1. ZB05
Structured Foreign Exchange 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 (林日辉 博士)
Doctor of Business Administration (Finance)
CFA CAIA FRM PRM MCSE MCNE
6:30pm to 9:30pm Wednesday 27th August 2014
2. 2
Why structured FX products?
Major structured FX products
RMB linked structured products
International standards
Sales and marketing
Customer services
Outline
3. 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
5. 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. 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. 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
Bank’s own investments
Banks earn interest income
8. 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
9. 9
Why structured products?
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. 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. 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. 12
Why structured FX products?
Major structured FX products
RMB linked structured products
International standards
Sales and marketing
Customer services
Outline
13. 13
Major structured FX products
Retail banking
Currency linked deposits
Principal protected notes
Corporate and private banking
Accumulators
Structured forwards
Pivots
14. 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. 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. 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
17. 17
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
18. 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. 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. 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
21. 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. 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. 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. 24
Why structured FX products?
Major structured FX products
RMB linked structured products
International standards
Sales and marketing
Customer services
Outline
25. 25
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
Offshore RMB – CNH
26. 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. 27
CNY/CHN TARF
Linked to performance of CNY or CNH
When customer’s profit has accumulated to an
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
33. 33
Why structured FX products?
Major structured FX products
RMB linked structured products
International standards
Sales and marketing
Customer services
Outline
36. 36
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
38. 38
Capital protection
Guarantee the redemption of the invested
principal at maturity
Participate to a certain degree in the
performance of underlying risky assets
40. 40
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
41. 41
Why structured FX products?
Major structured FX products
International standards
RMB linked structured products
Sales and marketing
Customer services
Outline
42. 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. 43
Customers’ preferred
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
45. 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. 46
Zero cost product
Bankers’ Trust vs P&G
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
P&G incurred a huge loss
P&G sued Bankers’ Trust for hiding the risk
47. 47
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
Wealthy retail banking customers
48. 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
50. 50
Risk assessment
of treasury products
Hedging instruments which are only allowed to be acquired by Professional Investors
under the regulatory guidelines from the HKMA and/or SFC.
5
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.
4
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.
3
Vanilla currency options and interest rate derivatives with optionality.2
Vanilla currency and interest rate derivatives without optionality.1
DescriptionLevel
51. 51
Why structured FX products?
Major structured FX products
International standards
Sales and marketing
RMB linked structured products
Customer services
Outline
52. 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
53. 53
Cost model
Sales and marketing
Customer services
Hedging
Raw material
Hedging
Back-to-back
Labour – traders
Settlement
Technology
54. 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
56. 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
57. 57
Market risk management
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. 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
60. 60
Notional method
( )
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
∑
61. 61
Portfolio netting
[ ]
N
k
k=1
N
k
k=1
Current expsoure with netting
= Max - Market value , 0
Current expsoure without netting
= Max - Market value , 0
Net-gross ratio
Current expsoure with netting
=
Current expsoure without net
∑
∑
ting
62. 62
Basel III
current exposure method
( )
N
k
k=1 k
EAD
= Current expsoure with netting
+ 0.4 + 0.6 × Net-gross ratio
Notional principal
×
× Credit conversion factor
Credit expsoure
= EAD + Total unrealized loss
- Total unrealized gain × 1 - hai
∑
( )r cut
63. 63
Credit conversion factor
for OTC derivatives
15.012.010.0Other
commodities
8.07.07.0Precious
materials except
gold
10.08.06.0Equity
7.55.01.0Currency rate
and gold
1.50.50.0Interest rate
Longer than 5
year (%)
1 to 5 years
(%)
Up to 1 year
(%)
Residual
maturity
64. 64
Operational risk
Mis-selling
Over promising return
Hiding risk
Variable payoff
Different on every payment
Terms and conditions
Human language insufficient to describe
mathematical payoff
Cross copying among banks
65. 65
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
70. 70
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