structured products and new ways of investing in old asset classes

Question 1

A structured product is

Answer 1

a pre-packaged investment strategy in the form of a single investment.

Question 2

typical structured product will consist of two components:

Answer 2

1. A Note – essentially a zero-coupon debt security that provides capital protection, ie guarantees a return of all or part of the initial investment at maturity. 
This is sometimes referred to as the “principal guarantee” function. The guarantee may only be in place if the structured product is held until maturity. 

   
   2. A derivative component that provides exposure to one or several underlying assets such as equities, commodities, FX or interest rates. 
Returns from the derivative can be paid out in the form of coupons during the lifetime of the product, or added to proceeds at maturity. 


Question 3

Example of structured product

Answer 3

Let’s say an investor invests £100 for 5 years. £90 of this may be used to buy a risk- free bond and the remaining £10 can be used to purchase the options and swaps needed to implement the desired investment strategy.
In some, more complex, structured products, the amount invest in the zero-coupon debt security can vary dynamically over time depending on a predetermined view. And in others, the capital protection may itself be dependent on the performance of the underlying assets.

Question 4

Advantages of Structured products

Answer 4

Advantages
Structured products are also typically provided in a packaged format that provides advantages to investors over investing directly in the underlying derivatives, for example:
1. Practical – investors may be unable to invest themselves in the underlying derivatives. 
This could be that investors are not allowed to invest directly or that the trading costs prevent it being worthwhile. 

2. The structured product also provides a pre-packaged investment strategy that does not require active intervention by the investor. 
This saves time and also the costs of expertise that would otherwise be required. 

3. Legal – the format may be designed to satisfy legal or regulatory requirements as to accessible investments for a retail or institutional investors. 
So, an investor who previously did not have direct access to certain derivatives may be able to invest indirectly in them. 

4. Tax – the tax treatment from the structured product may be more favourable than direct investment. 

5. Accounting – for example, the product may be structured so as to avoid income statement volatility from the underlying derivatives. 

6. Favourable expected return / risk profile – depending on the type of structured product, enhanced returns and/or reduced volatility are claimed for these products. 


Question 5

Opacity od structured products

Answer 5

When investing in structured products, investors can find it difficult to assess whether a quoted price is competitive. This reflects that a structured product is a composite of several market exposures (which may themselves be opaque) and will often contain counterparty risk based on the issuer.
Also, distribution costs are generally not explicit and are normally implicit in the quoted price. Whilst it may be possible to track prices from several issuers for a simple structure, and thereby establish that a competitive price has been achieved, this is much more difficult to achieve with more complex or exotic structures or where proprietary indices are being used.

Question 6

Two common examples include:

Answer 6

 Interest rate-linked notes and deposits 


 Equity-linked notes and deposits. 


Interest rate-linked notes 

An interest rate-linked note or deposit is structured to pay one of two coupons linked to an index rate defined over a specific range and over a reference period:
 a higher coupon if the indexed rate stays within a certain range during a reference period 

 a lower coupon or zero if the indexed rate is outside that range during the same reference period. 
Because of the rate range and the higher interest accrual when rates are within that range, these notes are sometimes also referred as Range Accrual Notes. 
Equity-linked notes 
A simple example of a structured product would be a 5-year bond with a maturity payment linked to the higher of 100% of the initial investment and the performance of the FTSE-100 price return index over the period. In this case, part of the initial investment would be used to purchase a zero-coupon bond to provide the return of the initial investment, and the remaining funds would be used to buy an equity call option. The investor does not receive coupons during the investment term and does not benefit from dividend income on the equity index. 
Such products can be sold to retail investors who would otherwise be unable to buy equity options and who wish to benefit from the upside in the equity markets, are prepared to forego regular income but do not wish to put their capital at risk. 


Question 7

Example

Answer 7

A bank issues a 5-year bond which entitles the holder to the return on the FTSE 100 up to a maximum level of 50% growth over the 5-year period. The bond has a guaranteed minimum level of return so that investors will receive at least x% of their initial investment back. Investors cannot redeem their bonds prior to three years.
Explain how the bank can determine the value of x% at which it makes neither profit nor loss.

Question 8

Solution

Answer 8

If an investor buys a bond, then the bank can invest the money in the FTSE 100 so that it is not exposed to movements in the FTSE 100. However, the bank is guaranteeing that investors will receive at least x% of their initial investment back. The bank can hedge against losses greater than this by buying a put option on the index with a strike price of x% of the current index value. This put option will cost a certain amount of money, p, say.
The bank is also limiting the investors’ return to 150% of their initial investment. Because of this, they can afford to sell call options with a strike price of 150% of the current index value. This call option will be priced at c, say. If c = p then the bank will make neither a profit nor a loss. So the problem reduces to working out the price of the call option c and then the value of x such that c = p.
In reality, using computers and a suitable option-pricing formula such as the Black-Scholes formula, this would take a matter of seconds.

