Wealth Management Structured Products
What is a Structured Product A structured products is a financial product which helps you to customize risk by combining two or more underlying financial instruments . Typically in India it is made of a combination of fixed income instruments like zero coupon bond and derivatives like options or swaps E.g. Lets say you have $100 investment in a structured product which invests $80 in zero coupon bond which matures to $100 in 3 years while the rest is invested in derivatives for capital gain Structured products help in capital preservation while the return component comprises of other underlying financial instruments like securities, credit, forex, interest rates like LIBOR, commodities, synthetic indexes or any combination of these instruments
Structured Product B
B
A
Issue Date
Derivative investment $ 20 Value of zero coupon bond $80
Value of derivative investments
Value of zero coupon bond $100 A
Maturity Date ( 3 years later)
Types of Structured Product Two most important types of structured products are listed below • Structured notes • Structured funds In India we have structured notes so we will discuss structured notes in detail. Structured funds are similar to notes as such they include derivative on underlying assets with fixed income component but they can also only consist of derivatives.
Structured Notes-SN SN is a debt instrument with coupons or the market value linked to value of an underlying index. Can have one or more embedded options or derivative strategy. • Divided into principal component which is usually a zero coupon bond • Returns component is usually options linked to an underlying asset class SN can be issued by banks or financial institutions while the holders of SN hold the credit risk of the notes Wrapper is the legal form in which the structured product is offered to the investor. A structured note takes the form of a debenture. All debentures are senior, unsecured and unsubordinated debt . Structured deposits are very similar to SN except they are types of deposits and not debentures
Types of underlying asset classes in Structured Notes • • • • • •
Equity linked notes Interest rate linked notes Commodity linked notes Forex linked notes Credit linked notes Mix of basket of the above mentioned asset classes
Types of Structured Notes Yield enhancement structures RAN (Range accrual note) In RAN the coupon is linked to the performance of a reference interest rate index such a LIBOR . Enhanced interest is accrued if the reference index remains with the predetermined level or low or zero coupon is accrued when the index outside the range The structure is made of fixed rate bond combined with digital options of different strike prices namely caps and floor with cap having higher strike price than floors RAN can be callable or non callable ……………… Which has a higher coupon and why………………..think and answer Callable option gives the right to the issuer not the investor to call the note before maturity
Trading range of a RAN between two levels Index level
Movement of the underlying asset class
Start date
Tenure in years
Expiry date
Structured Notes Inverse floater This structure note pays coupons that are inversely linked to a floating interest rate index. The initial coupon is much higher than the bank deposit and as the interest rates go up the coupon reduces depending on the leverage factor Max(X%-Leverage *Floating rate index, min coupon) Multiple Callable RAN This RAN has embedded callable option at each interest fixing date. The holder of the note will receive a higher yield as he will be selling a Bermuda option on the top of buying a RAN. The issuer has the right to terminate the structure if on various fixing dates if the implied forward rates prove to be higher than the strike fixed rates which exposes the holder to reinvestment risk
Structured Notes CPPI ( Constant Proportion Portfolio Insurance) In this structure the portfolio is dynamically balanced between risky and risk free assets depending on the market performance. When the markets go up more capital is allocated to risky assets and vice versa Lets see in detail Lets assume you have invested $10000 in CPPI. Let this amount be A The investors will place all their assets in risk free assets when the capital reduces to 9000.This level is considered the floor (F). The amount A-F is called the floor. CPPI is calculated as follows A multiplier M is calculated It depends on the maximum one day loss lets and investors risk profile. Assume that the maximum one day loss is 20% the calculator is derived by dividing 1/0.25=4
Structured Notes The investor should allocate 4000 to risky assets based on the calculation M*(A-F)=4(10000-9000)=4*1000=4000 The rest is invested in risk free assets The portfolio will be rebalanced periodically depending on the market value of the portfolio. If the value of the portfolio increases to 11000 then the amount allocated to risky assets in 8000 while if the portfolio reduces to 9500 then the amount allocated to risky asset reduces to 2000 Risk in this product is that if frequent rebalancing is not done and if the value touches the floor then all the assets are invested in risk free assets and the investor losses all the capital gains DPPI (Dynamic proportion portfolio insurance) DPPI is same as CPPI except the multiplier is not fixed and is allowed to fluctuate within a band 3-5 with the initial multiplier set at 4
