deriv survey

8/8/2019 Deriv Survey

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The use of structured products:

applications, benefits and limitations

for the institutional investor

Submitted by Anna Georgieva

Supervisors: Marcel Koebeli,

Marc Chesney, Pascal Botteron

December 2005


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0. Introduction

1. What are structured products?1.1.A definition1.2.The generic exposure types

2. Applications

2.1 Payoff diversity

2.2 Isolating risks and exposure

2.2.1 Volatility

2.2.2 Correlation

2.2.3 Inflation

2.2.4 Credit

2.2.5 Hedge Funds

3. The institutional investor

3.1Business needs and risk preferences3.2Institutional investors: readily invested in a structured product on the economy3.3Structured products, Indexation and the Core-satellite framework

4. Limitations of structured products as investment vehicles


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3

0. Introduction

The institutional investor is in the business of understanding, pricing and managing risks to earn a

return for the benefit of all stakeholders. In this paper I discuss how structured products can be used by

institutional investors.

In a perfect world (Arrow-Debreu state-claim framework) there exist enough securities to recreate any

payoff. Some assumptions of this idealized world are: there exist basic securities, Arrow securities,

that they have a risk-free payoff in any state, no transaction cost, no information asymmetry, all

investors have the same expectations. Then derivatives are redundant instruments, as they can be

replicated. The price of the replicating strategy should be equal to the price of the derivative; otherwise

there is an arbitrage opportunity.

Several research papers discuss the optimal existence of derivatives. [Merton 1971], [Carr Madan

2001], [Carr Madan 1998], [Liu Pan 2003], [Ross 1976]) The research results are usually dependant

on assumptions about the process of the underlying. The case of including derivatives in an investorsportfolio is usually solved making the assumption that investor preferences follow a certain

mathematical function. The optimal investment in derivatives is then determined as the solution which

maximizes the investors utility function. A closed form solution may or may not be available

depending on the assumptions about the underlying process and the utility function.

I treat the problem in a practical, applied way. Needless to say, financial markets have readily justified

the existence of derivatives and derivatives related products. The focus is on how structured products

can be handy to an institutional investor, as opposed to how do we price, replicate and hedge them.

While in the back of every properly priced derivative there is a lot of mathematics, in this paper I

focus on the investment interpretation and application.

I present structured products as a natural investment choice of an institutional investor who faces the

business constraints of a liability stream and of stakeholder and client expectations. Their main

applications are in creating risk-return flexibility, isolating risks and providing exposure opportunities.

I point at possible specific applications, but there is no almighty product that will magically solve all

investment problems and unless a specific investor is consider it is impossible to make a strong

statement about the best choice.

For a retail institutional investor, structured products present new ways to reach the investment needs

of clients by adding new products to the product basket, preserving the level of distribution fees and

increasing the ability to raise new money.

For the pension or trust fund investor, in particular in a core-satellite framework, structured products

provide payoff flexibility, bundled or unbundled exposure to new and old asset classes, and can be

optimally added as satellites to the investment portfolio.

For the asset manager in an insurance company, structured products stand out with their ability to

implement sophisticated investment views, and to isolate and hedge risks.

Research on the pricing and replication of some of these structures are widely available; others do not

have a closed-form solution. The most flexible approach is using Monte Carlo (MC) pricing tool

Based on the martingale approach of derivatives pricing, this approach can price any possibly payoff

and has gained widespread acceptance among practitioners.


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1. What are structured products?

1.1 A definition

Structured products are investment instruments that combine at least one derivative with traditional

assets such as equity and fixed-income securities. The value of the derivative may depend on one or

several underlying assets. Furthermore, unlike a portfolio with the same constituents the structured

product is usually wrapped in a legally compliant, ready-to-invest format and in this sense it is a

packaged portfolio.

The usual components of a structured product are a zero-coupon bond component and an option

component. The payout from the option can be in the form of a fixed or variable coupon, or can be

paid out during the lifetime of the product or at maturity. The zero-coupon bond component serves as

buffer for yield-enhancement strategies which profit from actively accepting risk. Therefore the

investor cannot suffer a loss higher than the note, but may lose significant part of it. The zero-coupon

bond component is a floor for the capital protected products. Other products, in particular variousdynamic investment strategies, adjust the proportion of the zero-coupon bond over time depending on

a predetermined rule.

From an economic point of view, the structured product can be broken down in two main components:

Investment view + Payoff structure = Structured product

The investment view is driven by factors such as:

Investor expectations towards the underlying: bearish, flat, bullish, range bound, ladder etc Choice of underlying. The underlying may be available in a readily investable format or has to

be synthetically extracted:

o Single stocko Basket of stockso Index or multiple indiceso Mutual fund, hedge fund, Fund of Hedge Funds, discretionary managero Systematically rebalanced strategyo Volatility, correlation, dispersiono Hybrido Credito Inflationo Commodities etc

The investment view may be based on fundamental or technical research. The choice of the underlying

may depend on the market, on the investors expertise, and on fundamental factors.

Payoff structure

The payoff structure is a mathematical formula applied on the underlying. The features of the payoff

structure will include:


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Cash flows timing: periodic coupons from an underlying that pays none; total lump paymentwhen underlying pays coupon; variable coupon or fixed coupon; fixed coupons during certain

periods of the life of the product etc.

Risk profile: leverage, conditional capital protection, partial capital protection, full capitalprotection

Maturity: Short-term, medium-term or long-term

The importance of both components is evident when we look at the fundamental exposure types in the

next section. The focus here is that despite the fact that the option types have been known for a long

time, the investment view gives them a different interpretation.

1.2 The fundamental exposure types

The fundamental exposure types are the generic option payoffs. Combining these with a long zero

coupon bond gives the primal structured products, some of which have not failed to go out of fashion.

Figure 1 shows clearly the interaction between investment view and payoff structure. Some authors

seem to refer to prefer bullish payoffs, and consider only the payoffs in upper row of the table,corresponding to the bullish investment view as structured products.

Fundamental exposure types

+

-

+

-

Premium

+

-

Premium

+

-

+

-

Premium

+

-Premium

Delta one

(Certificate)

Capital protected

products -

Yield enhancement

products

Bullish

investment view

Bearish

investment view

1) 2)

3) 4)

Figure 1

5


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6

The Delta one (certificate) provides full exposure to the underlying. Investor gains wealth as

underlying appreciates and loses wealth as the underlying depreciates. The payoff is the same

independent of the investment view. The other 4 payoffs are:

1) Bullish investment view, yield-enhanced or return-enhanced exposure capped upside,unlimited downside. Investor prefers to sell the upside potential and receive a higher return.

Investor is actually bullish on the underlying, but prefers to cash in the expected return, ratherthan wait for the uncertain appreciation to realize. Investor practically accepts the downside

risk of the underlying and receives a premium for that, which results in a higher yield

compared to the underlying.

