1.3 presentation slides
- 1. ZB05 Structured ForeignExchange Products for Wealth Management Services in Greater China 3 IFPHK CE credits 3 SFC CPT hours 3 MPFA non-core CPD hours Speaker: Dr. LAM Yat Fai (㜿㖍弱 ⌂⢓) Doctor of Business Administration (Finance) CFA CAIA FRM PRM MCSE MCNE 6:30pm to 9:30pm Wednesday 27th August 2014 2 Outline † Why structured FX products? † Major structured FX products † RMB linked structured products † International standards † Sales and marketing † Customer services 3 What is structured product? † Very complex cash flows † Prospectus difficult to understand † No risk disclosure † Small print in contract † High expected return at high risk † Mass destructive weapons 4
- 2. 5 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 „ 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 6 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 7 Structured treasury products vs structured credit products † Treasury structured products „ Linked to currency rate, interest rate, equity price or commodity price „ Majority made for and sold to corporate and private banking customers „ Banks earn service fees † Credit structured products „ Linked to credit events „ %DQN¶VRZQLQYHVWPHQWV „ Banks earn interest income 8 Structured FX products † Exempted from the SFO if sold by a bank under the supervision of the HKMA † The largest category of structured treasury products in terms of transaction volume † To capture earning potential under the current environment of „ extremely low interest rate „ higher FX volatility
- 3. 9 Why structuredproducts? † Customized to match the demand from individual investors in terms of „ return-risk characteristics „ cash flow patterns † Higher return vs lower risk † Early cash inflows vs late cash outflows 10 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 11 Evolution of financial products † First generation exotic options „ Binary, one-touch, no-touch, barrier options † Second generation exotic options „ Corridors, faders, step-up, step-down options † Fixed income with embedded options „ Currency linked deposits „ Principal protected notes † Multiple fixings „ Accumulator, decumulator, TARF 12 Outline † Why structured FX products? † Major structured FX products † RMB linked structured products † International standards † Sales and marketing † Customer services
- 4. 13 Major structuredFX products † Retail banking „ Currency linked deposits „ Principal protected notes † Corporate and private banking „ Accumulators „ Structured forwards „ Pivots 14 Currency linked deposits † At origination „ Customer makes a term deposit in HKD † At maturity „ If HKD per GBP rate target rate † Customer receives HKD principal + high interest „ If HKD per GBP rate target rate † Customer receives GBP principal + high interest bought at strike rate „ Worse performer of a simple HKD deposit and a simple GBP deposit 15 Currency linked deposits † Objective „ To seek high return under a low interest environment „ Psychologically acceptable to receive the foreign currency † Risk „ To acquire foreign currency at the target rate above the market rate at maturity „ Similar to investing in foreign currency † Trade off „ Give up the potentially higher return of currency rate 16 Principal protected notes † At origination „ Customer makes a term deposit † At maturity „ Customer receives the principal † Interim regular interest „ Linked to the performance of underlying currency rate
- 5. 17 Principal protectednotes † 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 18 Accumulators † At origination „ Customer makes a longer term deposit in USD † Every month „ If USD per GBP rate strike rate † Customer receives USD principal + high interest „ If USD per GBP rate strike rate † Customer receives GBP principal + high interest bought at strike rate 19 Accumulators † Objective „ To seek high return under a low interest environment „ Psychologically acceptable 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 20 Structured forwards † At origination „ The customer makes no deposits † Every month „ If USD per GBP rate strike rate † Customer receives Notional principal x (Spot rate ± strike rate) x P „ If USD per GBP rate strike rate † Customer pays Notional principal x (Strike rate - spot rate) x Q
- 6. 21 Structured forwards † Objective „ To bet on the direction of currency rate „ One contract with multiple bets † Risk „ Payment to bank when currency rate strike rate on fixing dates „ Similar to investing in several long/short currency option contracts 22 Pivots † At origination „ The customer receives upfront cash † Every month „ If USD per GBP rate upper strike rate † Customer pays Notional principal x (Spot rate ± upper strike rate) „ If USD per GBP rate lower strike rate † Customer pays Notional principal x (Lower strike rate - spot rate) 23 Pivots † Objective „ To receive upfront cash „ To bet on the stability of currency rate „ One contract with multiple bets † Risk „ Payment to bank when currency rate move beyond the strike boundaries on fixing dates „ Similar to enter several short positions in call and put options 24 Outline † Why structured FX products? † Major structured FX products † RMB linked structured products † International standards † Sales and marketing † Customer services
- 7. 25 RMB asunderlying 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 † Offshore RMB ± CNH 26 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 27 CNY/CHN TARF † Linked to performance of CNY or CNH † :KHQFXVWRPHU¶VSURILWKDVDFFXPXODWHGWRDQ upper limit, the contract terminates immediately „ A variation of upper knock-out barrier † Customer „ Profit target is met „ Principal is collected early than maturity † Bank „ Reduce the hedging cost (period) „ Pursue the customer enter another deal 28 Target accrual redemption forward † Bull and bear TARF † Dual-strike TARF † Gap TARF † TARF Pivot
- 8. 29 Bull andbear TARF 30 Dual-strike TARF 31 Gap TARF 32 TARF pivot
- 9. 33 Outline †Why structured FX products? † Major structured FX products † RMB linked structured products † International standards † Sales and marketing † Customer services 34 SSPA classification of structured products Yield enhancement † With capped upside potential † Without capital guarantee † Aim to generate a high return relative to treasury yield † Risk comparable to their underlying assets in case of adverse market conditions † The largest category of structured products 35 36
