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February 7, 2025.
OUR TAKE
Calling out autocallable pricing
Quants show popular autocallable pricing technique has a flaw that has been ignored until now
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Autocallables have been one of the most successful structured equity
products in recent years, providing investors with the ability to earn coupons
as
as
as high
high
high as
as
as 10%
10%
10% in a low-yield environment.
The products essentially have two types of barriers – upside and downside. If
spot remains within these bounds, investors would receive an above-market
coupon. The structure knocks out when spot hits the upside barrier,
returning principal and an improved coupon to investors. The investors also
sell the issuer a knock-in put option as part of the structure, so when the
2025 capital market expectations:
downside barrier triggers the put option, they could lose part of the principal. slowing but not sinking
To boost coupons, autocallables are often written on the lagged component of
a basket of underlyings.
as high
Given the
asdescription
10% of the product, it is not surprising that its pricing is
error-prone. Simple local volatility models – which calibrate very well to
vanilla prices – won’t cut it because they are not good at capturing the path-
dependent nature of autocallables.
This means the value of the product at any point in time would depend on the
path of the movement of the underlying rather than its absolute levels. So the
forward probabilities of events such as whether the lower barrier is knocked
in, given the upper barrier has not been breached, need to be estimated.
Market standard is to use a stochastic local volatility (SLV) model, which is
better at capturing path dependency. The trouble is, when SLV models are
used for a basket of underlyings, which is more common than a single
underlying, a well-known effect called decorrelation shows up. The addition
of a stochastic volatility component reduces the correlations between the
underlying spots to below their input levels. Multi-autocallable products are
typically long correlation, so lower correlation lowers the price. Overall,
autocallables are priced higher in SLV compared with local volatility models.
“When you go from local volatility to SLV you observe an effect that is often
referred to as decorrelation. It means that due to the volatility fluctuations in
the stochastic volatility model that are higher in the SLV model, the effective
realised correlation is smaller in this model than the local volatility model,”
says Patrick Kuppinger, head of equities and forex model validation at
Vontobel in Zurich, who was in the UBS business solutions team at the time
the article was written.
“What you would expect from that is, in isolation, it would have a negative
pricing impact on the autocallables.”
Kuppinger adds this is a well-known effect in the industry, and what quants
possibly do to correct for it is increase the correlations between the spots
before feeding them into the model.
In this month’s technical, The
The
The interplay
interplay
interplay between
between
between stochastic
stochastic
stochastic volatility
volatility
volatility and
and
and
correlations
correlations
correlations in
in
in equity
equity
equity autocallables
autocallables,
autocallables Kuppinger and Alvise De Col, head of
the loan portfolio advisory group in the global wealth management division –
and previously part of the business solutions team – of UBS in Zurich – show
there is a second opposing effect that biases autocallables priced using SLV
models – called bilocality. This means correcting for decorrelation alone does
not ensure the prices are somewhat free of unwanted biases.
Bilocality lowers the realised volatility in the SLV model compared to the
local volatility model, especially around the at-the-money levels of the put
option. Autocallables are short volatility, so when it is reduced the price goes
The interplaySo
up – an opposite effect to decorrelation. between stochastic
if this effect volatility
dominates, pricesand
are
correlations
driven higher in equity
rather thanautocallables
lower. Simply fixing the correlation – as quants
have been doing – will correct the prices in the “wrong direction” – they will
go further up, when they are already biased upwards.
“We were somewhat puzzled when we saw the effects were opposite in sign to
what we were expecting,” says De Col.
The fix
Given there is now a better understanding of these effects, the pair say quants
can fix the undesirable pricing issues. When the correlation between the
variances of the underlyings are large, bilocality is more likely to dominate,
they argue.
“In case you have a very large vol-vol correlation you see the bilocality effect
is the one that matters the most. Whereas in the case of no correlation
between the variances, the decorrelation is the most important effect. It’s the
call of the risk manager to decide what they like and what is actually more in
line with market behaviour,” says De Col.
Many quants focus on devising new ways to boost computing speed or
applying a complicated technique borrowed from physics to price exotic
derivatives. While these developments are crucial to progress in this field, it
also pays to dedicate time and effort into studying a model’s limitations for a
FOLLOW range of scenarios. As is made evident in this paper, sometimes the simple
fixes made on the basis of intuition alone may make matters worse.
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