Equity-Based Insurance Guarantees Conference November 14-15, 2011. Chicago, IL. Alternative Solutions for Variable Annuity Hedging

Equity-Based Insurance Guarantees Conference November 14-15, 2011 Chicago, IL Alternative Solutions for Variable Annuity Hedging Antoine Segaud

Alternative Solutions for Variable Annuity Hedging EBIG Conference Chicago 14 November 2011 (1305 Hrs 1350 Hrs) Antoine Segaud Director, Equity Derivatives Structuring & Strategy 1

Contents 1. A Basic Hedging Principle 2. Value-Added Hedges - Where Are The Opportunities? 3. Case Study: Down-and-Out Puts 4. Delta Product: Conditional Asian Option 5. Vega Product: Conditional Variance Swap 6. About BNP Paribas 14 November 2011 2 2

A Basic Hedging Principle Three desired properties of a hedging strategy: Low premium High convexity High Pay-Out Probability Any hedging strategy can only cover any two of these properties, Nicholas Cohen (*) Low Premium Tactical Hedges Bound Hedges High Convexity All-Weather Hedges High Pay-Out Probability (*) Head of Exotic Trading Americas, BNP Paribas GECD 14 November 2011 3 3

Contents 1. A Basic Hedging Principle 2. Value-Added Hedges - Where Are The Opportunities? 3. Case Study: Down-and-Out Puts 4. Delta Product: Conditional Asian Option 5. Vega Product: Conditional Variance Swap 6. About BNP Paribas 14 November 2011 4 4

Value-Added Hedges Where are the opportunities? 20% SPX 12-Month Return Distributions 15% Implied 31-Oct-11 Implied 1-May-07 Historical 1931 - Present Pre-Packaged Scenarios 10% 5% 0% -100% -75% -50% -25% 0% 25% 50% 75% 100% Source: BNP Paribas, Bloomberg Past performance is not indicative of future results, which may be better or worse than prior results. 14 November 2011 5 5

Value-Added Hedges Where are the opportunities? (cont d) Tactical Hedges High Convexity Low(er) Premium All-Weather Hedges Bound Hedges High Pay-Out Probability In a changing environment Vanishing risk appetite of historical liquidity providers Strong capital inflows in hedging strategies Skew is currently the most distorted parameter and is as high as it has been in the past decade more VA hedgers are now using alternative - and cheaper hedges: More flexible hedging program mandates are needed Bound hedges are a natural fit for Regulatory Based Capital driven strategies 12-Month SPX Skew (*) SPX 12-Month Returns - CVaR 70 (**) 0.7 06 0.6 0% Implied 31-Oct-11 Implied 1-May-07 Historical 1931 - Present Pre-Packaged Scenarios 0.5-10% 0.4-20% -13.2% -14.8% -16.0% 0.3-30% Nov-01 May-03 Nov-04 May-06 Nov-07 May-09 Nov-10-40% -33.7% Source: BNP Paribas (*) Difference in the implied volatilities of 20% and 80%-delta, 12-month put options, as a multiple of the ATM 12-Month implied volatility Source: BNP Paribas (**) Conditional value-at-risk at a 70% confidence level 14 November 2011 6 6

Contents 1. A Basic Hedging Principle 2. Value-Added Hedges - Where Are The Opportunities? 3. Case Study: Down-and-Out Puts 4. Delta Product: Conditional Asian Option 5. Vega Product: Conditional Variance Swap 6. About BNP Paribas 14 November 2011 7 7