Question 9

Other structured products

Answer 9

More complex structured products enable investors to gain exposure to a range of different underlying asset classes, and to take more complex investment views, for example that markets will remain bound within a particular range and not hit certain extreme high or low levels.
Examples include:
 FX and commodity-linked notes and deposits 

 Hybrid-linked notes and deposits 

 Credit-linked notes and deposits 

 Market-linked notes and deposits

Question 10

he risks associated with many structured products,

Answer 10

Tespecially those products that present risks of loss of principal due to market movements, are similar to those risks involved with derivatives. 
Risks for investors to consider include the followin Counterparty risk – there is exposure to the asset or entity that provides any guarantee on the product. For example, Lehman Brothers provided the guarantee on a number of retail and institutional structured products.
These “guarantees” were not worth very much when the company filed for bankruptcy in 2008!  Liquidity risk – typically the payout under the product, including any guarantees, are fixed for a given maturity date. If investors wish to access their funds prior to maturity then they will be typically be exposed to the cost and price at which the underlying derivatives can be unwound. 
These costs could well be greater if the investor needs the funds very quickly. 

 Complexity – structured products can have relatively complex payouts and exposures, and investors should understand the risks involved. 
In practice, very few investors will understand precisely how the value of the structured product moves with the underlying assets. 

 Legal / tax / accounting – investors should form their own view on the legal / tax / accounting benefits of the structured product and its suitability for their circumstances.

Question 11

What are the main advantages claimed for structured products over direct investment?

Answer 11

.

Question 12

What are the two main ways to reduce counterparty risk?

Answer 12

.

Question 13

recently developed classes of instrument used as new ways of investing old asset classes

Answer 13

:
 Index Funds 

 Exchange Traded Funds 

 Contracts for Differences. 
When comparing the different methods of achieving an investment allocation, it is important for an investor to understand any differences between the returns that might be achieved, and the risks and costs (fees and other expenses) of each method. 
Where direct investment in the underlying asset, derivative contract or structured product are viable options, these should also be considered. 


Question 14

Index Fund is

Answer 14

an ‘open-ended’ unitised collective investment scheme that attempts to mimic the performance of a particular index. As such, it is passive management in action.
Investment management styles are discussed fully in Chapter 20.
However, due to the impact of management expenses they are not widely used by institutional investors. As with all mutual funds, the investor purchases or redeems directly from the fund at NAV (calculated at the end of each trading day).

Question 15

Advantages of index funds include:

Answer 15

 low expertise – tracking a target index does not require significant investment expertise (and hence cost). 

 low dealing costs – tracking a target index boasts the low fees of passive management . 

 simplicity – the investment objectives of index funds are easy to understand. Once an investor knows the target index of an index fund, the securities held the index fund are easily understood. 

 no “style drift” – passively managed funds need not be concerned with the drift in investment style that can occur with actively managed funds. Drifting between investment styles can reduce a fund’s diversity and subsequently increase risk. 


Question 16

Exchange Traded Funds (ETFs) are

Answer 16

the ‘closed-ended’ investment trust equivalents of (mutual) Index Funds. An ETF represents shares of ownership of a unit investment trust (UIT) which holds portfolios of stocks, bonds, currencies or commodities. The investor purchases the shares on a stock exchange in a process identical to the purchase or sale of any other listed stock.
ETFs are an unusual type of security that mixes many of the features of unit trusts and investment trusts that you will be familiar with from Subject A301. On the one hand they are referred to above as “closed ended” because in normal conditions, the number of shares is fixed. This is like an investment trust.
However, authorised professionals, referred to as “Authorised Participants (APs)” can approach the manager of the ETF and swap shares in the underlying portfolio for newly created shares. This often happens in quite large sizes, rather than ones and twos.

Question 17

What do you think are the disadvantages of index funds?

Answer 17

.

Question 18

Example

Answer 18

Example
Suppose that an ETF tracks the FTSE100 index. If an AP approaches the manager with a bundle of the 100 shares in the FTSE100, he can exchange these for new shares in the fund. The process can work in reverse if the AP wishes to exchange some ETF shares for a bundle of FTSE100 stocks.
So the fund can be considered “open ended” in this sense and hence, is more like a unit trust.

Question 19

The ETF’s performance tracks

Answer 19

an underlying index, which it is designed to replicate. Although the first ETFs tended to track broad market indices, more recent ETFs have been developed to track sectors, investment styles, fixed income, global investments, commodities and currencies. By the end of 2012 global ETF assets were in the region of $2trn, with the largest single fund (SPDR S&P 500) having assets under management in the region of $120bn.

