1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 14
Comparison of different types of
structured products
August 2012

2. Chapter summary and outline
This chapter discusses the similarities and differences between
various types of structured products, and how products can have
the 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 study
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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”)
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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 payoffs
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5. Structured Products - 2
Classic 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 maturity
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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%.
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7. Illustration of a structured product - 2
Example: 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%
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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 products
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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 sale
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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
product
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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)
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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%
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13. Mitigating investment risks - 3
• Example of barrier levels and payoff outcomes
Price 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 asset
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14. Mitigating investment risks - 4
Product Objective Barrier Rebate Maturity Value
Barrier Note X Stock Price 130% 0% 100%
Appreciation
Barrier 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
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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 date
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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 early
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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.
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18. Similarities and differences if the structure were
in various forms
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19. Similarities and differences if the structure were
in various forms - 2
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20. Similarities and differences if the structure were
in various forms - 3
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21. Cross-product case study
Reverse 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 elements
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22. Cross-product case study - 2
Reverse 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 amount
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23. Cross-product case study - 3
Discount 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 Call
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24. Cross-product case study - 4
Discount 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 risk
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