IFPAC 2008 Conference Evaluating Structured Investment Products
Contents Introduction Choice of Product Strategies Examining Some Popular Structured Products Determining the Right Product Understanding the Limitations and Risks Avoiding Catastrophe 2
What Are Derivatives What is a Derivative? 1. Financial instrument whose value is derived from the value of an underlying asset. 2. Derivatives include Futures, Forwards, Options, Swaps, Warrants, etc. 3. Useful financial tools for both risk management and investment purposes. 4. Traded on various Exchanges as well as Over-the-counter. 5. Issued over different asset classes: Equity, FX, Commodities, Funds, Interest rates, etc. Basically, any underlying asset that is tradable and sufficiently liquid. Call and (Put) Options Buyer has the right, but not the obligation, to buy (sell) the underlying asset from (to) Seller at a fixed price (i.e. Exercise Price or Strike) within specified period. Growth of Exotic Options 1. Options offering interesting and complex payoffs/features, e.g. Barrier options. 2. Reasons: Advance in IT and financial modeling Banks increasing appetite for risk-taking Demand from increasing sophisticated investors 3
What are Structured Products Different Name, Same Product Structured Product = Structured Investment = Structured Deposit = Structured Note 1. Different ways of wrapping the same product 2. Different regulatory and legal regime 3. Structured suggests that products have undergone some form of financial engineering What are they 1. Hybrid products whose performance is linked to a selected underlying asset, e.g. index. 2. Usually a debt instrument (bond/deposit/debenture) with derivative(s) embedded. 3. Offer interesting variations of Risk-Return profiles that are different from conventional instruments (asset classes) like bonds, equities, currencies, etc. 4. Relatively complex multi-asset financial products. 5. Payoff formula is usually well-defined. 6. Linked underlying asset can be equity, FX, funds, etc. or combination of several assets. 7. Sometimes viewed as a separate Asset Class. 8. Asset-backed securities (ABS), REITs, ETFs are excluded. 4
Basic Building Blocks LEGAL WRAPPER (of selected currency) Debt instrument, i.e. Note, Bond Deposit Certificates Unit trusts or Funds DERIVATIVE (of selected underlying asset or assets) Vanilla options and forwards Exotic options and multi-assets Combination of options Path-dependent features e.g. Lock-in, Knock-in, Auto callable Local / foreign underlying Various asset classes UNDERLYING STRUCTURED PRODUCT 5
Motivation and Benefits 1. Efficient execution of market view Residual risk can be laid off ( sold ) in return for extra return. Or giving up some return in exchange for protection against certain risk. Remember the Bottom line: No Free Lunch! 2. Ability to modify and customise the investor s Risk-Return profile. Enhancing return/payoff profile, gaining capital protection or leverage 3. Offer other dimensions for trading: 1) Volatility 2) Correlation 3) Path-dependent 4. Provide more flexibility and more choices to investors. 5. Investor has direct input in product design decision. Feeling of in more control. Once transacted, investment is in auto-pilot mode. 6. Resolve regulatory and market access restrictions. Credit constraint in dealing with OTC derivatives Allow market access to restricted markets, e.g. Participation Notes/Certificates 6
Investor s Choice of Option Strategies 1. Investor BUYS option(s) Usually in principal-protected structures Limited downside, unlimited upside Lower risk 2. Investor SELLS option(s) Usually in yield enhancement structures Unlimited downside, limited upside Higher risk 3. Combination of BUY and SELL Options strategies Multiple options on multiple asset classes or underlyings 7
Investor s Choice of Risk Factors (Parameters) 1. Asset Class Equities, Currency (FX), Commodities, Interest rates, Credit, Funds, etc. Any asset class that is tradable and sufficiently liquid 2. Directional factor Bullish, Bearish or Market Neutral Straight-forward and most popular risk parameter A path-dependent strategy can be seen as a combination of Directional strategies Investors can maximise value using Path-dependent Options such as Barrier Options if they have strong views on the future path movement of the underlying 3. Volatility factor An important parameter that determines the value of an option Value can be created and priced from market view/expectation on Volatility 4. Correlation factor Most newer, complex derivatives feature this risk parameter Implied correlation has become more widely traded and priced 8
