Financial engineering is the quantitative methodology used for development of solutions to financial problems. It is often used for development of new financial products, such as an existing basket of vanilla financial products, or combining features of different financial products in a hybrid financial product, in order to enhance the yield or changing the risk aspects of the new product in accordance with the views of the client. The presentation on financial engineering and structured products is a presentation made at a conference regarding the products that have the unique feature of preserving the initial investment or a portion of initial investment along with the potential of increasing the yield of the investment.

1. Rabinder K. Koul
Managing Director and Head of Risk Services
Gateway Partners

2. Financial engineering is the quantitative and
technical development of financial strategies and
products. Financial engineers design, create, and
implement new financial instruments, models,
and processes to solve problems in finance,
allowing them to take advantage of new financial
opportunities.

3. Structured products are securities that combine the
features of a fixed income security with the
characteristics of a derivative transaction. Structured
products are investments that are fully customized to
meet specific objectives such as capital protection,
diversification, yield enhancement, leverage, and regular
income with access to non-traditional asset classes
among others.

4. In their simplest form, structured products offer investors full or
partial capital protection coupled with an equity-linked
performance and a variable degree of leverage.
Generally a structured product contains two components:
 A fixed income security that includes protection of a certain
percentage of the initial investment
 An instrument similar to an option on some underlying
asset class

5. The underlying asset class for structured products can be a
single asset or a basket of multiple assets.
Thus, the additional performance is dependent upon the
performance of the underlying asset class or basket of multiple
asset classes as is specified by the structured product.
The choice of the underlying asset class depends upon the
market outlook of the investor and the object of the product
design.
Due to the above conditions, structured products are prime
candidates for financial engineering.

6. As previously mentioned, structured products have two
components:
Risk free component - the risk free component is
guaranteed to return whole or part of the initial
capital. The principal portion is normally returned
only at the maturity of the contract.
Option exposure on some underlying single asset
or basket of assets

7. During the life of structured assets, both risk free
components as well as option components have
exposure to certain market risk factors:
Volatility
Underlying asset value
Dividends
Interest rates
Time to maturity

8. Classification of structured products can be based on an
underlying basket of single asset classes such as:
Interest rate linked products
Equity, equity index, equity basket, or equity index
basket indexed linked products
Foreign exchange or basket of foreign exchange
linked products
Commodity linked products

9. Classification of structured products can also be
based on the type of option that is part of the
structured asset:
Plain Vanilla Options
Exotic Options

10. Plain vanilla options can be further classified as:
Classic Options - simple call and put options with
well known return functions
Corridor Options - the pay out is dependent on the
underlying being quoted within a specified range
Guaranteed Options - similar to corridor option
product, but includes fixed minimum payments
that are guaranteed to the investor.
Turbo Options

11. The payout of a turbo product is doubled if the underlying is
quoted within a certain price range at maturity. This is the turbo
effect. There are three possibilities at maturity. If, for example, L
and K are lower and upper reference prices, then at maturity, if:
St fixing ≤ L, the product is redeemed in shares
L < St fixing < K, a cash settlement with s (2 St fixing - L)
occurs
K ≤ St fixing, the maximum amount s (2K - L) will be paid

12. Exotic options can be further classified as:
Barrier Products
Knock-in Products
Knock-out
Rainbow Products

13. Structured products that are linked to different asset classes
provide:
100% or large percentage of principal capital protection
depending upon investor needs. This is provided
independent of the performance of the underlying asset or
its index class.
In addition, it provides the potential for higher returns if
certain conditions are met. This is achieved by investing a
portion of capital in a derivative instrument like an option.

14. OPTION
BOND
ASSET
LINKED
NOTE
PAYOFF
Principal

15. The diagram shows that a structured product linked to an asset class
has:
A bond type investment - this guarantees the protection of a
certain percentage of the principal, which returns the
guaranteed principal at maturity,
An option/swap type instrument with payoff
 Either zero coupon if the underlying has not satisfied the
conditions of the structure
 Or participation rate times the changes in the underlying
asset if the conditions of the structure are met

16. The bond component of a structured product is the most
important part. It is also the major part of any structured
product. The bond component ensures that the investor will
receive the agreed upon amount of the investment at
maturity. The agreed amount can be 100 % of the invested
capital or it can also include partial protection depending upon
the product. Structured products in general have the
characteristics of a zero coupon bond but they may have
annual or semi-annual coupon payments.

