How to Invest in Structured Products E-Book

Andreas Bluemke

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 639

Veröffentlichungsjahr: 2009

Beschreibung

This book is essential in understanding, investing and risk managing the holy grail of investments - structured products. The book begins by introducing structured products by way of a basic guide so that readers will be able to understand a payoff graphic, read a termsheet or assess a payoff formula, before moving on to the key asset classes and their peculiarities. Readers will then move on to the more advanced subjects such as structured products construction and behaviour during their lifetime. It also explains how to avoid important pitfalls in products across all asset classes, pitfalls that have led to huge losses over recent years, including detailed coverage of counterparty risk, the fall of Lehman Brothers and other key aspects of the financial crisis related to structured products. The second part of the book presents an original approach to implementing structured products in a portfolio. Key features include: * A comprehensive list of factors an investor needs to take into consideration before investing. This makes it a great help to any buyer of structured products; * Unbiased advice on product investments across several asset classes: equities, fixed income, foreign exchange and commodities; * Guidance on how to implement structured products in a portfolio context; * A comprehensive questionnaire that will help investors to define their own investment preferences, allowing for a greater precision when facing investment decisions; * An original approach determining the typical distribution of returns for major product types, essential for product classification and optimal portfolio implementation purposes; * Written in a fresh, clear and understandable style, with many figures illustrating the products and very little mathematics. This book will enable you to better comprehend the use of structured products in everyday banking, quickly analyzing a product, assessing which of your clients it suits, and recognizing its major pitfalls. You will be able to see the added value versus the cost of a product and if the payoff is compatible with the market expectations.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Disclaimer

Foreword

Acknowledgements

Goal of this Book

Who Should be Interested

Content Summary

Part I - Individual Structured Products

Chapter 1 - Introduction

Chapter 2 - Generalities About Structured Products

2.1 A DEFINITION BY ANALOGY

2.2 BUYERS, SELLERS AND REASONS FOR INVESTING IN STRUCTURED PRODUCTS

2.3 READING A PAYOFF DIAGRAM

2.4 READING A PAYOFF FORMULA

2.5 READING A TERM-SHEET

Chapter 3 - The Categories of Structured Products

3.1 CAPITAL GUARANTEED PRODUCTS

3.2 YIELD ENHANCEMENT

3.3 PARTICIPATION

Chapter 4 - Behavior of Structured Products During their Lifetime

4.1 MAIN VALUATION AND RISK MEASURES

4.2 CAPITAL GUARANTEE

4.3 YIELD ENHANCEMENT

4.4 PARTICIPATION PRODUCTS

4.5 OTHER PARTICIPATION PRODUCTS

Chapter 5 - Common Special Features of Structured Products

5.1 QUANTO OPTIONS

5.2 BARRIER OPTIONS

5.3 AUTOCALL AND CALLABLE OPTIONS

5.4 ROLLING PRODUCTS AND PRODUCTS WITHOUT FIXED MATURITY

5.5 CONDITIONAL AND ACCUMULATING COUPONS

Chapter 6 - Functionality Options of Structured Products

6.1 PHYSICAL OR CASH DELIVERY WITH EQUITY-BASED PRODUCTS

6.2 CLEAN PRICE AND DIRTY PRICE

6.3 LENDING VALUES

6.4 ISSUE MINIMUM/MAXIMUM SIZE AND LIQUIDITY

6.5 FUNDING RATES AND COUNTERPARTY/CREDIT RISK

Chapter 7 - Foreign Exchange, Fixed Income and Commodity Products

7.1 FX-BASED STRUCTURES

7.2 FIXED INCOME STRUCTURES

7.3 COMMODITY STRUCTURES

Chapter 8 - Recent Developments

8.1 CUSTOMIZED INDEX PRODUCTS

8.2 ACTIVELY MANAGED CERTIFICATES

8.3 ELECTRONIC TRADING PLATFORMS

Part II - Structured Products in a Portfolio Context

Chapter 9 - Introduction to Part II

Chapter 10 - Classical Theory and Structured Products

10.1 DISTRIBUTION OF RETURNS SHAPES

10.2 CLASSICAL PORTFOLIO MANAGEMENT THEORIES

10.3 CLASSICAL THEORY AND STRUCTURED PRODUCTS

10.4 CONCLUSION

Chapter 11 - Structured Solution Proposal

11.1 PREFERRED DISTRIBUTION OF RETURN INVESTMENT PROCESS

11.2 DISTRIBUTION CLASSES: THE RETURN DISTRIBUTION CUBE

11.3 AN INVESTOR’S UTILITY (VALUE) CURVE

11.4 QUESTIONNAIRE

Chapter 12 - Return Distributions of Structured Products

12.1 PROCEDURE AND DATA

12.2 CAPITAL GUARANTEED PRODUCTS

12.3 YIELD ENHANCEMENT PRODUCTS

12.4 PARTICIPATION PRODUCTS

12.5 CONCLUSION: PRODUCT CLASSIFICATION

Chapter 13 - Structured Portfolio Construction

13.1 PORTFOLIO CONSTRUCTION PROCESS

13.2 CONSTRUCTING A STRUCTURED PRODUCT PORTFOLIO IN THEORY

13.3 PREFERRED RETURN DISTRIBUTION PROCESS VERSUS CLASSIC PORTFOLIO MANAGEMENT

13.4 INVESTOR PORTFOLIOS

Chapter 14 - Final Words

Appendix A - Glossary of Terms

Appendix B - Distribution of Returns: An Intuitive Explanation

Appendix C - Questionnaire

Appendix D - List of Figures

Appendix E - List of Tables

Appendix F - Index Information

Appendix G - Issuer and Product-Related Websites

Bibliography

Index

For other titles in the Wiley Finance series please see www.wiley.com/finance

© 2009 John Wiley & Sons Ltd.

Registered office: John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

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The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.

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Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

Library of Congress Cataloguing-in-Publication Data

Blümke, Andreas.

How to invest in structured products : a guide for investors and asset managers/Andreas Blümke.

p. cm.

Includes bibliographical references and index.

eISBN : 978-0-470-68487-0

1. Investments. 2. Asset management accounts. I. Title.

HG4521.B562 2009

332.63’2 - dc22

2009015952

A catalogue record for this book is available from the British Library.

