structured products: the eginner’s guide · structured products are bundled investment products...

Structured Products:The Beginner’s GuideAKRAM AYYASH (MSCF ’14)

OCTOBER 29 2013

Outline

1. Introduction

2. Swaps & Rates Derivatives

3. Options & Exotic Options

4. Credit Derivatives

5. Concluding Remarks

6. Useful References

AKRAM AYYASH 2October 2013

1. Introduction

WHAT & WHY OF STRUCTURED PRODUCTS


IntroductionWhat are structured Products?

Structured Products are bundled investment products offering returns based on the performance of an underlying security, basket of securities, or risk factors.

Though the family of assets called structured products contains a lot of complicated products some, such as vanilla swaps, can be quite simple

These products are created by Financial Engineering:

o Just as a mechanical engineer uses raw materials and the theory of mechanics to engineer a new machine, a financial engineer uses vanilla products and financial know-how to create a structured investment product.

The building blocks for these products can be any combination of stocks, bonds, forwards, options, as well as other structured products.


Introduction… But why do they exist?

In Financial Engineering, just as classical engineering, the whole is greater than the sum of the parts. Hence, structured products add value to investors that cannot be found using simple building blocks. Some benefits of these products are listed below:

Specific Return Profile

o Structured Products allow an investor to hedge a specific risk or take on a specific bet (e.g. the correlation between two currency pairs). In essence structured products serve the purpose of capitalizing on a customized market view.

Cleaning the Balance Sheet

o Structuring allows for the repackaging (recycling) of assets on the balance sheet as investment vehicles. This allows corporate clients as well as banks to remove assets from their books (e.g. securitized products).


Introduction… But why do they exist? (cont’d)

Yield Enhancement / Cost Saving

o Structured Products allow for the increasing or decreasing of yields as required. Yield Enhancement products allow investors to receive higher yields in a low yield environment (e.g. embedding a call option in a bond). On the other hand, some Structured Products, such as convertible bonds, allow the issuer to issue debt at a lower coupon (thus lowering yield) at the cost of an embedded option.

Credit Enhancement

o Structured Products allow for an improvement in the credit rating of a security, this makes it more attractive for investors to invest in low rated products (e.g. securitization of loans or mortgages).

Profitability

o The Investment Banks’ scale and market access gives them access to huge investor pools. This gives them an edge in hedging the risk associated with these produces and allows them to lock in structuring fees.


Introduction… And who on Earth buys this stuff?

In Finance, answering why a product exists, is linked to answering who is the client for this product. You never want to structure something that no one would buy!

As we said, investors in structured products can either be speculators or hedgers. In general:

o Hedgers, which include big money managers, such as insurance firms, commercial banks, pension funds, and asset managers, are sophisticated enough to understand these products and are big fans of them.

o Corporations are interested in hedging specific risks and turn to investment banks for solutions.

o Speculators are mostly large hedge funds who want to take specific bets using these products.

o Retail Investors and High Net Worth Individuals invest in these products for ‘diversification’ purposes, as well as bragging rights.


IntroductionSounds neat, what should I watch out for?

Since structured products are bespoke by design, there are several drawbacks for their usage, which can be primarily summarized as follows:

o Lack of Liquidity: Most of these products are one-off and it may be hard to find investors willing to take the other side at fair value

o Complexity: It is usually costly to hire someone to price these products and most of the time pricing is not very transparent. Big firms and well capitalized investors are less affected by this issue.

o Counterparty Risk: From an investor’s point of view, the product has value as long as the bank exists but no one will protect you if that bank defaults. The bank also has counterparty risk if the investor defaults.

So let’s jump right in and explore the multitude of these products…


2. Swaps & Rates DerivativesTHE BASIC STRUCTURES THAT INVESTORS LIKE


Swaps & Rates Derivatives30,000 ft. View

Swaps are by far the largest set of structured products in existence today; they are also, loosely speaking, the simplest.

A swap between two parties consists of two legs of cash flows, where each party pays the other one leg of the transaction. Exchange of notional may or may not happen at the maturity of a swap contract.


