Chapter 14 notes 2012 08 02


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Chapter 14 notes 2012 08 02

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 14Comparison of different types ofstructured productsAugust 2012
  2. 2. Chapter summary and outlineThis chapter discusses the similarities and differences betweenvarious types of structured products, and how products can havethe same wrappers and structures but yet have different features.It includes a multi-product case study.Chapter outline:• Same wrapper, seemingly same structures but different features• Similarities and differences if the structure were in various forms• Cross-product case studyfinlogIQ 2
  3. 3. Wrappers• Wrappers have certain benefits (and drawbacks)• For example: – Regular income payouts, favourable tax treatment and life insurance coverage• Common wrappers include deposits, notes and bonds, funds, warrants, insurance-linked policies (“ILPs”), exchange-traded funds (“ETFs”), and exchange-traded notes (“ETNs”)finlogIQ
  4. 4. Structured Products• Value proposition of structured products – Offers a range of investment solutions that improve on the risk-adjusted performance when compared to traditional investment products – Provide customized access to non-traditional assets like currencies, commodities and specialized indices• Cursory comparison with the income yields and potential appreciation of what appear to be similar traditional products should be avoided• Need to understand the risk exposure to underlying assets, which requires: • Looking at a representative market benchmark for that asset class, and • Derivative’s price paths and payoffsfinlogIQ 4
  5. 5. Structured Products - 2Classic Structured Product – Equity-Linked Structured Note• Equity Linked Structured Note – Debt instrument issued by financial institution – Consist of principal/ low risk component (zero-coupon bond) plus Return/ high- risk component (call option) – Holder has a long position in a zero-coupon bond, and long position in an equity call option – Primary Objective: Capital preservation from the bond – Secondary Objective: Generate a positive return from the value of the call option at maturityfinlogIQ 5
  6. 6. Illustration of a structured product• Zero-coupon bond – purchased at a price which is discounted to its face value ($100) – present value of $100 face value, discounted by the interest rate that is appropriate for the bond, PV = $100 / (1+ r) n − At maturity: value of zero coupon bond = face value − Discount sum is the difference between the issue price and face value is available for purchase of Equity call option• Option − the risky asset component of the structured note, expected to deliver the upside performance to the investor − No downside to this component because if call option is out of money, it expires worthless − If discount sum ($100 – PV) is equal to the price of the call option (option maturity = to the bond maturity and strike price = spot price at the time of issuance) − Hence, there is 100% performance participation on the upside movement underlying – It is not always the case of 100% participation rate • If the discount sum is less than the cost of the call option, product issuer buys fewer option contracts => participation rate will be less than 100% • If discount sum allows the issuer to purchase more call option contracts, the participation rate can exceed 100%.finlogIQ 6
  7. 7. Illustration of a structured product - 2Example: Two possible zero coupon bonds in a structured product: Bond A – Zero-Coupon Face Value = $ 100.00 Discount Rate = 5.0% Year to Maturity = 5 Present Value = $78.35 Discount Sum = $21.65 Bond B – Zero-Coupon Face Value = $ 100.00 Discount Rate = 7.0% Year to Maturity = 5 Present Value = $71.30 Discount Sum = $28.70 S&P 500 Calls Call premium $24.00 Potential Participation Bond A = 90.2% Bond B = 119.6%finlogIQ 7
  8. 8. Illustration of a structured product - 3• When evaluating structured note: – Important to understand underlying asset benchmark and the participating rate – has impact on upside performance and overall returns – Furthermore,100% principal payout is a forecasted number and is not guaranteed, – Subject to: • counterparty, credit, investment, liquidity and market risks as is the case with similar fixed income and over-the-counter (“OTC”) financial productsfinlogIQ 8
  9. 9. Interest rates and maturity• An important variable for fixed income products is interest rate• Price of bonds and the level of interest rates are inversely related and this has a particularly large impact on zero-coupon bonds• With Mark-to-market valuation – Investment position may show a loss during the holding period before maturity – If investors intends to hold it to maturity, he does not suffer an actual loss as the zero-coupon bond will reach par value and the original capital sum is returned to him (assuming no loss due to a credit or market event).• During holding period − Greater the risk in interest rate, longer the period to maturity, the greater will be the mark-to market loss• If liquidate before maturity − May face actual loss if the transaction price is based on the mark-to market value, which may be lower than the accreted book value at the time of salefinlogIQ 9
  10. 10. Other variables• Important factor which has impact on the embedded call option is the volatility of its underlying stock price• At the time of issuance, an ideal situation is one where interest rates are high and asset price volatility is low, assuming all other variables are held constant,• Higher interest rates will lower the present value of the zero-coupon and provide more funds for the purchase of the call option,• Lower volatility will make the equity options cheaper for the investment productfinlogIQ 10
  11. 11. Mitigating investment risks• One way to mitigate investment risk during holding period is to reduce the maturity term and have a shorter holding period• Use exotic options instead of conventional options to achieve this objective• Example in classical equity linked note – Consist of zero-coupon bond (principal/capital preservation component) and a call option (return/participation component), – Select an “up-an-out” barrier call option instead – barrier level set above the existing spot price – If price barrier is breached during the life of the product, the option is “knocked- out” and terminates, with no further upside participation for the investor• Advantage of Knock-out barrier options – Cheaper than conventional options with similar parameters – Hence, a zero coupon bond with a smaller discount amount is needed (ie tenor can be shortened)finlogIQ 11