Basic Product Types 1. Capital Guaranteed or Principal Protected Products Redemption of full or a large portion of the initial capital is assured. Investors typically buy options. Risk-adverse, conservative investors who cannot afford to lose capital. 2. Yield Enhancement Products Partial or full amount of initial capital is at risk. Investors typically sell options. Investors with high risk appetite and who desire higher income yield. 3. Leveraged Products Participation on the underlying asset is leveraged up. Investors typically buy options in leveraged amount. Investors with very high risk appetite. 4. Wrapper Products Designed to gain market access or participation. Participation Notes (or Certificates) 9
Example 1: Capital-Protected Structure PRODUCT NAME: Index-linked Capital-Protected UNDERLYING INDEX: KLCI Index MATURITY: 3 years PRINCIPAL AMOUNT: RM 1,000,000 ISSUE PRICE: 100% COUPON: 0% INDEX PARTICIPATION RATE (G): 60% CAPITAL GUARANTEE RATIO: 100% SETTLEMENT METHOD: Cash settled REDEMPTION AMOUNT (R): Redemption Amount 140% 130% Participation Rate (G) = 0.60 120% 110% 100% Strike=1400 90% R = 100% + ( IPR x G ) 100% 100% IPR: Percentage Rise of Index over Maturity. Assume Index Level on Start Date = 1400 Capital protection is only assured at maturity! 80% 70% 1000 1200 1400 Index Level at Maturity 1600 1800 2000 2200 10
Example 1: Capital-Protected Structure Pros 1. Initial capital is assured at maturity, i.e. 100% capital protection. 2. Upside participation in the selected stock index (market). 3. Out-performs bond/fixed deposit of similar tenure if stock market had performed well. 4. Similar to investing in a Balanced-type unit trust. Cons 1. Limited exposure to stock market. 60% Participation Rate in this example. 2. Underperforms stocks (e.g. index fund) if stock market had risen sharply. 3. In low interest rates environment, Participation Rates will be lower and tenure longer. 4. Investment capital is locked in over a long period. 5. Passive investment management. 11
Example 1: Capital-Protected Structure Enhancing the Structure Increasing the Participation Rate 1. Capping the index upside; e.g. call spread 2. Setting a higher strike level (for call option) 3. Use of Asian-style (Averaging) options 4. Extending the tenure 5. Sell option(s) on other underlying assets and taking some risks 6. Use of Path-dependent Options, e.g. knock-out and knock-in options Capturing and maximising the index upside 1. Use of Path-dependent Options, e.g. Barrier Options Lock-in feature to lock in when the index had reached a certain level Look-back feature to lock in the highest level reached 2. Such features come with additional cost; resulting in a lower Participation Rate 12
Example 2: Bull Equity-Linked Structure PRODUCT NAME: Bull ELS or Reverse Convertible UNDERLYING STOCK: Sime Darby MATURITY: 35 days ENTITLEMENT: 1 Bull ELS entitles 1 Share REFERENCE PRICE: RM 11.80 ISSUE PRICE: RM 11.107 EXERCISE PRICE: RM 11.210 YIELD-TO-MATURITY*: 9.67% p.a., if redeemed at RM11.21 REDEMPTION AMOUNT: (A) At Maturity, if Share RM 11.210 Redemption= RM 11.210 ( i.e. YTM=9.67% ) YTM 15% 10% 5% 0% -5% -10% Break-Even 11.107 YTM = 9.67% 10.60 11.00 11.40 11.80 STOCK PRICE (B) Otherwise, 1 Bull ELS redeems for 1 Sime Share Effective Share Purchase Price= RM 11.107-15% -20% * YTM = { (11.210 11.107) / 11.107 } ( 365 / 35 ) = 9.68% e.g. 3-month Bank Deposit: 3.0% 13
Maturity Payoff Example 2: Bull ELS SCENARIO 1 Final Price Exercise Price SCENARIO 2 Final Price < Exercise Price Investor pays on Issue Date. RM 11.107 Share price of Sime Darby at Maturity (i.e. Final Price). RM 12.00 RM 10.80 Redemption Amount received by Investor at Maturity. RM 11.21 1 share of Sime Darby Market value of shares held by Investor at Maturity. No shares held RM 10.80 Profit(+)/loss(-) on investment 11.21 11.107 = + RM0.103 10.80 11.107 = RM0.307 Return (in annualized simple yield) on investment. 9.67% 28.82% 14
