Xavier Ducros Director, Fund Linked Derivatives Structuring Rabobank Hong Kong May 25, 2008 Xavier is responsible for designing, developing and delivering fund linked products across Asia within Rabobank Hong Kong.
Xavier holds a post graduate masters’ degree in banking & finance at Paris Dauphine University (1996) and has twelve years of work experience. Before joining Rabobank in 2007 Xavier was in charge of the structured solutions with HSBC HK within their Structured Fund team. He loves sports and particularly tennis. Team Latte's Rahul Bhattacharya recently caught up with Xavier for a chat.

Team Latte:
What are fund derivatives? How do you structure them? Could you explain with a very simple example?

Is it something like an equity structured product whereby you have a hedge fund as an underlying and then you embed a call or a put option on this fund with a zero coupon bond?

Xavier Ducros:
Fund derivatives are at the crossroads of derivatives and asset management. It is usually structured using sophisticated derivatives or even simple derivative on a dynamically managed underlying.

You have indeed some similarities with equity structured products but also differences in the range of products.

A simple example of similarity could be a protected structured note paying at maturity 100% of your capital back and a fixed participation linked to the return of 3 different sector funds with the best performing sector fund allocated the highest weighting, for example 50%, the second best performing allocated a 30% weighting and the third fund allocated a weighting of 20%. Such product is being structured with a zero coupon and a rainbow option.

Team Latte:
So what are these dynamic underlying you mentioned and range of products in fund link derivatives?

Xavier Ducros:
They are typically managed by a fund or hedge fund manager so it includes mutual funds, fund of hedge funds, but these underlying can be as well basket of funds, hedge fund indices, customized indices which comply with specific rules or investment strategies. As these underlying are usually not traded on an exchange it requires careful selection and expertise in due diligence.

The range of products can be split in few categories. The simplest ones are pass-through or delta 1 products which offer investors one for one exposure to the underlying and are mainly used for investment access. Another range are leveraged products such as accreting strike call option or dynamic leverage certificate which are used to enhance the return with typically 2-3 times leverage on initial investment; these products are typically done on alternative investment underlying which differentiate this range from traditional equity products. The third category are protected products structured with CPPI mechanism, vanilla or various exotic options to protect the capital while providing a participation link to the return of the Underlying as mentioned in the earlier example. Finally the last category regroups all the other structures such as for example the portable alpha structure which objective is to improve the return of a classical beta investment.


Team Latte:
Over the last couple of years we have witnessed a significant growth in field of fund linked derivatives (FLD). There is now almost a new paradigm driving the development of fund linked derivatives. What is this new paradigm? How has the landscape for the FLD changed in the past decade?


Xavier Ducros:
With its origins in the mid 90’s it is true that the fund derivatives market has grown exponentially the past few years. This has been characterized not only by larger number of market participants but also by the growing demand and needs from investors for a wider range of products, yield and diversification benefits. Fund managers offer the active management of the underlying embedded in the derivatives, providing the alpha that is usually seek by investors while capturing or diversifying their AUM.

Today fund derivatives cover most underlying asset classes allowing asset allocation solutions, they offer access to underlying difficult to access and allow to secure performance by taking profit from a direct fund investment into a guaranteed structure. I would finally add that the strong performances with low volatility we have seen the past years have contributed to this expansion.


Team Latte:
Is the current credit crisis changing the landscape?


Xavier Ducros:
Obviously more houses will have to focus on niche areas as financing is getting more expensive and credit rating a key issue as many investors will not tolerate banks with a low rating. Some houses that were active are just no longer there. While investors’ needs are still there, the end of the bull market with increased volatility is not helping in some areas but also offer some opportunities toward uncorrelated underlying.


Team Latte:
A majority of protected products are today constructed using CPPI technology, how has this specific structure evolved?


Xavier Ducros:
Its origins date back 1980’s for Portfolio Management with the late 1990’s using this technique with the certainty of protection as gap risk is taken by investment banks. A second and third generation of CPPI has now come up with options on CPPI and highly structured CPPI such as for example best of CPPI.


Team Latte:
Could you explain a bit more on option on CPPI?

Xavier Ducros:
It consists of a zero coupon plus a call option on a dynamic portfolio that synthetically replicates the CPPI strategy. The payout is similar to a CPPI but the strategy runner does not need to run exactly the strategy during the life of the products. This allows highly tailored payoffs with coupons, lock-in, averaging, fixed threshold, minimum allocation etc…Such options require volatility assumptions and fits easily within risk management systems compared to traditional CPPI.


