1 The use of structured products: applications, benefits and limitations for the institutional investor Submitted by Anna Georgieva Supervisors: Marcel Koebeli, Marc Chesney, Pascal Botteron December 2005 2 0. Introduction 1. What are structured products? 1.1. A definition 1.2. The generic exposure types 2. Applications 2.1 Payoff diversity 2.2 Isolating risks and exposure 2.2.1 Volatility 2.2.2 Correlation 2.2.3 Inflation 2.2.4 Credit 2.2.5 Hedge Funds 3. The institutional investor 3.1 Business needs and risk preferences 3.2 Institutional investors: readily invested in a structured product on the economy 3.3 Structured products, Indexation and the Core-satellite framework 4. Limitations of structured products as investment vehicles 3 0. Introduction The institutional investor is in the business of understanding, pricing and managing risks to earn a return for the benefit of all stakeholders. In this paper I discuss how structured products can be used by institutional investors. In a perfect world (Arrow-Debreu state-claim framework) there exist enough securities to recreate any payoff. Some assumptions of this idealized world are: there exist basic securities, Arrow securities, that they have a risk-free payoff in any state, no transaction cost, no information asymmetry, all investors have the same expectations. Then derivatives are redundant instruments, as they can be replicated. The price of the replicating strategy should be equal to the price of the derivative; otherwise there is an arbitrage opportunity. Several research papers discuss the optimal existence of derivatives. [Merton 1971], [Carr Madan 2001], [Carr Madan 1998], [Liu Pan 2003], [Ross 1976]) The research results are usually dependant on assumptions about the process of the underlying. The case of including derivatives in an investor’s portfolio is usually solved making the assumption that investor preferences follow a certain mathematical function. The optimal investment in derivatives is then determined as the solution which maximizes the investor’s utility function. A closed form solution may or may not be available depending on the assumptions about the underlying process and the utility function. I treat the problem in a practical, applied way. Needless to say, financial markets have readily justified the existence of derivatives and derivatives related products. The focus is on how structured products can be handy to an institutional investor, as opposed to how do we price, replicate and hedge them. While in the back of every properly priced derivative there is a lot of mathematics, in this paper I focus on the investment interpretation and application. I present structured products as a natural investment choice of an institutional investor who faces the business constraints of a liability stream and of stakeholder and client expectations. Their main applications are in creating risk-return flexibility, isolating risks and providing exposure opportunities. I point at possible specific applications, but there is no almighty product that will magically solve all investment problems and unless a specific investor is consider it is impossible to make a strong statement about the best choice. For a retail institutional investor, structured products present new ways to reach the investment needs of clients by adding new products to the product basket, preserving the level of distribution fees and increasing the ability to raise new money. For the pension or trust fund investor, in particular in a core-satellite framework, structured products provide payoff flexibility, bundled or unbundled exposure to new and old asset classes, and can be optimally added as satellites to the investment portfolio. For the asset manager in an insurance company, structured products stand out with their ability to implement sophisticated investment views, and to isolate and hedge risks. Research on the pricing and replication of some of these structures are widely available; others do not have a closed-form solution. The most flexible approach is using Monte Carlo (MC) pricing tool Based on the martingale approach of derivatives pricing, this approach can price any possibly payoff and has gained widespread acceptance among practitioners. 4 1. What are structured products? 1.1 A definition Structured products are investment instruments that combine at least one derivative with traditional assets such as equity and fixed-income securities. The value of the derivative may depend on one or several underlying assets. Furthermore, unlike a portfolio with the same constituents the structured product is usually wrapped in a legally compliant, ready-to-invest format and in this sense it is a packaged portfolio. The usual components of a structured product are a zero-coupon bond component and an option component. The payout from the option can be in the form of a fixed or variable coupon, or can be paid out during the lifetime of the product or at maturity. The zero-coupon bond component serves as buffer for yield-enhancement strategies which profit from actively accepting risk. Therefore