BA

Leg 2

Notional 2

Leg 1

Notional 1 The complexity of a swap is related to how the cash flows are determined. These can be tied to interest rates (thus creating a vanilla interest rate swap) or can be indexed to currency rates, variance, correlation, inflation or any other risk factor.

The notional can be fixed or can vary over time.

Adding optionality to swaps can make their pricing even more complicated.

Swaps & Rates DerivativesVanilla Interest Rate Swap

Interest Rate Swaps are contracts in which one party pays the other a coupon equal to the spot interest rate multiplied by a notional, while receiving a fixed payment. The floating leg payment can be set either in advance or in arrears (we will not burden ourselves with this distinction going forward).


The Basic structure of an interest rate swap is shown to the right, with an accompanying cash flow diagram.

BA

Floating

Notional

Fixed

Notional

Party A receives floating (blue) and pays fixed (green)

Swaps & Rates DerivativesEmbedded Optionality: Cancellable Swaps

Usually embedded options are indicated in terms of the counterparty who is receiving floating (i.e. the one paying fixed). In the below example, that counterparty is A. A callable swap allows that counterparty to cancel the swap and settle it’s present value, while a puttable swap means that B has the right to end the swap (most likely when it is less favorable to A).


If halfway through the life of the swap, forward rates indicate scenario 1 is more likely, then A will call the swap to lock in profits. If however scenario 2 is more likely A might suffer a loss if B ‘puts’ the swap.

BA

Floating

Notional

Fixed

Notional

Party A receives floating (blue) and pays fixed (green)

scenario 1

scenario 2

Swaps & Rates DerivativesEmbedded Optionality: Cancellable Swaps (cont’d)

This embedded optionality comes at a price of course. Callable swaps are more expensive, so A cannot just pay the coupon rate on a vanilla swap, but has to pay a higher coupon to have the ‘luxury’ of ending the swap early. This can be justified as below:

Value of Callable Swap = Value of Vanilla swap + Call Options

Of course, A will be paying a smaller coupon if he enters into a puttable swap since he has to be compensated for the inconvenience of having the swap cancelled when it is profitable to him, this can be justified by:

Value of Puttable Swap = Value of Vanilla Swap – Put Options

Note that in all of the above, the value of the swap is computed from the perspective of Party A who is the fixed rate payer and the floating rate receiver.


Swaps & Rates DerivativesConstant Maturity Swap, Commodity Swaps

In a constant maturity swap (CMS), one leg is tied to an interest rate other than the spot rate. This constant maturity leg resets against a certain index, usually another swap rate. It is possible that the other leg can be a fixed leg or a floating leg tied to spot rates. CMS traders are often taking views on the shape of the swap curve (and hence the spot curve).

But why stop there. This leg can be also tied to something that is not an interest rate at all. A commodity swap is a contract where one leg constitutes cash flows dependent on the price of a commodity. The largest family of these involve oil. If a producer of oil wants to fix it’s income, it will enter into a commodity swap where it pays market price of oil in return of receiving a fixed cash flow.


BA

CommodityPrice

Fixed or Floating

BA

Longer Duration Swap Rate

Fixed or Floating

Constant Maturity Swap Commodity Swap

Swaps & Rates DerivativesVariable Notional: Accreting Principal Swaps (aka. Step-Up)

Another variable in swap structuring is the value of the notional over time. Swaps where the principal amount grows over time are called Accreting Principal Swaps. The basic structure still holds, the only thing that changes is the notional amount. Either one or both legs must have variable principal.


The diagram shows the cash flows of a swap where the notional on both legs is growing over time.

One application of this is when a company anticipates increasing receivables in the future and wants to hedge interest rate risk.

BA

Floating

Notional

Fixed

Notional

Party A receives floating (blue) and pays fixed (green)Notional Payments are omitted

Swaps & Rates DerivativesVariable Notional: Amortizing Swaps (aka. Step-Down)

The opposite of the Accreting Swap is an Amortizing Swap. Here the principal is diminishing over time. A popular application of this is to hedge mortgage securities, or any other flow of receivables where the principal is diminishing over time.


The diagram shows the cash flows of a swap where the notional on both legs is decreasing over time.

