This document discusses financial innovations in wealth management services, focusing on currency-linked structured products. It describes common structured products used in retail and corporate banking like currency-linked deposits, principal protected notes, accumulators, and target accrual redemption forwards. It also discusses the business model of structured products including their valuation, pricing, sales channels and revenue/cost models.

1. EF5603
Financial Innovations In
Wealth Management Services
Dr. LAM Yat-fai (林日辉博士)
Doctor of Business Administration (Finance)
CFA, CAIA, FRM, PRM, MCSE, MCNE
PRMIA Award of Merit 2005
E-mail: quanrisk@gmail.com
2:00 pm to 3:15 pm
Saturday
15 January 2014
2
Outline
Financial innovations
Retail banking
Corporate banking
Business model
3
Forward
4
Option

2. 5
Trading strategy
6
Evolution of
financial products
Spot
Linear derivatives
Forwards and futures
Vanilla options
European and American, call and put
Trading strategies
Bull spread, bear spread, butterfly, straddle
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Evolution of
financial products
First generation exotic options
Binary, Asian, Bermuda options
Barrier, one-touch, no-touch options
Second generation exotic options
Corridors, faders, step-up, step-down options
Structured products
CLDs, PPNs, accumulators, TARFs
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3. 9
Structured products
under the SFO
A financial instrument with its payoff determined by
reference to one or more of
the value, rate, level (or a range of value, rate, level) of
any type or combination of types of currency, interest,
equity, commodity, credit event or index
Everything
the value, rate, level (or a range of value, rate, level) of
any basket of more than one type or combination of types
of currency, interest, equity, commodity, credit event or
index
Excluding bonds, mutual funds and exchanged
traded products
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Defacto definition
Simple financial instruments
Without using derivatives
Financial instruments with derivatives for hedging
Using derivatives solely for hedging purpose
Derivatives for profit making
Single small or no initial cash outflow
Single payoff
Structured products
A combination of derivatives that results sophisticated
payoff structure
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Credit linked structured products
vs currency linked structured products
Credit linked structured products
Linked to credit events
Bank’s own investments
Bank earns interest income
Currency linked structured products
Linked to currency rate
Majority made for and sold to corporate and
private banking customers
Bank earns service fees
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Why currency linked
structured products?
Dream structured products
High return and no risk
No cash outflow but only cash inflow
Real structured products
Matching risk-return preferences
Matching cash in-out flow patterns
Common features
Look like deposits
不劳而获
Shorter term, usually with maturity less than one year
Early termination when sufficient earnings accumulated
Psychological comfortable when suffering from loss, e.g. rebate

4. 13
Currency linked structured products
Exempted from the SFO if sold by a bank
under the supervision of the HKMA
The largest category of structured products in
terms of transaction volume
To capture earning potential under the current
environment of
extremely low interest rate
high currency rate volatility
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Outline
Financial innovations
Retail banking
Corporate banking
Business model
15
Major currency linked
structured products
Retail banking
Currency linked deposits
Principal protected notes
Corporate and private banking
Accumulators
Target accrual redemption forwards
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High yield deposits

5. 17
Currency linked deposits
At origination
Customer makes a term deposit in HKD
At maturity
If HKD per GBP rate strike rate
Customer receives HKD principal + high interest
If HKD per GBP rate strike rate
Customer receives GBP principal + high interest
converted at strike rate
Worse performer of a simple HKD deposit and a
simple GBP deposit
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Payoff diagram
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Currency linked deposits
Objective
To seek high return under a low interest rate environment
Psychologically comfortable to receive the foreign
currency
Risk
To acquire foreign currency at the strike rate above the
market rate at maturity
Similar to investing in foreign currency
Trade off
Give up the potentially higher return of currency rate
20
Principal protected notes
At origination
Customer makes a term deposit in HKD
At maturity
Customer receives the principal
Interim regular interest
Linked to the performance of underlying currency
rate