17. If an amount A is invested for n years at an interest rate R
per annum and if R is compounded once per annum (i.e.,
m=1) then the terminal value of the investment will be:
𝐴(1+𝑅/𝑚) 𝑛𝑚
The interest rate R is contingent upon the satisfaction of the
conditions of the payoff being met.
Notice that if the coupon payment conditions are not
satisfied then one realizes a loss as compared to direct
investment in a zero coupon bond or couponed bond.

18. The maturity of the bond type component is same as that of
the structured product. The maturity period of the
structured product is generally short. It can vary anywhere
between 1-4 years.
Structured products can contain call back features under
certain conditions such as when the price meets the
condition of coupon payment. In this case, the coupon is
paid and the structure is called back. The bond type
component also matures and the guaranteed principal is
returned.

19. The option component provides the opportunity of a payoff for
structured products. The two types of options are:
Call Options - these are embedded in structured products if
the outlook for the value of the underlying asset class is
rising.
Put Options - these are embedded in structured products if
the outlook for the value of the underlying asset class is
falling.
The option component is also the risky part of any structured
product since the payoff depends on the performance of the
underlying.

20. Both calls and puts can belong to the following four types of options:
European Options - these can be exercised only at a specific time,
namely the maturity of the structured product
American Options - these can be exercised any time until the maturity of
the structured product
Bermuda Options - these have multiple exercise times until the maturity
of the product; this type of option is often used if a structured product
has a call back option
Asian Options - this type of option compares the average of certain
prices for a specified period with the strike price to determine if the
option is in the money at the time of exercise

21. If the option is not in the money, it expires without any
payoff.
If the option is in the money, there is a payoff from the
upside of the underlying asset. However, this upside
disbursement depends upon a factor called
participation rate.
Participation rate - determines the percentage of the
participation in the performance of the underlying

22. Participation rate is not set prior to expiry of issuance period. It
depends upon the issuing costs of the product and the value of
embedded option.
With participation rate PR, issue price of the product IP, service
costs SC, present value of the bond PB, and price of the option
component OP, participation rate is calculated as follows:
PR = [(IP – SC- PB)/ OP] X 100
Participation rate is also called Gearing.

23. PR = [(IP – SC- PB)/ OP] X 100
One can see that the level of interest rate, volatility of the
asset, price of underlying asset, and type of option all affect
the participation rate.

24. Commodity Linked Callable Structured Products
Consider a basket of three equally weighted USD denominated
commodities: WTI (West Texas Intermediate) oil, copper, and aluminum.
Assume the principal capital is 100% guaranteed.
Assume the product maturity to be three years, beginning 10 October
2012 and ending 9 Oct 2015.
Since the product is callable as soon as the coupon gets paid, the bond
matures as soon as the product is called.
Thus, the option on the basket is a Bermuda option.
Coupon payments are once a year.

25. Commodity Linked Callable Structured Products
Coupon Rate Schedule:
 First Year - 8.5%
 Second Year - 17%
 Third Year - 25.5%
Fixing Dates - daily
Pay Off Function:
 If basket price final > .95 X Initial Basket Price
 Pay Off = Initial Investment X Coupon
 Or Pay Off = 0%
Initial and final basket prices are determined at official closing time.

26. Commodity Linked Callable Structured Products
Consider a USD denominated commodity such as WTI oil.
Assume the principal capital is 100% guaranteed
Assume the product maturity to be three years, beginning 10 October
2012 and ending 9 Oct 2015.
Since the product is callable as soon as the coupon gets paid, the bond
matures as soon as the product is called.
Thus, the option on WTI oil is a Bermuda option.
Coupon payments are twice a year.
Initial investment minimum is $1000.

27. Commodity Linked Structured Products in USD
Coupon rate - 9%
Coupon frequency - biannual
Fixing dates - daily
Pay off function:
 If basket price final > 1.1 X Initial Basket Price
 Pay off = Initial investment X coupon
 Or pay off = 0%
Initial and final prices of WTI determined at official closing time of issue
date and maturity date

28. Commodity Linked Structured Products in USD
Fixing dates - daily
Pay off function:
 If on 10 Oct 2013 WTI Oil Price > WTI Oil Initial Price X 1.10
 If on 10 Oct 2014 WTI Oil Price > WTI Oil Initial Price X 1.20
 If on 10 Oct 2015 WTI Oil Price > WTI Oil Initial Price X 1.30
 Or pay off = 0%
Initial and final prices of WTI determined at official closing time of issue
date and maturity date