evaluating structured investment products

8/6/2019 Evaluating Structured Investment Products

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EvaluatingStructured Investment

Products

IFPAC 2008 Conference


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Contents

Introduction

Choice of Product Strategies

Examining Some Popular Structured Products

Determining the Right Product

Understanding the Limitations and Risks

Avoiding Catastrophe


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What Are Derivatives What is a Derivative?

1. Financial instrument whose value is derived from the value of an underlying asset.

2. Derivatives include Futures, Forwards, Options, Swaps, Warrants, etc.

3. Useful financial tools for both risk management and investment purposes.4. Traded on various Exchanges as well as Over-the-counter.

5. Issued over different asset classes: Equity, FX, Commodities, Funds, Interest rates, etc. Basically, any underlying asset that is tradable and sufficiently liquid.

Call and (Put) Options

Buyer has the right, but not the obligation, to buy (sell) the underlying asset from (to)Seller at a fixed price (i.e. Exercise Price or Strike) within specified period.

Growth of Exotic Options

1. Options offering interesting and complex payoffs/features, e.g. Barrier options.

2. Reasons:

Advance in IT and financial modeling

Banks increasing appetite for risk-taking

Demand from increasing sophisticated investors


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What are Structured Products Different Name, Same Product

Structured Product = Structured Investment = Structured Deposit = Structured Note

1. Different ways of wrapping the same product

2. Different regulatory and legal regime

3. Structured suggests that products have undergone some form of financial engineering

What are they

1. Hybrid products whose performance is linked to a selected underlying asset, e.g. index.

2. Usually a debt instrument (bond/deposit/debenture) with derivative(s) embedded.

3. Offer interesting variations of Risk-Return profiles that are different from conventionalinstruments (asset classes) like bonds, equities, currencies, etc.

4. Relatively complex multi-asset financial products.

5. Payoff formula is usually well-defined.6. Linked underlying asset can be equity, FX, funds, etc. or combination of several assets.

7. Sometimes viewed as a separate Asset Class.

8. Asset-backed securities (ABS), REITs, ETFs are excluded.


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LEGAL WRAPPER

(of selected currency)

Debt instrument, i.e. Note, Bond

Deposit

Certificates

Unit trusts or Funds

Vanilla options and forwards

Exotic options and multi-assets

Combination of options

DERIVATIVE

(of selected underlying asset or assets)

STRUCTURED PRODUCT

Path-dependent featurese.g. Lock-in, Knock-in,

Auto callable

Basic Building Blocks

Structured Products

Local / foreign underlying

Various asset classes

UNDERLYING


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Motivation and Benefits

1. Efficient execution of market view

Residual risk can be laid off (sold) in return for extra return.

Or giving up some return in exchange for protection against certain risk.

Remember the Bottom line: No Free Lunch !

2. Ability to modify and customise the investors Risk-Return profile.

Enhancing return/payoff profile, gaining capital protection or leverage

3. Offer other dimensions for trading: 1) Volatility 2) Correlation 3) Path-dependent

4. Provide more flexibility and more choices to investors.

5. Investor has direct input in product design decision. Feeling of in more control.

Once transacted, investment is in auto-pilot mode.

6. Resolve regulatory and market access restrictions.

Credit constraint in dealing with OTC derivatives

Allow market access to restricted markets, e.g. Participation Notes/Certificates

Structured Products


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Investors Choice of Option Strategies

1. Investor BUYS option(s)

Usually in principal-protected structures

Limited downside, unlimited upside

Lower risk

2. Investor SELLS option(s)

Usually in yield enhancement structures

Unlimited downside, limited upside

Higher risk

3. Combination of BUY and SELL Options strategies

Multiple options on multiple asset classes or underlyings

Structured Products


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Investors Choice of Risk Factors (Parameters)

1. Asset Class Equities, Currency (FX), Commodities, Interest rates, Credit, Funds, etc.

Any asset class that is tradable and sufficiently liquid

2. Directional factor

Bullish, Bearish or Market Neutral

Straight-forward and most popular risk parameter

A path-dependent strategy can be seen as a combination of Directional strategies

Investors can maximise value using Path-dependent Options such as Barrier Optionsif they have strong views on the future path movement of the underlying

3. Volatility factor

An important parameter that determines the value of an option

Value can be created and priced from market view/expectation on Volatility

4. Correlation factor Most newer, complex derivatives feature this risk parameter

Implied correlation has become more widely traded and priced

Structured Products


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Basic Product Types

1. Capital Guaranteed or Principal Protected Products Redemption of full or a large portion of the initial capital is assured.