2) Bullish investment view, capital protected exposure floored downside, unlimited upside. Theinvestor pays a premium to ensure downside protection, but keep the upside exposure.

3) Bearish investment view, yield-enhanced exposure capped upside, unlimited downside.However the structure pays of when the underlying decreases in value.

4) Bearish investment view, capital protected exposure floored downside, unlimited upside.Again the structure pays as expected if the underlying decreases in value.

Typically, only payoff type 2), the long call, payoff is considered a capital protected payoff. Yet for an

outright bearish investor, this payoff is detrimental as it leaves him exposed to an appreciation of the

underlying.

The investment view is intrinsically connected to the split between yield-enhancement products, where

the investor chooses the higher risk-return combination, and capital protection, where the investorprefers a lower risk-return combination.

These generic payoffs have been embraced by the market. I show 3 widely known products that can be

directly matched to 3 of the generic payoffs and also present an investment case for their use. These

are:

1) The Delta One (Certificate) (Figure 2 & Figure 3)2) The Reverse Convertible as an example of bullish yield-enhancement payoffs (Figure 5

&Figure 4)

3) The Capital Protected Note as an example of bullish capital protected payoffs (Figure 6)

Other payoff structures cannot be easily classified as only yield-enhancement or capital protected type.

I discuss some of them Section 2.1


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The investor receives the full upside and downside of the underlying.

Certificates are a flexible way to invest in customized baskets and

implement fundamental long-only investment ideas.

Investor goes long a zero strike call.

Short-, mid- to long-term investment horizon.

Investor wants full exposure to the underlying.

Structure

Payout

Investment idea

Delta One (Certificate)

Certificates have the same payoff as the underlying

Underlying price

Performance

100

Initial price

Time

Price

100

Our investment view is based on an expected increase in peak sales of new products,

industry cost savings as the sales mix shifts towards secondary care, and positive volume

outlook in the US as new prescription drug benefits for seniors start in the end of 2005.

Structure

We go long a zero strike call on a basket of the following stocks: AstraZeneca, Novartis,

GlaxoSmithKline, Essilor International, Merck, Pfizer, Cardinal Health Inc.

The basket can be equally-weighted, performance-weighted or custom-weighted.

3 year maturity.

The certificate pays the performance of the basket.

Very low structuring fees.

Certificate on a Pharmaceutical Basket

We are bullish on European pharmaceutical companies

Figure 3

Figure 2

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Reverse Convertibles

Reverse Convertibles are yield-enhancement strategies with short maturity

A coupon is always paid.

Depending on the product features the investor is exposed to a different

degree to the downside of the underlying.

Investor go long a zero-coupon bond and short a put, or a short DIP put

Short-term investment horizon

Moderately bullish or range bound view

Structure

Payout

Investment idea

Time

Price

100

100

Initial price

Performance

Given the barrier for the DIN put or the strike for the short put we solve for the coupon.

The lower the barrier level the lower is the coupon.

This is a very popular yield-enhancement structure for a bullish investor.

Performance

Barrier

Underlying price100

Initial price

Priced examples

8.47%

1 year

80%

Porsche

9.8%5.9%Coupon

1 year

70%

Porsche

1 year

No barrier

Porsche

Maturity

Barrier

Underlying

Reverse Convertibles on Porsche3 examples with different barrier levels

Figure 5

14Figure 4

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9

Capital Protected Notes (CPN)

Capital protected notes are downside protected investments

100% of invested capital plus a coupon (or upside participation).

We go long a zero-coupon bond and long an option with upside

exposure.

Short-, mid- or long-term investment horizon.

Bullish on the underlying, but we want downside protection.

Structure

Payout

Investment idea

Underlying price

Performance

100

Initial price

Lower capital protection with

higher participation rate

Time

Price

100

Figure 6

The zero-coupon bond plus option component of the structure has direct implication on the taxation of

structured products. I review these in Appendix 2.

2. Applications of structured products in the portfolio of an institutional investor

In a general framework, the two applications of structured products are payoff flexibility and isolatingor bundling risks.

1. Payoff diversity and flexibility, payoff timing flexibility, leverage

It is almost impossible to define payoff diversity and flexibility that structured products can provide. I

present six structures that exemplify the payoff flexibility and diversity that structure products can

offer. These are:

1) The Autocallable (Figure 7,Figure 8 &Figure 9)2) The Reverse Convertible Autocallable (Figure 10 & Figure 11)3) The Springboard (Figure 12)4) The CertiPlus (Figure 13)5) The Plain Turbo Certificate (Figure 14)6) The Leveraged Airbag (Figure 14)


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The Autocallable and the Reverse Convertible Autocallable can be easily classified as yield-

enhancement products. The Springboard is a capital protected product. However the Certiplus, the

Plain Turbo Certificate and the Leveraged Airbag cannot be easily classified into one of the

fundamental exposure types, because they are vehicles to express sophisticated investment views.

All examples are applied to a single stock underlying. Considering how central correlation is in thepricing of baskets, I present examples in section 2.2.

The autocallable acts as a rational investor who has a range bound view on the underlying. If the

underlying appreciates enough, it is autocalled and the structure ceases to exist, that is, the payoff is as

if the investor has taken profit on the underlying. On the other hand of the underlying stays underwater,

the investor receives a coupon. The worst-case scenario occurs when the underlying goes down by

more than the investor expected. Then the investor will receive the bad performing underlying, but this

loss is nevertheless partially offset by the coupons that the investor receives until maturity.

Autocallables

Autocallables are yield-enhancement strategies

The structure autocalls if the underlying is above the trigger level in the

years before maturity. The investor receives a coupon equal to the number

of years multiplied by the initial coupon level.

If underlying matures above the initial level and has not been autocalled,

investor receives a coupon equal to the number of years multiplied by the

initial coupon level.

If underlying matures between barrier and initial price, investor receives

100% back.

If the underlying matures below the barrier, investor receives only theperformance of the underlying. This is the worst-case scenario.

We go long a zero-coupon bond, short a down-and-in put (DIP), long a

series of binary calls

High likelihood of coupon payment and partial protection.

Short- to mid-term investment horizon.

Range bound view on the underlying.

Structure

Payout

Investment idea

Figure 7

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The 4 scenarios show the representative payoffs of the autocallable structure.

In case 1 the structure ceases to exist after period 1, in all other cases it matures after 3

years.