- 10. Capital protection †Guarantee the redemption of the invested principal at maturity † Participate to a certain degree in the performance of underlying risky assets 37 38 Participation † Closely linked to the performance of their underlying currency rates, volatility and/or correlation † Sometimes feature a conditional downside protection or a leveraged upside 39 40
- 11. 41 Outline †Why structured FX products? † Major structured FX products † International standards † RMB linked structured products † Sales and marketing † Customer services 42 Sales and marketing † Sales „ Retail banking „ Corporate banking „ Private banking „ Bank branches and subsidiaries in China and Taiwan † Marketing „ Nice features of a structured product „ Strong sales channels ± the dominating factor 43 XVWRPHUV¶SUHIHUUHG characteristics of SP † Looked like a deposit † Low initial cash outflow † Initial cash inflow † Shorter term, usually with maturity less than one year † High nominal yield † Early termination when subject to sufficient earnings † Never loss † Large safety zone † Large potential loss only at extremity † Psychological comfort when suffering from loss „ Rebate, air bag, early termination 44 Payoff diagram
- 12. 45 Risk-return alternation † Treasuries „ Cash outflow: principal „ Interim cash inflows: fixed 0.5% semi annual interests † Principal protected „ Cash outflow: principal „ Semi annual interests invested in options „ Interim cash inflows: 0% to 10% semi annual interests 46 Zero cost product † %DQNHUV¶7UXVWYV3 * „ Long a call option at an upper strike „ Short many put option at a very small lower strike „ Total cost = Call price - many put price = 0 „ Eventually, the underlying asset price moves below the lower strike „ PG incurred a huge loss „ 3 *VXHG%DQNHUV¶7UXVWIRUKLGLQJWKHULVN 47 Major sales channels † Commercial bank „ Corporate banking † ³1RPLQDO´KHGJLQJ „ 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 † Wealthy retail banking customers 48 Risk assessment of investing in structured products † Market risk „ Sensitivity to underlying currency † 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
- 13. Risk assessment oftreasury products Level Description 1 Vanilla currency and interest rate derivatives without optionality. 2 Vanilla currency options and interest rate derivatives with optionality. 3 Currency options and interest rate derivatives with first generation exotic payoffs, and packages combining (a) a single currency option or a single interest rate derivatives, up to first generation exotic payoff, and (b) its underlying and/or cash positions to form a slightly adjusted first generation exotic payoff. 4 Any hedging instruments with currency and/or interest rate as underlying and with payoff more complex than that exhibited by currency options and interest rate derivatives with first generation exotic payoffs. These hedging instruments may be resulted by combining a few hedging instruments in Levels, 1, 2, and/or 3, and with other additional and/or customized features embedded. These hedging instruments are not prohibited from being sold to customers not classified as Professional Investors, under the regulatory guidelines from the HKMA and/or SFC. 5 Hedging instruments which are only allowed to be acquired by Professional Investors under the regulatory guidelines from the HKMA and/or SFC. 49 50 51 Outline † Why structured FX products? † Major structured FX products † International standards † Sales and marketing † RMB linked structured products † Customer services 52 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 „ Hedge 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
- 14. 53 Cost model † Sales and marketing † Customer services † Hedging „ Raw material † Hedging † Back-to-back „ Labour ± traders † Settlement † Technology 54 Raw material cost † Component approach „ Decomposition into component options and deposits „ Structured product = Sum of components † Monte Carlo simulation „ Exotic payoff which cannot be deposited into components 55 Monte Carlo pricing 56 Pricing † Price = Cost x (1 + profit margin) † Too cheap „ Loss on each sale † Too expensive „ No customer † Completion among banks force the convergence of price
- 15. 57 Market riskmanagement † Static hedge „ Back-to-back hedge the entire structured products „ Lower risk, lower profit and fixed hedging cost † Dynamic hedge „ Continuous Delta and Vega hedges with liquid underlying currency and vanilla options „ Higher risk, higher potential profit at variable hedging cost † Semi-static hedge „ Periodically re-balance with quantitative models † Component hedge „ Decomposition into component options and deposits „ Static, dynamic or semi-static hedge selected components † Hybrid hedge „ A combination of dynamic, semi-static and component hedge 58 Credit risk management † Customer deposits collaterals of high liquidity to the bank † The bank grants a credit line to the customer, covering the „ Upfront cash outflow „ Unrealized loss „ Potential future loss † Credit limit determined by „ value of vanilla collaterals „ loss from structured products „ discounted gain from structured products 59 Current exposure vs potential exposure Potential exposure Current exposure 60 Notional method ª§ · º «¨ ¸ » «¨ ¸ » «¨ ¸ » «© ¹ » «¬ »¼
- 16. N k ¦ k=1 k EAD Notional principal of component option = in short position × margin conversion factor Credit expsoure = EAD + Total unrealized loss - Total unrealized gain × 1 - hair cut
- 17. 61 Portfolio netting Current expsoure with netting ª N º « ¦ » ¬ ¼ = Max - Market value , 0 k k=1 Current expsoure without netting @ N ¦ = Max - Market value , 0 k k=1 Net-gross ratio Current expsoure with netting = Current expsoure without net ting 62 Basel III current exposure method EAD = Current expsoure with netting + 0.4 + 0.6 × Net-gross ratio
- 18. N § Notionalprincipal k · ¨ ¸ © ¹ ¦ k=1 k × × Credit conversion factor Credit expsoure = EAD + Total unrealized loss - Total unrealized gain × 1 - hai r cut