Typeset in 10/12pt Times-Roman by Laserwords Private Ltd, Chennai, India

This book is dedicated to my wife and children

Disclaimer

This book has been written for the purpose of information and discussion only. All information is indicative only, and should not be considered as advice in any way whatsoever including, but not limited to, legal, tax or other advice. This book shall not be construed as, and does not form part of, an offer, nor invitation to offer, nor a solicitation or recommendation to enter into any transaction. Some calculations are expressed in their simplest form and may differ from those used by practitioners. Some definitions are related purely to the contents of this book and may not fit in other circumstances. Although all material has been prepared with care, no representation, warranty or assurance of any kind, express or implied, is made as to the accuracy or completeness of the information contained herein. No act or omission of the author or the publisher in relation to the information contained herein shall constitute or be deemed to constitute, a representation, warranty or other undertaking of the author or the publisher. No representation is made as to the reasonableness of the assumptions made within or the accuracy or completeness of any back-testing. Any data on past performance or back-testing contained herein is no indication as to future performance. Neither the author nor the publisher can be held accountable for any direct, indirect, incidental or consequential losses arising from the use of this book or reliance on parts of its contents, or other information contained herein. The author is not sponsored, funded or otherwise financially supported by any corporation or firm cited herein. All rights reserved.

Foreword

In general, investment product clients include pension funds, foundations, endowments, insurance companies, banks, investment intermediaries and retail investors. Each group faces a unique set of investment objectives and constraints that must be addressed in order to effectively manage their investment portfolios. Reality shows that these considerations are, unfortunately, rarely confronted in a systematic way, which leads to avoidable misallocations of investments. This book is one of the first contributions on the topic that includes a comprehensive list of factors an investor needs to take into consideration before investing. This makes it a great help to any buyer of structured products. It also gives guidance on how to construct a portfolio of structured products. Given the large number of products typically present in portfolios nowadays, this is a significant addition to the existing literature.

It is essential to identify the needs, targets, and risk tolerance of the investor, as well as the constraints under which the investment portfolio must act, and to formulate an investment strategy that consolidates these potentially conflicting requirements.

The next step, after identifying the client’s objectives and constraints, is to determine the investor’s expectations regarding the development of the capital markets, by separately identifying his views about different asset classes and sectors. These forecasts of risk and return characteristics form the basis for constructing portfolios that maximize the expected return for a given level of risk.

Once this is done, the strategic asset allocation for the investor can be determined. Here one combines the above gathered information regarding expectations, risks, needs and constraints to determine target asset class weights. The definition of maximum and minimum asset class weights is an optimal way to build up a simple risk-control mechanism. The investor may seek both single-period and multi-period horizons in the return and risk characteristics of asset allocations. A single-period horizon has the advantage of being straightforward but a multi-period horizon better addresses the liquidity and tax considerations that arise from rebalancing portfolios over time.

Many institutional and retail investors make portfolio allocations to alternative investments, such as structured products and hedge funds, that are comparable in size to those they make to traditional asset classes, like equity and bonds. In doing so, such investors may either seek risk diversification and/or yield enhancement. Investors who take advantage of the opportunities presented by alternative investments may have a substantial advantage over those who do not, as long as they fully understand the risk and return potentials of these investments. Therefore, performance evaluation and attribution provide an essential measurement service to investment managers and investors themselves.

Although there are many books describing the functionalities of structured products, the above-mentioned issues, especially the use of structured products in a portfolio context, remain mostly untouched. The main contribution of this book lies in focusing on the above issues and finding solutions that are suited to the daily use for investment advisors and portfolio managers. The contributions can be divided into four parts.

First, the distribution of returns cube is a development of the risk and return decision of an investor, since it widens the definition of risk by allowing the skew and kurtosis to enter in addition to the standard deviation. While a low standard deviation is always preferable for a risk averse investor in a non-portfolio context, the choice of the correct skew and kurtosis also depends on other preferences.

Second, to determine these preferences, the book provides a comprehensive questionnaire. By applying the latest results from the field of behavioral finance, it seeks to prevent investment advisors and investors from applying less than ideal decisions.

Third, it offers an analysis of the return distributions of common structured products, which not only provides useful results but also offers valuable advice on how to analyze future investment options. This is done by approximating not only the mean and standard deviation, but also the skew and the kurtosis of the distribution, which must not be neglected in investment decisions.

Finally, the book’s contribution lies in combining all the above-mentioned results to show how to ideally construct portfolios and how to implement structured products to reach the most value added.

Jan SchochEFG Financial Products AG Partner Manager Financial Engineering & Distribution

Acknowledgements

It is a particular concern of mine to thank those who helped me to write this book.

My first thanks go to my team colleague, Dr Christian Bührer, whose input I always appreciated; to Daniel Huber for reading the first draft of the book and providing feedback before anybody else; to Jan Schoch, Christoph Baumann and Christian Sperschneider for their early support of the project and back-test spreadsheet programming; to Florence Tato for her insights on customized indices.

I am deeply indebted to John Marion, as well as to Matthew Cornes, Janis Nitsios and Edward Ennis, for their helpful grammatical revision and constructive content suggestions for various parts of the book.

A warm thanks go to the Wealth Engineering crew: Christoph Boner for guiding my thoughts in the search for a model integrating structured products in a portfolio context; Dr Ana-Maria Matache and Dr Ilya Karmilov for teaching and assisting me with the kurtosis and skew of return distributions; Dr Thomas Stadler for the tool to calculate a product’s behavior during its lifetime; Jürg Sturzenegger and Ernst Näf for their encouragement and support to finish the project.

I also wish to thank Peter Pilavachi, Alain Krüger, Alain Alev, Jad Nahoul, Christoph Roos, Markus Engeler, Konstantin Gapp, Lorenz Roder, Jacques Sebban, Markus Jetzer, Richard Baker, François Péningault, Marcel Köbeli, Guillaume Subias, Karim Shakarchi, Robert Zimmermann, Sascha Ziltener, Patrick Stettler, Michela Borgia, Miguel Haupt, Thilo Wolf, Urs Kunz, Christina Halin, Christoph Roos, Mario Koglin, Jan Auspurg, Thomas Frauenlob, Pierre Bès, and the many other product specialists not listed here, for sharing their knowledge of structured products and providing numerous examples, as well as for the discussions on market views and appreciated comments about the structured product industry.