Summary terms

11.5%

100 CHF

3 years

70%

Porsche

Invested

amount

Coupon

Maturity

Barrier

Underlying

Time

Price

100

70

1) 2)

3)

4)

Payoff

65%

100%

100 + 3*11.5% = 134.5%

111.5% (autocalled after 1 year)

Case 4

Case 3

Case 2

Case 1

65

Autocallable of Porsche

Underlying price100

Initial price

Coupon

Barrier

level

Underlying price

Performance

100

Initial price

Coupon

Barrier

level

1 2 3

1) Autocalled at the end of period 1; Investor

receives 100% of invested capital + coupon.

2) Product continues until maturity and pays

100% of capital + coupon equal to =

(number of years * coupon).

3) Product continues until maturity; Investor

receives 100% of invested capital only.

4) Product continues until maturity; investor

receives the performance of the underlying.

Underlying price100

Initial price

Barrier

level

Time

Price

100

Barrier

1) 2)

3)

4)

1)

2)

3)

4)

Autocallables

Barrier Autocallable payoff

Figure 8 &Figure 9

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Autocallable Reverse Convertible

10

tf

UNDERLYING

UNDERLYING

An autocall occurs in year i if the following occurs

Example for Swiss underlyings, 3 years, 60% Barrier, CHF

Underlying CouponUBS

Novartis

Roche

Swiss Re

Ciba

Credit Suisse

4.00%

3.50%

5.20%

5.00%

3.95%

4.90%

Underlying price100

Initial price

Coupon

Barrier

level

Underlying price

Performance

100

Initial price

Coupon

Barrier

level

1 2 3

1) Autocalled at the end of period 1; Investor

receives 100% of invested capital + coupon.2) Product continues until maturity and pays a

coupon every year. 100% of capital is

repaid at maturity.

3) Every year a coupon is paid. At maturity the

investor receives 100% back..

4) Every year a coupon is paid. Since the

barrier is triggered the investor receives the

performance of the stock at maturity.

Underlying price100

Initial price

Time

Price

100

Barrier

1) 2)

3)

4)

1)

2)

3)

4)

Underlying

Coupon

Autocallable Reverse Convertible

Autocallable on the Spread

Figure 10 & Figure 11

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Underlying price

Performance

100

Initial price

Springboard

The Springboard profits from a sophisticated upside exposure view

The springboard provides leveraged exposure up to the level of the

short deleveraged call

Long leveraged zero-strike call, short deleveraged call

Short- to mid-term investment horizon.

Bullish range bound view

Structure

Payout

Investment idea

Time

Price

100

Figure 12

Underlying price

Performance

100

Initial price

Barrier Strike

CertiPlusThe CertiPlus products combine downside protection up to a certain level and upsidepotential

We cash in a high coupon as long as the underlying stays between the

barrier level and the strike level, but we are exposed to the downside

below the barrier

We go long a zero strike call and long a down-and-out put (DOP)

Short- to mid-term investment horizon

Range bound bullish/bearish on underlying

Structure

Payout

Investment idea

Time

Price

100

Figure 13

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Plain Turbo Certificate Outperformance between the 2 strikes.

Full downside exposure.

Long ATM call, long zero strike call,

short 2 OTM calls.

Short-term investment horizon.

Variations

Turbos generate an Outperformance compared to the Underlying

Underlying price100

Initial price

Cap Level

Leveraged Airbag

Outperformance on the upside and partial

downside protection.

Long zero strike call, long ATM put,

short a leveraged OTM put, long a fraction

of an ATM call.

Mid-term investment horizon.

Underlying price100

Initial price

Strike

Level

Performance

Performance

Figure 14

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2. Isolating risk and gaining exposure: volatility, correlation, inflation, credit, hedge funds

Structured products provide the capacity to isolate and trade asset classes that are mixed-in in

traditional assets or may not be directly investable due to constraints on the asset side or the investor

side. I look at 5 specific investment classes: volatility, correlation, inflation, credit and hedge funds.

Not all of them are recognized as asset classes; however the existence of structured products showsinvestor interest.

An asset class is a set of investments that exhibit similar and distinctive investment characteristics

(return, volatility and relationship to the returns of other investment assets). The asset class represents

a distinctive type of risk. For accepting this risk any rational investor expects to earn an appropriate

return. The rational investor judiciously accepts risk and expects an appropriate return.

2.1 Volatility

Derivatives are both directional and volatility instruments (Neftci provides an excellent exposition).That is, the investor makes a bet both on the direction which the underlying will take and on implied

vs. actual volatility. If the actual volatility exceeds implied volatility the long side of the transaction

will realize a profit, assuming all other factors the same. Vice versa, if the actual volatility is lower that

implied volatility the short side of the transaction will realize a profit at the maturity of the option.

Volatility is an exogenous input in the Black-Scholes (or another pricing formula or Monte carlo

simulation) and it shows the volatility view of the investor.

The specific dynamics of volatility can be summarized in the following 4 points

It jumps when the market crashes It reverts back towards its long-term mean

It experience high and low regimes It is usually negatively correlated with the underlying asset return

[GM 1998], [Qu 2000] discuss volatility as an asset class. [Carr and Madan 1998] provide the

replication and pricing formula for volatility and variance swaps.

Volatility structured products can be used to make sophisticated bets on volatility. An excellent

exposition on the pricing of volatility products are the classic [Derman ??], [Hosker ??] and [Mougeot

2005]. The following table summarizes some of the applications.

Straddle Delta-

hedgedoption

Variance

swap

Gamma

swap

Conditional

varianceswap

Corridor

varianceswap

Correlat

ionswap

Volatility bet + + ++ ++ ++ ++

Volatility

hedging

++ + + ++

Dispersion

trading

+ ++ ++

Correlation

trading

+ ++ ++

Asymmetric

vol bets

- + ++ ++

Smile

trading

++ ++ + +


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While volatility swaps on currencies exist, the main application seems to be in equity index and swap

rate volatility. For an indexed investor, the volatility swap is of direct interest as it can help be used to

manage the tracking error. Apart from the swaps presented above, other volatility products are:

Volatility options An example is a call option on volatility. The option gains rapidly in valuewhen volatility increases sharply.

Volatility swaps combined with equity futures volatility swaps entail an implicit directionalview on market price movements. There is evidence of negative correlation between the equity

market performance and the level of volatility. Volatility tends to be high during market

crashes. Thus, the seller of volatility swaps has an implicit expectation that the equity market

will increase in values and the buyer has an implicit expectation that the equity market will

decrease in value. To hedge the directional effect of the volatility swap the investor can trade

equity futures.

Volatility bonds the coupon is proportional to the difference in the swap rates of a certainmaturity, for example the 20 year swap rate, between the start and the end date of each year.

The investor is buying a series of 20 year swaption straddles.

Here I show an example where variance swaps can be directly used to hedge secondary guarantees

offered by insurance companies. Secondary guarantees exist in two forms: death benefits and living

benefits. Among living benefits the most popular product are the guaranteed minimum withdrawal

benefits (GMWBs), which guarantee the principal, may allow step-ups and allows set percentages of

withdrawal each year, even if account values is zero. The key attraction to customer of this product is

the protection against another bear market and they give life insurers a competitive advantage over

mutual fund providers.

