Structured Products Handbook In Association with RBS

Transcription

1 Structured Products Handbook In Association with RBS

2 Contents Welcome 3 Introduction to FVC 4 Background to Structured Products What is a structured product? 5 History and the Current Market 6 Common Features in Structured Products 7 How a Structured Product is Constructed 8 Analysing and Rating Structured Products 1 Key Elements Asset Classes and Underlying Assets 11 Credit Quality of Issuers 12 Single and Multi-Asset Products 14 Dividends and the Cost of Protection 15 Different Pricing Regimes 16 Bringing Products to Market 17 Secondary Markets 18 Use of Structured Products within a Portfolio 19 Regulation and Compensation Schemes 2 How to Trade RBS Structured Products 22 Major Product Types Introduction to Product Types 23 Capital Protected 24 Accelerated Tracker 26 Reverse Convertible 28 Autocall 3 Defensive Autocall 32 Bull Bear 34 Range Accrual 36 Synthetic Zero/Growth Certificate 38 Product Comparison 4 Five Reasons to Recommend Structured Products 41 Key Risks 42 Glossary 43 2 FVC Structured Products Handbook

3 Welcome May 212 Dear Financial Professional, At Future Value Consultants we have sought to provide wealth managers and financial advisers with accessible and relevant services. This is the fourth version of our popular structured products handbooks and we are delighted to bring this latest edition to you in association with the Royal Bank of Scotland. Royal Bank of Scotland selected Future Value Consultants because of our experience in the UK through our research channel as the most widely used source of analysis on structured products available to wealth managers and financial advisers. In turn Future Value Consultants is pleased to help Royal Bank of Scotland disseminate information to wealth managers, advisers and salespeople about structured products as we believe that education has an important part to play in this industry. This is a critical time in the investment world with the advent of RDR and other regulatory changes coupled with technology advances and product innovation. In addition, the financial climate remains turbulent and difficult. RBS have proven themselves a major force in UK structured products over many years with a broad range of products and a commitment to innovation and service. FVC has been providing research on structured products in the UK since 1999, covering over 2 products in that time. This handbook aims to explain how structured products work and what they can achieve for investors. We have divided the content into fifteen individual sections covering different aspects of structured products followed by an in-depth look at some of the most important product types. If you have any comments or feedback about this handbook please contact us, we would very much like to hear from you. Yours faithfully, T.M. Mortimer Managing Director, Future Value Consultants Limited tim.mortimer@futurevc.co.uk Contact details for the Royal Bank of Scotland can be found on the back cover of this handbook. FVC Structured Products Handbook 3

4 Introduction to FVC Future Value Consultants (FVC) is a research, product design and analytics consultancy specialising in structured products and algorithmic strategies. FVC s flagship service is its structured products research reporting service, which now covers the whole of the UK and US markets, as well as products from other markets globally. Its methodologies, analysis and web-delivered tools have been used by many thousands of professionals in the industry. It pioneered the concept of quantitative analysis of structured products in 1999 and remains the market leader. FVC has taken the concept of consistent and independent analysis, which is common in the mutual fund and bond world, and extended those techniques to analyse structured products. Concentrating on price, returns and risk, FVC produces clear, accessible analysis that is useful to all those in the structured products market, from issuers to advisers. These services are used by advisers and wealth managers in particular to enable them to assess structured products by using the independent research and analysis that FVC provides. In a marketplace with many different investments issued constantly such a service provides a vital role as advisers seek to provide the best service for their investors and satisfy their own compliance requirements. In the UK over 2 products have been assessed by a service that has a track record of over ten years. It is accessed by many thousands of advisers and features prominently in the selection process of adviser networks and wealth management groups. FVC also performs independent valuations and index calculation services that are used by many institutional clients. It provides valuations, consultancy and support to its clients on their derivatives and structured products portfolios. FVC believes that good valuation services require a combination of reliable models, accurate data and sound business experience. This enables it to provide valuations in line with market practice and to provide reconciliation and insight when there is a discrepancy between the issuer and valuation agent. The index calculation business specialises in both algorithmic and bespoke indexes. FVC started its index calculation business in 27 and first acted as calculation agent for complex algorithmic indexes. This leverages its expertise in complex instruments and analysis from its structured products business. All of FVC s services combine usability, the latest web-delivered technology and cutting-edge techniques in research and analysis in structured products, derivatives and other related areas. It is the goal to provide clients with total solutions addressing all of their requirements. FVC supports industry conferences, education initiatives and media events, and has been selected to contribute analysis to Structured Products Magazine since 27. It has developers and business analysts with a wide range of experience. Its clients include many of the largest global investment banks as well as product providers and institutional buyers of structured products. 4 FVC Structured Products Handbook

