A major challenge for long-term investors is extracting risk premiums while maintaining limited exposure to downside risks, writes Stoyan Stoyanov.

Structured investments could play a significant role in addressing the volatility of Asian markets. Structured investment strategies are based on derivatives with a pay-off function and features tailored to investors’ needs. Although many strategies exist, they usually contain an asset and derivative structure designed to provide a particular pay-off at maturity. Some popular structures allow investors to gain access to the upside potential of the distribution of the asset while providing downside protection.

Demand for structured products is on the rise in Asia. The overall maturity of Asian markets and the heterogeneity of regulation across countries, however, create challenges in designing the derivative structure. The derivatives market that has been growing most rapidly is the equity derivatives market. Consequently, structured equity investment products appear less costly to design on a relative basis and, because of the high expected growth of Asian economies, they are also attractive to institutional investors.

The main challenges come from the features of Asian equity markets that distinguish them from the European and the US markets – they are more volatile and, perhaps more importantly, volatility derivatives are difficult to obtain. This is because the equity derivatives market remains relatively immature despite its recent growth and derivatives based on option-implied volatility indicators are not widely available.

In recent research supported by Societe Generale Corporate & Investment Banking, we explore the characteristics of Asian equity markets and document significant departures from normality for all markets, whether developed or emerging. This means that returns on Asian equity indexes do not conform to a normal distribution with stable mean and volatility. We also find that the volatility of Asian markets, excluding Australia and New Zealand, is higher than that of the European and US markets. Since the volatility of Asian equity markets is generally higher and volatility risk is difficult to hedge for Asian investors in the absence of volatility derivatives, it makes sense to consider structured equity investment strategies with a target-volatility feature.

From a theoretical perspective, target volatility strategies can be rationalised in the framework of dynamic asset allocation models. Extending the framework developed by Robert Merton with stochastic volatility leads to a fund separation theorem in which the component responsible for performance generation can be interpreted as a target-volatility strategy. Dynamic asset allocation models also imply that an efficient way to deal with the problem of extreme risk arising from stochastic volatility is to construct a portfolio with constant volatility.

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