BA

Floating

Notional

Fixed

Notional

Party A receives floating (blue) and pays fixed (green)Notional Payments are omitted

Swaps & Rates DerivativesVariable Notional: Conventions, IAR Swaps, Balance Guaranteed Swaps

It is customary to have only one leg of the swap vary in notional. Also it is customary to indicate a constant notional on the term sheet and have the coupon rate itself change. Of course this has the same effect of keeping the coupon rate fixed and changing the notional.

Index Amortizing Rate Swaps (IAR) are a special type of amortizing swaps where the rate of amortization is tied to an index. The rate at which the notional principal amount decreases varies with a specified short-term interest rate. This is structured so that the principal amortizes faster when interest rates fall and slower when rates rise. There may be a lockout period during which the principal does not amortize. This is perfect for hedging mortgage cash flows, as people tend to refinance when rates fall.

Balance Guaranteed Swaps offer the perfect tracking of a cash flow. The principal on a Balance Guaranteed Swap moves in lock-step with the actual balance on a bond.


Swaps & Rates DerivativesCross Currency Swaps

A very important swap structure is the cross currency swap. This entails the exchange of two cash flows in different currencies. The coupons on each leg may be either fixed or floating.

The marking feature of such swaps is that the notionals will have to be exchanged at the maturity. The reason being is that while the notional amounts where struck so that the PV of the swap is zero, as time progresses the exchange rate will vary and this will result in an economic benefit to one party of the swap.


Since there is a huge risk in the final payment, these swaps are usually marked to market at every point in time, to mitigate counterparty default risk.

BA

Currency 2 (₤)

Notional 2 (₤)

Currency 1 ($)

Notional 1 ($)

Swaps & Rates DerivativesCaps and Floors

Caps and Floors are bets on interest rate movements. In a cap the investor receives whatever excess amount interest rates achieve above a certain cap multiplied by a notional. In a floor the investor receives the amount of interest that is below a certain floor multiplied by a notional.

o Cap = Stream of Cashflows Ci where at each period i:Ci = [Ri – K]+

o Floor = Stream of Cashflows Ci where at each period i:Ci = [K – Ri]

+

From the above we can see that a Cap is a series of Caplets and the Floor is a series of Floorlets.


PV

Spot Rates

Cap Strike Time

Swaps & Rates DerivativesRange Accrual Notes

In a range accrual note, the investor is paid as long as the interest rate remains within a predefined range. This is one of the more attractive structures due to it’s relative simplicity but sophistication.

For example let’s say an investor wants to bet that the spot rates will remain within a certain band, a range accrual note will pay them the following at every period :

o Ci = (Fraction of Days where rate was within band)x (Reference Coupon) x (Reference Notional)


Time

70% of the time within range

15% of the time within range

1 2

C1 = (70%)qref Nref

C2 = (15%)qref Nref

Reference Rate

PV

Swaps & Rates DerivativesInflation, Variance, Correlation Swaps

This last family of swaps expands the reach of these derivatives beyond interest rates.


BA

Inflation Linked Cashlow (e.g. Inflation Rate,

CPI)

Fixed Coupon Rate

BA

Realized Variance on an underlying

Fixed Coupon Rate (strike)

BA

Realized Correlation on a

basket of underlyings

Fixed Coupon Rate (strike)

Inflation Swap Variance Swap Correlation Swap

Swaps & Rates DerivativesInflation, Variance, Correlation Swaps (cont’d)

The variance swap is a popular instrument, it can be replicated via options and forwards. It provides a pure bet on variance (or volatility), and it does a better job at this than options (since you would need to delta hedge options to get a pure volatility bet, more on that later).

Closely related are volatility swaps, where the cash flows exchanged are tied to volatility and not variance.

Inflation Swaps are very popular instruments for managing inflation. The main class of inflation derivatives are inflation protected notes (like TIPS). Inflation swaps are typically priced on a zero coupon basis (i.e. no coupons are exchanged, payments are compounded, and all cash flows are transferred at maturity)

Though there are plenty of instruments used to bet on correlation, the correlation swap is the purest of them. We will see more ways to bet on correlation later on.


Swaps & Rates DerivativesAll the knobs together

How exotic a swap is, is usually a function of the structurer’s creativity , the client’s daringness, and the degree to which the swap is customized.