Team Latte:
With recent volatility in the market is CPPI strategy really suitable for investors knowing it is a gamma negative structure? Options as well must be pretty expensive?


Xavier Ducros:
I agree that risk of disinvestment or rapid de-leverage is increased so careful design of the structure with reasonable gearing and buffer is key for CPPI to be suitable. Some asset classes are showing however much lower volatility that for example the equity markets which means that selection of the right underlying on such structure is very important. It is correct that traditional including call options are as well more expensive leading to lower participation capital guaranteed structures. But there are ways to reduce the price of the option by capping for example the vol while still offering an attractive payoff with reduced market timing risk and high upside potential.


Team Latte:
In what aspect the pricing models on the fund derivative side differs from the equity derivative models?


Xavier Ducros:
Options on funds are always based on a modeling of the underlying commonly represented by the Black and Scholes model.

But this model does not represent a gap in the behavior of the fund and it takes the basic assumption to hedge continuously on the underlying.

But mutual funds, let alone hedge funds are not liquid assets and always have a delay in the publication of their NAV which makes the calculation of the hedge imprecise. Moreover, there is no option market for fund like there is on stocks so it is difficult to estimate accurately the volatility to input in the model.


Team Latte:
You mentioned the Black-Scholes model for pricing options on the fund? Why not the Monte Carlo simulation model? Does any pricing model have a specific advantage over the other?


Xavier Ducros:
Path dependent options such as for example CPPI or some exotic fund options come from Monte Carlo simulations and such simulations assumes a model for the process of the risky asset which is the fund. As mentioned, Black Scholes is a regular model but has some limits and concerns due to the fund characteristics. You can read some in depth quant research on all the models available and their characteristics but whatever the model, you will have to input assumptions and parameters. As an example, Jump diffusion models have for example the advantage to capture break out risk but the result will depend on the assumptions. So depending on which product you will be pricing a model might be more appropriate or less.


Team Latte:
What challenge you are facing in structuring new payoff on funds?

Xavier Ducros:
Funds can’t be shorted which automatically limit the number of payoff you are able to offer as you can’t be delta negative. Discontinuity is also an issue in hedging as these underlying funds do not have the liquidity of other asset classes such as FX or Equity for example. New payoffs based on the dynamic volatility of funds have become very popular recently, however it is particularly challenging to calibrate these stochastic models especially there is no option market on the underlying.


Team Latte:
Volatility and gap risk might be challenging to hedge in the fund derivative space, how can these risks be managed in a trader book?


Xavier Ducros:
Yes volatility hedging is indeed challenging. For mutual funds you can use proxy underlying on which volatility can be hedged or you have to recycle the risk by selling other type of products such as reverse convertible, variance swap. For CPPI structures, Gap or Stability Notes can also be used to hedge gap risk.


Team Latte:
What are the key steps in fund link structuring from conception to execution?


Xavier Ducros:
It starts with the selection of the underlying with its due diligence then the pricing of the structure, all the Monte Carlo simulations and backtesting of the product, the presentation, the term sheet. And obviously the entire legal aspects link to it in terms of trading agreement, investment guidelines on the underlying and as well all the internal approvals with the required departments before execution can be done.

Team Latte:
How do you manage to differentiate at Rabobank from other service providers in this competitive environment?

Xavier Ducros:
First of all we are a AAA rated bank with a strong balance sheet which gives us a natural competitive advantage especially in the current environment for fund linked products. Moreover fund linked products tend to be longer dated than on other asset classes and investors have then a much lower tolerance for low rated issuer.

We also differentiate by designing structures which leverage the bank culture and expertise offering investors a true unique package and services. That is the case for example in the Food and Agribusiness or sustainability space.


Team Latte:
You have been working many years in derivatives, what excites you in fund derivatives?

Xavier Ducros:
Learning new things! In funds you have to deal with a wide range of story and underlying such as new energy, climate change, agriculture, commodity, property, healthcare, alternative investments etc... So you have to be on top of all the key issues the world face today. In funds you have to believe first in the Underlying rather than the payoff like it is the case in other derivatives. I think it is much more enriching and fascinating from a personal point of view.

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