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"The investment banks supplying structured products were effectively buying options from investors" How to understand this quote from this source?
I would think the investors are usually had (long) the call option on equity index in many structured products, so the bank should be short option instead of buying options from investors?
I suspect the link is describing autocallable notes of some sort. Typically investors (the buyers of these notes) get high coupon rates in return for selling downside protection, i.e. they sell put options (usually with barrier) to the bank to finance these coupons. That means that as the index moves down approaching the put option barrier the banks become more and more long vega, which they have to hedge by selling vol in the market.
Autocallables come in many flavours, are in my opinion quite (read: very) complex but therefore extremely interesting, and they can create some weird volatility dynamics.
The specific quote you reference from the article is from a section explaining why/how the current environment came to be. Note that 'current environment' in the context of this article is almost 16 years ago as the article is dated October 2004.
The specific paragraph from that section is referring to the long end of the volatility curve where banks were buying options to place them in structured products that they would then sell to investors.
The next paragraph of the same section goes on to mention how banks had to aggressively sell volatility to offset the negative volatility convexity that was resulting within their books.
Generally, the portion of the article that you are asking about is just setting the stage for the types of structured products that the author thinks are attractive. Given the market/volatility setup described in the first half of the article, what is attractive to the author is described in the second half of the article.
Also note that at that time, VIX futures had just come out only a few months prior in early 2004, and had very low volume and open interest. VIX options were not yet 'invented' (for lack of a better term) nor were weekly options on S&P 500 or any other broad index for that matter. So to achieve the effective volatility exposure options were limited compared to today.
Preamble
It is in general true that structured products can be decomposed in simpler products (linear and options for example). Regardless of the decomposition of the specific product, it is typical for the bank to "buy" some rights from the customer. This is the way to grant a higher (expected) yield in structured products: there is no free lunch, if structured products have higher (than vanilla) coupons it is because you give up some "returns" in specific future scenarios. This was all abstract, let's go for an example:
Callable Bonds
Callable bonds are (often but not necessary) fixed coupon bonds that the issuer can call back before the natural maturity paying a prespecified price (typically on par).
You can see how the investor has "sold the right" to buy back the bond to the issuer. In exchange, this leads to a higher yield requested by the investor. Indeed callable bonds have to have higher coupons (everything else being equal) than non-callable bonds, otherwise who would invest in such a product? I mean, why give up a right without asking anything in return?
The point
Now I chose a specific product that involves "buying" options not to prove my point, but to show you the actual meaning of structured products: to offer a higher return (than vanilla products) to the investor, therefore making the product a bit more interesting for specific segments of customers. And to get higher returns, customers have to give up some rights: that's why these products involve issuers buying options. Nonetheless you can always structure your product so that the issuer is selling rights (like putable bonds), but it's very unusual.
Sources: I work in a bank doing exactly what I described =)
unless one knows the details on this very structured product, one can simply speculate.
there are every imaginable structured product out there, and one involving receiving an option in one of the legs for the issuer is definitely possible.
Structured Products issuers must hedge dynamically most of the risks associated with a product. This means depending not only on the type of product issued but also the market conditions throughout the product's life (i.e the time to maturity), issuers will need to buy or sell various market instruments; including volatility related hedges (varswaps, listed/otc options, volswaps, barrier options etc. that best fit their exposure and P&L constraints at time of re-hedging).
In other terms, a product will initially create a short volatility position or a long volatility position, depending on its very features (a.k.a its payoff). Most income products such as the infamous autocallables very popular firstly in Asia and then in Europe, would usually generate the latter for issuers. But such initial position may be reversed at various stages of the product life and with varying velocity rates (volatility of volatility became more of a pricing focus post-BFC as an example).
Very interestingly, the old Risk Magazine article referenced in the question showcases perfectly the very stark contrast between then and now for issuers: instead of steadily growing equity markets mechanically creating a downward trend for volatilities - trend itself further compounded by issuers of income structured products becoming more and more exposed to long term volatilities and eventually forced-sellers, adding further pressure to the downward market. That was then... Now Fast Forward To The Future and today's markets: where not only short term dividend yields abruptly trended towards zero but volatility curves also shifted upward markedly, creating the almost exact opposite market conditions and lots of headaches along the way for issuers (cf risk.net - reuters - ifr).