On the one hand, parsimony implies that one always wants to have a simple solution, while on the other sophisticated problems force you to add layers of complexity. In general when structuring a swap you have all the following knobs to turn for each leg:

o Fixed or Variable Principal

o Fixed or Variable Coupon

o Variable Coupon Tied to what? (interest rate, and if so what tenor, variance, correlation, inflation, etc.)

o Currency of each leg (and day count convention)

o Embedded Optionality (who has the option, and when can they exercise)

o Embedded Caps or Floors


3. Options & Exotic OptionsTHIS IS WHY YOU BECAME A QUANT!


Options & Exotic OptionsIntroduction

Options are contracts that give the owner the right but not the obligation to buy or sell an underlying at a predetermined price on a predetermined date (or set of dates). Options are primarily viewed as ways to trade volatility. However, the two other important risk factors in pricing options are the value of the underlying and the time to maturity. More complicated options allow for more exotic bets.

The underlying can be an equity or equity index, a commodity, an interest rate, a forward or any other security. The underlying can be a single asset or a basket of assets.

Option prices give a way to back out a market volatility estimate. The most common Implied Volatilityrepresents the volatility that when plugged in the Black-Scholes formula gives the market price of the option.


Options & Exotic OptionsGreeks

The way to communicate the sensitivities to different risk factors is via Greeks. Greeks represent the partial derivatives of an option with respect to a risk factor (i.e. how much is the expected change in price given a change in a risk factor).

There are plenty of Greeks however the most famous ones are:

o Delta = Derivative with respect to Underlying Price (contrast that with bond Duration)

o Gamma = Second order derivative with respect to Underlying Price (contrast that with bond Convexity)

o Vega = Derivative with respect to Underlying Volatility

o Theta = Derivative with respect to time

The higher the order of the Greek the less useful they are (think Taylor Expansion!)


Options & Exotic OptionsQuoting Conventions

To quote an option you need to specify two quantities, Moneyness and Maturity.

oMoneyness is an indication of how near or far the strike price is to the current underlying price (i.e. how much in the money is the option).

oMaturity corresponds to how close the option is to expiry.

Equity options are usually traded with a fixed strike value, and a fixed exercise time.

FX options are usually traded with a fixed delta, and a fixed tenor (time to maturity). Furthermore, most trades are usually done in combinations. Investors either trade risk reversals or butterflies (affectionately called riskies and flies). These are more direct bets on volatility.


Strike Date 1

Price Strike

… …

Strike Date n

Price Strike

… …

…

The dates and strikes are fixed for equity options

Tenor

De

lta

1wk 1mo 3mo

5d … … ...

10d … … …

25d … … …

The tenors and deltas are fixed, but these will correspond to different strike prices

and maturity dates as time changes

America

Europe

Bermuda

Options & Exotic OptionsPayment Features

Option payoffs have different features, some of the most popular are:

o European: One exercise date only

o American: Daily exercise between the present and maturity

o Bermudan: A finite set of exercise dates (hence somewhere in between European and American options)

o Asian: The underlying is not the price, but rather the average of the price over a time period.

o Digital: The payoff does not increase if you are more right about your view. If you will exercise you will get one unit of currency (or one unit of the underlying) regardless of what the difference is between the underlying and the strike.

oQuanto: The payment is in a different currency than that of the underlying.


Options & Exotic OptionsBasic Combinations

Spreads: Buying and Selling an equal number of options with varying Strike or Maturity

o Vertical (in strike)

o Horizontal (in maturity, aka Calendar Spreads)

o Diagonal (Combination of Vertical and Horizontal Spreads)

o Box (involves four options with no delta, a pure interest rate play)

Straddle: Long at the money call and put (volatility play)

Strangle : Long out of the money call and put (cheaper volatility play)


Straddle Strangle

Bull Vertical Spread

Options & Exotic OptionsBasic Combinations (cont’d)

Risk Reversal: Long a call, short a put, both out of the money

o Volatility Skew play

o In FX, ‘riskies’ are quoted in Implied Volatility:RR = IVcall(25d) – IVput(-25d)

Butterfly: Long in the money and out of the money options, short two at the money options

o Limited risk volatility (smile) play

o In FX, ‘flies’ are also quoted in Implied Volatility:FF = IVcall(75d) + IVcall(25d) – 2xIVcall(50d)


Out of Money Calls

Out of Money Puts

OOM CallsOOM Puts

Payoff Diagram IV Diagram

Risk Reversal

Butterfly

Options & Exotic OptionsDouble No Touch, Double One Touch

Double No Touch pays off a certain amount of money (or asset) if the underlying does not reach two pre-determined levels.

