6. Structured Products Flashcards
1
Q
What is a structured product?
A
• A type of investment product or asset.
• Provides customized risk-return profile not found in basic conventional products (such as bonds or shares).
• Constructed using multiple components
• 1/more of the components derives its value from the price/value of another underlying reference asset/entity, i.e. a derivative.
2
Q
What are the features (role played by structured products) that share similarities with unit trusts/mutual funds?
A
• Diversification
- ability to package exposure to multiple securities/asset classes
• Access to markets
- provide access to asset classes/markets that aren’t easily accessible to retail investors.
- eg: commodity markets — costly for retail investor to open an account in an exchange (due to minimum size requirements).
- enable individual investor to easily gain exposure to different geographical markets (eg: country with restrictive/protective barriers to foreigners entering the domestic markets — India and China)
3
Q
What are some of the structured products features which are not available via mutual funds/unit trusts?
A
• Access to different strategies
- traditional investment product’s default position is “long-only” — only profit when the price goes up.
- ability to short the market (sell high first, buy back low later) is restricted for many less-developed markets incl. Msia — restricted to large financial players.
- Structured products allows the use of these strategies (e.g. profit from a bear market) — embedded options can be structured to profit from all types of market movements (bullish, bearish, flat).
• Achieving leverage
- eg: using an option whereby the option price may only be a fraction of the underlying asset — option buyer can gain exposure that is larger than buying the underlying asset outright (i.e. buying in the cash market).
- returns can be leveraged — possible to earn more than 10% even if the underlying stock goes up by 10% only
- Investing directly in stocks gives investors unleveraged returns (i.e. if a stock goes up/down by 10%, the investor makes/loses 10%)
- BUT downside risk can also be amplified, increase market risk exposure
• Non-linear asymmetric payoffs
- customise risk-return payoff profile — combination of derivatives & exotic options (basket options, knock-ins, knock-outs etc)
- cater to different needs of different investor types.
- BUT doesn’t reduce/eliminate risk
• Principal protection
- principal protection up to 100% is possible — protect against capital loss + can capture any potential gain from the performance of the underlying assets.
4
Q
What are the different types of structured product (SP) issued in Msia?
A
- banking institutions
- SP issued via structured notes/negotiable instrument of deposit (NIDs).
- Due to variable nature of the returns, banks will issue NIDs in the form of floating rate negotiable instrument of deposit (FRNID) or NID-i (Islamic equivalent) - unit trust companies
- SP issued via capital protected funds, close/open-ended wholesale funds. - insurance/ takaful companies
- SP issued via structured investment-linked policies (ILPs), single/regular premium insurance products.
- ILPs are insurance products which provide insurance coverage + structured investment returns.
- premium paid by investors are used to buy insurance coverage & investment units in managed funds.
5
Q
What are the risks in structured products that don’t exist in traditional investment products?
A
Liquidity, credit, market risks
6
Q
Explain the liquidity risk in structured products (SP).
A
- 2 levels — structured product liquidity + embedded derivative liquidity
1. structured product liquidity - risk profiles of any 2 SP may not be identical since they are unique (even if features are alike) + react differently to changes in market rates — not easily tradeable.
- no active secondary market — to exit investment, need to sell it back to the ori issuer — significant liquidity risk as there is only 1 buyer & create credit risk
2. embedded derivative liquidity - derivatives are customized & hence unique — illiquidity arise, introduce a large bid-ask spread to the derivative pricing — can cause the mark-to-market values to be adversely impacted (i.e. lower bid price or higher offer price).
7
Q
What are other risks that are present in traditional investment products & structured products?
A
Mismatch, legal & currency risks
8
Q
Explain the credit risk in structured products (SP).
A
- risk that the issuer of the structured product may default & unable to repay the principal/returns
- need to examine issuer’s credit risk (rating agencies) & be aware of the possibility that the issuer can’t meet its financial obligations & costs associated with a given level of default risk.
- SP that r linked to credit exposures (eg: credit-linked notes (CLN)) have 2 levels of credit risk — underlying credit/reference entity credit risk & issuer credit risk
9
Q
Explain the market risk in structured products (SP).
A
- risk that investment value will change due to a change in value of market factors like interest rates.