Thank you to all the client advisors I have had the pleasure to work with; you are too numerous to be mentioned here, but you are remembered.

I really enjoyed every step of the publication process with Pete Baker and Aimee Dibbens at Wiley Finance, whom I thank for their support, encouragement and guidance for a first-time writer.

I thank my parents, especially for granting and supporting my education. Without you, I would not be where I am today.

Last but not least, a very big thank you to my family, for the long hours of solitude they endured while I wrote chapter after chapter of this book. The door will stay open from now on.

Goal of this Book

The intention of this book is to familiarize financial practitioners with structured products commonly used in Europe. It is specifically designed for investors already using or considering the use of structured products in their portfolios, and for investment advisors1 working in private banking who may recommend products to their clients. Professional money managers such as asset and portfolio managers will also find valuable processes and criteria for use in evaluating structured products as potential investments in their portfolios. The products are not only considered as stand-alone financial constructs, but also in the context of the portfolio into which they would fit. Further consideration is given to the market conditions at the time of investment, and which type of products qualify for the given conditions. In addition, an original approach of establishing an investor’s risk-return profile is developed and a method to build a preferred portfolio including, but not limited to, structured products is presented.

After reading this book, investors will be able to differentiate and classify the products they see in the market, on the different issuers’ websites or in newspaper advertisements, and know which ones would roughly fit into their portfolio. Structured products end-users will understand the fine points of the products and learn how their secondary valuations evolve during their lifetimes.

Investment advisors will be able to better comprehend the use of structured products in everyday banking. Quickly analyzing a product, assessing which of their clients it fits, and recognizing its major pitfalls will become common practice with the help of the methods included in this book. Advisors will be able to see the added value versus the cost of a product and whether the payoff is compatible with their market expectations. Elements of behavioral finance theory help the advisor understand the choices of his2 clients and advise them correctly on structured products investments.

In addition to the above, the book proposes a practical process for selecting between basic assets (like bonds or stocks) and structured products having those basic assets as underlying. Portfolio and asset managers can take advantage of this method to structure their portfolios efficiently with different types of return distributions. Timing, structure and characteristics of products in relation to those of their underlying assets are discussed. Classical theories like Modern Portfolio Theory are analyzed from a structured products perspective. An innovative approach to asset allocation and asset classification opens new horizons compared to the classical risk-return methodology. Portfolio and asset managers will be able to integrate fully structured products into their investment processes.

Abundant studies about the effect of options of any sort on portfolios have been published in the specialized press such as The Journal of Finance or The Journal of Portfolio Management . However, these articles are written in a high-level technical way and are intended for a professional audience. An end-investor, and probably even some of the professional money managers, would be hard-pressed to find the advice or knowledge they were looking for in these publications. In this book, care has been taken to keep the text flowing easily, with the help of diagrams and tables. The products and the concepts are described simply, but encompassing enough detail that the reader can make a complete image of them.

Who Should be Interested

In this book, the whole value chain of structured products is considered using an impartial, unbiased approach. From the conception of the product to the end-user, who is the final investor in the product, every aspect is analyzed. Hence, the book addresses the following large audience:

• private individuals investing in financial markets;

• high net worth individuals;

• investment advisors of banks (otherwise known as relationship managers, customer relationship officers, client advisors);

• independent investment advisors;

• investment consultants;

• asset managers;

• portfolio managers;

• mutual fund managers;

• pension fund managers;

• structurers (buy-side and sell-side);

• family offices;

• education officers.

The book focuses on products typically used in private banking. Institutional investors will also find many useful explanations and descriptions of products, but CDOs, structured finance (like for the municipal market), and mortgage- or asset-backed types of products are not treated herein.

The book does not include many mathematical formulas. Many concepts are explained in words, graphics and examples rather than in formulas or complex diagrams, as it is not the goal of the book to prove known mathematical concepts, nor is the target audience interested in crunching numbers.

However, some prerequisite knowledge is required. It is assumed that the basic option theory (calls and puts) as well as the definitions of yield, interest rate and the time value of money are understood. In short, having a rough idea how financial markets generally work makes the reading easier.

Content Summary

This book is divided into two parts. The first deals with structured products as individual, stand-alone investments. The second examines structured products in the portfolio context.

The first part can be read in chronological order for readers who have little or no experience in structured products. The first chapters are used to introduce basic concepts in an easy and understandable way. People familiar with the concept might want to skip some chapters, like “Reading a payoff diagram”. After the reader has familiarized himself with the terminology and basic characteristics, the approach and analyses become more complex. In the later chapters, the reader will discover how a product behaves during its lifetime, why it does so, and how to avoid common and less common pitfalls. Products across all asset classes are considered.

The second part addresses the implementation of structured products in portfolios considering investment preferences. Not only private investors, but also portfolio and asset managers, will find helpful concepts for integrating structured products in their decision processes and ultimately their managed portfolios. Classical modern portfolio theory is revised to adapt to the asymmetrical return distributions of structured products, and the investor’s classic investment preferences of risk and return (sometimes in the light of behavioral finance aspects) are enhanced with skewness and kurtosis of returns, both concepts being duly described. A questionnaire will help to define the investment preferences, and extensive back-testing of products yields the typical distribution of returns for major product types. Ultimately, examples of portfolios combining the investment preferences with the analyzed products are built.

At the end of the book, a glossary of technical terms will help the reader understand the jargon used in connection with structured products. An intuitive description of return distribution shapes and a list of websites referring to issuers of structured products and related topics are also provided.