Double One Touch pays off a certain amount of money (or asset) if the underlying reaches either of two pre-determined levels. This is the exact opposite of the Double No Touch.

October 2013 AKRAM AYYASH 31

Time

Price

Time

Price

It is clear that a Double No Touch is a short bet on volatility while the Double One Touch is a long bet on volatility; both have no directional preference. Can you think of a way to replicate this options using digital options?

Options & Exotic OptionsBarrier Options

Knock-In (Calls) Knock-Out (Calls)


Note the following parity

Up and In + Up and Out = Vanilla Call = Down and In + Down and Out

The reason these options are attractive is due to the fact that they are cheaper than vanilla ones: there are far less scenarios where these options can generate a payoffs than scenarios for vanilla options.

This idea of barrier can also be applied to put options as well.

Time

Price

Down and In

Strike

Barrier

Time

Price

Up and In

Strike

Barrier

Time

Price

Up and Out

Strike

Barrier

Time

Price

Down and Out

Strike

Barrier

Options & Exotic OptionsLook-back, Forward Start, and Cliquet Options

Look-back options pay according to the max (or min) of an underlying process. In either case the strike can be fixed or equal to the value of the process at maturity.

Forward Start Options are options that will set in a future date. There are two times to consider here, the setting time and the pay-off time. In general when the option sets, it is struck at the money.


A series of forward starting options is called a Cliquet option or Ratchet Option.

Time

Price

Look-back Option

Fixed Strike

MAX

[Smax – K]+

[Smax – ST]+

Time

Price

Forward Start Option

Fixed Strike[ST – ST1]+

T1

Options & Exotic OptionsSwaptions

A swaption is an option on entering a swap, a swaption contract should specify both the option parameters and swap parameters.

In a payer swaption the party will pay fixed and receive floating on the swap, a receiver swaption is the opposite.

The Swaption Vol Surface


TenorDuration of the underlying Swap

Mat

uri

tyw

hen

th

e sw

apti

on

mat

ure

s an

d

the

swap

sta

rts

1yr 2yr 3yr 4yr 5yr

1yr

2yr

3yr

4yr

5yr

Implied Volatility Surface of Swaptions

Option MaturesSwap Starts if Option Exercised

Option Starts

Option Maturity

Swap Tenor

Options & Exotic OptionsSwaptions (cont’d)

Swaptions are available in either European, Bermudan, or American exercise. The market is very large and the primary clients are companies looking to hedge their long term interest rate risk.

The risks can either be from future operational cash flows (e.g. a company projects a fixed flow of revenues in the future), or from financing needs (e.g. company plans to issue debt in the next year).


Options & Exotic OptionsMultiple Underlyings: Spread Option


Time

Spread

Strike Payoff = [(S1 – S2) – K]+

Time

Price

S1

S2

These options may be used to speculate on the difference between two assets without taking a directional bet directly on either.

These options are popular with commodity underlyings as they give an investor exposure to the physical procedure:

o Crack Spread Spread between crude oil and petroleum products.

o Spark Spread Spread between electricity price and price of fuel.

o Crush Spread The spread between soybean and soymeal or bean oil futures.

A spread option is an option whose underlying process is the price difference (i.e. spread) between two different assets.

Options & Exotic OptionsRainbow Options and Correlation

A rainbow option is an option whose payoff is linked to the performance of a basket of underlying assets. The number of assets is referred to the colors of the rainbow

o Basket Options: the payoff is tied to the average of the underlyings (or a weighted average of those). These can be as vanilla as index options (e.g. options on S&P 500).

oWorst-of Basket Options: the payoff is tied to the worst performing member of the underlying basket.

o Best-of Basket Options: the payoff is tied to the best performing member of the underlying basket.