Case Study: Continuous Down & Out Puts Barrier Option Definition: Continuous Down & Out Puts are similar to Vanilla Put Options, unless, at ANY time before maturity, the underlying trades below the predefined barrier. In this case the option knocks out, and the pay-out is 0. Significant Discounts to Vanilla Put Options are the norm with Down & Out Puts Current Discounts are at historical highs Current Discounts to Vanilla Puts (**) 100% 80% 60% 40% 20% 0% 52% 67% 82% 90% Barrier = 50% Barrier = 60% Barrier = 70% Barrier = 80% Source: BNP Paribas (**) Premium Discount for a 12-Month, at-the-money SPX Put, that knocks-out if at any time SPX trades below the Barrier level, vs. a Vanilla at-the-money Put Barrier Option Pay-out (*) 60% 50% 40% 30% 20% 10% 0% -10% -80% -60% -40% -20% 0% 20% 40% 60% 80% (*) Pay-Out at maturity for a 12-Month, ATM Put Option, 50% KO, assuming the underlying NEVER traded below 50% during the term of the trade Historical Discounts to Vanilla Puts (***) 80% 60% 40% 20% - 7% 63% 31% 37% 52% 30-Apr-07 30-Oct-08 31-Dec-09 31-Dec-10 31-Oct-11 Source: BNP Paribas (***) Historical Premium Discount for a 12-Month, at-the-money SPX Put, that knocks-out if at any time SPX trades below 50% of its initial level, compared to a Vanilla Put 14 November 2011 8 8

Case Study: Continuous Down & Out Puts (cont d) Barrier Options look good in the Real World. Discrepancy between the current Implied World and the Real World is at an all-time extreme But are more complex to manage for economic exposure Delta, Gamma and Vega vary significantly from Vanilla Options; Gamma can reach extreme values when barrier is close and maturity is short When putting Barrier Options on, spread Barriers & Maturities! SPX 12-Month Return Distribution KO Probability for Pre-Packaged Scenarios (*) 100% 80% 60% Discount to Vanilla KO Probability bilit in Pre-Packaged P Scenario 90% 82% 67% 52% 40% 20% 11% 0% 1% 2% 0% Barrier = 50% Barrier = 60% Barrier = 70% Barrier = 80% Source: BNP Paribas (*) () Probabilities for 12-Month at-the-money yp puts, varying barrier levels Down & Out Gamma Profile (**) Implied 31-Oct-11 Implied 1-May-07 Historical 1931 - Present Pre-Packaged Scenarios -100% -75% -50% -25% 0% 25% 50% 75% 100% Source: BNP Paribas Past performance is not indicative of future results, which may be better or worse than prior results. DOP Gamma Vanilla Put Gamma Ratio (rhs) 12 11 10 9 8 7 6 5 4 3 2 1 Time-to-maturity (Months) Source: BNP Paribas (**) Gamma Profile for an at-the-money SPX Put, that knocks-out if at any time SPX trades below 50% of its initial level, varying Maturity, compared to a Vanilla Put. 100% 80% 60% 40% 20% - 14 November 2011 9 9

Contents 1. A Basic Hedging Principle 2. Value-Added Hedges - Where Are The Opportunities? 3. Case Study: Down-and-Out Puts 4. Delta Product: Conditional Asian Option 5. Vega Product: Conditional Variance Swap 6. About BNP Paribas 14 November 2011 10 10

Interesting Delta Product: Conditional Asian Option Conditional Asian Option A Conditional Asian Put differs from a Regular Asian Put in that the final average will only be based on observations that are in a pre-defined range. Interesting Discounts to a Regular Asian Put Option Maturity: 5y Observation Frequency: Monthly Strike: At-the-money Observation Barrier: 50% Shows a 40% Discount to a Regular Asian Put. and 75% of its initial delta 120 100 Conditional Asian Pay-out 80 60 40 Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 Spot Conditional Observation Barrier Cond. Asian Avg Reg. Asian Avg Monthly Asian Avg Source: BNP Paribas, Bloomberg Historical Pay-Out vs. Regular Asian Puts (*) 60% 50% 40% Regular Asian Conditional Asian 30% 20% 10% 0% Jan-35 Jan-45 Jan-55 Jan-65 Jan-75 Jan-85 Jan-95 Jan-05 Source: BNP Paribas, Bloomberg (*) Historical Pay-Out for a 5-year, at-the-money SPX Conditional Asian Put, taking observation only above 50% of the initial level, compared to a Regular Asian Put Past performance is not indicative of future results, which may be better or worse than prior results 14 November 2011 11 11