- present in any risky financial product
- underlying asset performance affects derivative component’s performance in SP, which affects SP’s returns
- BUT investors may have higher market risk compared to traditional investment product due to:
1. Leveraged exposure: use of options as a derivative component can cause asymmetric payoffs — gains/losses can be amplified — eg: if the underlying stock rises 5%, SP linked to the same stock may provide returns of 10% instead
2. Impact of volatility: options cause SP’s value to be sensitive to underlying asset’s volatility — volatility drives the option value
3. Multiple exposures: SP can combine simultaneous market exposure in a single product, giving rise to hybrid instruments — eg: SP that r exposed to interest rates & commodities.
10
Q
What is mismatch risk in structured products?
A
- risk that the investments don’t match investors’ requirements like risk/return objectives and risk tolerance
• Tenure: Short investment horizon vs long tenor investment.
• Income needs: product that only pays at maturity vs need for periodic income
• Risk tolerance: A retiree seeking capital protected investment, buying a non-principal protected structured product instead
11
Q
What is legal risk in structured products?
A
- risk associated with uncertainty in the applicability/interpretation of contracts, laws or regulations.
- if there are any changes to regulations, guidelines or laws, there may be changes to the terms & conditions (T&C), including early termination
- Investors may be caught in a situation where T&C changes aren’t appropriate for them, hence causing potential legal risk
- investors need to ensure that they don’t breach any legal limitations that may apply to investing in structured products.
12
Q
What is currency risk in structured products?
A
- exists when the principal/returns of SP are denominated in a currency other than investor’s preferred currency
- Investing in SP that r denominated in foreign currencies exposes investors to currency fluctuations, causing gains/losses
13
Q
What is Zero-coupon Negotiable Instrument of Deposit (ZNID)?
A
- principal protected structured product
- issuer promises to repay the principal amount invested at maturity regardless of the performance of the underlying
- issued at discounted price
14
Q
What are the features of Zero-coupon Negotiable Instrument of Deposit (ZNID)?
A
• represents bank’s liabilities/obligation being the issuer of the NID.
• discounted instrument — price will always be below par
• doesn’t pay any coupon — coupon rate is zero
• potential return varies & not guaranteed
15
Q
How does the principal protection feature in ZIND arise?
A
- issued at a discount, ZNID value converges to the principal amount @ maturity, which provides the principal protection feature.
- only the principal amount (not the return) is protected, if held to maturity
16
Q
What’s the formula to calculate ZNID value at issuance?
A
ZNID discounted price = principal amount/[(1+r)^n]
where,
r = Interest rate (ZNID discount rate)
n = Number of years
17
Q
assume an investor invests 100% of the principal amount for a 3-year structured product. & prevailing interest rate is at 3%. What’s the discounted price?
A
ZNID discounted price = 100/[(1+3%)^3]= 91.51%
100% – 91.51% = 8.49% of the principal amount available as funding for purchase of the option component.
* in actual products a portion of the funding will go towards the payment of fees for the issuer.
18
Q
What are digital options?
A
- option that provides fixed payoff, regardless of the underlying price as long as the option is in the money
- aka binary options/all-or-nothing options.
- option holder can either get 0 or fixed amount of payoff
- Depending on the strike price & payoff level, can be structured to be cheaper than a plain vanilla option
19
Q
What are Knock-in and knock-out options?
A
- exotic options
- aka barrier options — has predefined barrier which act as a trigger
- path dependent — performance of the option relies on the level of the underlying price movement & price changes
20
Q
Example of knock-in option.
A
- option starts out in a “deactivated” state — option doesn’t exist yet
- If the underlying price touches/move past a predefined barrier, the option is “activated”
• Three-year Call option
• Underlying = Stock ABC
• Strike = RM5
• Knock in Barrier = RM6
• Current stock price = RM4 - risk to option holder — won’t get returns if the price never moves higher than RM6 — investor needs to be bullish on the underlying price performance (believes that the price will exceed RM6 for the option to be activated)
- aka up-and-in option
21
Q
knock-out example.