the investor cannot suffer a loss higher than the note, but may lose significant part of it. The zero-coupon bond component is a floor for the capital protected products. Other products, in particular various dynamic investment strategies, adjust the proportion of the zero-coupon bond over time depending on a predetermined rule. From an economic point of view, the structured product can be broken down in two main components: Investment view + Payoff structure = Structured product The investment view is driven by factors such as: • Investor expectations towards the underlying: bearish, flat, bullish, range bound, ladder etc • Choice of underlying. The underlying may be available in a readily investable format or has to be synthetically extracted: o Single stock o Basket of stocks o Index or multiple indices o Mutual fund, hedge fund, Fund of Hedge Funds, discretionary manager o Systematically rebalanced strategy o Volatility, correlation, dispersion o Hybrid o Credit o Inflation o Commodities etc The investment view may be based on fundamental or technical research. The choice of the underlying may depend on the market, on the investor’s expertise, and on fundamental factors. Payoff structure The payoff structure is a mathematical formula applied on the underlying. The features of the payoff structure will include: • Cash flows timing: periodic coupons from an underlying that pays none; total lump payment when underlying pays coupon; variable coupon or fixed coupon; fixed coupons during certain periods of the life of the product etc. • Risk profile: leverage, conditional capital protection, partial capital protection, full capital protection • Maturity: Short-term, medium-term or long-term The importance of both components is evident when we look at the fundamental exposure types in the next section. The focus here is that despite the fact that the option types have been known for a long time, the investment view gives them a different interpretation. 1.2 The fundamental exposure types The fundamental exposure types are the generic option payoffs. Combining these with a long zero coupon bond gives the primal structured products, some of which have not failed to go out of fashion. Figure 1 shows clearly the interaction between investment view and payoff structure. Some authors seem to refer to prefer bullish payoffs, and consider only the payoffs in upper row of the table, corresponding to the bullish investment view as structured products. Fundamental exposure types + - + - Premium + - Premium + - + - Premium + - Premium Delta one (Certificate) Capital protected products - Yield enhancement products Bullish investment view Bearish investment view 1) 2) 3) 4) Figure 1 5 6 The Delta one (certificate) provides full exposure to the underlying. Investor gains wealth as underlying appreciates and loses wealth as the underlying depreciates. The payoff is the same independent of the investment view. The other 4 payoffs are: 1) Bullish investment view, yield-enhanced or return-enhanced exposure – capped upside, unlimited downside. Investor prefers to sell the upside potential and receive a higher return. Investor is actually bullish on the underlying, but prefers to cash in the expected return, rather than wait for the uncertain appreciation to realize. Investor practically accepts the downside risk of the underlying and receives a premium for that, which results in a higher yield compared to the underlying. 2) Bullish investment view, capital protected exposure – floored downside, unlimited upside. The investor pays a premium to ensure downside protection, but keep the upside exposure. 3) Bearish investment view, yield-enhanced exposure – capped upside, unlimited downside. However the structure pays of when the underlying decreases in value. 4) Bearish investment view, capital protected exposure – floored downside, unlimited upside. Again the structure pays as expected if the underlying decreases in value. Typically, only payoff type 2), the long call, payoff is considered a capital protected payoff. Yet for an outright bearish investor, this payoff is detrimental as it leaves him exposed to an appreciation of the underlying. The investment view is intrinsically connected to the split between yield-enhancement products, where the investor chooses the higher risk-return combination, and capital protection, where the investor prefers a lower risk-return combination. These generic payoffs have been embraced by the market. I show 3 widely known products that can be directly matched to 3 of the generic payoffs and also present an investment case for their use. These are: 1) The Delta One (Certificate) (Figure 2 & Figure 3) 2) The Reverse Convertible – as an example of bullish yield-enhancement payoffs (Figure 5 &Figure 4) 3) The Capital Protected Note – as an example of bullish capital protected payoffs (Figure 6) Other payoff structures cannot be easily classified as only yield-enhancement or capital protected type. I discuss some of them Section 2.1  The investor receives the full upside and downside of the underlying.  