Contents 1. A Basic Hedging Principle 2. Value-Added Hedges - Where Are The Opportunities? 3. Case Study: Down-and-Out Puts 4. Delta Product: Conditional Asian Option 5. Vega Product: Conditional Variance Swap 6. About BNP Paribas 14 November 2011 12 12

Interesting Vega Product: Conditional Variance Swap Conditional Variance Swap A Conditional Variance Swap differs from a regular Variance Swap in that: Volatility is calculated on the observations that are in a predefined range Vega is adjusted by the number of observations in the range Interesting Discounts to a Variance Swap Maturity: 5y Observation Barrier: 50% Shows a Carry cheaper by 4 Volatility Points and 65% of the initial Vega of a Regular Variance Swap 120 100 80 60 40 Conditional Variance Swap Nov-06 Nov-07 Nov-08 Nov-09 Nov-10 Nov-11 15 10 5 0-5 -10-15 -20 Non-observed Returns Conditional Observation Barrier Source: BNP Paribas, Bloomberg Historical Pay-Out vs. Regular Var Swaps (*) Conditional Variance Swap Regular Variance Swap Jan-35 Jan-45 Jan-55 Jan-65 Jan-75 Jan-85 Jan-95 Jan-05 Source: BNP Paribas, Bloomberg (*) Historical Pay-Out for a 5-year 50% Up Conditional Variance Swap, struck at current level Past performance is not indicative of future results, which may be better or worse than prior results. 14 November 2011 13 13

Contents 1. A Basic Hedging Principle 2. Value-Added Hedges - Where Are The Opportunities? 3. Case Study: Down-and-Out Puts 4. Delta Product: Conditional Asian Option 5. Vega Product: Conditional Variance Swap 6. About BNP Paribas 14 November 2011 14 14

A Global Powerhouse Total assets of $2.8 trillion* Market Capitalization of $48 billion ( 35 billion), as of November 1 st, 2011** Over 200,000 employees worldwide with over 18,000 in the US 13,000 corporate and institutional clients Over 20 million retail clients AA- (stable outlook) by Standard & Poor s Rating Group, a rating of Aa2 (under review) by Moody s Investor Service Ltd, and a rating of AA- (negative outlook) by Fitch Ratings. A rating (1) is subject to downward revision, suspension or withdrawal at any time by the assigning rating organization(s) (2) does not take into account market risk or the performance-related risks of the investment and (3) is not a recommendation to buy, sell or hold securities. Selected Peers S&P Long term Issuer Ratings Institution S&P Credit Rating Moody's Credit Rating BNP Paribas AA- Aa2 HSBC AA- Aa2 Credit Agricole A+ Aa2 Deutsche Bank A+ Aa3 Societe Generale A+ Aa3 JP Morgan A+ Aa3 UBS A+ Aa3 Barclays A+ A1 Credit Suisse A Aa2 RBS A A3 Goldman Sachs A A1 Bank of America A Baa1 Morgan Stanley A A2 Citigroup A A3 Total Assets in $ Billion* 3,070 2,795 2,691 2,399 Deutsche Bank 2,323 BNP Paribas 2,313 HSBC 2,289 Barclays 2,220 RBS Credit Agricole 1,936 JP Morgan 1,680 Bank of America 1,600 Citigroup Societe Generale 1,174 UBS 937 Credit Suisse 831 Goldman Sachs Morgan Stanley *Source: Bloomberg November 1 st, 2011, assets as reported in latest report (where appropriate, exchange rates are determined as the one-day average exchange spot rate close prior to the period end date). ** Source: Bloomberg November 1 st, 2011 Market Capitalization in $ Billion 152 128 86 66 55 48 47 40 36 35 32 31 19 17 HSBC JP Morgan Citigroup Bank of America Goldman Sachs BNP Paribas UBS RBS Deutsche Bank Barclays Credit Suisse Morgan Stanley Societe Generale Credit Agricole 15