The main risk for the insurer offering such a guarantee is a prolonged equity downturn which poses a

catastrophe type risk. The GMWBs will go deep in the money potentially creating large losses forthe insurance company if they are not properly hedged.

Because secondary guarantees are long-term illiquid benefits with liabilities that are expected to

extend over a 20-30 year time period and contain the uncertainty of policyholder utilisation rates, there

are essentially no financial derivatives that can be found to form a perfect hedge. Even if derivatives

were available for 20-30 year periods, the counterparty risk over such long durations would be

unacceptably high.

The long-term illiquid nature of the benefits means that they are suited to dynamic hedging strategies.

The insurer will establish a portfolio of fairly short-dated futures and put and call options which can be

rolled over providing a rolling hedge to offset the guarantee risks based on assumptions about futuremarket behaviour and policyholder utilisation. The dynamic element of the strategy lies in using

futures and options that are typically fairly short dated at around 3-9 months as these are normally the

most liquid. By rolling the positions over and adjusting those to reflect changes in the book, often on a

daily basis, a fairly effective continuous hedge against most market risks can be achieved.

The three Greeks of concern are:

Hedging Greek Risk Typically used instruments

Delta Change in the market value of the

fund

Equity Futures

Vega Change in the market volatility Put and call options (straddles)

Rho Change in interest rates US Treasury futures


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The straddles are the easiest way to partially hedge volatility, however they do not provide pure

exposure to volatility. The problem with the straddle is that once the stock price has moved away from

the initial level, the straddle delta is not zero anymore. Also, since both options are initially in the

money, straddles are usually expensive.

For the insurance company, the variance swap is the best hedging solution. The variance swap is aforward contract that pays at maturity the difference between the realized variance of an underlying

and the initially defined variance strike price K.

Carr and Madan show that the variance swap can be replicated by a continuum of puts and

calls inversely wghted by the sware of their strike price. The solution is model-free. The perfect hedge involve buying a continuum of put with strike from 0 to Fo, the current

level, and buys a continuum of call options with strikes from Fo to infinity:

The Variance Swap

Buyer and seller exchange payments based on the level of variance

Variance buyer Variance seller

NKVariance*

N*2

+=

0

0

)(1

)(12

][ 020 02,0

2

F

FrT

TfdKKC

KdKKP

KT

eV

Figure 15

2.2 Correlation

Correlation is a key input into the pricing formula of baskets of securities. Therefore, in a manner

similar to betting on volatility, the investor can bet on correlation. If realized correlation is lower or

higher than the implied correlation the investor may realize a gain or loss depending on whether the

investor is long or short correlation.

While in linear payoffs correlation and volatility are positively correlated, there are payoffs where the

investor can profit from high volatility and low correlation of the stocks in the basket. These are the

so-called dispersion payoffs. I give an example to show why such a product can be interesting for an

investor.

17


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Correlation is usually measured as

BA

BA

BACov

,

),(, = and =

n

ii BBAAn

BACov 1 ))((1

),( and )ln(1

A

i

A

iiS

SA

= , =

n

iAn

A 11

This formula clearly makes the assumption that the log returns of the two assets are normally

distributed, and may underestimate or overestimate true correlation if this is not the case.

Correlation is a measure of the diversification and is closely linked to the volatility of the basket.

To show the link between correlation and volatility, let us consider a basket of two stocks, A and B,

and assume that both have a constant volatility of 25%. As the correlation increases from -100% to

100% the volatility of the basket will increase at a decreasing rate and will finally be equal to the

arithmetic average of the volatilities of the two stocks (Figure 16). The non-linear rate of decrease isdue to the fact that volatility is a power function in correlation.

Correlation in %

-100% -50% 0% 50% 100%

0%

5%

10%

15%

20%

30%

25%

Volatilityofthebasketin

%

Correlation in %

-100% -50% 0% 50% 100%

0%

5%

10%

15%

20%

30%

25%

-100% -50% 0% 50% 100%-100% -50% 0% 50% 100%

0%

5%

10%

15%

20%

30%

25%

0%

5%

10%

15%

20%

30%

25%

Volatilityofthebasketin

%

Figure 16

Correlation is not considered a separate asset class, possibly due to its direct linked to volatility.

Correlation in credit derivatives markets has become a key input commensurate to volatility in equity

derivatives markets. I discuss it briefly in section 2.4. Correlation between asset classes is also still a

research topic.

Correlation is also the measure of diversification. Correlation is low when the stocks in the basket

move apart, and is high when the stocks in the basket move concordantly. When the market is bullish

and correlation is high, the investor wants to be long correlation, so that he can profit from the

leverage effect. Yet, when market is bearish and correlation is high the investors wants to be short

correlation, so that he can benefit from the diversification effect.

Dispersion bets are bets that stocks in the basket will move in different directions. The best payoff isachieved when we take the difference between the best performing stock and the worst performing

stock. This can be achieved through a combination of a long lookback call plus a long lookback put.

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This is obviously the primal volatility trade, and due to the lookback feature it can be prohibitively

expensive.

With the proper payoff structure, the dispersion of the stocks in the basket can generate higher IRR or

consistent and uncorrelated performance.

First, I compare the price and the IRR of a structured product that pays off the average of call spreadson a basket of stocks and a structured product that pays the call spread on the average of basket of

stocks. I introduce the floor and the cap in order to obtain financially sensible prices and results.

Basket of Call Spreads

The coupon is the average of the call spreads on the underlyings

100% of invested at maturity.

The coupon depends on the return of the stocks in the basket and is

capped.

The annual coupon is paid accordingly to the following formula:

We go long a zero-coupon bond and 3 long call spreads on the indecis.

Mid- to long-term investment horizon.

Moderately bullish on a basket of 3 indices (NKY, SPX, FTSE)

But we want downside protection.

Structure

Payout

Investment idea

=

3

1 i,0

ti, ,Min,31

i

CapLevelIndexIndexFloorLevelMax

Figure 17

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Call Spread on a Basket

The coupon of the Call Spread on a Basket depends on the average performance of a

basket

100% of invested at maturity.

The coupon depends on the average return of the stocks in the basket

and is capped.

The annual coupon is paid accordingly to the following formula:

We go long a zero-coupon bond and a long call spread on the indices in

the basket.

Mid- to long-term investment horizon.

Moderately bullish on a basket of 3 indices (NKY, SPX, FTSE)

But we want downside protection.

Structure

Payout

Investment idea

=

3

1i i,0

ti,,

Index

IndexMinx

3

1, CapLevelFloorLevelMax

Figure 18

I choose 2 indices that are correlated (the S&P 500 and the FTSE 100) and one (the Nikkei) that is not

correlated.