Investors typically buy options. Risk-adverse, conservative investors who cannot afford to lose capital.

2. Yield Enhancement Products Partial or full amount of initial capital is at risk.

Investors typically sell options.

Investors with high risk appetite and who desire higher income yield.

3. Leveraged Products

Participation on the underlying asset is leveraged up.

Investors typically buy options in leveraged amount.

Investors with very high risk appetite.

4. Wrapper Products

Designed to gain market access or participation.

Participation Notes (or Certificates)

Structured Products


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Example 1: Capital-Protected Structure

PRODUCT NAME: Index-linked Capital-Protected

UNDERLYING INDEX: KLCI Index

MATURITY: 3 years

PRINCIPAL AMOUNT: RM 1,000,000

ISSUE PRICE: 100%

COUPON: 0%

INDEX PARTICIPATION RATE (G): 60%

CAPITAL GUARANTEE RATIO: 100%

SETTLEMENT METHOD: Cash settled

REDEMPTION AMOUNT (R):

R = 100% + ( IPR x G ) 100% 100%

IPR: Percentage Rise of Index over Maturity.

Assume Index Level on Start Date = 1400

Capital protection is only assured at maturity!

Redemption Amount

70%

80%

90%

100%

110%

120%

130%

140%

1000

1200

1400

1600

1800

2000

2200

Index Level at Maturity

Participation Rate (G) = 0.60

Strike=1400

Structured Products


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Pros

1. Initial capital is assured at maturity, i.e. 100% capital protection.

2. Upside participation in the selected stock index (market).

3. Out-performs bond/fixed deposit of similar tenure if stock market had performed well.

4. Similar to investing in a Balanced-type unit trust.

Cons

1. Limited exposure to stock market. 60% Participation Rate in this example.

2. Underperforms stocks (e.g. index fund) if stock market had risen sharply.

3. In low interest rates environment, Participation Rates will be lower and tenure longer.

4. Investment capital is locked in over a long period.5. Passive investment management.

Example 1: Capital-Protected Structure

Structured Products


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Example 2: Bull Equity-Linked Structure

PRODUCT NAME: Bull ELS or Reverse Convertible

UNDERLYING STOCK: Sime Darby

MATURITY: 35 days

ENTITLEMENT: 1 Bull ELS entitles 1 Share

REFERENCE PRICE: RM 11.80

ISSUE PRICE: RM 11.107

EXERCISE PRICE: RM 11.210

YIELD-TO-MATURITY*: 9.67% p.a., if redeemed at RM11.21

REDEMPTION AMOUNT:

(A) At Maturity, if Share RM 11.210

Redemption= RM 11.210 ( i.e. YTM=9.67% )

(B) Otherwise, 1 Bull ELS redeems for 1 Sime Share

Effective Share Purchase Price= RM 11.107

* YTM = { (11.210 11.107) / 11.107 } ( 365 / 35 ) = 9.68%e.g. 3-month Bank Deposit: 3.0%

Structured Products

YTM

-20%

-15%

-10%

-5%

0%

5%

10%

15%

10.60 11.00 11.40 11.80

STOCK PRICE

YTM = 9.67%

Break-Even11.107


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Maturity Payoff

SCENARIO 1

Final Price Exercise Price

SCENARIO 2

Final Price < Exercise Price

Investor pays on Issue Date. RM 11.107

Share price of Sime Darby atMaturity (i.e. Final Price).

RM 12.00 RM 10.80

Redemption Amount received byInvestor at Maturity.

RM 11.21 1 share of Sime Darby

Market value of shares held byInvestor at Maturity.

No shares held RM 10.80

Profit(+)/loss(-) on investment 11.21 11.107 = + RM0.103 10.80 11.107 = RM0.307

Return (in annualized simpleyield) on investment.