Diversified and Stable Business Platform The Group is active in 3 core businesses: Retail banking: A strong base of recurring income with a significant footprint beyond France Investment Solutions: A full range of services for retail and institutional investors Corporate Investment Bank: A global powerhouse with a strong presence in Asia, US, Middle East and Europe One of the lowest Credit Spreads among peers Corporate & Investment Banking 1,746 mn Investment Solutions 1,551 mn 10,032 mn* An important global player Q3 2011 Revenues Retail Banking 5,961 mn** * Including non-operating division earnings ** Including 100% of Private Banking in France (excluding PEL/CEL effects), Italy and Belgium Rabobank 114 5 Year CDS Spreads (Bps) Q3 2011 Net Income (Millions USD) HSBC 142 Source: Bloomberg November 2nd, 2011 Source: BNP Paribas, Bloomberg, November 2nd, 2011 JP Morgan 143 Bank of America 6232 Wells Fargo 145 JP Morgan 4262 Credit Suisse 153 UBS Deutsche Bank 188 197 Wells Fargo Citigroup 4055 3771 Barclays Citigroup 215 232 Santander Morgan Stanley 2547 2199 Commerzbank 240 UBS 1238 BNP Paribas 250 254 BBVA 1136 Credit Agricole Goldman Sachs Santander Royal Bank of Scotland 267 297 300 Societe Generale Deutsche Bank Credit Suisse 1075 1024 831 BBVA 302 BNP Paribas 764 Societe Generale 321 Commerzbank 35 Morgan Stanley 343 350-393 Bank of America Goldman Sachs 16 16

A Strong Global Counterparty with a Diversified Business Model Selected Peers S&P Long term Issuer Ratings Institution S&P Credit Rating Moody's Credit Rating BNP Paribas AA- Aa2 HSBC AA- Aa2 Credit Agricole A+ Aa2 Deutsche Bank A+ Aa3 Societe Generale A+ Aa3 JP Morgan A+ Aa3 UBS A+ Aa3 Barclays A+ A1 Credit Suisse A Aa2 RBS A A3 Goldman Sachs A A1 Bank of America A Baa1 Morgan Stanley A A2 Citigroup A A3 Revenue of the operating divisions Fourth quarter, 2010 EUR/USD rate: 1.3809 as of March 2, 2011 Retail banking 6,012 million 58% 26% 16% Corporate and investment banking 2,688 million Investment solutions 1,651 million 17 17

BNP Paribas A Global Player BNP Paribas operates in more than 80 countries on 6 continents The Group employs 205,300 people worldwide*, of which 68% are outside France Americas 19,400 Europe 162,500 Headquarters in Paris North America 15,200 Africa South America 4,200 Middle East 2,200 8,100 Asia 12,500 Oceania 600 * Figures as of June 30th 2011 18

About BNP Paribas: A strong counterparty for today s markets S&P Credit Rating Moody's Credit Rating Fitch Credit Rating RABOBANK AAA Aaa AA+ HSBC BANK PLC AA Aa2 AA One of the 6 strongest WELLS FARGO BK AA Aa3 AA- credit ratings* in the JPMORGAN CHASE AA- Aa1 AA- banking world BNP PARIBAS AA- Aa2 AA- One of the global banks BANCO SANTANDER AA- Aa2 AA- with the least amount of BBVA AA- Aa2 A+ write-downs & credit BARCLAYS BANK-UT AA- Aa3 AA- losses and capital raised* (as of November CREDIT SUISSE A+ Aa1 AA- 2 nd 2011 **) CREDIT AGRICOLE A+ Aa2 AA- DEUTSCHE BANK-RG A+ Aa3 AA- Market capitalization of 35.8 billion as of SOC GENERALE A+ Aa3 A+ November 2 nd 2011** UBS AG-REG A+ Aa3 A CITIBANK NA A+ A1 A+ MORGAN STANLEY B A+ A1 A BANK OF AMER NA A+ A2 A+ ROYAL BANK SCOT A+ A2 A GOLDMAN SACHS GP A A1 A+ * Within its peer group **Source: Bloomberg. Source: BNP Paribas, Bloomberg, November 2nd, 2011. For S&P, rating for Long Term Foreign Issuer Credit is quoted. For Moody s, rating for Senior Unsecured Debt is quoted. For Fitch, rating for Long Term Issuer Default is quoted (*) Senior Unsecured Debt is not available so the Issuer Rating is quoted. A credit rating (i) is subject to downward revision, suspension or withdrawal at any time by the assigning rating organisation, (ii) does not take into account market risk or the performance-related risks of the investment, and (iii) is not a recommendation dti to buy, sell or hld hold securities. 19