Historical Performance

0

50

100

150

200

250

300

350

400

450

500

Dec-90 Oct-91 Aug-92 Jun-93 Apr-94 Feb-95 Dec-95 Sep-96 Jul -97 May-98 Mar-99 Jan-00 Nov-00 Sep-01 Jul -02 Apr-03 Feb-04 Dec-04

Index

NKY FTSE S&P 500

Performance of the 3 indices during the backtest period 20-Dec-1990 until 20-Dec-2005

Figure 19

20


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The correlation matrix fed into the MC prices is the same. (3 year period 20-Dec-2002 until 20-Dec-

2005, daily observations)

Correls (avg) 57.00%

20-Dec-02 UKX NKY SPX

UKX 100.00% 51.59% 67.84%

NKY 51.59% 100.00% 51.56%

SPX 67.84% 51.56% 100.00%

Figure 20

The call spread on the basket clearly dominates the average of the call spreads, because of the bubble

period. The call spread on the basket is a dispersion trade compared to the basket of call spreads as the

average of the basket out or underperforms the individual call spreads as the indices disperse up or

down, while the call spread on the individual indices does not allow them to disperse outside of the

cap and the floor. Despite the fact that there is no leverage applied, we observe a leverage effect thatwill clearly be stronger if correlation would increases and vice versa.

Price and IRR Comparison

Underlying Indices: SPX, NKY, FTSE

Maturity of 5 years with annual coupons

Floor 95%, cap 120%

Charts on the left show IRR distribution(top) and historical IRR

0%

10%

20%

30%

40%

50%

-4.9%to

-0.7%

-0.7%to

3.5%

3.5%to7

.7%

7.7%to1

1.9%

11.9%to

16.1%

16.1%to

20%

Call spread on basket Basket of call spreads

Call spread on

basket

Basket of call

spreads

Average 9.93% 7.76%

Min -5.00% -5.00%

Max 20.00% 18.82%

Price 21.99% 22.18%

Range

Call spread on

basket

Basket of call

spreads

-4.9% to -0.7% 18% 18%

-0.7% to 3.5% 6% 5%

3.5% to 7.7% 10% 8%

7.7% to 11.9% 12% 44%

11.9% to 16.1% 23% 20%

16.1% to 20% 30% 5%

-10%

-5%

0%

5%

10%

15%

20%

25%

Dec-95

Dec-96

Dec-97

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

Basket of call spreads Call spread on basket

16-Apr199611-Jul-2001

Figure 21

21


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23/42

Dispersion Price and IRR

Underlying Indices: SPX, NKY,

FTSE

Maturity of 5 years with annual

coupons

Cap level 5.5%

Charts on the left show IRR

distribution (top) and historical IRR0%

10%

20%

30%

40%

50%

60%

2.8%to3

.2%

3.2%to3

.6%

3.6%to4

%

4%to4

.4%

4.4%to4

.8%

4.8%to6

%

0%

1%

2%

3%

4%

5%

6%

7%

Dec-95

Jun-96

Dec-96

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05

Average 4.73%

Min 2.81%

Max 5.50%

Price 20.80%

Range Frequency

2.8% to 3.2% 0.4%

3.2% to 3.6% 4.6%

3.6% to 4% 7.9%

4% to 4.4% 15.8%

4.4% to 4.8% 20.7%

4.8% to 6% 50.6%

Figure 24

2.3 Inflation

Inflation presents a major risk to institutional investors concerned with capital preservation. The

purpose of inflation derivatives and inflation structured products is the transfer of inflation risk.

Although cash instruments already exist (inflation-linked bonds) inflation derivatives allow for tailor-

made solutions. I discuss some of these after a brief review of the market.

Inflation products are attractive to banks, pension funds, mutual funds and insurance companies.

Institutions that are natural inflation payers can benefit from issuing inflation-linked debt in the market

or from selling inflation. Inflation derivatives are attractive to debt investors who prefer real returns

rather than nominal returns or to investors who are looking to hedge their inflation exposure.

Furthermore, inflation linked securities will have a lower nominal cost to the issuer reflecting the

lower risk premium as the real rate is guaranteed.

23

Investment managers face implicit inflation risks. Inflation receivers are typically institutional

investors who need to pay inflation-linked cash flows. For example, the liabilities of pension and

superannuation funds, workers compensation insurers and disability insurers are linked directly to

inflation or indirectly linked to inflation through salary or other income levels. Furthermore, fixed-income specialist mutual funds/unit trusts have been established to invest in inflation indexed

securities. If the current trend of a changeover from defined-benefit to defined contribution pension

schemes continues, retail investors and mutual funds can become key players in the market of private


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pension schemes, long-term savings solutions and retirement income products and they will look to

provide inflation hedge for their clients.

The Market for Inflation Products

Overview of the participants in the gloabal inflation market

Inflation Payers

Sovereigns

Utilities

Agencies

Project Finance

Real Estate

Retailers

Other

Payers/receivers

Investment banks

Hedge funds

Relative value funds

Other

Inflation receivers

Pension funds

Insurance companies

Inflation mututal funds

Retail banks

Corporates (ALM)

Others

Global

Inflation

Market

Figure 25The case of inflation as a separate asset class is discussed in [Borutta 1997] and [Lamm 1998]. The

key arguments for considering inflation as an asset class considering its risk-return characteristics are:

Inflation linked securities will underperform conventional investments in times of low inflation,but will outperform at times of high inflation. This is a distinguishing return feature.

Inflation linked securities have lower volatility than conventional securities The correlation of inflation linked securities with other asset classes is similar to conventional

fixed-income securities. At time of high inflation however, it will be negative as inflation

linked securities will not experience loss of value.

The whole variety of fixed-income payoffs such as forwards, various option on inflation, swaptions on

inflation etc, can be applied to inflation. Unlike inflation-linked bonds, inflation derivatives can be

applied as an overlay on the existing asset allocation, or included as partial hedges.

The inflation swap is a flexible solution to hedge inflation risk. It is a bet on the breakeven inflation

level and is similar to an unfunded interest rate swap, except for the fact that the underlying payments

depend on the level of an inflation index.

24


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Breakeven Inflation

If we think of nominal yields as being (~ Fisher equation):

Rearranging the equation:

Breakeven inflation is the spread between nominal yield and real yield

InflationyieldRealyieldNominal +=

yieldRealyieldNominalinflationBreakeven =

(Ex- ante) (Ex- post) Investor PreferenceBreakeven

inflation = Actual/realizedinflation Investor is indifferent between anIL bond and a nominal bondBreakeven

inflation > Actual/realizedinflation Investors make money by holding nominal bonds asinflation component of payout is less than expectedBreakeven

inflation < Actual/realizedinflation Investors make money by holding IL bonds as theyreceive protection from higher than expected inflation

Figure 26

For institution with an inflation exposure

Hedge concentrations of inflation risk

Hedge inflation exposures that are not traded in the cash market

Easily match the maturity of the inflation exposed liability.

