Chapter 8 fx structured products

Managing Market Risk Under The Basel III Framework
Copyright © 2016 CapitaLogic Limited
Chapter 8
Foreign Exchange
Structured Products
Managing Market Risk Under The Basel III Framework
The Presentation Slides
Website : https://sites.google.com/site/quanrisk
E-mail : quanrisk@gmail.com

Copyright © 2016 CapitaLogic Limited 2
Declaration
Copyright © 2016 CapitaLogic Limited.
All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
Authored by Dr. LAM Yat-fai (林日林日林日林日辉辉辉辉),
Principal, Structured Products Analytics, CapitaLogic Limited,
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration (Finance),
CFA, CAIA, FRM, PRM.

Structured products
Participating forwards
Target accrual redemption forwards
Scandal: Citic Pacific 2008
Outline

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

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

Structured treasury products vs
structured credit products
Treasury structured products
Linked to FX 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
Bank’s own investments
Banks earn interest income

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
low interest rate
higher FX volatility

Why structured products?
Customized to match the demand from
individual investors in terms of
Cash flow patterns
Risk-return characteristics
Early cash inflows vs late cash outflows
Higher return vs lower risk

Evolution of financial instruments
Foreign currencies
Unfunded derivatives
FX forwards
Insurance type derivatives
Call options and put options
Trading strategies
Butterfly, risk reversal, straddle, strangle , spread
Structured products
Participating forwards, target accrual redemption forwards

Structured products
Outline

Forwards vs options
YesYesUpside profit
YesNoPremium
13,55837,238
Volume
(USD bn)
NoYesDownside loss
OptionForward

Synthetic forward
FX rate at maturity
Payoff
Call
PutSpot rate

Zero cost synthetic ATM forward
LossProfitChance
LossProfitAmount
Short ATM
put
Long ATM
call
≈
≈

Chance to make profit
vs amount of profit
Chance to make profit/loss
Amountofprofit/oss
Call
Put
ATM
ITM
OTM
Expected amount of profit
=
Expected amount of loss

LossProfitChance
LossProfit
Expected
amount
Short OTM
put × Many
Long ITM
call × 1
>
<

FX rate at maturity
Payoff
Call
Put
Spot rate

Structure
Long one ITM call
Short many OTM put
Cost
Zero
Profit
Higher chance but smaller amount
Loss
Lower chance but larger amount
https://www.dahsing.com/en/html/treasury/hedging_ser
vices/participating_forwards/participating.html

Major issue
The accelerated loss in case the FX rate moves
against the strategy at maturity
Objective
To reduce the potential amount of loss
Without increasing the chance of loss
Solution
To reduce the potential amount of profit

Structured products
Participating forward
Outline

Capped paymentTreatment to termination bonus10.
USD 200,000Bonus target9.
MonthlyFixing frequency8.
30 December 2016Maturity date7.
USD 1.5600 per GBPStrike rate6.
Domestic currencySettlement approach5.
GBP 2,000,000Put notional principal4.
GBP 1,000,000Call notional principal3.
GBPForeign currency2.
USDDomestic currency1.
ValueParameter

Multiple fixing

Bonus target
Bonus target
Cash inflows from
call options

Target knock-out
For a series of participating forwards
A bonus target is set such that on any fixing day, if
the accumulated cash inflows from the ITM options
is above the bonus target, all the fixings afterward
will expire immediately
The bonus target limits
The maximum potential profit
The value of the ITM call options
Less OTM put options to be short
The maximum potential loss is also limited

Digital knock-out
For a series of participating forwards
A barrier rate is set such that on any fixing day, if
the FX rate is above the barrier rate, all the fixings
afterwards will expire immediately
The barrier rate further limits
The maximum potential profit
The value of the ITM call options
Less OTM put options to be short
The maximum potential loss is also further limited

The most popular FX structured products among
corporate banking and private banking customers
Zero cash outflow at origination
Look similar to regular deposits
Regular cash inflows
Customized for risk-return preference
Higher chance to make profit with smaller amount of
profit

Bear TARF
FX rate at maturity
Payoff
Call
Put
Spot rate

Dual-strike TARF
FX rate at maturity
Payoff
Call
Put
Spot rate

Protection gap TARF
FX rate at maturity
Payoff
Call
Put
Spot rate

Pivot TARF
FX rate at maturity
Payoff
Call
Put
Spot rate

Revenue model
Investment bank
Synthesize a TARF with call and put options
Mark up a profit
Sell to a commercial bank
Commercial bank
Acquire a TARF from investment bank
Mark up a profit
Sell to an investor

Sales and marketing
The attractive product features of a TARF
The professional sales team which performs
the marketing
The price of a TARF
The post sales customer services

Structured products
Participating forward
Outline

Suitability assessment
Suitability
assessment
Investor profiling Product assessment
Product risk level
Product features
Risk tolerance level
Know your client
Exempt for
hedging purpose

2008 AUD losses controversy
Projected AUD exposure AUD 1.6 bn
TARFs AUD 9 bn
Loss USD 2 bn

AUD controversy 2008
Share price dropped 55% to HKD 6.52 from
HKD14.52
SFC sought compensation on behalf of 4,500
investors
Chairman Mr. Larry YUNG stepped down
General manager Mr. Henry FAN stepped
down

Chapter 8 fx structured products

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