5 1 What is a structured product? Structured products are investment products designed to offer a predefined payoff profile from the performance of an underlying asset. Structured products are created to meet the requirements of many types of investors. This is achieved through offering different levels of exposure, risk, return and protection to a particular asset or assets to satisfy an individual investor s requirements. These offer investors a chance to meet their specific goals, some of which cannot be achieved through investing in simpler financial products available in the market. Structured products are commonly used as a form of enhanced investment to be included in a diversified portfolio. Most UK structured products are equity-linked and offer either full capital or partial protection. On the upside they seek market-linked returns or high target levels of income. Structured products are usually subject to a certain level of participation or a maximum return which means, in certain cases, they may underperform against direct investments in strong market conditions. However, this is balanced by reduction of risk to the investor. Thus investors give up some upside in good market conditions, in return for some protection against losses in a bearish market. Structured products also offer the investor an opportunity to invest in a range of mainstream and alternative asset classes which include the world s major equity indices, commodities, commercial and residential property, currencies and particular industrial sector indices. It is often difficult to gain access to these markets directly, therefore structured products act as an investment vehicle to them. They allow investors to make returns on markets over a given period of time while still maintaining a level of risk control. A structured product linked to a non-traditional asset class can also offer the investor a lower risk way of accessing that underlying. With a suitable choice of underlying assets and risk profiles, structured products extend the range of investments in a way which unlocks a whole class of investment opportunities. Generally products are backed by major financial institutions. Listed products are traded on an exchange where they can be traded like stocks or a fund and usually become available as soon as the product terms are hedged. With retail products the issuer, distributor or plan manager will produce literature at the time of launch of each new investment into the market. The brochure identifies the terms and key features of the product. The investor should be fully aware of the features of each investment how the product fits into their portfolio. This handbook aims to educate by breaking down the key components that go into a structured product through clear explanations and illustrated examples. FVC Structured Products Handbook 5

6 2 History and the Current Market The UK structured products market has been active in the retail and institutional arena since the early 199s. Many market developments have been seen in that time. During the 199s, volatility levels were relatively low and interest rates were also quite high. This scenario led to the growth of guaranteed equity bonds as such products were then known, many issued under a life insurance wrapper. Such products were simple capital protected investments and they continued to be popular during most of the 199s. The next major change in UK structured products was dictated by the continued stock market volatility that started in 1997 following crises in Asia and Russia. Volatility stayed at high levels and the dot-com boom ensured rising equity markets in the period This was combined with falling interest rates and so many investors sought alternative income bearing products. Necessarily these involved risk to capital and consequently reverse convertible income products grew in popularity. The peak of issuance in these products was between 1999 and 21 which coincided with the peak in equity markets. Unfortunately the ensuing bear market in the FTSE-1 Index and other major equity indices meant that the vast majority of these investments lost significant amounts of capital, leading them to be dubbed precipice bonds by the press. Between 23 and 27 structured products changed again with the popularity of the super-tracker type accelerated return product and the growth of auto-calls. This was due to a combination of market parameters and attitudes to risk as investors sought to recoup losses in a risk controlled manner. They were happy to accept maximum returns capped at a sensible level to either boost the chance of achieving this or to control risk. Simple capital protected products have generally been rarer with other constructions such as digitals becoming more popular. Since 27 the investment world has been dominated by credit worries. Major bank failures and bailouts have caused funding levels to rocket and this has impacted product terms and their associated risk. Everyone now accepts that it is vital to assess credit risk as well as market risk. There has in general been a flight to quality in the use of issuers with those with stronger credit ratings as well as increased usage of deposit wrappers which may benefit from compensation schemes. There has also been an increase in the use of collateralisation and other credit mitigating techniques. Since 21 government stability particularly in the Eurozone has also had an impact. In 29 the FSA published a number of regulatory directives for UK structured product business. It looked at the quality and balance of product brochures but also focused squarely on the quality of advice given to investors particularly with regards to risk. The aim of these directives was to ensure that issuers and advisors alike adopt sound selling practices. As RDR continues to draw nearer the FSA further acted in to undertake an important review of practice of distributors. This includes making sure that products are properly assessed and scrutinized before being brought to market. The new requirements detailed in RDR apply to product providers and retail investment advisers as part of the FSAs consumer protection strategy. 6 FVC Structured Products Handbook

