Mrs. Watanabe, Volatility, and financial innovation

There used to be a famous saying in the tech sector "If you wanna have a peek at the future of technology, fly to Tokyo and see what's trending there at the moment..." . Japan has always been considered an innovative nation.

If that logic applies also for financial innovation, we have merely scratched the surface of structured notes, and yield enhancers...

For over two decades the BOJ has kept its interest rate around zero, which means that households have two alternative when seeking yield

Buy stocks, or buy Uridashi Bonds

For those who are not familiar with Uridashi Bonds, these are JPY denominated bonds linked to high yielding assets, that are sold to institutional investors and household investors in japan that offer enhanced yield.

That all sounds very lucrative, as Japanese investors can get higher yield on their investment, but, as financial markets don't let you have free lunch, these bods are basically exotic derivatives wrapped and sold at premiums to investors Usually structures desks at banks

will come up with some exotic product (let's say Worst-off basket), stick few assets that they may have/don't have on their portfolio that has some degree of correlation and high yield, and turn it into a note that pays X% interest given some condition(s)

This is where it gets interesting.... as these products are basically exotic derivatives the have embedded vega/correlation risk that the bank is (usually) short... and these, in most cases, low delta strikes for long maturities (as these bonds' maturities are 5-20yrs)

Two uridashi bonds that I remember the most from back in the days that I worked on the pricing side are NZDJPY,AUDJPY uridashi and N225-EUR payout...

during the mid 90s/early 2000s the NZD,AUD uridashi was massive in issuance, which made the dealers massively short low delta

puts in AUDJPY and NZDJPY (like 40-50% OTM for 10ys)... as these bonds neared maturity in 2007-2008 they were less than 2d puts... In the aftermath of Lehman the AUDJPY hit a lot of these triggers making the move even exaggerated (I recall the AUDJPY dropping 10% in one day)

The other type was a hybrid product of N225/EUR payout, which blew up on the right tail event in 2012... dealers were massively short both topside vega and eurjpy-n225 correlation (UBS lost about sf190mm)...

With the entire global market in ZIRP we are most likely to see

more and more yield-enhancers like the uridashi bonds as money has no alternative (I recall @vol_christopher writing about it in his Alchemy of Risk)... investors and structures will become more greedy as vols and rates diff get compressed, and there has to be a pressure valve

to offset this dynamic....

@Ksidiii will probably be more into the nitty gritty on how the structures desk run the risk of these exotic structures, but they obviously turn the vega/correlation/gamma dynamic to be more more complicated than looking at the SPX GEX...

Just my 2c