Part I

Individual Structured Products

1

Introduction

Structured products have been on the rise since the late 1990s but then lost the trust of the investors in the credit crisis of 2008. Global statistics are difficult to gather, but an estimated EUR 1000 billion of structured products investments were held in portfolios worldwide as of 2007. According to the Swiss Association of Structured Products SVSP3, assets of over EUR 220 billion were invested in structured products held at Swiss banks in 2007, which amounted to roughly 6.5% of total assets under management in Switzerland. In Germany, the second-biggest market, about EUR 134 billion were held in portfolios. Since then, the amounts have sharply decreased. Nevertheless, individual as well as institutional investors have recognized the benefits structured products generate with their specific risk-return profile that cannot be replicated by the usual investment vehicles such as equities or bonds.

In fact, the structured product market grew so fast and became so diverse with thousands of payoff profiles in all asset classes, that many stakeholders, be they banks, financial regulators or private or institutional investors, were caught unaware and had no systems, rules, laws or processes to cope with the sheer amount of innovation that appeared in so little time. However, professionals in their respective fields reacted quickly and allocated enough resources to handle structured products: systems were programmed, rules and laws came into effect, and processes were implemented. The two stakeholders that were partially left out in the resource allocation were those furthest out in the value chain: the investment advisor and the end-user. Structured products knowledge was slow to come to private banking investment advisors, and hence to investors being advised by them.

The success of the financial industry as a whole, as well as that of individual products, is measured by the revenues they generate. Consequently, the industry’s best interests are served by satisfying the needs of the investors. Whatever type of product sold most must therefore inevitably be the one preferred by investors. But does the end-user really know what he is buying, even though the terms are written on the final term-sheet? Have his preferences correctly been assessed, or have they possibly been framed in such a way that the investor only believes that one or the other product corresponds to his preference? The author supposes that a majority of private and institutional investors do not have a deep enough understanding about the products’ functioning and the associated risks. How could they? Even the professionals do not always agree and sometimes are not aware or don’t consider all the risks embedded in the products.

The volume-driven incentive structure of the industry and the relatively poor end-user knowledge has led to markets becoming overwhelmingly concentrated in a certain type of product, based on investors’ uninformed preferences and decisions. In one of the largest structured product markets, Switzerland, the private banking clientele’s appetite for one particular type of product from 2004 onwards outshone any other product category offering, despite the fact that more attractive and financially superior (on an after-tax basis), products could be invested in. This ravenous consumer appetite caused issuers to push the cost-minimizing and volume-maximizing structure known by the name of “worst-of barrier reverse convertible”! It first brought about the assignment to investors of financial stocks in the subprime crisis of 2007/08 and distorted many portfolios’ risk structure in addition to producing heavy losses. As the crisis deepened and stocks plunged on a broad basis, all kind of stocks were assigned. In another large market, Germany, it was the “discount certificate” that took the lion’s share of the investor’s attention. A similar tendency happened on the other side of the globe, where clients in Hong Kong, Singapore and other Asian countries rushed to the “leveraged stock accumulator”. In Korea, the attention was focused on the “autocallable reverse convertible”. All the above-mentioned products were based on similar construction techniques and met with the same fate: a large number of their barriers were broken through, thus knocking the embedded short options in, much to the chagrin of the investors.

Structured products, which have never enjoyed a particularly good image, have become disreputable, particularly after the subprime/credit crisis. Especially since the demise of Lehman Brothers, structured products have come under heavy criticism. Aren’t CDOs4 structured products? Aren’t bad mortgages repackaged by financial institutions and sold as CDOs? Isn’t the source of the subprime crisis bad mortgages? Didn’t the subprime crisis develop into the worst financial crisis since the 1930s and make everyone the poorer? Yes, yes, yes and again, yes. Yet it’s not the investment vehicle that is to blame; rather it is the people participating in the game, and that includes everyone from the structurer to the final investor.

If anyone opens a European financial newspaper, journal or review and takes a look at the advertisements, he will notice that many of them are about structured products. Those ads are not about complex structures like CDOs, which are products used by institutional investors such as insurance companies or pension funds. Instead, most ads are promoting what seem to be simple investment strategies based on popular themes or commonly-known stocks or indices. Their content usually consists of great sounding but meaningless slogans, double-digit coupons or bonuses, nice pictures, fancy product names not found in any dictionary and colorful graphics as well as a lot of small print. In fact, structured product promotions don’t differ that much from car or holiday ads. The only difference is that product names like “Reverse Convertible”, “Bonus Certificate” or “Capital Guaranteed Product”, commonly-found word combinations in structured products, are not as explicit as “The new Toyota Avensis” or “Sunny Holidays in Ibiza”. However well conceived or badly presented, structured product advertisements are still only just that: advertisements. They simply represent a means for a product issuer to tell its potential clients that there is a new product on the market, and to encourage investment in it. Beyond that, the advertisement isn’t helpful to the private investor. A sensible person doesn’t buy a car or book a trip based only on the information included in the advertisement. The car is a complex machine, which needs to be examined closely, test-driven, have its options tried out . . . The holiday needs to be analyzed, flights checked, hotel rooms and locations scrutinized . . . The same goes for a potential investment in a structured product which - if anything - is a complex form of investment. Not only must the structure fit in the investor’s portfolio, but also its maturity must match - or at least not exceed - his estimated holding period; the worst-case scenario should be considered and the potential effect such a scenario would have on the portfolio measured, etc. Falling into a habit of investing in the same structure repeatedly just because it seems to work well is one of the worst mistakes that investors can make. Unfortunately, besides the four universally acknowledged fundamental forces of nature (strong, weak, electromagnetic and gravitational), in the author’s view, there is a fifth, obviously stronger than all the others: the force of habit. In the years from 2003 to 2007, numerous private investors found structured products attractive, cashed in high coupons or bonuses and were happy. Many repeated, multiplied and even leveraged investments as if they were a bonanza, until a bear market and the bankruptcy of Lehman Brothers came along. Suddenly everybody was finger-pointing structured products as being responsible for the whole disaster. Many structured product investments turned out to be unsuitable for some portfolios, and at least some investors found out that the worst-case scenario could not be borne. Many complained about having received bad advice. Despite the products’ poor performance in the recession that followed the bull markets, the products themselves should not be seen as the cause of the investor’s ire. As in a car crash, it’s not the car that is responsible for the harm done, it’s the driver behind the wheel. If the car had an unknown technical flaw, one can blame the constructor. If it had a known flaw, blame the seller or reseller. Finally, if the car was not fit to be driven on the road, one could even blame the authority that gave it permission to be driven in the first place. In any case, the car is not responsible. The same goes for structured products. The structurer constructing it, the seller marketing it, the client accepting it, the regulator watching it, the management cashing it, all bear a partial responsibility, but the product itself is innocent. Whatever may have been, it’s useless to play the finger-pointing blame-game or dwell on the things of the past. So why not take a fresh start and reconsider structured products as just what they are: an investment vehicle or tool that can be useful when searching for investments that match one’s risk-return profile.