7 3 Common Features in Structured Products The three most fundamental components of a structured product are the underlying asset, the issuing entity and the maturity horizon. If an investor is uncomfortable with any of these aspects of the investment, it is highly unlikely to be suitable. Capital Protection Some structured products focus on capital protection while others offer greater potential returns by taking capital risk. Capital protected products achieve their protection by sacrificing some market upside and/or the dividends associated with the underlying. Barriers Capital-at-risk products usually offer features to reduce exposure to decline in the underlying asset, for example by use of a barrier. The two main types of barriers used in the UK market are the final day (European) barrier, which is only observed on the final day of the investment and the daily closing or intra-day (American) barrier type, which are both observed throughout the life of the product. The intra-day barrier is more likely to be breached than the daily closing barrier because there are more opportunities to fall below. Conversely, the European barrier is the least likely to be breached because there is only once chance to be breached. If the barrier is breached because the asset falls below the barrier level then capital will be directly at risk in some way. In the UK barriers for index linked products are often set at a level of 5% of the initial level of the underlying asset. It is often the case that a lower (deeper) barrier is present for a product linked to a more volatile asset such as an emerging market or single stock. Market Participation and Capping Participation or gearing is commonly used to describe the level of upside exposure to the underlying asset. Leveraged exposure to the growth of an asset comes at the cost of reduced downside protection because it is impossible to provide both. Growth products with longer terms tend to offer higher market participation rates. This is because the cost of protection can be spread over a longer period of time thereby allowing more upside exposure to be retained. While a provider will seek to offer high participation rates, sometimes products have a cap so that no underlying growth beyond a certain level will be passed on to the investor. Averaging Averaging refers to the method of calculating the reference underlying s final level. The simplest products are termed pointto- point, i.e. they depend on the relative levels on the first and last day of the investment term. The most common use of averaging is to define the final level of the underlying for calculating the product return as the average value over a certain period of time. Final index averaging can be useful as it may soften the impact of sudden falls in the last stages of the investment term. However, it can also constrain growth in a rising market. Autocalls An autocallable product is one that can be redeemed prior to maturity if the underlying asset(s) reach the required level on a pre-defined date during the product term. Products that include an autocall feature are commonly referred to as kick-out products and usually pay the investor a fixed return plus their initial capital if the auto call feature is triggered. FVC Structured Products Handbook 7