The swap is off-balance sheet and there is no regulatory charge

For investors and arbitrageurs

Take a view on inflation, go long or short inflation which may not be possible with

inflation linked bonds

Inflation buyerInflation

Seller

The Inflation Swap

Applications

Net Index Increase

LIBOR - spread

Fixed rate

Or

Figure 27

25


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26

2.4 Credit

Credit-sensitive bonds are one of the first yield-enhancement investments available. By investing in

corporate bonds and loans, or sovereign debt the investor receives an additional return spread over the

risk-free rate. The investor however is exposed to the default of the counterparty.

The credit-sensitive bond is (similar to) a short put on the value of the company. While credit risk hashistorically been regarded as illiquid, credit derivatives have successfully isolated it from the

underlying credit asset (bond, loan etc). The CDS is the basic credit derivative, and economically it is

a short put. Packaged with a bond component, the CDS is similar to a reverse convertible. Unlike the

reverse convertible however, the premium is paid over the life of the product. FtD baskets are the

credit equivalent of the worst-of-put baskets from the universe of equity products.

Historically, credit has been regarded as illiquid. This has been due to sensitivity bank-client

relationship and the high administration costs and market frictions.

Structured credit products have the capacity to provide pure exposure to credit risk. Furthermore, theyprovide the investor with the ability to trade credit in a liquid format with relatively low transaction

costs.

The use of credit derivatives allows the separation of credit and liquidity premiums on the credit-

sensitive securities. For the traditional credit investor, this means that instead of investing in relatively

illiquid corporate bonds, he can invest in highly liquid securities and overlay with credit derivatives,

economically achieving the desired yield-enhancement effect but maintaining high liquidity. This is a

major benefit for the liquidity-conscious ALM investor.

Credit risk has low correlation with property and casualty risk. Therefore it makes a valuable addition

to the investment portfolio of an insurance company.

The [BAA 2004] outlines the market for credit structured products is comprised of the following

products as follows:

CDS Synthetic CDOs Index linked structures Credit linked notes Credit spread products Asset swaps

Total return swaps Basket products Equity-linked products

CDS take up to 51% of the market and are the building block of the credit market. Synthetic CDOs,

index linked structures, some credit linked notes, basket products and credit spread products use single

name CDS.

CDS are short puts on credit, and thus can be straightforward described as yield-enhancement products.

Index linked structures can be in delta one form or may be used as underlying and combined with a

payoff structure. Asset swaps ant total return swaps are economically similar to the delta one payoff.Credit linked notes and credit spread products are similar to the equity structured products presented in

Section 2.1. Basket products are similar to baskets of options, typically the options being single name

CDS.


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29/42

Sensitivities of the CDO Equity Tranche

[Thompson, Minh, Greenberg 2004] show that CDOs provide diversification to the credit inverstors in

two ways:

Exposure to credit risk with less interest rate risk than corporate bonds

Leveraged exposure to credit since CDO tranches are options on the loss of the credit pool

Realistic asset allocation and statistical studies are not feasible due to insuffiecient historical data

Optimizing a portfolio of credit with a CVaR they show that including CDO tranches can expand the

efficient frontier of a credit investor

Figure 31

2.5 Hedge Funds

The case of investing in hedge funds has been increasingly drawing the attention of institutional

investors. While hedge funds have not been definitely classified as a separate asset class, structured

products are available to meet the institutional investors interest and overcome the difficulties of

investing directly.

Two potential features make hedge funds attractive for an institutional investor: superior investment

management and niche investment strategies that can profit from market inefficiencies.

As an investment vehicle, hedge funds exhibit specific constraints:Limited liquidity

No secondary market

Long valuation and settlement cycle

Low transparency

Yet, these and several big blow-ups during the last decade have failed to cool the investors interest.

As an investment vehicle, hedge funds exhibit higher return and higher volatility, potentially leverage

and are exposed to gap risk

29


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Popular structured products on hedge funds provide:

Full exposure plain certificate, total return swap Capital protection typically zero-coupon bond plus call option, CPPI, option on CPPI Leverage option on CPPI, leveraged total return swap Portable Alpha investor wants exposure only to the positive alpha of the hedge fund manager.Therefore the investor goes long the hedge fund and shorts the hedge fund index or another

benchmark.

Packaged solution - Collateralized Fund Obligations

Hedge Fund Structured Products

Dynamic principal protection

Static principal protection

Bank provided leverage

CFO Equity

Exotic options

Call options

CFO Senior Tranche CFO Mezzanine

Direct

investment

Higher risk-returnLower risk-return

Source: Man Investements

Most popular structured products on hedge funds

Managed accounts: the newcomer in the product pallette

Managed account platforms are vehicles for

perfomance duplication of pools of hedge funds

They take over administrative tasks that make

investing in hedge funds difficult

Heavy due dilligence and control

Reporting and riks management

Provide liquidity

Administration of the segregated pool

Leverage

41%

Better tax

treatment

13%

Risk

management

7%

Regulatory/Accounting

6%

Customised

basket

8%

Principal

protection

23%

Other

2%

Benefits of structured HF products for investors

Source: Man Investements Source: Lehman Brothers, Credit Agricole

Figure 32

30


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32

3. The institutional investor

3.1 Business environment and risk preferences

Institutional investors are large investors who accumulate wealth capital, manage it and disburse it to

match an uncertain liability stream. As long as the asset stream is greater than the liability stream there

is a surplus, or vice versa, there is a deficit. As deficits accumulate, the company will experience

deterioration of its financial position and may reach insolvency.

The academic framework to modelling the behaviour of the investor uses utility functions. The CARA

and the CRRA utility function families seem to be particularly popular as they have tractable

optimization solutions. However, as [Clarkson] points out, the limitations of mathematical modellingof the risk perception of an individual may be outweighing the benefits.

The utility functions approach is mathematically elegant and provides the basis for determining ht

optimal investment weight in a portfolio of a risky and a risk-less asset. In the case of derivatives and

structured products investments, the risk-averse investor then should naturally prefer capital protected

products, due to their downside protection. The risk-loving investor should prefer yield-enhancing

structured products, which active take on risk and receive a higher return. However, the institutional

investor cannot be classified as risk-averse, risk-neutral or risk-loving.