Structured Notes ETN(Exchange traded notes) They are structured notes listed on exchange and traded on exchange with risk on capital. They work like ETF except they do not have a tracking error and have different tax treatment. They have greater liquidity as compared to unlisted SN and are also exposed to the credit quality of the counterparty Index Linked Notes They are linked to an index and offer a minimum return on the capital apart from capital guarantee. The participation rate can be capped at a value for e.g. 10% p.a. Participatory Notes( PN) A tool used by foreign investors to invest in India in securities which is not registered with SEBI. PNs are issued by Indian companies and the underlying assets are stocks and any dividends or capital gains are received by holders of PNs
Structured Notes Notes linked to CDS (Credit Default Swap) These are non principal protected notes with underlying credit default swaps linked to companies. Since CDS is not liquid in India apart for some companies like Reliance, ICICI Bank to name a few Lets see how a CDS is structured
Knock Out Structures These are exotic structures where the pay off depends on the barrier level with respect to the underlying asset. If during the life of the option the price reaches or crosses the barrier level ( trigger level), a barrier event occurs and the option either Gets triggered and becomes operational or gets extinguished and expires The options barrier can be triggered with respect with the underlying asset’s Price level (Stock etc.) Index level ( Market level etc.) Exchange rate level (Forex) Interest rate level (LIBOR) A value computed by specific value for a customized basket
Knock Out Structures
Up & In calls and Down & In puts: These options work like a European option which are out of money and get triggered until the barrier is reached and the option become active Up & out calls and Down & Out puts: These options are in the money and the option terminates when the level is triggered
Types of Knock Out Structures Single Barrier Option When the barrier is reached the option is knocked out. The barrier level is the Call price and with respect to strike price 1. For a call barrier option the call price is higher or equal to strike price 2. For put option the call price is lower or equal to the strike price Lets see an example for call option Strike Price: 5 Knock Out Price : 9 Current Spot Price : 6 Case 1: At expiration spot price : 8…… Is the option worthless…. Case 2: at expiration spot price : 9.5….Is the option worthless….
Types of Knock Out Structures Double Barrier Option There are two barriers with one barrier at either side of the strike price One barrier is higher than the strike price and one lower than the strike price Double barrier options are know as double knockout options Lets see an example Strike price : 7 Knock out level 1 : 6 Knock out level 2 : 9 At expiration if spot price >= 9 or <=6, then the option is worthless If at maturity the option is worth 8, is the option worthless?..............
Advantages of Barrier Options Barrier options are cheaper and have more diverse selection since many views are Higher returns on capital since if the barrier conditions are satisfied Disadvantages They are OTC (over the counter) so less liquidity, credit risk as well as high upfront option premium
ELN Equity linked note : Nifty Lets see an ELN equity linked note to Nifty ELN linked to Nifty is of 5 years with capital guarantee at maturity .Further the product gives 120% participation in the equity markets i.e. 1.2 times the return on the index at the end of 5 years. Lets see the payoff Let the present value of Nifty be S0 and the level of Nifty after 5 years be S5. The initial amount invested be A. The payoff at maturity consists of minimum payoff of invested principal amount A Plus 1.2 times the appreciation of Nifty on the invested amount A 1.2*(S5-S0/S0)*A if S5>S0 or else just the principal A Total payoff= A+1.2*A*(S5-S0/S0) for S5>S0 =A+1.2A/S0max(0,S5-S0) Let A=10000, S0=5000
Equity linked note : Nifty This means that the payoff has a zero coupon bond of face value A along with 1.2A/S0 European call options with strike price S0 A=10000, S0=5000 so 1.2*10000/5000=2.4 call options are embedded in each note Now lets price these options After 5 years the price of the investment is principal A plus 2.4call options Lets say a compared zero coupon bond of 5 years is of yield 9% Calculating present value of the investment t=0, $10000
t=5y, $10000+2.4c
10000=(10000/(1.09)^5+2.4c=6499.3+2.4c where c is the value of each call option Calculating for c=1458.6 is the value of each call option in the note