A
- option starts out in a “activated” state
- If the underlying price touches/move past a predefined barrier, the option is “deactivated”/knocked-out,
• Three-year Call option
• Underlying = Stock ABC
• Strike = RM5
• Knock-out Barrier = RM8
• Current stock price = RM4 - risk to option holders — won’t get returns if the price moves higher than RM8 — investor is betting that the underlying price will increase moderately (buying a call is bullish on direction of the underlying price movement), i.e. won’t exceed RM8
- aka up-and-out option.
22
Q
Example of a structured product where the embedded option is purchased by the investor.
A
3-year product, investor invested RM100k = bought:
• a ZNID (91.51%) — costs RM91,510 — comes with principal protection component — accrete to par value (RM100k) at maturity in 3 years’ time.
• RM1k paid to bank as fees
• remaining RM7,490 pay the premium to buy a call option on the S&P500 index with strike at 2200.
- investor hopes S&P500 index will increase (above the 2200 strike level) in the next 3 years
- Principal protected structured products will typically involve the purchase of option (option held by investor) — as an option buyer, the worst possible outcome is the loss of the premium paid, which is already accounted for as the funding made available from the ZNID structure.
23
Q
Callable range accrual structured product with KLIBOR as the underlying
A
- 5-year product, investor invested RM100k =bought
• right to receive coupon (higher than the prevailing deposit rates) subject to the underlying reference falling within the specified range. - issuer holds call option, has the right to buy back the entire structure at par (principal amount as the strike price) before maturity if desired
- product has an embedded call option “sold” by the investor to the issuer
- premium built into the coupon rate, hence the higher coupon rate compared to the prevailing deposit rates.
24
Q
when the options underlying are a form of index (eg. stock indices), the options are typically cash-settled as it is not possible nor feasible to physically deliver/own an entire index with all its multiple constituents.
A
25
What is the key selling point for most callable structured products?
higher yields
26
What is the risk in a callable structure?
1. Issuer exercise the call option — early terminate the product when it generates returns in excess of conventional investment — limit investors’ chances to earn the higher returns.
2. Issuer doesn’t exercise the call option when prevailing interest rates are higher than the coupon rate — investor forced to forgo the higher prevailing rates by being locked into a potentially long term structure
- investor can liquidate their investment — sell it back to the issuer, but may jeopardise the principal
27
What is Callable Range Accrual with KLIBOR as the Underlying?
- enables the issuer to call back (terminate & redeem) the product after the pre-defined “non-call” period — it’s this callable feature that enables the product to pay a coupon rate higher than the standard deposit rates
- assume product has a 5-year tenure, the non-call period is typically set at 6 months to 1 year.
28
Whats the risk of Callable Range Accrual with KLIBOR as the Underlying?
- exposed to reinvestment risk
- investor can only enjoy the enhanced coupon rate during the non-call period (i.e. the first year).
- Once the non-call period is reached, the issuer will call back the product (if the higher than average coupon payout is likely to continue) & pay the investor the original principal amount
29
How to make options cheaper assuming the investor has moderately Bullish View?
1. Use a Knock-out
- assume stock is currently trading at RM4, set knock-out barrier at RM7
- option premium even cheaper (compared to bull call spread) — forego additional profit above RM7 + option terminated if ever the price touched/surpass RM7
2. Bull call spread
- buy ITM call option (lower strike price) + sell OTM call option (higher strike price)
- strike at RM5, premium at RM1.
- don’t think stock price will exceed RM7 — thus willing to forego gains above RM7
- By foregoing the gains, option premium reduced to RM0.8 (thanks to the sale of the call option).
30
How to make options cheaper assuming the investor has Very Bullish View?
- use Knock-in
- strike at RM5, barrier at RM7
- option starts off being dormant & only triggered if the price exceed/touch RM7
- if at maturity the underlying price reached RM6.99 but never touched RM7, option still expire even though the underlying price is above the strike
31
How does Knock-in & Knock-out make options cheaper?
- even lower option premium as the option starts off dormant & has the potential to be deactivated even after the knock-in barrier is reached
- chances to exercise the option (i.e. receive the payoff) is much slimmer, but compensated by the cheaper option premium.
32
How does callable feature make options cheaper?
higher return from the implied premium paid by the issuer for the call option
33
What is a Range Accrual Structured Product ?
provides a periodic coupon (usually higher than normal deposit rates) subject to an underlying reference rate/price/index staying within a pre-defined range.
