I have a question regarding the skew impact. Though I understand the origin of the skew, but I can't figure out the reasoning in this sentence below:-Banks' structured products desks are generally short skew due to the popularity of so-called vega-minus structures - for instance, worst-of baskets and cliquets. This effectively means structured product providers are long volatility when the stock market rises, and short volatility when equity spot prices fall. What is vega plus and vega minus structures ? Why cliquet and worst-of basket are short skew ? Why short skew means dealers are long volatilty when stock market rises and short volatility when equity spot falls ?How about the skew on product like Target Redemption Notes, AutoCallable certificate, etc. ? How can I figure out the skew impact ?Lastly, how to hedge this skew ?Look at this article which I found quite interesting:-Sizing up skewStructured products providers' methods for hedging skew are fairly homogeneous. Some banks, however, are searching for ways to refine their approach to hedging by transforming skew risk into an investment palatable to sophisticated investors. By Rachel Wolcott.Any serious structured products house will be exposed to skew. These days, most banks are content to hedge this risk using vanilla strategies. However, a small faction of equity derivatives players believe there is a better way to cope with skew exposure. They argue that products purpose-built to pass skew to investors will give banks a more accurate hedge. Others contend these new products do not serve to repackage any risk per se, but are simply another financial instrument."There are complex flow strategies that allow for a better monitoring of the skew risk than vanilla options," says Laurent Marquis, global head of options at BNP Paribas in Paris.The magnitude of skew risk on dealers' books came to light in 2003, when the global equity markets began to rally and some banks found themselves exposed to sizeable short skew positions, leading to large mark-to-market losses.Skew - which reflects the fact that implied volatilities vary with strike levels - exists because of a structural imbalance in the equity derivatives market. Historically, investors have purchased out-of-the-money puts to hedge their equity positions and sold out-of-the-money calls for premium. Consequently, volatility for low strikes has increased, while volatility for high strikes has decreased.Banks' structured products desks are generally short skew due to the popularity of so-called vega-minus structures - for instance, worst-of baskets and cliquets. This effectively means structured product providers are long volatility when the stock market rises, and short volatility when equity spot prices fall. When equity markets rallied in 2003, but with low levels of volatility, banks that had not hedged their short skew positions were left nursing hefty losses.Since then, there has been considerable effort made either to recycle skew risk or to put measures in place that work to prevent skew from accumulating. For the most part, banks are sticking with simple hedging strategies or are changing the way they conduct their structured products business."The first thing that happened was we changed the structure of the payout we were selling to clients," says Alan Zagury, head of equity exotics risk management for Europe at JP Morgan in London. "That's one kind of innovation that occurred in the market in order to change the structured products themselves. We sell to the same customers, but change the payout to either get a much more mixed exposure or even unwind the exposure that was in the books before."JP Morgan and others have created an array of products that effectively allow banks to buy back skew exposure. One example is the annual review note, which first appeared in 2003 and has been extensively sold to private banking clients. Generally sold in two- to three-year maturities, annual review notes pay investors a high coupon so long as the price of the underlying - usually a basket of stocks or equity indexes - is above a certain barrier on semi-annual or annual observation dates.The investor sells a downside put to finance this payout. If the underlying index or stock basket is above the barrier on the observation dates, the notes redeem early and pay the high coupon. However, if the price of the underlying does not breach the barrier during the note's life and is below the put strike at maturity, the investor is left with a short put position.Thanks to products such as the annual review note, dealers say market flow is more balanced. However, there is still a need to hedge skew, and most of this activity is conducted using the options market on a daily basis. "The first way we try to unwind skew positions is in the broker market through plain vanilla options. It's what we do all day," says Franck Lacour, who heads Barclays Capital's volatility business in London. "We are trying to keep our skew position under control. We are given positions by clients and we try to unwind as we go. And if we can't do it through a swap with a hedge fund, we do it through the broker market with plain vanilla options."Crucial to managing skew risk is understanding what kind of exposure a bank possesses, enabling it to dynamically rebalance portfolios of exotic risk using vanilla products and strategies."What has been a key aspect of managing exotic risk over the past few years, more than being very innovative in how you package skew, is trying to identify within a particular book the areas of the volatility surface to which you are exposed," says Gilles Dahan, Citigroup's