Certificates are a flexible way to invest in customized baskets and implement fundamental long-only investment ideas.  Investor goes long a zero strike call.  Short-, mid- to long-term investment horizon.  Investor wants full exposure to the underlying. Structure Payout Investment idea Delta One (Certificate) Certificates have the same payoff as the underlying Underlying price Performance 100 Initial price Time Price 100  Our investment view is based on an expected increase in peak sales of new products, industry cost savings as the sales mix shifts towards secondary care, and positive volume outlook in the US as new prescription drug benefits for seniors start in the end of 2005.  Structure – We go long a zero strike call on a basket of the following stocks: AstraZeneca, Novartis, GlaxoSmithKline, Essilor International, Merck, Pfizer, Cardinal Health Inc. – The basket can be equally-weighted, performance-weighted or custom-weighted. – 3 year maturity.  The certificate pays the performance of the basket.  Very low structuring fees. Certificate on a Pharmaceutical Basket We are bullish on European pharmaceutical companies Figure 3 Figure 2 7 Reverse Convertibles Reverse Convertibles are yield-enhancement strategies with short maturity  A coupon is always paid.  Depending on the product features the investor is exposed to a different degree to the downside of the underlying.  Investor go long a zero-coupon bond and short a put, or a short DIP put  Short-term investment horizon  Moderately bullish or range bound view Structure Payout Investment idea Time Price 100 100 Initial price 13 Performance  Given the barrier for the DIN put or the strike for the short put we solve for the coupon.  The lower the barrier level the lower is the coupon.  This is a very popular yield-enhancement structure for a bullish investor. Performance Barrier Underlying price 100 Initial price Priced examples 8.47% 1 year 80% Porsche 9.8%5.9%Coupon 1 year 70% Porsche 1 year No barrier Porsche Maturity Barrier Underlying Reverse Convertibles on Porsche 3 examples with different barrier levels Figure 5 14 Figure 4 8 9 Capital Protected Notes (CPN) Capital protected notes are downside protected investments  100% of invested capital plus a coupon (or upside participation).  We go long a zero-coupon bond and long an option with upside exposure.  Short-, mid- or long-term investment horizon.  Bullish on the underlying, but we want downside protection. Structure Payout Investment idea Underlying price Performance 100 Initial price Lower capital protection with higher participation rate Time Price 100 23 Figure 6 The zero-coupon bond plus option component of the structure has direct implication on the taxation of structured products. I review these in Appendix 2. 2. Applications of structured products in the portfolio of an institutional investor In a general framework, the two applications of structured products are payoff flexibility and isolating or bundling risks. 1. Payoff diversity and flexibility, payoff timing flexibility, leverage It is almost impossible to define payoff diversity and flexibility that structured products can provide. I present six structures that exemplify the payoff flexibility and diversity that structure products can offer. These are: 1) The Autocallable (Figure 7, Figure 8 &Figure 9) 2) The Reverse Convertible Autocallable (Figure 10 & Figure 11) 3) The Springboard (Figure 12) 4) The CertiPlus (Figure 13) 5) The Plain Turbo Certificate (Figure 14) 6) The Leveraged Airbag (Figure 14) The Autocallable and the Reverse Convertible Autocallable can be easily classified as yield- enhancement products. The Springboard is a capital protected product. However the Certiplus, the Plain Turbo Certificate and the Leveraged Airbag cannot be easily classified into one of the fundamental exposure types, because they are vehicles to express sophisticated investment views. All examples are applied to a single stock underlying. Considering how central correlation is in the pricing of baskets, I present examples in section 2.2. The autocallable acts as a rational investor who has a range bound view on the underlying. If the underlying appreciates enough, it is autocalled and the structure ceases to exist, that is, the payoff is as if the investor has taken profit on the underlying. On the other hand of the underlying stays underwater, the investor receives a coupon. The worst-case scenario occurs when the underlying goes down by more than the investor expected. Then the investor will receive the bad performing underlying, but this loss is nevertheless partially offset by the coupons that the investor receives until maturity. Autocallables Autocallables are yield-enhancement strategies  The structure autocalls if the underlying is above the trigger level in the years before maturity. The investor receives a coupon equal to the number of years multiplied by the initial coupon level.  If underlying matures above the initial level and has not been autocalled, investor receives a coupon equal to the number of years multiplied by the initial coupon level.  