ANALYSIS
The cliquet: hard to price, difficult to manage We look at the dynamics of pricing cliquet options on the construction of long-term products mostly seen in the retirement space, and why they have lost weight and presence in the market. by Tim Mortimer
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any investors need long-term solutions for capital growth or income with controlled risk. This is particularly true for investors seeking retirement solutions having built up a portfolio over time. The typical profile is someone ten to fifteen years from retirement seeking to extract some further gains from their portfolio but turning their focus to income generation and capital preservation. The fund management world and those using a broker or platform for self-investment have adopted several trusted approaches for many years. These include reducing risk levels over time (such as the age in bonds rule which advocates one percent of your portfolio in bonds per year of your age, eg 55% at age 55) or following 60/40 splits in favour of equities in the buildup phase and reducing risk much later. Structured products are clearly well positioned to address this goal because of their defined returns, emphasis on income or targeted growth and risk control. Most structured products tend to be three to six years in length depending on the preferences of the market they are issued in. This maturity range is particularly
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true of capital at risk products because that length generally gives the best trade off in terms of yield, upside and risk. Beyond this horizon the necessary index or stock options to help the hedging process are less liquid, particularly those linked to single stocks. This will result in fewer banks willing to quote for longer dated products and product terms reduced because of the increased risk reserving that will take place. Longer maturities make sense for capital-protected products because they can give more upside in exchange for the interest given up and the credit risk taken on. While simple participation products have been seen in many cases there are various problems to contend with. One is that writing long dated options has a lot of risk for banks caused by long term dividend and volatility assumptions. There is also the question of likely performance and future returns. If a product is offered with ten or more years full capital protection it is highly debatable that this is a sensible allocation of funds for the investor. Even if the protection is priced fairly the investor must take the view as to whether it makes sense and fits their views over the long term. As an alternative product, the cliquet payoff has been familiar