8 4 How a Structured Product is Offered Structured products can be bought in three ways: through a plan manager, as a securitised/ listed instrument or through a private bank. The plan manager and securitised routes are similar in that products are designed for large investor bases and mostly of small to medium case sizes. Private banking distributed products tend to be more bespoke aimed at more wealthy or sophisticated investors. Whoever is responsible for product design will need to carry out extensive research in order to match investors requirements and then try to assess which features can be realistically achieved in current market conditions. In the case of a private bank or plan manager once a potential product design is reached one or more investment banks are contacted to request indicative prices for the intended product. The price of the assets will depend on market conditions, the cost of hedging and (in the case of fixed terms offered for a significant period) the uncertainty of the provider meeting the expected sales volume. Securitised and listed instruments are brought to market by an issuing bank directly which will issue products it believes are competitive and appropriate for the target market. Structuring Capital protected and capital at risk products are constructed quite differently from each other. Capital protected products include features to provide the return of capital at maturity, while giving the investor the opportunity to benefit from market growth. Capital protection is typically ensured through the purchase of a zerocoupon bond with the rest being spent on options or an income stream which cannot return less than zero. This requires the bulk of the investment being put into a deposit which at maturity will reach 1% or some other target value of the amount invested. The amount of money available to purchase call options or an income stream is dependent on the interest rate and length of the investment term. Higher interest rates and longer investment terms lower the cost of capital protection which results in a higher participation rate or higher potential returns. An alternative is to produce a capital-at-risk product in order to offer potential higher returns. In this instance, put options are sold to generate value which is used to buy more call options to increase the participation level of the product. However, capital is at risk if the market falls below some pre-defined level. The same strategy is used by high-income structured products where put options are sold to enhance the level of the income stream. Competition Another feature of the structured products markets is that more issuers will seek to compete for simpler more liquid products but a significantly fewer number of banks are willing to engage in more complex products, those of exceptional long maturity or linked to unusual underlying assets. Managing the Sales Process The case of plan managers is the only one of the three to have significant volume risk because of the need to offer the product at fixed terms to the investors of the plan manager. Both parties will agree the amount or range of product volume to be purchased based on expected sales figures. The bank takes on the risk of under or over selling and may incur further costs if prices move 8 FVC Structured Products Handbook

9 significantly from the time of the quote to the time the product is hedged. Product providers opt for variable hedging if they do not want to commit to a pre-defined level of volume of sales. Variable hedging is, however, more expensive, often making the terms of the product less competitive. Listed or securitised products do not carry this risk as terms are set on the day of pricing and future trading occurs at the banks bidoffer prices. Private banking trades are agreed generally with the client base already approached and demand established. In order to manage its risk the investment bank may purchase an amount of the underlying asset or options traded on an exchange to hedge its principal exposures to the market, volatility and interest rates. The volatility of an underlying asset is a key factor in determining the price of call options, which are sensitive to the volatility of an asset because the option benefits from market appreciation but does not suffer from losses. Call options for product linked to volatile underlying assets are more costly which results in lower participation rates. Higher volatility also makes put options more expensive. The level of complexity in product design can be considerable for wealthier or institutional investors, but generally would be broken down into two core parts: Counterparty Selection The capital return element of a structured product is generally provided by the investment bank that delivers the derivative-linked payoff as well, but this is not always the case for larger investments. Typically the product structurer would identify a bank whose credit risk profile is suitable for the investor. For example, if the structured investment forms less than 5% of a portfolio and the investor is seeking aggressive growth, a less secure institution may be suitable, but for a cautious investor allocating a large portion of their wealth, it may be more suitable to spread the risk among a number of stronger financial institutions. Alternatively, a collateralised solution may be sought where the bank puts up government bonds, or other paper of very strong credit-worthiness as collateral, on a daily basis which are available to the investor if the bank fails. Payoff Selection The investment return (payoff) can deliver virtually anything the investor needs and the product structurer would normally source this from the most suitable of a number of counterparty institutions. In order to win the business, the ability of a bank to provide suitable secondary market pricing, regular valuations and other services would be taken into account in addition to a competitive price for the derivative assets. The underlying assets to which the product is linked can range from a portfolio of funds chosen for the client, through to commodities, individual stocks, equity indices or any combination of these. FVC Structured Products Handbook 9