Question 20

An important characteristic of an ETF is

Answer 20

the opportunity for arbitrage. When the ETF price starts to deviate from the underlying net asset value (NAV) of the component stocks, participants can step in and take profit on the differences.
This is the AP activity referred to earlier.
As usual, the actions of arbitrageurs result in ETF prices that are kept very close to the NAV of the underlying securities.
This is one of the big advantages of ETFs relative to investment trusts, which often trade at substantial discounts to the NAVs of the company. This does not happen with ETFs.

Question 21

several different types of ETFs, including:

Answer 21

1. Index ETFs – these are similar to index funds in that they hold securities and 
attempt to replicate the performance of a stock market index. 
Popular families of index ETFs include:
    SPDRs (which track the S&P 500 and major sectors of this index) 

    iShares (which cover broad-based US, international, industry sectors, fixed income and commodities) 

    PowerShares including the QQQQ NASDAQ 100 ETF. 
ETFs will not exactly replicate index performance due to tracking error. This is due to differences in composition, management fees, expenses and handling of dividends. 

   
   2. Commodity ETFs – these invest in commodities, such as precious metals and futures. Among the first commodity ETFs were gold exchange-traded funds, which have been offered in a number of countries (see iShares above). 

   3. Bond ETFs – examples include VIPERs (which range from broad-based to industry sector as well as international and bond ETFs) 

   4. Currency ETFs 

   5. Actively managed ETFs 

   6. Leveraged ETFs – a special type of ETF that attempt to achieve returns that are more sensitive to market movements than non-leveraged ETFs. They require the use of derivatives.

Question 22

Differences between ETFs and unit trusts and investment trusts

Answer 22

 Costs (annual fees) – ETFs generally charge lower fund management fees (“annual management charges”) than either unit trusts or investment trusts. This is because they are usually tracker funds, which can be run very cheaply. 

 Costs (commission) – ETFs are exchange-traded so trading incurs commissions and stock exchange trading fees, similar to an investment trust. There are no bid/offer spreads set by the managing company as is the case for unit trusts. 

 Tradability – ETFs can be traded in exactly the same way as shares in real time. This is an advantage relative to unit trusts, where the manager will generally trade only once a day. 

 Diversification – Because they are designed to track indices, some of which have several thousand shares, they may be very diversified portfolios.

Question 23

Contract for Differences (CFD) is

Answer 23

a contract stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at contract time.
For example, a CFD provider may quote an offer price of £4 for one share in Tesco. Let’s say that we buy 100 Tesco CFDs at this price to be settled the next day. If on the next day, the Tesco share price increases to £4.20, then we will be paid 100 × 20 pence = £20.
If the difference is negative, then the buyer pays instead to the seller.
If on the next day, the Tesco share price decreases to £3.85, then we will lose
100 × 15 pence = £15.

Question 24

CFDs allow investors to

Answer 24

take long or short positions and, unlike futures contracts, have no fixed expiry date, standardised contract or contract size. Trades are conducted on a leveraged basis with initial margins typically ranging from 1% to 30% of the notional value.
Let’s say that we have a 5% margin requirement of £20. With a typical 0.1% commission (40 pence), the total initial outlay would be £20.40.

Question 25

CFDs are available

Answer 25

over-the-counter in the UK, Europe, Australasia, the Far East and Canada. CFDs are not permitted in the US (due to restrictions by the US SEC on OTC financial instruments). Exchange-traded CFDs have recently been introduced in Australia.
CFDs were initially used by hedge funds and institutional investors to hedge their exposure to stocks in a cost-effective way.
Based on equity swaps, they had the additional benefit of being traded on margin and being exempt from stamp duty.
Originally (in the early 1990s) they were offered on LSE shares but have expanded to include indices, many global stocks, commodities, treasuries and currencies.
By the late 1990s CFDs were being offered to retail investors. They were popularised by a number of UK companies, whose offerings were typically characterised by online trading platforms that made it easy to see live prices and trade in real time.

Question 26

The most popular types of CFD are now based on

Answer 26

the major global indices (Dow Jones, NASDAQ, S&P 500, FTSE, DAX and CAC). CFD-related hedging is estimated to account for more than 25% of the volume in the London Stock Exchange.

Question 27

Initial and variation margin applies to CFD trading.

Answer 27

As with most OTC derivative trading, there is residual counterparty risk that the counterparty to the contract fails to meet their financial obligations.
If the counterparty to a contract fails to meet their financial obligations, the CFD may have little or no value regardless of the underlying instrument. This risk is mitigated slightly by the margining system

Question 28

Other risks include:

Answer 28

 market risk - the main risk with a CFD is market risk, as the contract is designed to pay the difference between the opening price and the closing price of the underlying asset. 

 liquidity risk - if prices move against an open CFD position additional variation margin is required to maintain the margin level. The CFD provider may call upon the party to deposit additional sums to cover this, and in fast moving markets this may be at short notice. If funds are not provided in time, the CFD provider may close/liquidate the positions at a loss for which the other party is liable.