Example 2: Bull ELS Pros 1. Superior yield over bank s Fixed Deposit if market view had been correct. 2. Target Buying at below RM 11.21 Effective purchase of shares at RM 11.107 if view had been wrong. Must be happy to buy or be long the shares at RM 11.107. 3. Enforces market/investing discipline, instead of trying to time the market. No leverage. Cons 1. Relatively more risky. Suffers loss if share falls below RM 11.107 (break-even price). Potential loss is unlimited. 2. Potential upside is limited. Maximum yield 9.67% p.a. (or 0.93% in absolute terms). 3. Unattractive Risk-Return profile. Investor takes substantial risk for a small 0.93% pick-up. 4. Investment is locked in for 35 days. 5. Requires full capital upfront. Cannot leverage. 15
Example 2: Bull ELS Enhancing the Structure Achieving a higher yield 1. Setting a higher exercise price (or strike). 2. Select stocks that are more volatile. 3. Extending the tenure. 4. Use Worse-of Put option Addition of another risk factor (correlation) into the pricing. Select stocks with higher negative correlation(s); higher option value. Negative: Investor will have risk exposure to more than one stock. 16
Example 3: Auto-callable with Digital Coupon PRODUCT NAME: Auto-Callable USD Quanto Nikkei-linked Notes with Digital Coupon and Knock-in feature REFERENCE INDEX: Nikkei-225 MATURITY: 5 years PRINCIPAL AMOUNT: USD 100,000 INITIAL INDEX LEVEL: 15,700 COUPON: Payable in USD on a quarterly basis, determined as follows: (A) 11.00% p.a. if Index 13,600 on each Observation Date (B) 0% if otherwise. OBSERVATION DATES: 5 Market Days before each coupon payment date REDEMPTION (R): Payable in USD if Early Redemption has not occurred, and is determined as follows: (A) R = 100% if Knock-In Event has not occurred before maturity; (B) R = 100% [Final Index Level / 15,700 ] if otherwise. FINAL INDEX LEVEL: Index level at maturity. KNOCK-IN EVENT: Considered to have occurred if Index trades at/below 10,000 at any time before maturity. EARLY REDEMPTION: Automatically early redeemed if Index Trigger Level on any Observation Date. TRIGGER LEVEL: 16,000 17
Nikkei-225 Index price performance Early redemption triggered after only 6 months. 1/9/06 COB: Nikkei=16,134 Put Knock-in = 10,000 Issued 8/3/06 Nikkei=15,700 18
Example 3: Auto-callable with Digital Coupon Pros 1. Good possibility of receiving high interest coupons over 5 years Earns 11% p.a. coupon if Index 13,600 i.e. 13% decline from initial level 15,700 2. Good possibility of early redemption Index only have to rise 2% (15,700 16,000) after 3 months or thereafter Outperforms similar maturity time deposit if it had early redeemed after 3 months 3. Low possibility of capital being at risk (i.e. Knock-in Event triggered) Index has to decline 36% (15,700 10,000) 4. No currency risk if you are a USD based investor (i.e. Quanto-ed ) Cons a. Potential income and capital loss if Nikkei had crashed below 10,000 b. Long investment holding (5 years) and equity risk exposure if not early redeemed c. Upside is capped (total income = 55% p.a.) d. Coupons have a digital payoff, i.e. either 11% or 0% e. Re-investment risk, in the event of early redemption 19
Example 3: Auto-callable with Digital Coupon Enhancing the Structure Achieving a higher yield 1. Setting a higher threshold Index level for coupon determination 2. Setting a higher Knock-in Level 3. Setting Observation frequency to intra-day (continuous) for Knock-in Event 4. Leveraging on the short Put option Reducing the risk 1. Replacing the short put with a put spread (e.g. 20% spread) Limit the potential capital loss to the spread (i.e. 20%) Trade in for a lower coupon 20
Example 4: Structured Warrants ( SW ) When and Why invests in SW 1. Desire for Gearing (leverage) Gain large market exposure with small investment outlay High risk, high return and more speculative in nature 2. Limited downside, unlimited upside and cash extraction strategy Defensive strategy in times of very volatile, bullish but nervous market 3. Arbitrage and volatility trading 4. More Trading-driven and shorter term investment horizon SW positions must be actively monitored Beware of time decay Usually not intended to be held until expiry 21