This book casts a critical eye on the world of structured products and the factors that influence it. It helps end-investors to consider structured products from different angles and take rational, considered investment decisions. Have a look at the advertisements in the newspapers again after reading this book; they will surely appear different.

2

Generalities About Structured Products

2.1 A DEFINITION BY ANALOGY

A strict definition of structured products would state that:

Structured products are financial assets, which consist of various elemental components, combined to generate a specific risk-return profile adapted to an investor’s needs.

So far, so good; but which components are combined together, what’s a specific risk-return profile and how does an investor know that it’s adapted to his needs? For one, there is no limit to the possible permutations; think of Lego bricks - dozens of different objects can be built with the same bricks. Given enough bricks, the possibilities become quasi-infinite. Likewise, structured products are formed by combining options with bonds or options with other options, and there are millions of options and bonds. The options themselves must be based on something: a stock, an index, a yield curve or a commodity - options exist on practically everything. When an option allows (or forces) an investor to buy or sell a certain asset, it creates a certain return profile linked to a particular risk. So the combination of options on certain assets with or without a bond component creates a specific risk-return profile. Options are often considered as risky instruments best left to the speculators but, in certain arrangements, they rather reduce the risk of an investment when comparing it to the underlying asset. Whether any particular arrangement of options is suitable for an investor remains for him to decide. The second part of this book helps the investor to determine which kind of risk (and return) is likely to be suitable for his needs.

The product’s mathematical payoff formula5 could be of help. The “specific risk-return profile” of each product is after all fully defined in it. Indeed, the final value of a product can be directly calculated by its payoff formula. However, few people really have the time to replace symbols with numbers in complex, often unintuitive, equations written on the term-sheets. Even if that exercise is performed, it tells the investor less than it should because the probability of actually getting any specific result is not included in the calculation. In fact, it is not even necessary to understand the full mathematics behind every term-sheet. Think of it like a toaster or coffee machine: it’s pointless knowing what amount of electricity is needed to toast the bread or heat the water, only the purpose and the operation of the machines must be known. As with everyday household objects, investors only need to know how and when to use the products, and not necessarily how they are constructed. It is nevertheless important to know the general purpose as well as the most important key points of a structured product. For most people, understanding the purpose of a product in words or through a graphic is much easier than studying the math behind it and then drawing the conclusions from them.

To begin with, let’s first examine the purpose of structured products through an example that everyone, even somebody altogether without financial experience, can understand.

Let’s imagine a person, Dominique, who wants to drive from Paris to Milan. To do so, he would buy a car. Now, imagine that Dominique wants to invest in equities: he would buy a stock. Reverting to his trip from Paris to Milan, he might think: “Hmm, the road could be long and dangerous; maybe I should buy a car with an airbag and an anti-lock braking (ABS) system, to increase safety.” The stock market equivalent of buying an airbag and ABS system would be buying a capital guarantee on top of his stock investment. This simple action, combining stock exposure with a capital guarantee, would already form a structured product.

Dominique further reflects that he wouldn’t know how to get from Paris to Milan and that a global positioning system (GPS) in the car would be helpful. He doesn’t know either if this is the right moment to enter the stock market. Similarly, Dominique could add a look-back option to his stock investment together with the capital guarantee. This would add another optional feature to his structured product. Table 2.1 summarizes the situation.

Table 2.1 Structured products and car analogy

It is thus possible to compare the construction of structured products to the construction of a car and its various options. As mentioned, structured products often consist of a financial underlying asset and an option pasted together. The financial asset can be a stock, an index, a commodity, a fund, etc. The option can be a call or a put; it can be plain vanilla or exotic. Several options can be added to the underlying. Also, a single structured product may be linked to several underlying assets. So a product may quickly become complex, and with all the different option strategies and the different underlying assets to choose from, the number of possibilities rapidly becomes tremendously large. Add to that the fact that several underlying assets can be combined with several options and the number of possibilities approaches infinity. Add the time dimension (the same product issued one day later will not have the same parameters due to market movements) and the possibilities are indeed infinite.

Adding options does cost money and leaves investors like Dominique with less to begin with. Does it pay off? How does one know? As with the car, it might be a good idea to include some features that are or may become useful, even though no one would ever hope to use some of them. Including an airbag with the car is a sensible thought to protect the driver, but he would actually do his utmost to prevent its use. The ABS also comes in handy, but it also comes into play only as a last resort. These options are not free, they each have a specific cost and they can be thought of as insurance. They prevent or lessen the impact of the worst-case scenario, a crash. A structured product with a capital guarantee relates to this category. No matter what the underlying does, the investor will not lose his capital, since it is protected. Does an investor want a capital guarantee to be triggered when his product matures? Certainly not, since if that scenario were to occur, it would mean that the underlying did not behave as expected and the return on capital would likely be zero percent. Yet a logical reason to spend money on a capital guarantee would be the uncertainty about the future performance of an underlying asset. Since it is seldom possible to know beforehand how an asset price will evolve in the future, investors with low risk appetite will be better off with the option than without.

What about the GPS in the car? This feature can be considered as a performance enhancement . It allows a driver to reach a destination faster without losing his way. In structured products, it can be compared to the look-back feature. A look-back allows the buyer to set the level of strike of an option some time after it was bought. The buyer will always select the best point for himself: if he bought a look-back call, he will choose the lowest point the market reached within the look-back period; if it was a put, the highest point will be selected. Hence the name of the option, look-back: the buyer looks back at what the market did and chooses the best strike for himself, improving his performance. Obviously, this feature can be quite expensive.