34
why is Range Accrual Structured Product’s coupon rate much higher than normal deposit rates?
investor in the structured range accrual note essentially sold options (a series of digital options) to the issuer & the premium paid by the issuer is implicitly priced into the higher coupon rate
35
What is the Payoff formula (assuming annual coupon payment)?
Nominal amount x (M/N) x coupon rate
M = number of (observations) days that the reference index falls within the range
N = total number of (observations) days in the interest period
36
Reference index : 3m-KLIBOR
Coupon rate : 5.00%
Notional amount : RM500k
In Year 1, the 3m-KLIBOR fixes inside the range (0 – 3.50%) every day of the year. As such M=N=365. So the payoff is :
RM500k x 5% x (365/365) =RM25k
37
Reference index : 3m-KLIBOR
Coupon rate : 5.00%
Notional amount : RM500k
In Year 2, due to expectations for rate hikes in the later part of the year, the 3m-KLIBOR fixes inside the range (0 – 3.60%) only for half the year (182 days). As such M=182, whereas N=365. So the payoff is:
RM500k x 5% x (182/365) =RM12,466
38
The risks of not receiving any returns for range accrual structured products depend on
1. prevailing level of interest rate (i.e. the spot rate) and its curvature (the steeper the curve, the higher the volatility, higher probability index fixing outside of the range)
2. volatility of the interest rate reference index
3. width of the pre-defined range.
39
What factors can exchange the range accruals’s rate of return?
1. Expectations for short term interest rate to increase in future (if rates are expected to be lower, issuer likely to call back)
2. Volatility of interest rates increases
3. Width of the range decreases (narrower range = larger coupon)
4. Frequency of callability by Issuer
40
Explain the callable feature of the range accrual.
- callable feature enables the issuer to call back the product at par after a pre-defined non-callable period has passed.
- when a range accrual product pays the full coupon (i.e. the reference index is inside the range all the time) & is expected to continue doing so, the issuer will call back the product at the earliest possible date — investor can only enjoy the full coupon rate during the non-callable period.
41
How does volatility affect coupon rate for index that’s already within the range or outside of the range at a moment?
1. If underlying index ady lie within the range
- the higher the index’s volatility, the lower the probability it’ll stay within the range, investor can set higher coupon
2. If underlying index lies outside of the range currently
- the higher the index’s volatility, the higher the probability it’ll move inside the range
42
What is a dual currency investment?
structured product that is linked to the performance of an underlying currency pair
43
What are the key features of a dual currency investment?
• short tenor (due to FX rates volatility) with maturity from 1 week to 1 month
• high yields — comes from the premium “paid” by the issuer for the option — can get double digit especially when event risks materialise
• investor will invest in the base currency & may be repaid in the alternative currency
• combines a money market deposit component + option component on the FX rate (investor has effectively sold an option to the issuer)
44
Currency pair: GBPMYR
Tenor: 7 days
Base currency: MYR
Spot rate for GBPMYR: 5.2500
Strike rate: 5.2000
Enhanced Yield: 8.00% p.a.
Principal amount: RM500k
Alternative currency: GBP
Scenario where FX rate on fixing date: 5.3000 – GBP has appreciated against MYR.
investor receives: principal + interest in the base currency.
Principal = RM500k
Interest = RM500k × 8% × (7/365) = MYR767.12
Total = RM500,767
45
Currency pair: GBPMYR
Tenor: 7 days
Base currency: MYR
Spot rate for GBPMYR: 5.2500
Strike rate: 5.2000
Enhanced Yield: 8.00% p.a.
Principal amount: RM500k
Alternative currency: GBP
Scenario where FX rate on fixing date: 5.1500 – GBP has depreciated against MYR.
investor receives: principal + interest in the alternative currency (converted at the strike rate (5.2)
Principal = RM500k
Interest = RM500k × 8% × (7/365) = MYR767.12
Total = RM500,767
Conversion = 500,767/5.2 = GBP 96,301.37 = RM495,952.05 (converted @ spot rate 5.15 — 96,301.37 × 5.1500 = RM495,952.05)
- In this example, the investor has sold a put option on GBP to the issuer — when the GBP spot rate drops below the strike rate, the issuer exercises the put option & sells the GBP (buys MYR) to the investor at the higher rate being the strike rate — hence investor suffers losses in the principal amount in Ringgit terms
46
What factor determines whether there is principal gains/losses in a dual currency investment?
spot FX rate at maturity
47
What are the factors that affect dual currency investment’s pricing?
1. Volatility: The higher the currency pair’s volatility (i.e. more possibility of breaching the strike rate) the more expensive the premium = higher yield
2. Spot rate vs strike rate (moneyness): If strike rate is near the spot rate (i.e. close to being In-the-Money), the premium increases = yield increases
* in the money: call (put) option — when underlying’s price above (below) strike price
3. Tenor: longer tenor increases the time value of the option = higher premium & yield
48
What are Equity linked notes (ELN)?
- structured products which provides a predefined return based on the performance of underlying equity/basket of equities
- relative high yield comes from the premium “paid” by the issuer to the investor for the put option
- At maturity, investors may
1. redeem the full principal amount + predefined return
2. redeem by taking delivery of the physical underlying shares at the predefined strike price (when share price at maturity is below strike price)
3. choose the cash settlement option — receive the value of the shares in cash.
49
What are Equity linked notes (ELN) redemption scenarios at maturity?
If Share Price at maturity is:
- At/above the strike price = 100% of principal amount + Fixed coupon
- below the strike price = receive shares = (100% of principal amount + Fixed coupon)/strike price
50
Underlying: Shares of ABC Corp
Current (spot) share price: $12.00
Strike price: $10.00
Fixed coupon: 8% (outright flat rate)
Tenor: 3 months
Principal amount: $100k
Scenario 1: Share price of ABC at maturity: $15.00
Investor receives 100% of principal amount + 8% = $100k + $8k = $108k
- investor received an 8% gain.
- if invested directly into shares of ABC corp, would have realized a 25% gain instead (15.00 – 12.00)/12.00 = 25%
51
Underlying: Shares of ABC Corp
Current (spot) share price: $12.00
Strike price: $10.00
Fixed coupon: 8% (outright flat rate)
Tenor: 3 months
Principal amount: $100k
Scenario 2: Share price of ABC at maturity: $11
Investor receives 100% of principal amount + 8% = $100k + $8k = $108k
- investor received an 8% gain.
- if invested directly into shares of ABC corp, would have realized an 8.3% loss instead (11.00 – 12.00)/12.00 = -8.3%
52
Underlying: Shares of ABC Corp
Current (spot) share price: $12.00
Strike price: $10.00
Fixed coupon: 8% (outright flat rate)
Tenor: 3 months
Principal amount: $100k
Scenario 3: Share price of ABC at maturity: $8
Investor will still receive the fixed coupon BUT paid in shares
Number of shares
= (Principal amount + Fixed coupon)/Strike price
= ($100k + $8k)/$10= 10,800 shares
BUT 10,800 shares are only worth $86,400 (10,800 x 8) — suffered a 13.6% loss.
- if the investor had invested directly, would have suffered a 33.3% loss instead (8.00 – 12.00)/12.00 = -33.3%
- In this example, the investor sold a put option on shares of ABC Corp at a strike of $10 to the issuer — when ABC’s share price drops below the strike price, issuer exercises the put option & sells the shares to the investor at the higher rate which is the strike rate.
53
What are the Factors that impact ELN pricing?
1. Volatility: The higher the volatility of the share price (i.e. more possibility of breaching the strike price) = more expensive premium & higher yield
2. Spot rate vs strike rate (Moneyness): If strike price is near the spot price (i.e. close to being In-the-Money), the premium & yield increases
3. Tenor: longer tenor increases the time value of the option = higher premium & yield
54
What is credit linked note aka CLN?
- structured product which has an embedded credit default swap to provide the credit risk exposure for the CDN holder
- CLN issuer transfers he credit risk to the CLN investor — exposed to issuer’s & reference entity’s credit risk
- CLN investors are willing to take on reference entity’s credit risk & in exchange receives periodic coupon payment (coupon rate x invested amount)
- functions similarly to a plain vanilla bond issued by reference entity
- assuming no default @ maturity, CLN issuer redeems CLN & CLN holder gets back full invested amount
55
What are the terminologies used in CDS that are similarly used when illustrating the operations of CLN?