London-based head of equity derivatives trading for Europe, Middle East and Africa. "It is not obvious when you look at a contractual aspect of a particular exotic book to see where your vega exposure lies and what your skew exposure is."Exotic traders and risk managers now put a lot of effort into identifying exposures in portfolios made up of several thousand positions dispersed across different market levels - which has created a very wide area of exposure on the volatility surface. They're looking for how a change in shape of the volatility surface will affect a bank's profit and loss in their structured products book and are weighing up their skew exposure."The key is to identify a rather small set of points, in strike and time, which best replicates, aggregates and approximates those exposures. You can then look at implementing very plain vanilla hedging strategies that would balance the mark-to-market impact of a change in the shape of the volatility surface," says Dahan. "To hedge the skew, the issue is not necessarily trying to find a very smart product to trade the skew with the market - it's first trying to identify as stable as possible a representation of where your exposures are, hence allowing you to use vanilla strategies to balance your book. Indeed, as spot and volatility move, your vega and skew exposures change and your existing hedge may become stale; you want to minimise the cost of rebalancing your hedge."Offering products with offsetting risk profiles together with vanilla hedging strategies have usually been enough to allow firms to handle skew. Some banks, however, are seeking to create products they say will allow them to more accurately hedge their skew positions instead of depending on proxies. In addition, these products are aimed at opening up new pools of liquidity by tapping further into hedge funds' and institutional investors' increasing appetite for exotic equity risk."We have some very nice ways today to benefit from the skew and not work with a proxy," says Arnaud Sarfati, head of equity-linked structured products at Societe Generale Corporate and Investment Banking (SG CIB) in Paris. "The more vanilla approaches to hedging skew are more of a proxy. We are working on more refined ways to place the skew."Sarfati declined to elaborate on specific products SG CIB has in the pipeline. However, the development of packaged skew products, to be sold to hedge funds and ultra-sophisticated institutional investors, is work the French bank is taking extremely seriously. Creating new skew products to complement vanilla hedging strategies is viewed as a huge competitive advantage for SG CIB."Skew is kind of a holy grail," says Sarfati. "When you find a way to really work on skew without using a proxy, I would say that is a hot topic."BNP Paribas is also devoting resources to researching a hedge that is easy to control, more path-dependent and better matched to the risks in its portfolio. "We're currently looking at products that can control not only the skew but also the volatility of the skew," says Marquis. "When the market parameters move, how is the sensitivity to skew going to react? Regarding our large exotic exposure, that's a very important dynamic."The French banks' enthusiasm for inventing skew products is not unique. However, equity derivatives bankers at rival firms question whether they will, in fact, serve as hedging tools or solely become stand-alone financial products and a way for banks to make money. This division in opinion reflects banks' differing views overall to hedging skew."There are ways to repackage skew and there are innovative financial products, but repackaging skew and laying off skew risk is probably not as urgent as the laying off of other kinds of risks like correlation risk or the vol of vol risk banks have been very innovative in trying to shift off their books," says Murray Roos, European head of flow exotic trading at UBS in London.Correlation or vol of vol risk is not that easily traded in the vanilla markets, so banks need to come up with innovative ways to market those risks to hedge funds. That need for complexity isn't there when it comes to skew, says Roos. "Skew is like a tap: it is quite regulated, and you can go and buy and sell skew as much as you want at the prevailing prices," he says. "Banks don't have to do anything funky to hedge their skew risk."Citigroup's Dahan agrees: "We haven't looked at something brand new in terms of packaging skew. Within the universe of available products, we try to find the most liquid and the most appropriate. Vanilla strategies, which include variance and, when spreads tighten further upside and downside variance, no matter how boring they might sound, remain a favourite tool to dynamically hedge such exposure."While dealers debate the merits of more complicated skew products for hedging, one thing is clear: these types of packaged offerings are central to building business with the hedge fund client base. "Being able to provide a hedge fund client base with a product suite that allows them to take the risk they want is key for an equity derivatives franchise," says UBS' Roos.Up until last June's bout of volatility, conditional variance trades had been the primary way hedge funds were playing skew. Conditional variance swaps allow investors to take a view on volatility, but returns are recorded only on days where the underlying spot price is above a predetermined level (upside variance, or up var) or below a particular level (downside variance, or down var).The most common trade was the so-called 95/105 strategy, in which clients purchase an up var swap on an index struck