The two paragraphs above discuss the investor’s possibilities and needs. Assessing them correctly is a tricky exercise, which is often neglected or assessed too quickly and without proper consideration. Yet, that need assessment is the most important step in the value chain of investing in structured products.

Extending the above reasoning to encompass all possibilities on all assets, structured products can be defined as a toolbox of options, with which investors build their preferred risk-return profile by specifying their desired options, as they would build the car of their dreams according to budget. The cost of too many options may become prohibitive and needlessly increase the complexity of a product; is it useful to have a mini-bar and two large LCD TV screens in the car? It may be nice to have, yes, but superfluous to fulfill the car’s primary mission, which is to transport someone from A to B. When constructing or choosing a structured product, best avoid features that are not necessary, but stick to those features deemed essential.

Structured products are not an asset class by themselves, even though some practitioners like to think so. Rather they are means to either enhance the performance or reduce the risk of an asset or a portfolio, independent of the asset class on which they are based. Structured products are no freebies, and there’s no such thing as a “Harry Potter” product summoned with a magic wand. A product always has a cost associated, even if it is only an opportunity cost. Whether a particular product is of use to any particular person is an analysis that only this person can make, because only he knows his own risk-reward profile.

2.2 BUYERS, SELLERS AND REASONS FOR INVESTING IN STRUCTURED PRODUCTS

2.2.1 Institutional buyers

Institutional investors around the world buy, hold and trade structured products. They include pension funds, insurances, banks, municipalities, non-profit institutions, asset managers, hedge fund and mutual fund managers. An institutional investor will select structured products as an investment vehicle when other, classical, vehicles are not available or do not fit his investment needs. Suppose, for instance, that a pension fund has a future liability stream whose payoff depends on the level of the interest level of the EUR 3-month Libor (EURIBOR) interest rate and the yearly stock performance starting in five years and for the next 10 years after that date. Such a liability can seldom be matched by classical assets like single bonds. It requires a structured product. The product could have a payoff that pays a low fixed coupon for the first five years and then switches to a floating coupon linked to the 3-month EURIBOR. In addition, the floating coupon increases by 3% if the yearly stock performance is positive. This product will match the liability stream more closely than other investments, which is (or should be) the primary reason for an institutional entity to invest in a structured product. Another frequent reason for institutional investors to choose structured products as an investment vehicle is the replication of strategies that would not be possible or be too onerous by means of classical instruments.

2.2.2 Private buyers

Private investors usually have simpler needs and targets. Their reasons for holding structured products are the prospect of gaining more than a riskless interest rate would otherwise yield, optimizing returns, or participating in the performance of an underlying asset while protecting their notional conditionally or unconditionally.

Take the case of our fictional character Dominique, who would like to invest EUR 8 million but who needs those funds in three years’ time for a project he has pledged to support. While he could purchase bonds maturing in three years, he is not satisfied with the yield of the risk-free rate. In other words, he would like an investment with upside potential without putting his capital at risk. Dominique does not rely on a steady coupon stream for the next three years (suppose he has other sources of income) and would consider risking the interest he would otherwise have gained with bonds to purchase calls on various underlying assets. Such an investment strategy can be achieved by means of a capital guaranteed product portfolio. After consulting with his advisor on the current market opportunities, forecasts and structuring factors, he decides to allocate his capital as shown in Table 2.2.

Table 2.2 Sample structured product portfolio6

The products need not be described or understood down to the last detail at this point. Suffice to know that all of them are 100% capital guaranteed in EUR at maturity and all have the potential to generate a return that is higher than the risk-free rate. Thus, they correspond to his prerequisites as mentioned above.

Let’s look at the products’ potential performance. The first one can appreciate up to 40% (the level of the cap) and performs if the European equity market rises. The second, betting on the appreciation of a basket of emerging currencies against Dominique’s reference currency (the EUR), has unlimited upside potential. Finally, the third product generates an interest nearly double that of the risk-free rate as long as the short-term interest rates stay below a certain threshold, which is far away from the present level (the threshold is 7%, and the current level is 2.5%7). The large upside potential of the first two products means that if only one of them performs well, it is likely that the performance of the whole portfolio will be higher than the risk-free rate.

On the portfolio construction side, it is interesting to note that the third product, linked to the level of the short-term interest rate, is somewhat uncorrelated or even negatively correlated with the first two.8 Consequently, if the equity and the emerging market currency notes do not perform, then it is likely that at least the interest rate note will generate a positive performance.

Another important point in the portfolio’s construction is the shorter maturity of the emerging market currency note than Dominique’s investment horizon. The currency note expires after 1.5 years, either on the capital guarantee if the currencies did not appreciate against the EUR (case a) or above it if they did (case b). In both cases, a reinvestment is necessary. In case a), he gets a second chance to “re-strike” a new product: if the emerging market currencies did not appreciate, then it is likely that they depreciated, (they seldom stay at the same level) and the product would have poor chances to perform going forward anyway. Constructing a new product with a new at-the-money strike will raise the chances for a positive performance for the remaining 1.5 years. In case b), the positive performance of the first product can be “locked-in” by constructing a new capital guaranteed product that would include the original notional plus the performance to date. That performance, being now capital guaranteed, cannot be lost again. Note that the new product need not be based on the same underlying currencies than the previous one. It need not even be a product on emerging market currencies. After the product’s expiry, a new assessment of the macro-economic and micro-economic situation should be undertaken. Subsequently, the structuring factors should be assessed in order to determine the final structure of the new product for the remaining 1.5 years. This procedure shows that products with a shorter maturity than the investor’s investment horizon can be implemented in a portfolio without difficulty. The third product’s maturity is mentioned to be 3 years (max); in fact, the issuer of the product can redeem it prior to maturity in certain circumstances.9 Suffice to say that, at this point, Dominique isn’t certain as to when the product will be redeemed, only that it cannot be after 3 years. Hence, a similar approach as for the second product will be used if an early redemption occurs.