  12. 12. Mitigating investment risks - 2 Bond A – Zero-Coupon Face Value = $100.00 Example of structure Discount Rate = 5.0% with shorter maturity, Years to Maturity = 3 and knock out barrier Present Value = $86.38 options instead of Discount Sum = $13.62 conventional call S&P 500 Calls option 3-year KO barrier contracts Call premium = $12.00 Potential Participation Bond A = 113.5%finlogIQ 12
  13. 13. Mitigating investment risks - 3• Example of barrier levels and payoff outcomesPrice of Option’s Underlying Example Payoff Asset (x = 25%) < 100% < 100% Face value of zero-coupon bond (forecasted 100% ) > 100% > 100% Face value of zero-coupon bond & and (forecasted 100% ) below barrier level (1+x%) < 125% + Upside participation (on underlying asset) > 100% ≥ 125% Face value of zero-coupon bond & (forecasted 100% )at or above strike level (1+x%) + Rebate (zero or positive) on underlying assetfinlogIQ 13
  14. 14. Mitigating investment risks - 4 Product Objective Barrier Rebate Maturity ValueBarrier Note X Stock Price 130% 0% 100% AppreciationBarrier Note Y Deposit Rate & 115% 3% 100% Upside Barrier Note Z Bond Return 100% 8% 100%In summary:• Products with barrier options and have shorter maturity: – More appealing to investors compared to the classic structure – Reduces the impact of mark-to-market fluctuations finlogIQ 14
  15. 15. Callable features• There are other product features that can lead to early termination and accelerate the redemption process• Have an “Auto-call” mechanism − Automatically callable if certain conditions are met − Autocallable products are embedded with one or more barrier options, and barrier levels are set at the time of issuance − If barrier level is breached, a mandatory callable event occurs and the product terminates automatically• With an auto-callable product, the investor does not have to wait until maturity to get his investment capital or any investment returns that have been generated up to the time the call event occurs• If no barrier event occurs during the life of the product, it runs until the predetermined expiry datefinlogIQ 15
  16. 16. Callable features - 2• There are two types of autocallable structured products• American barrier options – Barrier event can take place at any time during the life of the product• Bermudan options – Barrier levels are observed on specified dates or at specific time intervals• Other features – Option with “Knock out” barrier is active (KO) but terminates at predetermined levels above or below the initial spot price – Option with “Knock in” barrier is inactive at issuance (KI) but becomes active when the asset price breaches the barrier level• With an auto-callable structured product: – Holding period horizon can be shorter than the maturity term – The return component can be zero if the option is out-of-the money or even have a negative value if the structured product has a short put or a short call position – With autocall - Investor faces call risk due to uncertainty on the exact holding period as well as reinvestment risk if the product is redeemed earlyfinlogIQ 16
  17. 17. Product risks – short option positions• Important to properly analyse risk inherent in some auto-callable products as it involve selling put or call options• Premium received from options Is used for the yield payout of the structured payout• Investors should know that yield of such structured products – Does not from participation in the underlying asset’s performance, but – Comes from premiums received from the sale of options.• Exposure for a short put or a short call position must be clearly understood.finlogIQ 17
  18. 18. Similarities and differences if the structure werein various formsfinlogIQ 18
  19. 19. Similarities and differences if the structure werein various forms - 2finlogIQ 19
  20. 20. Similarities and differences if the structure werein various forms - 3finlogIQ 20
  21. 21. Cross-product case studyReverse Convertible• Appeals to investors seeking enhanced yields• The low-risk component is long a zero-coupon bond• While high risk component is a short put option• Issued at 100%• Upside performance capped at a specific level• Downside is based on the short put option• The return to the investor is capped and cannot exceed the sum of these two elementsfinlogIQ 21
  22. 22. Cross-product case study - 2Reverse convertible (cont)• Downside risk – depends on value of the underlying asset• If the asset price falls significantly, the investor faces the full extent of the fall in the asset price and the prospect of losing the entire investment amount• In such a situation, investor only left with the coupon amount• Returns profile: – Asymmetric as positive upside payout is capped, while – downside exposure is to the full extent of the investment amountfinlogIQ 22
  23. 23. Cross-product case study - 3Discount Certificate• The construction is different from a reverse convertible, although payoff is similar• Consists of a long position zero- strike call option and a short call position on a given stock• The strike - is at-the-money or out- of-the money• The diagram is just like that of a reverse convertible with similar parameters• Put-call parity:• c + PV(x) = p + s• Reverse Convertible = Discount Certificate Bond (Note) + Short Put Long Call (Zero strike) + Short CallfinlogIQ 23
  24. 24. Cross-product case study - 4Discount Certificate (cont)• Premium received from the sale of the calls is offsets the cost incurred from the purchase of a zero-strike option• Product is issued at a discount to face value – Investment sum the investor puts in is less than the amount an investor pays for a similar reverse convertible• At time of maturity or redemption, if underlying is above the strike price – The investor will not receive a full coupon payout, but receives the face value of the certificate – The return is the difference between the issue price (below par) and par• In both cases, the upside payout is capped as the products get knocked out when the asset price rises and breaches the barrier level• On the downside, the short put component of the reverse convertible and the short call component of the discount certificate expose the investor to the full decline of the stock price, with the entire amount of the investment capital at riskfinlogIQ 24