You can already see the Best-of Basket Options will be expensive, and so they are less traded than Worst-of Options. The typical underlyings are either currency pairs, or stock indices in different markets. Best-of and Worst-of options constitute a correlation play.

Mountain Range Options are an even more exotic option class that combine the characteristics of path dependence and having a basket of underlyings.


Options & Exotic OptionsRainbow Options and Correlation (cont’d)


The diagrams to the left heuristically show why a worst-of option is long correlation.

In a very similar fashion we can determine that best-of options are short the correlation of the underlyings.

This same logic will be applied later on to see how first loss tranches are usually long correlation while senior tranches are short correlation in securitized products.

Time

Price

Time

Price

High Correlation: Worst-of option has a payoff if the basket overall

goes up, else it expires worthless.

Time

Price

Low Correlation: Worst-of option will expire worthless most of the

times

$$

Options & Exotic OptionsClosing Remarks

Options can be very exotic and they are one of the most complicated financial derivatives. For some classes, prices are available in closed form, but most of the time a simulations are needed to price them.

Options are primarily bets on volatility. However we have seen that one can express directional views on the underlying as well as bet on interest rates and correlation using options.

For structuring options one has the latitude to change any of the following:

o Selection of Underlying (basket or single asset, price or average, or min / max etc.)

o Exercise style (European, Bermudan, American)

o Payoff style (pay by cash, pay by security, digital or not, quanto)

o And of course the Maturity and the Strike, and whether it is a call or put


4. Credit Derivatives

THE WEAPONS OF MASS DESTRUCTION


Credit DerivativesWhat is Credit

Two Quotes to put you in the right mood:

“Commercial credit is the creation of modern times and belongs, in its perfection, only to the most enlightened and best-governed nations. Credit is the vital air of the system of modern commerce. It has done more, a thousand times more, to enrich nations that all the mines of the world.”

-- Daniel Webster, March 18, 1834

“CDOs prolonged the mania, vastly amplifying the losses that investors would suffer and ballooning the amounts of taxpayer money that would be required to rescue companies like Citigroup and the American International Group. But for these me-first firms, stuffing questionable loans into CDOs in 2005 and 2006 meant that the mortgage merry-go-round had a few more profitable turns left in it.”

-- Gretchen Morgenson, 2011


Credit DerivativesClassification

Credit Derivatives are instruments that are used to hedge or speculate on Credit Risk. Credit events include defaults, as well as changes in credit ratings. The counterparties in these contracts are sometimes referred to as protection buyer and protection seller.

Credit Derivatives can be classified as either Funded or Unfunded. The distinction is whether the protection buyer puts up any money upfront (funded) or not (unfunded). Another way to look at it is whether cash flows from the default-able assets are used to settle claims (funded) or not.

o Funded Derivatives constitute primarily of CDOs, CLNs, and securitized products

o Unfunded Derivatives constitute primarily of CDSs, kth to defaults, and synthetic CDO products.

Another way to classify credit products is by underlying – single entity (e.g. CDS on a company) or multiple entities (e.g. a tranche in a securitized product).


Credit DerivativesCredit Default Swap

In a credit default swap (CDS), the protection buyer pays the protection seller a certain amount of coupon at every period where the contract is alive. If, by the end of the contract, no credit event occurs to the reference entity, nothing happens. If, on the other hand, the reference entity undergoes a credit event during the life of the CDS, the protection seller has to pay the protection buyer. The amount is usually the change in price of the asset due to the credit event.


The diagram shows the cash flows of a CDS. Party A is the protection buyer. The top diagram depicts the cash-flows where there is no credit event whereas, the lower diagram indicates the transfers if a credit event occurs.

BA

Protection

Periodic Coupons

Reference Security

Credit Event

No Credit Event

Credit DerivativesCredit Linked Note

A protection buyer can also sell a credit linked note (CLN) on a reference entity. This note is struck at par and will mature just as any other bond in case there is no credit event. However, if there is a credit event, the protection seller will redeem the note (forfeiting any future cash flows from it) in return for the reference entity.