at 95% and sell down var at 105%. This trade allows investors to monetise skew by collecting carry between the two strikes. In turn, investment banks are buying back skew.In the 95/105 trade, investors are long variance when the spot market rises, and are short variance when the spot market falls (Risk October 2006, page 44). During the life of the trade, the investor collects a premium for every day volatility stays between two strikes. This trade worked well until June's market correction precipitated a spike in volatility."It unravelled very quickly when we had the market correction and it moved out of the range," says Barclays' Lacour. "Not only were clients short variance, but they were short skew and it proved to be a very painful experience."When the equity markets plunged, investors realised the mark-to-market volatility on the 95/105 strategy could be quite brutal. Appetite for this trade has diminished, but dealers are not giving up on conditional variance swaps and are in fact continuing to build on these structures, as well as promoting options on variance. Despite last year's setback, this area of the market is evolving quickly, having moved from trading predominately variance swaps to conditional variance. And dealers expect variance products to become a sustainable part of their business in future."I think the market is ready to take a leap forward," says UBS' Roos. "It is constantly looking at isolating term structure, skew and vol of vol via these types of products."Structurers have been using conditional variance swaps as a basis for new trade ideas by changing the strikes, the structure and the portfolio composition. They are looking at all the different kinds of trades they can do with the instrument, rather than focusing on just one strategy."Now we have a product (conditional variance) that allows you to take a lot of different views," says Cyril Levy-Marchal, head of flow equity derivatives trading for hedge funds in Europe at JP Morgan. "There are a lot of questions around the packaging and marketing of that, rather than purely on the modelling."Trades done in the past three to six months have taken advantage of the current steep skew curve. Currently, there is a mismatch between short-term products giving long skew exposure and long-term products creating short skew positions, which has resulted in a steep curve. This skew effect means upside variance is cheaper than a standard variance swap, so clients have bought up var to capitalise on that. Another approach has been to sell down var and collect a premium upfront. Dealers find their clients are now more open to these new takes on the conditional variance trades."With the conditional variance swap alone, the investor is able to slice the skew exactly the way a client wants," says Levy-Marchal. "Previously, clients wanted to sell volatility right along the curve. Now, if their view is that the skew very close to the money is too steep, but they don't want to take a crash risk, they can sell a 95/105 corridor swap and just be exposed to volatility in this range. There is a lot more flexibility for these strategies."Most of the 95/105 trades have so far referenced an equity index, a point SG CIB's Sarfati says contributed to their poor performance last June. SG CIB had taken a slightly different approach to conditional variance swaps, avoiding structures linked to an index and instead creating products linked to baskets of stocks."Using a basket of stocks means some are going up and some are going down, which gives better diversification in terms of the underlying," says Sarfati. "We think the best way to extract value from skew is to focus on a basket of stocks rather than indexes."Dealers such as SG CIB are secretive about their new skew products because they believe these developments will give them a massive competitive advantage when it comes to being able to recycle skew risk cleanly and efficiently. Meanwhile, benign equity market conditions mean dealers' skew hedging strategies haven't really been tested. When the next market anomaly occurs - a market crash with high volatility or a bull run with low volatility - the efficacy of skew hedging practices will be revealed. Whether those using plain vanilla strategies will fare just as well or better than those seeking to match their exposures more precisely will come to light only when the various techniques are tested.Dealers who have weathered losses related to unhedged short skew positions have learned their lessons and pay close attention to their exposures. However, there is some concern that newcomers to the structured products market may not be hedging adequately or pricing skew correctly. They might not be the only ones left exposed in the event of a market downturn. In some quarters, the lack of urgency behind developing new ways to buy back skew could be interpreted as a sign of complacency. Dealers may be happy to keep a short skew position on their books now, but as history demonstrates, they won't if the market moves against them.TextText

Anybody ? That should be relatively straightforward

Thanks, I now understand it.But why cliquet structure is also short skew ?

cos' of the reset feature maybe?

cliquet structures have (local/global) caps and (local/global) floors. any structure with caps and floors will be skew dependent. the reason cliquets are especially sensitive to skew is because they are essentially a ladder of SEVERAL skew-dependent (ie capped/floored) forward starting options.

Hi,Can someone give some intuitive explanations as to why capped/floored structures are skew dependent?

because they are embedded risk reversals