10 5 Analysing and Rating Structured Products FVC has pioneered research methodologies for structured products since 1999 and covers all UK structured products. FVC has developed objective and consistent methodologies that generate ratings and statistics on all structured products allowing easy comparisons of one product with another. The first part of an FVC report contains a product summary and product description, outlining the key features and terms of the product. This description provides a clear summary of the product s terms as well as a comprehensive review which details the advantages and disadvantages of the product compared to others currently out in the market. Important product features such as the choice of underlying asset, the investment maturity and choice of investment wrappers are shown as well as the offer period and key dates. The report usually includes the product literature and contact details supplied by the provider along with their contact details. Many users look to the report service as an efficient way of keeping up with the market. However the real differentiator lies in the quantitative analysis. The report contains scores examining key properties of value, return and risk as well as charts to demonstrate potential returns. Value Score The value score is obtained by an independent estimate of the market price of the assets calculated by FVC. It uses prevailing market data which is used to estimate the offer price of the product components. This includes effects of interest rates, volatility and credit spreads. Because the product is valued at a time shortly after it is hedged it is possible to estimate how good or poor value the product represents. This score is updated weekly to show the effects of changing market conditions allowing the comparison of the product with those that are issued subsequently. The value score assesses implied fees in the same way that a fund would look at TER. The estimate of value is translated into a score ranging from to 1 for easy comparison purposes. 1 FVC Structured Products Handbook Return Score The return score is based on a different methodology. Five market scenarios are selected representing high and low market growth and high and low volatility as well as a central neutral assumption. The probability distribution of the product is calculated under each of these scenarios and a risk adjusted average return value is calculated. The higher the best of these numbers compared to the distribution of market peers will lead to a higher assessment of returns. These numbers are also converted to a scale of to 1 for benchmarking purposes. Risk The risk score (riskmap) calculates the expected total shortfall of the product below the risk-free rate taking into account both the effect of product market volatility and the effect of issuer credit. The riskmap is also expressed on a scale of to 1, and the risk number is decomposed into the contribution from market risk and credit risk. Probability Charts The use of probability charts show how the product might be expected to perform under the same five market assumptions used in the return score calculation. Charts of probabilities of various absolute returns as well as performance compared to cash returns are also shown as are the probabilities with and without the effect of credit risk taken into account.

11 6 Asset Classes and Underlying Assets The most common types of underlying asset classes used in the UK structured product market are equity indices, equity baskets, commodities, mutual funds and commercial & residential property indices. Less frequently used underlyings include hedge funds, currencies, ETFs and custom indices. Equity Indices Most structured products in the UK market are linked to major global equity indices. The FTSE 1 Index has always been the most popular choice of underlying asset used in structured products in the UK market. Other regular choices include US market index S&P-5, Eurostoxx-5 (representing Europe) and the Japanese Nikkei-225. Major indices are the most liquid of the asset classes and therefore dealing in the underlying shares, futures and options is cheaper and more easily achieved. Additionally equity indices are by definition more representative and less volatile than a small basket of stocks, which is why they may be seen as a more sensible investment option. They are also the most natural and recognisable choice for investors. Baskets A basket usually incorporates several equity indices, stocks or other assets in one product. Each asset is allocated a specific initial weight in the basket. A basket is sometimes used as a bespoke choice to achieve a certain positioning or allocation, for example, using ten stocks in the same sector. Commodities Commodities and commodity index-linked products can be used to diversify an investor s portfolio. Commodities also offer investors an opportunity to invest in an asset class which has historically had lower correlation to equities and bonds but have obvious rationale particularly in times of demand led inflation. Inflation Products linked to the performance of inflation can be used within a portfolio to provide real returns that preserve spending power. Whilst the standard equity linked growth and income products issued in the UK offer a means to generate high headline returns there is no guarantee that they will keep pace with inflation. Commercial and Residential Property Investing in property is another way to diversify a portfolio. Like commodities, the value of property does not necessarily correlate with equities, so it can help to spread risk. Both types of property are generally less liquid than other asset classes and dealing costs can be higher for anyone trying to invest directly. Funds Funds are essentially a portfolio of stocks or other instruments. These are either actively managed by fund managers with a view to outperforming benchmarks or lower-cost tracker funds to simply mirror the performance of indices, regions or sectors. Proprietary Indices There has been a rise in the amount of structured products linked to proprietary indices. These types of indices are designed to provide exposure to a particular underlying or asset class following a rules-based strategy to either control risk (such as volatility controlled strategies) or to generate outperformance (e.g. momentum or relative value based strategies). FVC Structured Products Handbook 11