Would there be an alternative investment strategy for Dominique to reach his goal? Several can be envisioned; for instance, convertible bonds would match the request. They have the same payoff structure as capital guaranteed products; they even pay a minimum coupon. However, they are principally linked to the equity market. Investing the whole portfolio in convertible bonds would link the portfolio’s risk too much to the equity market. In bearish times, convertible bonds fare poorly, usually yielding less than the risk-free rate. Another possibility would be an investment in high yield or emerging market bonds. The yield on those instruments is usually far above the risk-free rate, which also fits the request. Yet that would mean taking an additional credit risk, because the high yield principally reflects the issuer’s default probability. Note that Dominique also bears the issuer risk when investing in structured products. However, this risk can be lowered substantially by selecting product issuers that boast a high credit rating. Such a strategy maintains the upside potential of the portfolio and minimizes the downside risk, which is not feasible with a high yield or emerging market bond portfolio.

This sample case illustrates the usefulness of structured products in reaching an investment target. Buyers should always keep their targets/constraints in mind when investing. Structured products can be of help to reach or to optimize those targets.

2.2.3 Sellers (issuers) of structured products

Structured product sellers mushroomed until the subprime and credit crises of 2008. Nearly every major and middle-sized financial participant in the banking sector built a structured product offering for its internal or external clients. Investment banks, wholesale banks, retail and private banks, state-owned banks, brokers and finance boutiques - all were entering and subsequently expanding their structured product business. The main reason for financial actors to enter the structured product business was profit. As with every business in this world (from pizza restaurants to computer chip manufacturers), structured products supposedly generate a profit for the manufacturers and sellers. Or at least everyone thinks they do. Unlike a pizza that earns EUR 1.00 for the restaurant the minute it changes hands if it is sold for EUR 6.00 and cost EUR 5.00 to manufacture, a structured product’s profit can only be measured at its expiry. When the product is sold (which would be the moment the investor buys it), its manufacturing costs are not known. A mathematical model determines a “fair value” for the product at the issue date, which the issuer raises by a spread; the total amounts to the issue price. The spread is supposed to be the issuer’s profit, but it also serves to pay for the service the issuer has to deliver for the lifetime of the product: secondary market prices, listing costs, term-sheet production, adjustments for corporate actions, settlement, etc., and last but not least, hedging. All these factors apart from hedging can be more-or-less determined at the issue date. Hedging, simply put, are the trading activities the issuer must undertake during the lifetime of the product to transform the mathematical model’s “fair value” plus the spread into a real profit. For example, the mathematical model will tell the trader every day of the product’s life: “buy 100 shares of company XYZ”, or “sell 20 shares of company XYZ”. Several times a day, the trader will have to make one or more deals to hedge the risks embedded in the product. Depending on how well the mathematical model has been programmed and how efficiently the issuer’s trader can execute the orders will determine the issuer’s ultimate profit. Product issuers usually hedge every risk they can. They try to live on the spread they take at the issue date of the product, or on the bid-ask spread in the secondary market. However, even the most advanced trading models cannot hedge every single risk of some structured products. The issuer’s profit, if any, can therefore only be determined at maturity. Of course, in normal market situations, the spread the issuer takes is more than enough to cover the hedging risks, but in market turmoil, hedging may become difficult or outright impossible. If the situation is severe, like in the financial crisis that began in 2008, hedging costs can wipe out several years of an issuer’s past profits.

To offset some of the risks, an issuer’s interest is to have a large trading book, with as many positions (or products) as possible. The reason is cross-hedging: some of the products cancel each other out, in terms of risk. A simple example: a bank simultaneously issues a call warrant and a discount certificate on the stock of Assicurazioni Generali SpA (an Italian insurer). Taken from the issuer’s perspective, if both have the same maturity and strike, the risks are reduced, because the short volatility position of the warrant is offset by the long volatility position of the discount certificate.10 The issuer can lock-in the bid-ask spread of the volatility with little risk. Having many such positions associated with a large client base creates economies of scale in terms of hedging. The more clients that buy and sell the bank’s products, the higher the chance that hedges offset themselves, creating low-risk benefits. The concept is similar to that of the FX market: if on the same day, an investor buys EUR 1 million against USD while another does the reverse trade, the bank locks in the margin between the two trades, taking no risk, and books a profit. A large trading book with many underlying assets also allows an issuer to become more competitive against smaller rivals. Prices for product buyers will be more attractive, as the spread the issuer takes diminishes.

This all sounds very complex, doesn’t it? It really is; structured products are ruled by mathematics. But then, so is the GPS in the car and even more so a computer or a portable telephone. Nearly every household object is controlled by mathematical formulas and functions, even the fridge and the coffee machine. But the end-user doesn’t necessarily need to understand the program code in his cell phone that enables him to call a friend, just how to use the object efficiently; the same is true for structured products. If some of the above reasoning seems unclear or difficult to understand, take heart! The next chapters will clarify all there is to know, step by step.

Just one more comment before going into detailed matters on the products: issuers are also interested in the marketing potential that structured products offer. New products are a way to access the wealthy individuals and institutional asset managers. It gives the issuer the opportunity to contact its clients with a new story. A bank issuing a new product would typically advertise it in newspapers, on websites or per email, its sales force ordered to call its internal or external clients boasting of the product’s advantages. The bank’s brand gains in awareness; its name is recognized by an increasing part of the investor population. A larger audience raises the amount of potential business. There is a saying in investment banking that “volume attracts volume”. Hence, some banks’ strategy is to issue dozens or even hundreds of products simultaneously in order to show presence in the market. It doesn’t matter if the products attract no volume at the issue date. Some stock exchanges, like Frankfurt or Stuttgart (Euwax) in Germany have lowered listing costs so much that listing a product there costs virtually nothing. But in terms of product statistics compiled by the exchanges, the issuers with most products rank in the first quartile, and are perceived as strong players in the market. Private clients are attracted to the issuers with the largest product palette and often tend to be more sceptical towards smaller players.

2.3 READING A PAYOFF DIAGRAM

The most intuitive way to understand structured products is in graphical form. This section focuses on the so-called payoff diagrams, which are graphical representations of the mathematical formulas that characterize each product. It is important for the reader with little experience in structured products to fully understand how a payoff diagram is read, as it is the basis for many product illustrations not only in this book, but also in every other publication, newspaper advertisement or industry-specific website.

