflation adjusted rent income), and large project financing companies (because their revenues are mostly linked to inflation) as well as commercial banks if their funding short-term deposit rate is highly linked to inflation levels. Pension funds on the other side, are inflation receivers and can better match their inflation linked pensions with or inflation bonds or derivatives.

The inflation derivative market has grown in line with the cash market, and is most liquid for those products that use the same indices as the government bonds. (e.g. UK RPI, US CPI, Euro HICP, French CPI etc.) The following plain vanilla inflation swaps represent just a small subset of the universe of products in the asset class but a very liquid and popular set of asset liability management tools, especially in G7 currencies.

A cryptocurrency (or altcurrency) is a digital asset designed to work as a medium of exchange using cryptography to secure the transactions and to control the creation of additional units of the currency. Cryptocurrencies are classified as a subset of digital currencies and are also classified as a subset of alternative currencies and virtual currencies.

by Leonardo Reos, FRM

Currency markets have experienced significant volatility in the past few months, especially after recent global geopolitical and global events. Global trade and direct investment have suffered in the meantime as larger uncertainties take hold in decision making. For multinational companies, exporters and importers, higher currency volatility can take a significant toll in their bottom line. Therefore is paramount to consider different hedging strategies.

by Leonardo Reos, FRM

High liquidity in the FX markets combined with meticulous and rigorous money market management can provide a pickup in yield and a sound alternative to a short term, low volatility product.

by Leonardo Reos, FRM

Currency Notes, Apple ELNs, Swaps and Volatility - Latest trends in the markets across asset classes affecting issuance.

Controling Risks and Choosing Rewards - A brief introduction to the world of structured investment products for either retail and institutional use.

There’s no single definition of a structured product. In the most general sense, they are packaged investment vehicles that wrap a derivative strategy based on one or more underlying and is sold, traded and valued as a single security. They can be linked to a single security or a basket of securities, interest rates, indices or benchmarks, commodities, credit spread, foreign currencies, or hedge funds. Some SPs offer a “principal guaranteed”, meaning that the principal amount is protected at maturity by its issuer, though the security could trade higher or lower in its life. As an example, if an investor invests $100 in a 5yr principal protected note tied to the S&P500 index, the issuer simply invests in a risk-free bond that has sufficient interest to grow to $100 after the five-year period. This bond might cost $80 today and after five years it will grow to $100. With the leftover funds the issuer purchases the options, forward/future, swaps and or other strategy tied to S&P500 index. Most other SPs take a non-principal protected, meaning they do not guarantee their principal at maturity. Even though investors can just trade both separately, the cost and transaction volume requirements of many options, swaps and other derivatives are beyond many individual investors.

While SPs are for investment or speculation purposes and include some form upfront principal investment, some are tailored to hedge a particular exposure to the market, therefore are just a structured OTC derivative without the use of a principal investment, using only the notional to derive its value. Risks are usually much greater, and there’s a need of extra documentation or higher collateral margins.

As such, structured products were created to meet specific needs that cannot be met from the standardized exchange or OTC traded financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend.

The U.S. Securities and Exchange Commission (SEC) Rule 434 (regarding certain prospectus deliveries) defines structured securities as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows".