L16 - Structured Products I Flashcards
1
Q
What are structured products/bonds?
A
- ”. • Structured products are investment products that provide a return that is predetermined with reference to the performance of one or more underlying markets.
- Structured products are investment products that combine at least one derivative with traditional assets such as equity and fixed-income securities
- Structured products are investment products that provide a payoff linked to a “formula”.
- structured bonds are a specific structure product that use a bond
2
Q
Why do investors use structured products?
A
- Capital Protection
- won’t lose your money (inflation loss etc.)
- High yield
- Diversification (underlying and payoff)
- can allow you to make money when the market is neutral not moving just up or down
- e.g. an instrument will pay you a coupon when the market doesn’t move
- Access to new strategies (Switch to recovery)
- switch from stock in a downturn
- invest in an instrument that allows you to recover from losses faster
- Risk reduction
- Fiscal efficiency
- used to reduce the amount of tax you may on capital gains
the more you move left the more risk you end up taking
3
Q
Example of Capital Protection?
A
- Grey is underlying
4
Q
Example of yield enhancement?
A
- Example uses discount certificates
- looks like a short put
- the market is looking stable and you want to increase your return
- now taking on an extra risk (could lose money if the price rises too much)
5
Q
Example of Participation product?
A
- you participate in the underlying but not in a long, delta one way
- In the twin win
- If the market goes up you make money
- if the market goes down you make money up to a certain point then you start losing
- In the twin win
6
Q
Example of the leverage effect with structure products (TURBO)?
A
- Give you leverage on the upside and downside
- used for short day trading position or to hedge your position with a small amount of capital
7
Q
How else can structured products be classified?
A
- structure products can be classified into the following too:
- Capital Protection
- Capital is protected in full or up to a certain percentage, but not going to lose it all or even more (leverage)
- Conditional capital protection
- you have capital protection if something does not happen
- Paid an 11% coupon up to the fall of the underlying of 30% then you hit the barrier and you will lose the same amount as the underlying without the coupon payment
- don’t have a maximum loss
- you can have an upside and downside barrier, aswell as a discrete and continuous barrier
- discrete will have a barrier on the day it matures
- continuous barrier changes every day @ 30% below the opening price for example
- you have capital protection if something does not happen
- Non-capital protection
- may have leverage on the upside but none on the downside –> but you have no capital protection so lose the same as the underlying does
- there will usually be a cap on the downside
- Leverage
- These have built in stop losses you get taken out of the market so you arent risking and losing more like with margin
- Capital Protection
8
Q
What are the three ways to make a capital-protected/equity protected product?
A
- need ot make sure you have 100% capital production with the payoff ((0 , (final underlying% - initial underlying%))
- You can create them in three ways
- Zero coupon + underlying
- Zero coupon + call option
- Underlyin asset + put
9
Q
How do you create a capital protection product with a zero-coupon bond and a risky asset?
A
- Buy a ZCB –> if the issuer doesn’t default you receive 100 (buy at 97 for example)
- Capital is protected
- Allocate remaining capital to the underlying
- e.g. have 100, allocate 3 to equity and 97 to the ZCB
In the first case the market goes up and in the second it does down –> you will gain in the first case whereas in the second while you lose the equity part you don’t lose your initial investment
10
Q
Pros and cons of a capital-protected structured product made up of a ZCB + a risky asset?
A
11
Q
What the problem with the fees in structured products?
A
- They are ‘implied’ which also could mean not transparent
- You are not sure how big the fee is
- However due to regulation all information is in the KID of the product (Key Information Document)
- includes risk,return and cost
12
Q
What do you need to create a structured product?
A
- Zero coupon
- Protection
- discount = 1/(1+r)^maturity of option
- Price = protection * discount
- Fee (charged by the bank - don’t usually want to change this)
- Option
- Option price (derived using BSM model)
- participation
- cost = option price + participation
- Total cost of structured product = Price of ZCB + Fee + cost of option
13
Q
What do you want the value of the structured product to be equal to?
A
- to how much protection is wanted to be covered
- e.g. offering 100 for 100% protection
- this could be done by changing participation
- can be done by changing the strike price
* Although this work in financial terms may be hard to explain to the investor
* the higher the base rate the lower the payoff ( this should be compensated by a higher participation rate or higher capital protection
- can be done by changing the strike price
- to affect the option usually change the maturity
* this changes the ZCB by lower the value if it increased while simultaneously increases the value of the option(more uncertainty so you have to pay more)
- to affect the option usually change the maturity
- could change volatility
* This means finding a different underlying with lower volatility
* using a well-diversified basket of stocks as the underlying can reduce volatility- A basket of indices tends to be less volatile than an individual index due to the imperfect correlation between the component indices. Since lower volatility means cheaper calls, this will improve the participation rate. The degree of participation increase is a function of the correlation.
- could change volatility
- find one with different dividends yields
* don’t receive dividends with options so if this increases the value decreases as you discount the dividends you are losing –> have high dividends to reduce the cost of the structured products (THIS IS FOR CALL OPTIONS)
* MAKE PUT OPTIONS MORE EXPENSIVE
* . A small increase in the dividends can be enough to increase significantly the participation rate
- find one with different dividends yields
14
Q
How can Conditional option protection reduce the cost of a structured product?
A
by buying a product with a barrier will usually be cheaper than the full capital protection version
15
Q
How can we change the ZCB in the structured product to change its costs?
A
- Reduce its protection level based on the capital market
16
Q
Creating a structured product with a zero-coupon + call option?
A
- Capital protection is given by the sum of two positions
- ZCB or a fixed rate deposit to provide a minimum return
- Call option on the underlying risky asset to provide equity linked to the upside
- Payoff = ZCBT + Max (ST-S0, 0)
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