12 7 Credit Quality of Issuers The credit quality of the issuer is an important aspect to be taken into account when analysing the risk in a structured product. In today s turbulent investment world, it is widely accepted to be at least as important as market risk. The construction of a structured product involves the purchase of assets by the product provider from the issuing entity (an investment bank). Credit quality is the ability of the counterparty to honour its obligations, that is remain solvent until the product s maturity. Lehman Brothers Collapse Prior to the financial crises of 27 and 28, relatively little attention was paid to the credit quality of issuers, (certainly those of A rating or above) as it was assumed that all issuers were stable institutions representing little risk. Funding levels were low meaning that banks did not have to offer much higher than the riskfree rate when seeking to raise funds. In the last few years that has changed and today credit considerations are critically important and will likely remain so for the foreseeable future. Credit rating agencies such as Standard and Poor s, Moody s and Fitch assign ratings which vary from AAA to D (definitions and naming vary a little between agencies). These are used as a guide to indicate the likelihood of default. These ratings have long been used in assessing the financial stability of a company, however agencies have come under criticism for the accuracy and relevance of their ratings following the collapse of many financial institutions and other companies with reasonable ratings. Credit Default Swaps There has been an increasing trend towards using credit default swaps (CDS) levels to reflect the credit quality of the issuer. The CDS of a company is expressed as a number which indicates the size of the credit risk involved in investing with a particular company. The CDS level represents the market level for institutions to insure against credit events from the issuing entity. This may be used as an estimate of the return investors should expect to earn over the riskfree rate by investing with a particular issuer as a fair compensation for the credit risk taken on. For this reason, providers may choose issuers further down the credit risk curve to enable them to produce a product that has optically more attractive terms. It is important for advisers to be aware of the identity of the issuer and judge their credit quality to assess whether the returns are in line with risk involved in investing in the product. An issuer with a high credit spread may offer higher returns on product than an issuer with a low credit spread, as the investor should get adequate compensation for the credit risk taken on. Collateralisation Some investors place very high importance on capital protection and therefore may be uncomfortable taking direct issuer credit risk. Collateralisation has emerged as the process used to back products for such investors. Assets held independently by a custodian are used as collateral to pay out returns in the event of issuer default. There are different collateralisation mechanisms but generally because of the additional costs incurred with this process and the lower rate of interest earned collateralised products generally offer less attractive terms. 12 FVC Structured Products Handbook

13 The graph below displays the average five year CDS of six major issuers of structured products in the UK Lehman Brothers collapse Major losses for AIG Greek bailout Eurozone crisis 15 Average CDS 1 5 Mar 8 Mar 9 Mar 1 Mar 11 Mar 12 Source: Reuters The graph illustrates the effect global market events have had on the financial stability of these major institutions which include: Barclays Bank Plc Morgan Stanley HSBC Bank Plc Royal Bank of Scotland Plc Lloyds TSB Bank Plc UBS AG The first spike in the graph was around the time that Bear Stearns was sold to JP Morgan Chase in March 28. The sale was as a result of Bear Stearns over exposure to the sub-prime mortgage crisis. The next significant peak was in September 28 after the collapse of Lehman Brothers. Unlike the Bear Stearns situation, the US government let the bank file for bankruptcy which subsequently sent shockwaves throughout the financial system. The CDS levels of major banks rose significantly during this period. September 28 also saw AIG being bailed out by the US government causing more market panic. CDS levels began to fall but remained volatile during the last quarter of 28. In March 29, AIG announced huge losses for the last quarter of 28. This caused major international indices, including the FTSE 1, to fall sharply. There were signs of slow recovery beginning in April 29 which caused a fall in CDS levels and the FTSE 1 began a recovery. The rise in CDS levels and subsequent decline in the FTSE 1 from March 21 can be attributed to the effect of the debt crisis in Greece. During this period, Greece requested a bail out and S&P downgraded Greece to BB+ causing stock markets to plummet. Global stock markets fell in August 211 amid growing concerns over the European Sovereign debt crisis, in particular towards Spain and Italy. Additionally United States treasuries lost their AAA credit rating. This caused panic in stock markets which remained volatile for the rest of the year. FVC Structured Products Handbook 13