The diagram shows the cash flows of a CLN. Party A is the protection buyer. The top diagram depicts the cash-flows where there is no credit event whereas, the lower diagram indicates the transfers if a credit event occurs.

BA

Face Value of Note+Protection

Periodic Coupons+ Note

Reference Security

Credit Event

No Credit Event

Credit DerivativesTotal Return Swap

In a total return swap (TRS) the protection buyer (or TRS Payer) will pay the total returns on a reference security in exchange for a floating coupon and a spread. If a credit event takes place, the protection seller (TRS Receiver) will pay the par value of the bond and receive the recovery value of the reference security.


The TRS allows for the exchange of the returns on the reference security without the exchange of its ownership. In a credit event the swap is usually terminated and the returns are calculated based on the recovery value

BA

Face Value of Note+Protection

Periodic Coupons+ Note

Reference Security

Credit Event

No Credit Event

Pay total returns

Receive Libor + spread

Credit DerivativesMultiple Underlyings: k-th to default

A kth to default security (KtD) will pay off the loss on default if k or more securities within a basket of reference bonds default.

o A First to Default (FtD) will pay the loss if any one of securities within the basket default.

Using the same analogy we used for basket options we can deduce that investing in a FtD is equivalent to having a short correlation position. If correlation is low, the probability of at least one underlying defaulting will increase and the payoff will be more likely of such a security.

KtD’s offer exposure to correlation and leverage, a feature we will also see in CDOs.


Credit DerivativesSecuritization

Securitization is the process of pooling a set of receivables and issuing notes of varying credit ratings and tenors that are backed by those receivables.

The benefits of securitization are plenty:

o For investors it allows for instant diversification, access to notes with specified credit ratings, ability to get higher yields if they want.

o For the owners of the assets, it allows for a leaner balance sheet (assets are written of to a special purpose entity) and access to cheap funding.


Senior Tranche

MezzTranche

Junior Tranche

Junior Tranche

Equity

Pool of Assets

Notes and Equity to Investors

Interest + Principal

Cash flows from Asset Pool

Credit DerivativesSecuritization (cont’d)

Almost any cash flow stream can be securitized. We make a distinction based on collateral:

o Asset Backed Securities (ABS)o As vanilla as credit card, student loan, or auto loan receivables. As esoteric as equipment leases.

oMortgage Backed Securities (MBS)o Mortgages, which can be separated into commercial and residential as well as agency and non-agency.

o Collateralized Debt Obligations (CDO)o Debt obligations, which can be corporate bonds, or loans.


Credit DerivativesMBS and Prepayment

The pool of assets backing mortgage backed securities (MBS) are mortgages. The mortgages can be either commercial or residential. The security itself can be structured so that it is either a pass through or a more complicated structure such as interest only (IO) or principal only (PO).

A lot of MBS in the US are issued by one of the 3 Government Sponsored Entities (GSE): Fannie Mae (FNMA), Freddie Mac (FRMC), Ginnie Mae (GNMA). These are agencies. The rest are private label deals or non-agencies.

We have to add that agency MBS are indirectly backed by the ‘full faith and credit’ of the US Government. As a result these securities are not usually viewed as credit products.


Credit DerivativesMBS and Prepayment (cont’d)

There are two risk factors in MBS:

o Prepayment Risk: If interest rates are attractive (low in this case) mortgages will be refinanced which shortens the maturity of the cash flows. Furthermore, as the principal is paid in its entirety, there will no further interest payments, and hence IO investors will be subject to a high loss.

o Credit Risk: This is the same risk as in other securitized products, where defaulting on payments causes less cash-flow to go into the waterfall and hence, a smaller payoff to investors in the structure.


Credit DerivativesCDOs, CLOs, and CDO squared

Collateralized Debt Obligations (CDO) can be thought of as asset backed securities where the pool of assets comprises of debt instruments such as bonds (CBO), or loans (CLO). Sometimes CDOs have other tranches of CDOs as their collateral and such a structure is called CDO-squared.

The CDO manager works with an investment bank (underwriter) to structure such a deal. The collateral manager’s job is to select good quality collateral at a good price. The underwriter funds the purchase (by setting up a warehouse and extending a line of credit) and generates the notes.