9.67% 28.82%

Structured Products

Example 2: Bull ELS


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Pros

1. Superior yield over banks Fixed Deposit if market view had been correct.

2. Target Buying at below RM 11.21

Effective purchase of shares at RM 11.107 if view had been wrong.

Must be happy to buy or be long the shares at RM 11.107.

3. Enforces market/investing discipline, instead of trying to time the market. No leverage.

Cons

1. Relatively more risky.

Suffers loss if share falls below RM 11.107 (break-even price).

Potential loss is unlimited.

2. Potential upside is limited. Maximum yield 9.67% p.a. (or 0.93% in absolute terms).3. Unattractive Risk-Return profile. Investor takes substantial risk for a small 0.93% pick-up.

4. Investment is locked in for 35 days.

5. Requires full capital upfront. Cannot leverage.

Example 2: Bull ELS

Structured Products


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Enhancing the Structure

Achieving a higher yield

1. Setting a higher exercise price (or strike).

2. Select stocks that are more volatile.

3. Extending the tenure.

4. Use Worse-of Put option

Addition of another risk factor (correlation) into the pricing.

Select stocks with higher negative correlation(s); higher option value.

Negative: Investor will have risk exposure to more than one stock.

Structured Products

Example 2: Bull ELS


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Example 3: Auto-callable with Digital Coupon

PRODUCT NAME: Auto-Callable USD Quanto Nikkei-linked Notes with Digital Coupon and Knock-in feature

REFERENCE INDEX: Nikkei-225

MATURITY: 5 yearsPRINCIPAL AMOUNT: USD 100,000

INITIAL INDEX LEVEL: 15,700

COUPON: Payable in USD on a quarterly basis, determined as follows:

(A) 11.00% p.a. if Index 13,600 on each Observation Date

(B) 0% if otherwise.OBSERVATION DATES: 5 Market Days before each coupon payment date

REDEMPTION (R): Payable in USD if Early Redemption has not occurred, and is determined as follows:

(A) R = 100% if Knock-In Event has not occurred before maturity;

(B) R = 100% [Final Index Level / 15,700 ] if otherwise.

FINAL INDEX LEVEL: Index level at maturity.

KNOCK-IN EVENT: Considered to have occurred if Index trades at/below 10,000 at any time before maturity.

EARLY REDEMPTION: Automatically early redeemed if Index Trigger Level on any Observation Date.

TRIGGER LEVEL: 16,000

Structured Products


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Structured Products

Nikkei-225 Index price performance

Issued 8/3/06Nikkei=15,700

Early redemption triggeredafter only 6 months.1/9/06 COB: Nikkei=16,134

Put Knock-in = 10,000


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Pros

1. Good possibility of receiving high interest coupons over 5 years

Earns 11% p.a. coupon if Index

13,600 i.e. 13% decline from initial level 15,700

2. Good possibility of early redemption

Index only have to rise 2% (15,700 16,000) after 3 months or thereafter

Outperforms similar maturity time deposit if it had early redeemed after 3 months

3. Low possibility of capital being at risk (i.e. Knock-in Event triggered)

Index has to decline 36% (15,70010,000)4. No currency risk if you are a USD based investor (i.e. Quanto-ed)

Cons

a. Potential income and capital loss if Nikkei had crashed below 10,000

b. Long investment holding (5 years) and equity risk exposure if not early redeemedc. Upside is capped (total income = 55% p.a.)

d. Coupons have a digital payoff, i.e. either 11% or 0%

e. Re-investment risk, in the event of early redemption

Structured Products



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Enhancing the Structure

Achieving a higher yield1. Setting a higher threshold Index level for coupon determination

2. Setting a higher Knock-in Level

3. Setting Observation frequency to intra-day (continuous) for Knock-in Event

4. Leveraging on the short Put option

Reducing the risk

1. Replacing the short put with a put spread (e.g. 20% spread)

Limit the potential capital loss to the spread (i.e. 20%)

Trade in for a lower coupon

Structured Products



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Structured Products

When and Why invests in SW

1. Desire for Gearing (leverage)

Gain large market exposure with small investment outlay

High risk, high return and more speculative in nature

2. Limited downside, unlimited upside and cash extraction strategy

Defensive strategy in times of very volatile, bullish but nervous market

3. Arbitrage and volatility trading

4. More Trading-driven and shorter term investment horizon

SW positions must be actively monitored

Beware of time decay

Usually not intended to be held until expiry

Example 4: Structured Warrants (SW)