If underlying matures between barrier and initial price, investor receives 100% back.  If the underlying matures below the barrier, investor receives only the performance of the underlying. This is the worst-case scenario.  We go long a zero-coupon bond, short a down-and-in put (DIP), long a series of binary calls  High likelihood of coupon payment and partial protection.  Short- to mid-term investment horizon.  Range bound view on the underlying. Structure Payout Investment idea Figure 7 10 [...]... to assume that the degree to which the 32 portfolio stakeholders can exercise control over the institutional investor and business and regulatory environment will be one of the determinants of qualitative “utility” function of the institutional investor To summarize, the institutional investor: In this framework, the institutional investor benefits from the use of structured products as they help me... expensive With the proper payoff structure, the dispersion of the stocks in the basket can generate higher IRR or consistent and uncorrelated performance First, I compare the price and the IRR of a structured product that pays off the average of call spreads on a basket of stocks and a structured product that pays the call spread on the average of basket of stocks I introduce the floor and the cap in order... points out, the limitations of mathematical modelling of the risk perception of an individual may be outweighing the benefits The utility functions approach is mathematically elegant and provides the basis for determining ht optimal investment weight in a portfolio of a risky and a risk-less asset In the case of derivatives and structured products investments, the risk-averse investor then should naturally... reduced If the risky asset increases in value, leverage may be introduced The amounts invested in the risky asset and in the bonds are function of • • • • The volatility of the risky asset and the riskless asset The liquidity of the risky asset The returns of the risky asset The interest rate term structure Because the rebalancing occurs non-continuously, the CPPI is actually exposed to gap risk If the risky... relationship and the high administration costs and market frictions Structured credit products have the capacity to provide pure exposure to credit risk Furthermore, they provide the investor with the ability to trade credit in a liquid format with relatively low transaction costs The use of credit derivatives allows the separation of credit and liquidity premiums on the creditsensitive securities For the traditional... as a long call and a short put option on the value of the firm On the other hand, [Markowitz] first showed that an investor should invest in some combination of a risk-free asset and the market portfolio, with the optimal weights determined by the investor s utility function If we view the value of a stock index as a call option on the whole economy, and ignore cash for a while, the investor is actually... the investment portfolio of an insurance company The [BAA 2004] outlines the market for credit structured products is comprised of the following products as follows: • • • • • • • • • CDS Synthetic CDOs Index linked structures Credit linked notes Credit spread products Asset swaps Total return swaps Basket products Equity-linked products CDS take up to 51% of the market and are the building block of. .. the investor makes a bet both on the direction which the underlying will take and on implied vs actual volatility If the actual volatility exceeds implied volatility the long side of the transaction will realize a profit, assuming all other factors the same Vice versa, if the actual volatility is lower that implied volatility the short side of the transaction will realize a profit at the maturity of. .. rate Potential leverage benefits can actually recover the cost of the CPPI On the other hand, the CPPI is not appropriate for range bound risky asset as the rebalancing will generate transaction costs and slippage 31 3 The institutional investor 3.1 Business environment and risk preferences Institutional investors are large investors who accumulate wealth capital, manage it and disburse it to match... non-stochastic nature Furthermore, the institutional investor may face the requirements of various stakeholders The investor is risk averse up to a certain threshold, yet beyond that maximizes expected profit Risk aversion however in this case is not related to the preference of more wealth to less wealth The institutional investor is first and foremost concerned with the avoidance of bankruptcy or regulatory . to exist, that is, the payoff is as if the investor has taken profit on the underlying. On the other hand of the underlying stays underwater, the investor receives a coupon. The worst-case scenario. 100 Initial price 13 Performance  Given the barrier for the DIN put or the strike for the short put we solve for the coupon.  The lower the barrier level the lower is the coupon.  This is a. 1 The use of structured products: applications, benefits and limitations for the institutional investor