Figure 2.1 is an example of a payoff diagram showing a capital guaranteed product on an asset (for example the Eurostoxx50) with 100% capital guarantee, 100% participation to the positive performance up to a cap of 120% of spot price.

Figure 2.1 Capital guarantee with cap

Source: Bloomberg, own calculations

Formally, the payoff diagram illustrates the profit and loss of a product as a function of the underlying asset’s price. It consists of two axes and one or more payoff lines. In our example, two payoff lines are drawn.

The horizontal (x) axis represents the market price of the underlying asset. It may be scaled in percent as in the example or in absolute values. Its value increases from left to right. The price level of the underlying asset at which the product was issued is usually normalized at 100% and placed around the middle of this axis, as shown in the example.

The vertical (y) axis represents the gain (if above zero percent) or the loss (if below zero percent) the investor realizes at maturity. The point at which the vertical axis has a value of 0% is called the breakeven point. This is the point at which the investor neither gains nor loses money (in nominal terms). On the payoff graphs of some issuers and publications that point has a value of 100%, which then denotes the value of the product at inception. In that case, the reference of the axis is not the profit and loss the investor makes when the product expires, but the redemption price of the product at maturity in percent of its issue price. To calculate his profit or loss, the investor must deduct the sum initially invested from the result shown by the payoff line.

The market payoff line shows the underlying asset’s profit or loss as a function of its market price. It is usually represented by a 45° straight line. Of course, depending on the scale of the axes, it may appear to be steeper or flatter. In Figure 2.1, the slope is flatter because the graphic is slightly elongated. As long as the scales are correctly labeled, it is of no consequence. Point 1 correctly shows that a drop in the price of the underlying asset by 20% results in a corresponding loss of 20% for an investor who would have bought the underlying asset (not the product) at 100%.

The product payoff line symbolizes the product’s profit and loss as a function of the market price of the underlying asset. One can observe that the loss is limited to 0% and the gain to 20% in the case of the example above. The breakeven point is located where the product payoff line crosses the vertical axis from negative to positive profit and loss. Since this product is capital guaranteed to 100%, the line runs parallel to the 0% level when the underlying asset drops below 100%. In this example, Point 2 shows the maximum return an investor can achieve with the product. Note that Point 1 cannot be reached with the product, and neither can Point 3 , which depicts an increase of 30% of the underlying asset. Both Point 2 and the breakeven are called inflection points. Each inflection point is linked to a special level of a structured product, such as the strike or the barrier of an embedded option. In some special cases, a payoff in graphical form is not possible or practical.11 In those cases, the product can only be described in words, flowchart diagrams12 or tables. The shape of the product’s payoff gives the investor a rough indication about whether that product appeals to him or not.

In its classical form, the payoff diagram only shows what the investor can gain or lose at maturity. Nothing is said about how the product behaves during its lifetime and, furthermore, no indication is given about the chances or risks of realizing the indicated product outcome. In other words, the graphic tells nothing about the chances of ending on any specific point of the product line. This is annoying for the end investor, as some payoffs may demonstrate incredibly attractive payoffs, but the best case might actually have very little chance of being achieved. Thankfully, at least some of the issuers (e.g. EFG Financial Products) are moving in the right direction and now discloses some of the risk figures either directly on their term-sheets and/or on their website. The difficulty for the end-user then lies in the interpretation of the numbers, but at least when they are available they can be analyzed.

With their Derivative Map, the SVSP has been trying to create a standard for representing structured products in a graphical form. Unfortunately, the standard that the SVSP wants to generalize has not been adopted by all market participants, so similar payoffs are often represented differently, depending on the issuers’ marketing departments. As the issuers strive to improve their marketing material, they may change the design of their diagrams, which sometimes makes it difficult for the occasional user of structured products to find the diagram they are accustomed to. To illustrate this point, Figure 2.2 shows two diagrams of the same payoff type: a worst-of barrier reverse convertible on three stocks.13 These diagrams were extracted from term-sheets of well-known product issuers in Switzerland: Julius Baer and EFG Financial Products.

Figure 2.2 Different representations for similar products

Source: Julius Baer, EFG FP

A closer look at the Julius Baer graph will reveal that the barrier is shown as a dot on the horizontal axis. Both payoffs are in fact identical, only the chosen representation is different. Note that while the Julius Baer representation illustrates the effective payoff for a specific product with the correct scales, EFG FP uses a template without scales that fits all products of this category, in this case barrier reverse convertibles. At least the two mentioned issuers do provide payoff diagrams on their term-sheets. Sadly, the majority of other issuers do not even include one in their sales documents.

2.4 READING A PAYOFF FORMULA

The payoff formula, which is an exact mathematical expression or a decision tree, describes how to calculate the precise amount of money an investor gets back at maturity when the product expires. It is useful to know how to read a payoff formula, as only few issuers provide payoff diagrams on their term-sheets. Moreover, some payoffs cannot be displayed efficiently in graphical form. For example, in a decision tree, if there are too many “if - then - else” clauses, the payoff diagram becomes impossible to draw.

The diversity of formulas is large as there are many product variations. Here is a simple payoff formula example of a capital protected note on an index:

One of the easiest ways of reading it is to take the formula apart, starting from inside out and from right to left. Take the last term first:

Inside the square brackets, there are two terms, a zero, and a quotient. Let us disassemble the quotient. It is in fact a simple performance calculation: first, the difference between the level of the index at maturity (IndexFinal) and that of the index level at the issue date (IndexInitial) is taken. The result can be either a positive or a negative number. This is then divided by IndexInitial, which is the basis; the result of the operation is the index performance expressed as a percentage. If the index has risen since the product was initially launched, the percentage will be a positive number, and if it has fallen, it will be negative. Therefore, inside the square brackets, the first term is equal to 0 and the other can be either positive or negative. Looking just outside the brackets, there is the word “Max”. This is a mathematical function for selecting the maximum (higher) result from the two terms inside the brackets. So if the result of the division is positive, that term will be selected; if negative, then the term 0 will be selected. This part of the formula forms in fact the capital guarantee; negative performances are not taken into account.

The whole term is then multiplied by 90%. This calculates the level by which the product participates to the upside performance of the underlying asset, as this number multiplies the positive performance of the index.