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Some of the features/mechanisms offered

1. Lock-in

2. Knock-in and Knock-out3. Digital payoff

4. Cap on cumulative (total) return

5. Auto Callable (i.e. early redemption trigger)

6. Averaging out of risk (or return)

7. Daily accrual (i.e. payoff determined on a daily basis)

8. Currency immunisation

9. Correlation play

10. Best of, Worst of and relative performance

Offering More Flexibility, More Opportunities, More Possibilities and More Choices

Structured Products


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Today: If you have a View, theres a Way

TRADING STRATEGY & ACTION

MARKET VIEW CONSERVATIVE AGGRESSIVE

Bullish Buy Stocks Buy Futures / Sell Puts

Very Bullish Buy Call Warrants Buy Futures / Buy Calls

Bearish Buy Puts Short Futures / Sell Calls

Very Bearish Buy Puts Short FuturesBullish but nervous Buy Call Warrants or Buy Stocks + Buy Puts

Bearish but nervous Buy Puts

Neutral / Sideways / Range Sell/Buy Options Sell Options (e.g. straddle)

Lower Volatility anticipated Sell OptionsHigher Volatility anticipated Buy Options

Path movement of underlying Buy/Sell Path-dependent Options

Structured Products


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Determining the Right Product

1. Identifying the Underlying Asset Class

Which asset class and market: Equities, FX rate, etc.

2. Market View and Market Timing?

Bullish, Bearish or Market Neutral

3. Determine your Investment Objective and Risk-Return Profile

Minimum, Average and Maximum potential return?

Maximum (affordable) potential capital/income loss? Risk appetite?

Asset allocation (more conservative) or return-driven (more aggressive)?

4. Do you have holding power?

Are you able to ride through the market volatility or downside?

Structured Products


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Understanding the Limitation and Risks

1. Making the distinction between and Trading and Investment

2. Structured Products are intended to be held until maturity. Not for trading

3. Secondary market liquidity risk

No secondary market. Very much a bilateral contract.

Early redemption risk. Investor can only unwind trade with the issuer.

4. Pricing may not be straight-forward, especially for complex, multi-asset products

Multi-asset, more features means larger built-in margin and wider bid-offer spread.

Pricing models not readily available to investors.

Try to avoid Products linked to less liquid underlying

5. Credit risk exposure to the Issuer

Major consideration if tenure is long (> 3 years).

6. No free lunch!

If the risk is perceived to be higher, the option will be priced higher, and vice-versa.

Structured Products


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Avoiding Catastrophe: Due Diligence and Suitability

1. Has the Investor the capability to understand?

Investment experience and education background

2. Is the Product consistent with investment objectives and risk-return profile?

Looking for an Apple, bought an Orange !!

3. Is the Product suitable for the Investor in relation to his financial standing, etc?

4. Read the Product Terms, Disclaimers and fine print, etc.

. Return of up to X% .

Be careful if the terms are too good to be true

Structured Products


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Disclaimer / Risk Warning

This material has been prepared and published solely for informational purposes only, andshould not be construed as a solicitation or an offer to buy/sell any securities/products orrelated financial instruments. No representation or warranty, either expressed or implied, isprovided in relation to the accuracy, completeness or reliability of the information containedherein, nor intended to be a complete statement of summary of the securities, market, etc.referred to herein.

Structured Products, Warrants and Derivatives can be volatile instruments and investing in

them involves significant risk. These products are subject to a number of risks and mayresult in a complete or partial loss of an investment in them. No person should deal in anytype of Structured Products, Warrants or Derivatives unless he/she understands the natureof the relevant transaction and the extent of his/her exposure to potential loss. Eachprospective investor should consider carefully whether such instruments are suitable for itin the light of its circumstances and financial position. Prospective investors of any

Structured Products and Warrants should therefore consult their own legal, tax,accountancy and other professional advisers to assist them in determining the suitability ofany Structured Product or Warrant for them as an investment and for their particularcircumstances.

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