The institutional investor faces the problem of matching a certain liability stream. The stream may be

of stochastic or non-stochastic nature. Furthermore, the institutional investor may face therequirements of various stakeholders. The investor is risk averse up to a certain threshold, yet beyond

that maximizes expected profit. Risk aversion however in this case is not related to the preference of

more wealth to less wealth. The institutional investor is first and foremost concerned with the

avoidance of bankruptcy or regulatory action. I will call the amount of wealth below which the

institutional investor may start experiencing increasing cost of capital due to bankruptcy concerns the

minimum sustainability threshold. For a defined-benefit pension fund that has to provide a minimum

guaranteed return on the beneficiaries assets, the minimum sustainability threshold is this minimum

return. For a life insurance company it is the minimum guaranteed rate of return embedded in the life

insurance products.

Now, lets assume that the institutional investor can meet this requirement at a satisfactory level, forexample with a probability of 99% over a horizon of 3 years. Then for any budget above this level we

cannot assume that the investor will be acting a risk-averse manner. Any budget above the minimum

threshold has to be spent in a way that maximizes the firms value or the beneficiaries profit. That is,

the institutional investor is expected to judiciously take risks and exercise professional expertise, and

we can describe this behaviour more as risk-neutral rather than risk-averse. That is, the investor will

expect constant additional return for each risk he accepts. Investing in a risk-averse manner in this case

is detrimental to stakeholders, as it is equivalent to paying for double protection that is actually not

necessary. This is further supported by the fact that any investor, be it risk-averse, risk-neutral or risk-

loving benefits from diversification, assuming that assets that are not perfectly positively or negatively

correlated exist.

We might be able to justify even risk-loving behaviour, if the manager remuneration is positively

dependent on the return of the. Indeed, it is more realistic to assume that the degree to which the


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portfolio stakeholders can exercise control over the institutional investor and business and regulatory

environment will be one of the determinants of qualitative utility function of the institutional

investor.

To summarize, the institutional investor:

In this framework, the institutional investor benefits from the use of structured products as they helpme better:

Hedge a liability stream and a minimum threshold level when hedge instruments are notavailable on the market

Accept risks judiciously in order to earn return Diversify in order to manage risks

The implications of this line of thought are that the institutional investor will invest in structured

products, because they provide a flexibility that is not available in traditional assets and they isolate

risks, so that the investor can take diversified or non-diversified views.

3.2Institutional investors: readily invested in a structured product on the economy

Structured products are not a new invention, but the development of financial theory has helped us

understand better the ways we transact financially.

In his groundbreaking work, [Merton] shows that the value of the equity and the bonds of a company

can be represented as a long call and a short put option on the value of the firm. On the other hand,[Markowitz] first showed that an investor should invest in some combination of a risk-free asset and

the market portfolio, with the optimal weights determined by the investors utility function.

If we view the value of a stock index as a call option on the whole economy, and ignore cash for a

while, the investor is actually holding a long call + risk-free bond. Any investor that has been invested

in the traditional equity/risk-free bond/cash portfolio has actually been holding a structured-product-

like portfolio.

Let S represent the value of the whole equity market, p and c are a put and a call on the equity market

(as represented by the stock index), and is the value of risk-free discount instrument, that pays K

in time T, the implicit assumption being that the investor is interested in investing in a finite period of

time T.

rTKe

Then the put-call parity holds

rTKecSp

+=+

We see that the typical long-only equity plus government bond portfolio is actually the right-hand side

of this equation. For an investor who also invests in corporate bonds, it is easily shown that he is

actually holding delta-one like payoff on the whole investable company universe.

Because the investor cannot directly access the true firm value of all investable companies, by holding

a portfolio of zero-coupon bond, equities and corporate bonds, he has gained exposure to the aggregate

33


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investable firm value by creating a portfolio of 2 options and one zero-coupon bond - a structured

portfolio payoff. (Figure 33)

34

Figure 33

3.3 Structured products, indexation and the core-satellite framework

The institutional investor manages its liability exposure by investing the available assets passively by

indexing the assets or can try outperforming the market by either managing them actively or

employing an outside active manager.

Indexation is the construction of a portfolio that is designed to provide returns that match as close as

possible a certain benchmark. Indexation is an improper name for a investing in a customized

benchmark. An index aims to represent a market or a particular risk such as a style, sector etc. A

benchmark tries to be representative of a management strategy, and there is no requirement to stick to

a particular index. The index is expected the represent the pure systematic risk factor. Thus it supportsthe construction of a benchmark and is not a substitute for allocation. The benchmark may or, more

often, may not be a readily available market index, and this creates the need for a synthetic index that

will reflect the liability needs of the institutional investor.

The three practical implementations of indexation:

Pure indexation indexing the whole portfolio Enhanced indexation strategy this approach seeks to modestly outperform the index while

essentially retaining the characteristics of the index

Core-satellite strategy - indexing significant portion of the total capital and investing the non-index part in active alpha portfolios.

Indexation is superior to active asset allocation in:

Its ability to match a liability stream It avoids the problems of potential market impact of large changes in asset allocation It is more cost efficient in the meaning that fees are paid only for pure alpha and not for beta

performance

The satellites are generally of smaller size and are invested in a larger variety of investmentstrategies; this also provides a greater diversification benefit

Delta-one exposure to the value of all

investable companies

Equity + Zero-coupon bond Corporate bonds


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Major indexed investors are pension and trust funds. The benefits of indexation stand out in

international equity investment, where significant additional costs and inefficiencies may significantly

dent the performance.

In the perennial discussion of passive vs. active asset allocation, structured products can be used as

investment tools on both sides.

On the one hand, they can provide exposure to pure risks, which if considered separate asset classes

should be included in the portfolio of an institutional investor, due to their diversification benefits,

such as credit, volatility and inflation. Alternatively they can be used to hedge risks which the investor

is not willing to take.

On the other hand, structured products can be used to gain exposure to superior investment

management skills, to exploit niche strategies or to implement investment bets. Thus they can be

directly applicable in an active investment management framework.

The core-satellites framework which stands between the purely passive and the purely activeapproaches has recently gained prominence. The French government introduced this approach to

manage part of the state pension fund. CALPERS, the largest pension fund employs it as well.

The Core-Satellite Asset Allocation Framework

The Core-Satellite approach

ALM model

Defined-benefit or defined contribution scheme

Core portfolio tracks the liability stream

Split of alpha and beta

Core portfolio is beta-only portfolio, Satellite portfolios

are alpha-only portfolios

Invested in highly efficient markets: mostly government

bonds, broad equity indecis

Cost-efficient, purely passive investment approach

May include a hedging strategy if there is a minimumguaranteed return on the liability stream

Yield-enhancement strategies, pure diversification

strategies, active alpha managers, concentrated

portfolios, market-opportunity strategies

No particular or customized benchmarks

Practical issues

I. Construct an ALM model of the

pension scheme

II. Divide portfolio into Core part

and Satellite part

III. Core portfolio

IV. Satellite portfolios

Figure 34

The core-satellite framework has developed to overcome the natural mismatch between of the

available investment classes, such as equities, bonds etc, and the liabilities of an institutional investor.