The notes are structured with different credit ratings to attract different investors. A portion of the equity tranche is maintained by the manager.

A distinction is usually made between:

o Balance Sheet CDOs: those primarily issued to remove assets off of balance sheets.

o Arbitrage CDOs: those used to capture the spread in funding between the notes and the debt instruments. The majority of CDOs are arbitrage motivated.


Credit DerivativesSynthetic CDOs: CDX Index Tranches

Another way to structure a CDO is via a pooling of CDS. The synthetic CDO will pay protection sellers using cash flows received from the insurance premiums. When defaults happen the structure will pay protection buyers money.

Synthetic CDOs are ‘cheaper to assemble’, and that explains their popularity.

This idea of pooling CDSs was used to create an index for CDS. The CDX and iTraxx index families are the credit equivalent to S&P 500 for equity indices.

o CDX Indices include high yield (HY) and investment grade (IG) components

o They include the most liquid CDS contracts

o The index is reissued every 6 months


Credit DerivativesSynthetic CDOs: CDX Index Tranches (cont’d)

CDX indices are available in tranches which allows for exposure to a particular part of the loss distribution. Tranches are defined by attachment and detachment points. Note that a tranche buyer is buying protection.

The London Whale was speculating on the CDX IG 9 index tranche. He took a very large position and was going to get away with it, but as European Financial Crisis was brewing he was no longer able to maintain his position and hedge funds ‘ate his lunch’.

o The ‘whale’ was aggressively shorting the 10 year CDX IG 9, betting that the credit market will strengthen.

o Boaz Weinstein in Feb 2012 recommended buying the index. It wasn’t until May of 2012 that concerns over the European Crisis started causing the index to appreciate beyond the price JP Morgan was able to manipulate.


5. Concluding Remarks

LET ’S RECAP


Concluding RemarksStructured Products

Structured Products come in a lot of flavors. They are largely driven by investors’ needs and appetite for sophistication.

A happy medium between a simple solution and an effective solution should always be sought in structuring such deals.

Hopefully this presentation gives you an indication of the multitude of products out there and what are they used for.


Concluding RemarksAfter the Crisis

After the financial crisis, it became apparent that counterparties need a lot of measures to protect against each other’s default. A standard part of any Structured Product deal today is dedicated to handling counterparty risk:

o ISDA Master Agreements and Credit Support Annex are the industry standard to specify the terms of the deals

o Collateralization, Marking to Market, and Central Clearing are all measures that counterparties take to mitigate counterparty risk.


Concluding RemarksDerivatives: Good or Bad?

“The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”

-- Warren Buffet 2002

While some may argue that derivatives have a net negative impact, it is infeasible to go back to a time when these instruments did not exist – the genie is indeed out of the bottle! The basic role of the financial services industry, transferring risk, is greatly facilitated by such instruments.


6. Useful References

LEARN MORE


Useful ReferencesBooks

o Introduction to Structured Finance

oWilmott Introduces Quantitative Finance

o Options Volatility and Pricing

o Options, Futures, and Other Derivatives

o Credit Derivatives & Synthetic Structures:A Guide to Instruments and Applications

o Interest Rate Swaps and Other Derivatives


Useful ReferencesWebsites

o Banks Marketing Material: Google “Bank Name” + “Structured Products”

o Rating Agencies Websites, as well as SEC, ISDA, Bloomberg, and Markit

oWikipedia (and slightly less reliable investopedia)

o Global Derivatives: http://www.global-derivatives.com/

oMy-Structured-Products: http://www.my-structured-products.com/Home

o Investment and Finance: http://www.investment-and-finance.net/encyclopedia.html

o Credit Derivatives: http://credit-deriv.com/

o Leveraged Loan: http://www.leveragedloan.com/


http://www.global-derivatives.com/

http://www.my-structured-products.com/Home

http://www.investment-and-finance.net/encyclopedia.html

http://credit-deriv.com/

http://www.leveragedloan.com/

Thank You!

Thank you for going through this lecture, let me know if you have any questions

Special thanks to my peers Akshat Bhatnagar, and Carol Zhang as well as the MSCF Class of 2014 for helping me edit this presentation.


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