Could anyone here explain to me why the seller of this structure is Short Skew? and how can a trader hedge this structure?Thanks in advance.Autocallable (Single Index):On each anniversary date, if an upside barrier is breached, redemption = 100%+ Coupon. Othewise indexation on a vanilla call at maturity. Barrier level increasing each year (e.g 110%/120%/...). Coupon level increasing.

To zeroth order this is a bond plus (ATM?) call, so the skew will come in from the autocallable feature.If the market crosses one of the special anniversary levels, then the total payout will be like a shorter dated bond plus extra value due to the market having risen. So this is an extra payout, sort of like a call spread (that the hedger is short).Imagine it as being like a european binary-like payout - i.e., the limiting case of a call spread with anotional inversely proprtional to the strike spread - an upmove in the index gives the buyer an additional but limited payout.If you sell a european binary you are short the skew, hence the skew exposure in this.I am not in front of any models, but I am guessing that as this structure only depends upon spot-start-type features, like strikes all determined in advance, and as there are no "real barriers" (only single-date european binary-like events) which can be strongly affected by stochastic vol, the pricing and hedging is not that bad, at least on the equity derivatives side.I expect a reasonable initial hedge will consist initially of a certain weighting in tight call spreads at each maturity to imitate the european-binary-like autocallable feature, plus a certain weighting in the overall long dated call option that provides the payout if the thing is not terminated early. Obviously there is an overall delta hedge as well.One thing to think about though is the interest rate hedge. If the stock market goes up, the duration of the structure goes down, so i bet this structure is quite sensitive to the correlation of the stock market and the interest rate market. I don't know whether there is a huge correlation between the equity market and the yield curve steepness, but that is in there as well!If you decide to ignore this effect (maybe just to get one limiting case of the overall price) then i bet this is pretty well behaved numerically. I doubt that you need a stoch vol model - you can probably do this with a monte carlo based upon the implied probability density from the european options at each anniversary. As the first autocall appears at year 1, you could use a Heston MC sim without jumps to see how different the pricing is under SV.To test the sensitivity to bond-equity correlation, you could modify the MC sim so that the bond market goes down as the stock market goes up, to get a conservative price. You can see this is the vulnerability: if the market has rambled up to a higher level, looking like you are likely to cash out early, and then the market dumps and there is a flight to Treasurys/Bunds/etc, you will have been underhedged on the long dated bond that gives back the 100% payout if the stock market goes down. In other word, duration of the structure lengthens when the stock market goes down, and it will be "too late" (that correlation feeling ...) to buy the bond hedge (rec on an IR swap, etc) as bond prices will have rallied.If you want to ignore skew (as another model sanity check maybe) you should be able to do this on a tree or a grid pretty easily.Again, I don't have a model in front of me -- anyone please correct me here if I got it wrong!

hi, erstwhile,just a quick question, for the normal autocallablestructure, the structure itself should be long the correlationof equity and interest rate.is this because if the structure get called early,the seller lose money on the increase of interest rate also???or some other reason???thanks a lot...

hi, erstwhile,just a quick question, for the normal autocallablestructure, the structure itself should be long the correlationof equity and interest rate.is this because if the structure get called early,the seller lose money on the increase of interest rate also???or some other reason???thanks a lot...

generally if something is autocallable there is a discontinuity according to whether the autocall level is breached. Discontuity = digital behaviour = skew

Discontuity = digital behaviour = skewThat is for the case of simple autocallable structure, what about a TARN on future cliquet performances, you could get extreme dependence on local aspect of the forward skew.

I agree with erstwhile you dont need a sto vol model to price this as there is no significant negative convexity of vol. to start with, like for a reverse cliquet or a napoleon. the strcuture is lightly concave in vol if you asset goes up sharply right after inception because if becomes a short zero bond, and all you short vega exp. coming from your hedge needs unwinding...likely in an enviromenent of higher vol. Having said that, if your structure of binary calls is financed by a down and In Put, potentially affected by the anniverary barriers or ven only knocking in on the last day of the structure, you may need to price if under various scenarios of skews and gen. vol levels.

Now, if you use a stoch. model these days, there is not s single chance for you to get a trade done (if you are a market maker) as the market has reached a level of competitivity never seen before of such structures (SG, BNPP, and JPM very wisely killing the margins on these structures)

Hi Sir,Regarding the TARN, could you please explain me the sensibility of this structure to IR( Long?) and correlation Eq/IR(short?).Regarding the Skew, it is not very clear what it is... What is the difference between smile, skew?Thanks a lo for your help.T.Thibault.muir@gmail.com

Jezza,When you say, in case of upmove you have to unwind ealier you short vega exposure arising from the call spreads (we suppose you are long the structure) at a higher vol level, you suppose the vol increases when the spot goes up.Am I wrong?Kokoon