35


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Broad market indices are not appropriate benchmarks because they are not a natural hedge to the

liability stream. This calls for a synthetic benchmark that replicates the liability stream.

Securities with the required maturity or risk-return profile may be unavailable. Embedded minimum

guarantee liabilities can be hedged either through investing in a zero-coupon risk-free bond with the

same maturity, if such is available, or through dynamic replication. This presents a case to apply

derivatives overlays or structured products that will provide timing and risk-return flexibility.

An investment manager should not be paid for accepting beta risk, but only for the positive alpha that

they generate. Alpha and beta risk and the remuneration paid for accepting them should be clearly split.

Constraining the active managers with tracking error limits is suboptimal as it constraints the alpha

around the benchmark. Then the risk budget is not fully spent on the alpha strategy. Active managers

should be given more freedom to implement their investment skill and should not be imposed tracking

error mandates that render them passive

Below I present the approach of Calpers and approach in the core-satellite framework, Liability-Driven Investment. Structured products naturally fit in a core-satellite or enhanced indexation portfolio

as satellites.

Core-Satellite Framework Calpers

Investment policy

Goal #1: Implement strategic asset allocation in an effective and cost-efficient way

Goal #2: Seek added value through tactical asset allocation

Implementation:

Beta drivers and alpha drivers are split and monitored separately

There are no restricted securities; thus the funds may invest in high-yield bonds, hedge funds etc

Calpers, the largest pension fund in the US, employs a type of core-satellite assetallocation

Passive

Enhanced Index

Concentrated

portfolios

Non-linear

payoffsMarket

segmentsAbsolutereturns

Long only

Beta drivers Alpha drivers Active risk

Active

return

Figure 355

36


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Liability-Driven Investing

Core portfolio, called Minimum Risk Portfolio, is invested in very low-risk or risk-free securities and

closely matches the liability stream

There is no consensus about structure of the core portfolio, yet generally discussed strategies are

Government bond liability matching

However longer-term maturities may not be available

If investor chooses to roll-over shorter-term securities, he forgoes the long-term premium

Cash + Swap liability matching

Enter into long-term swap agreements

Perfect replication at the cost of flexibility (liabilities may change over time)

Customized benchmark: government bonds + swaps

As satellites, the fund employs pure alpha strategies, targeting yield enhancement and diversification

Portable alpha strategies, concentrated portfolios, credit risk etc

Figure 36

4. Limitations

Structured products are not an asset class. Structured products may allow access to one or several asset

classes, but they are investment vehicles that do not carry original risk factor.

For capital guaranteed products, capital guarantee typically applies only if the product is held until

maturity.

For some products there may be liquidity issues: There may not be a secondary market; secondary

market may be illiquid.

Fees, fees, fees hidden and obvious, nothing comes for free

Mark-to-model risk, especially for longer maturity options

As investment vehicles, structured products may suffer from performance transparency as it may be

difficult to establish benchmarks.

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Taxation of Yield-Enhancement Products

Criteria

Not transperant

Transperant

TaxationProduct

Yield

Enhancement

Products

Fully tax-exempt

Total return taxation

Taxable amount equal to

Final price less Purchase price

and is taxable at maturity

Coupons are taxable when

paid

Coupons are taxable only

partially

Maturity of less

than 1 year

(Discount Certificates, etc)

Maturity of more

than 1 year

(Reverse

Convertibles etc)

Main differentiation depends on maturity

Longer maturity products are considered non-transperant unless shown otherwise and arepartially or fully taxable

Shorter maturity products are tax exempt

Taxation of Capital Protected Products

Criteria

Option part is always tax-free

Non UIP (High

coupon discount

bond)

UIP (Zero-couponor very low coupon

deep discount bonds)

TaxationProduct

Capital

Protected

Products

Total return taxation

Taxable amount equal to Final

price less Purchase price and is

taxable at maturity

Coupons are taxable when paid

Coupon is taxable when paid

Discount appreciation is payable

at maturity

Modified Taxation

All payments from the bond

component are taxable at maturity

Not transparent

products

Transparent

Products

Bond

component

Option

component

Main differentiation is between transparent and non-transparent products

UIP (French: interet unit predominant, Deutsch: berwiegend einmalverzinslich) products

have an annual interest rate on the bond component that is higher that half of the IRR of the

whole product; These are usually deep-discount bonds

39


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40

References:

[Arbeleche Dempster Medova 2003] Arbeleche S, Dempster M A H, Medova E A, Thompson G W P,

Villaverde M, Portfolio management for pension funds Judge Institute of Management, Working

paper 05/2003

[Arrow 1964] Arrow K, The role of securities in the optimal allocation of risk-bearing, Review of

Economic studies, 31, p. 91-96, 1964

[AXA 2004] Annuity Product Overview, September 2004

[Bahra 1997] Bahra B, Implied risk-neutral probability density functions from option prices: theory

and application, Bank of England, 1997

[BBA 03/04] British Bankers Association Credit Derivatives Report 2003/04

[Blake 2001] Blake D, UK Pension Fund Management: How is Asset Allocation Influenced by the

Valuation of Liabilities The Pensions Institute, Discussion paper PI-0104, 2001

[Blake 1999] Blake D, Portfolio choice models of pension funds and live assurance companies:

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[Borutta 1997] Borutta, Hansjorg Real bonds the real McCoy 1997 SBC prospects

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[Carr Madan 2001] Carr P, Jin X, Madan D, Optimal investment in derivatives securities, Finance and

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[Carr Madan 2001] Carr P, Madan D, Optimal positioning in derivative securities, Quantitative

Finance , 1, 2001

[Carr Madan 1998] Carr, Peter and Madan, Dilip, 1998, Towards a theory of volatility trading, in

Robert A. Jarrow, ed: Volatility: New Estimation Techniques for Pricing Derivatives, Chapter 29,

pp.417-427, Risk Books, London. Chris, Neil and Morokoff, William, 1999, Market Risk for

Variance Swaps, Risk, 12

[Carr Madan 1998] Carr P, Madan D, Optimal derivative investment in continuous time, Optimal

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[Cox Huang 1989] Cox, J.C., Huang C.F., Optimal consumption and portfolio policies when asset

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[Davis 2002] Davis E P, Pension funds and European financial markets, Presented at the AustrianNational Bank, 2002


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[Davis 2002] Davis E P, Financial institutions - help or hindrance in resolving the pension problem,

RIIA Pensions Conference, 2005

[Davis 2003] Davis E P, The crisis in pensions - what does it mean to the asset management industry,

JP Morgan pensions conference, Stationer's Hall, 2003

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