• Protection buyer: party that transfers the credit risk away = insurance buyer
• Protection seller: party that takes on the credit risk = insurance seller (insurer)
• Credit events: pre-defined events that will trigger the termination of the product (Eg: reference entity bankruptcy, failure to pay, obligation acceleration, repudiation & moratorium)
* repudiate: borrower refuses to honor this contract & stops making the agreed-upon payments)
• Recovery value: % of the debt obligation that will be recovered by a creditor
• Loss given default, LGD: % of losses on a debt incurred by the creditor (Recovery value = (1 – LGD))
56
Scenario 1
In CLN, If the reference entity doesn’t default on any of its debt obligation…
the investor will be repaid the principal amount in full, similar to a plain vanilla bond at maturity.
57
Scenario 2
Prior to maturity, a credit event occurs. Based on the results of the CDS credit event auction (determines the recovery value of debt owed by the debtor/reference entity), the recovery value is $0.66 which means that for every $1 lent to ABC Corp, creditors will only be able to recover 66 cents. How much will the investor lose?
The investor will lose 34% of his principal & can only edeem 66% of the original principal. Thereafter, the product ceased to exist.
58
Credit linked note pricing (i.e. the coupon payable) is driven primarily by the following factors:
1. Credit risk of the underlying reference entity: The higher the credit risk, the more risky it is for the protection seller (CLN Investor) = higher coupon rate
2 Interest rate: sensitive to prevailing interest rate movements
3 Recovery method (Fixed versus Floating)
- floating recovery value: relies on the outcome of the credit event auction — recovery value reflects the actual market’s perception of the company’s value.
- fixed recovery value: fixed payoff, usually set at a low level, even as low as 0 recovery — increases the losses for the CLN investor — to compensate for this increased risk, a higher coupon rate will be paid
59
What is Collaterized Debt Obligation (“CDO”),;Collaterized Loan Obligation (“CLO”)?
- a form of asset backed security (“ABS”) where the “asset” pool consists of loans.
- issued by SPVs (Special Purpose Vehicles) which are shell companies setup for the sole purpose of raising capital via the issuance of securities such as CDO/CLO.
- CDO is viewed as a promise by the SPV to pay the CDO investors a coupon payment using the cash flow received from the asset pool.
60
What is the key defining feature of CDOs/CLOs?
use of tranching — slicing the CDO into different tranches, which have exposure to different level of risks
61
Explain the different level of risks in CDOs/CLOs.
• Credit risk: If defaults in the pool causes the cash flow to be insufficient to pay all the tranches, the lower tranches would incur the losses first, which have have lower credit ratings/higher credit risk = higher coupon rates whereas the senior tranches above will have a lower coupon rate.
• Reinvestment risk: If large number of borrowers prepay (partial or in full) the loans in the asset pool, generate extra cash flow to be received by the SPV — extra cash are paid to the higher tranches first = partially/fully redeemed ahead of the original maturity date
62
What is CDO squared or CDO and what caused the 2008 financial crisis?
- asset pool contains loans + other CDOs (CDOs are of lower quality which provides higher coupon)
- problem: the visibility into the creditworthiness & thus cash flow generating ability of the end-borrower is obscured by the multiple layer of securitization
63
What is Hybrid structured products?
- structured product which combine different exposure to multiple asset classes using derivatives.
- investor can access 1/more of the following asset classes, interest rates, equities, currencies, commodities, credit etc — includes access to markets which are relatively costly to invest in directly
64
What are the benefits of Hybrid structured products?
• Diversification: can be used to replicate the benefits from portfolio diversification. - As long as the individual asset classes have lower correlation among themselves, the benefits of diversification can be realized.
- also reduces the portfolio volatility & improve the risk adjusted returns
• Enabling arbitrage: the ability to go both long & short in different asset class
simultaneously will enable investors to profit from any market discrepancies.
- also makes it possible to implement market neutral strategies that attempt to capture performance attributed to alpha (excess return)