Diversified, Profitable, Stable Group Global Footprint with Offices in 83 Countries Europe 162,200 staff 2,833 locations Source: BNP Paribas Headcount on December 31 st, 2010 North America 19,500 staff 240 locations Latin America 15,100 staff Africa 44 locations 9,800 staff 266 locations Middle East 2,200 staff 8 locations Asia 11,000 staff 85 locations Oceania 600 staff 9 locations Balanced Business Portfolio CIB: Diversified Client Revenue Latin America $3,709 2,688 mn Corporate & Investment Banking 1,651 $2,287 mn Investment Solutions l i 26% 16% $14.2 10.3 bn bn 58% 6, $8,297 012mn Retail Banking Source: BNP Paribas. These figures reflect BNP Paribas revenue mix for 4Q10 (Operating divisions) North America Rest of Europe 4% 19% 33% 29% 11% 4% Italy Asia and Emerging Markets (excl. Latin America) France 20

EQD Overview: Flow Derivatives Top dealer in Volatility, Correlation and Dividend Derivatives worldwide Comprehensive Developed and Emerging Market Coverage Coverage of over 1,250 stocks and Indices worldwide Leading market maker in all major equity indices with global 24/24 cross-index books Leader in Complex Flow and Exotics for the Institutional and Hedge Fund client base Award-winning leader Among the top 5 dealers worldwide for OTC single stock equity derivatives: #2 for Eurostoxx 50 index Options (EUREX as of December 2011 (YTM)) #2 for OTC single-stock equity options in Europe #1 for Swaps and Options on Dividends #1 Vanilla Dispersion/Correlation Trades and Lite Exotics/Structured Flow Options #2 Market maker overall for Volatility/Variance Swaps Market leader in dividend Futures: #1 for Eurostoxx 50 Index Dividend Futures #1 Dividend Futures listed in the TSE, SGX and HKex Strong balance sheet for Delta One products Clients Hedge Funds Asset Managers Mutual Funds Pension and Endowment Fund Insurance Companies Products Exchange-traded and OTC options Index and Equity Swaps Variance and Volatility Derivatives Dispersion and Correlation Derivatives Dividend Derivatives Multi-asset, Exotic, and Hybrid Derivatives Emerging Market Access and Derivatives Innovations Conditional Variance Swaps Dispersion on Latam Derivatives Bloomberg page: BEDS Source: Risk Institutional Investors end-user Rankings 2010, Risk Inter-dealer survey 2010 Global Leader in Complex Flow* 21 21

Introduction to BNP Paribas U.S. Equities A 331-person cash equities, convertibles, derivatives and prime brokerage sales & trading team providing: Content Risk Management Expertise Equity Derivatives Corporate Access Asian Equities Prime Brokerage U.S. Equity Strategy team focused on Energy, TMT*, Event Driven, Capital Structure, Convertibles and Equity Derivatives We specialize in bringing g a range of risk management innovations to institutional investors (example: Janus Growth-Protected Series) BNP Paribas is a dominant market maker in global equity derivatives U.S. and Asian Corporates #1 in Asian Corporate Access** BNP Paribas has 70 publishing analysts in 10 Asia-Pacific countries including China, India, Singapore and Japan BNP Paribas Prime Brokerage provides a fully integrated front-to-back solution for hedge funds and long-only investment managers A FULL SERVICE PLATFORM Cash Equities Capital Markets Convertibles Electronic Trading ETFs Listed & OTC Options Prime Brokerage Swaps Structured Products Technology, Media & Telecom ** Greenwich Associates 22

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