Some of the features/mechanisms offered 1. Lock-in 2. Knock-in and Knock-out 3. Digital payoff 4. Cap on cumulative (total) return 5. Auto Callable (i.e. early redemption trigger) 6. Averaging out of risk (or return) 7. Daily accrual (i.e. payoff determined on a daily basis) 8. Currency immunisation 9. Correlation play 10. Best of, Worst of and relative performance Offering More Flexibility, More Opportunities, More Possibilities and More Choices 22
Today: If you have a View, there s a Way TRADING STRATEGY & ACTION MARKET VIEW CONSERVATIVE AGGRESSIVE Bullish Buy Stocks Buy Futures / Sell Puts Very Bullish Buy Call Warrants Buy Futures / Buy Calls Bearish Buy Puts Short Futures / Sell Calls Very Bearish Buy Puts Short Futures Bullish but nervous Buy Call Warrants or Buy Stocks + Buy Puts Bearish but nervous Buy Puts Neutral / Sideways / Range Sell/Buy Options Sell Options (e.g. straddle) Lower Volatility anticipated Higher Volatility anticipated Path movement of underlying Sell Options Buy Options Buy/Sell Path-dependent Options 23
Determining the Right Product 1. Identifying the Underlying Asset Class Which asset class and market: Equities, FX rate, etc. 2. Market View and Market Timing? Bullish, Bearish or Market Neutral 3. Determine your Investment Objective and Risk-Return Profile Minimum, Average and Maximum potential return? Maximum (affordable) potential capital/income loss? Risk appetite? Asset allocation (more conservative) or return-driven (more aggressive)? 4. Do you have holding power? Are you able to ride through the market volatility or downside? 24
Understanding the Limitation and Risks 1. Making the distinction between and Trading and Investment 2. Structured Products are intended to be held until maturity. Not for trading 3. Secondary market liquidity risk No secondary market. Very much a bilateral contract. Early redemption risk. Investor can only unwind trade with the issuer. 4. Pricing may not be straight-forward, especially for complex, multi-asset products Multi-asset, more features means larger built-in margin and wider bid-offer spread. Pricing models not readily available to investors. Try to avoid Products linked to less liquid underlying 5. Credit risk exposure to the Issuer Major consideration if tenure is long (> 3 years). 6. No free lunch! If the risk is perceived to be higher, the option will be priced higher, and vice-versa. 25
Avoiding Catastrophe: Due Diligence and Suitability 1. Has the Investor the capability to understand? Investment experience and education background 2. Is the Product consistent with investment objectives and risk-return profile? Looking for an Apple, bought an Orange!! 3. Is the Product suitable for the Investor in relation to his financial standing, etc? 4. Read the Product Terms, Disclaimers and fine print, etc.. Return of up to X%. Be careful if the terms are too good to be true 26
Structured Warrants/Products Disclaimer / Risk Warning This material has been prepared and published solely for informational purposes only, and should not be construed as a solicitation or an offer to buy/sell any securities/products or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor intended to be a complete statement of summary of the securities, market, etc. referred to herein. Structured Products, Warrants and Derivatives can be volatile instruments and investing in them involves significant risk. These products are subject to a number of risks and may result in a complete or partial loss of an investment in them. No person should deal in any type of Structured Products, Warrants or Derivatives unless he/she understands the nature of the relevant transaction and the extent of his/her exposure to potential loss. Each prospective investor should consider carefully whether such instruments are suitable for it in the light of its circumstances and financial position. Prospective investors of any Structured Products and Warrants should therefore consult their own legal, tax, accountancy and other professional advisers to assist them in determining the suitability of any Structured Product or Warrant for them as an investment and for their particular circumstances. 27