6. 21
Risk-return alternation
Fixed deposit
Cash outflow: principal
Interim cash inflows: fixed 0.01% monthly
Principal protected
Cash outflow: principal
Monthly interests invested in highly leveraged
options
Interim cash inflows: 0% to 10% in a sudden
22
Principal protected notes
Objective
To reserve the investment principal
With a potential to earn higher coupon rate
Risk
To loss the interest
Hidden vulnerability
Chance of getting high coupon return is very very
small
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Outline
Financial innovations
Retail banking
Corporate banking
Business model
24
Accumulator
At origination
Customer makes a longer term deposit in USD
Every month
If USD per EUR rate strike rate
Customer receives USD principal + high interest
If USD per EUR rate strike rate
Customer receives EUR principal + high interest
bought at strike rate

7. 25
Multiple fixings
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Accumulator
Objective
To seek high return under a low interest environment
Psychologically comfortable to receive the foreign
currency
One deposit amount for multiple fixings
Risk
To acquire foreign currency at the strike rate above the
market rate on fixing dates
Similar to investing in foreign currency
Trade off
Give up the potentially higher return of currency rate
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Accumulator with knock-out
If the currency rate is above a knock-out rate
during the life of an accumulator, knock-out
occurs and the principal is returned to the
investor
To reduce the hedging cost of the issuer
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Target accrual redemption forward
At origination
The customer makes no cash outflow
Every month
If USD per EUR rate strike rate
Customer receives
(Spot rate – strike rate) × Notional principal
If USD per EUR rate strike rate
Customer pays
(Strike rate - spot rate) ×Notional principal × 2
Redemption
If the aggregated received cash target, the TARF ends

8. 29
Bull TARF
30
Multiple fixings
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Bear TARF
32
Dual-strike TARF

9. 33
Survival gap TARF
34
Pivot TARF
35 36

10. 37
RMB as underlying currency
China trade emerges
RMB becomes popular in Taiwan and Hong
Kong
Companies using RMB as transaction
currency
Outlook of appreciation of RMB
Controlled free trade on RMB
Customer base
Companies with businesses in mainland
China
Individuals with investments in mainland
China
Wealthy Chinese as an emerging sector of
private banking
Downside risk: forced to acquire RMB at a
unknown price
Offshore RMB – CNH 38
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Outline
Financial innovations
Retail banking
Corporate banking
Business model
40
SSPA classification
of structured products

11. 41 42
Sales and marketing
Sales
Private banking
Corporate banking
Retail banking
Marketing
Nice features of a structured product
Strong sales channels – the dominating factor
43 44

12. 45
Major sales channels
Commercial bank
Corporate banking
“Nominal” hedging
Private banking
Professional Investor under the SFO
Corporate private banking
Private banking customer in legal form of a company
dedicated for investments
Wealth management services
Risk assessment of investing
in structured products
Market risk
Sensitivity to underlying currency and value-at-risk
Credit risk
Default of structured product issuer
Operational risk
Very tedious settlement procedure
Liquidity risk
No secondary market due to high degree of customization
Legal risk
Lengthy contract with difficulty to understand legal terms
Wealthy retail banking customers 46
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Revenue model
Financial engineering – investment bank
Construct with liquid underlying currency and vanilla options at a
lower cost
Sell to a wholesaler at a higher price
Pocket the price-cost differential
Dynamic hedging through out the life of the structured product
Subject to market risk and operational risk
Intermediary – commercial bank
Buy from an investment bank at a lower cost
Sell to a customer at a higher price
Pocket the price-cost differential
Subject to operational risk and credit risk
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Cost model
Sales and marketing
Customer services
Hedging
Raw material
Dynamic hedge
Static hedge: back-to-back
Labour – traders
Settlement
Technology

13. 49
Valuation
Component approach
Decomposition into component options and
deposits
Structured product = Sum of components
Monte Carlo simulation
Exotic payoff which cannot be deposited into
components
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Pricing
Price = Raw material + operating cost + profit
Too expensive
No customer
Too cheap
Loss on every sale
Completion among banks force the
convergence of price
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Other back office functions
Settlement
Decompose a structured product into many
fixings
To be settled on individual fixing basis
Very tedious due to the variable payoff
Subject to high operational risk
General ledger
Each fixing generate one set of GL transactions
A challenging topic to accountants
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Documentation
Term sheet
Deal confirmation
Fixing ticket
Portfolio statement
Online enquiry

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