14 8 Single and Multi-Asset Products In the UK, the majority of structured products are linked to a single asset such as an index, equity, or commodity. The popularity of these products comes from the fact that they are easier for the provider to construct and generally easier to understand from an investor s perspective. Products linked to multiple assets provide investors with the opportunity to diversify the risk in their portfolio and can offer more targeted strategies for return. We define single asset products as those linked to a single index or strategy even though that underlying may itself be quite bespoke. Multi-asset products can be divided into two fundamental types. Firstly we consider baskets of assets. A basket is a collection of assets with given weightings. The payoff of the product is a function of the basket value. For these types of products, the performance of individual elements in the basket does not have any (direct) bearing on the product payoff, except through its influence on the basket return. Secondly we consider what might be termed true multi-asset structured products. These refer to products which look at each asset s performance individually in some way rather than calculating a payoff which is simply a function of the basket (average) performance. These types of products are generally more complicated than simple basket products both from an investor s point of view and also from a risk management perspective. The returns of many multi-asset products are based upon either the best or worst performing asset. Examples of this type of product include rainbow products, worst of kick-out and worst of reverse convertibles. The correlation between each asset plays a crucial role in such products. The most common examples of multi-asset products in the UK market are worst of auto-calls or reverse convertibles. The downside risk taken on by the investor is linked to the worst performing of two or more indices over the investment period. Although the indices may be major indices with which the investor is comfortable, clearly the downside risk is greater than that of any of them individually. The product s return cannot be expressed as a simple basket combination of the indices. Another example of a multi-asset product is the rainbow. The performance of each asset is calculated at maturity and the weights are calculated by giving higher weights to the best performing assets according to a pre-defined formula. The correlation between assets affects the pricing and prospects of all multi-asset products. For reverse convertibles or auto-calls a higher coupon or return is offered as compensation for taking a capital return linked to the worst performing index. The investor is hoping for high correlation so that the lower or lowest asset is not much worse than the average of all the assets. Conversely for rainbow products assets that have little or no correlation to one another make this product more attractive as the investor would need one asset to significantly outperform another in order to achieve a better return than would have been offered by the conventional basket product. 14 FVC Structured Products Handbook

15 9 Dividends and the Cost of Protection A very common feature of structured products in the UK market is capital protection. Products offering full capital protection at maturity help neutralise market risk. In this case investors receive full capital return at maturity regardless of the performance of the underlying asset. However, these products are still subject to credit risk from exposure to the issuing institution. In bull markets, some commentators may argue that buying capital protection is unnecessary as markets are rising. Conversely these same commentators are likely to say that in a bear market either asset levels have bottomed out making further protection unnecessary or that capital protected products will only return full capital at maturity even though this represents outperformance over a direct investment. Both these arguments are illogical and misleading. There is no such thing as markets going up or down, only that they have already gone up or down. Therefore capital protection is likely to remain an important feature for many investors in any market environment. However different pricing regimes (particularly high volatility levels) can make the cost of protection very expensive hence making the structured product solution unattractive. If an investor is risk-averse for some reason, for example because they are approaching retirement or feel that their current portfolio is too risky, or they change their mind about market sentiment then they would be unlikely to consider investing directly into equities or other risky assets. In such cases looking for a capital protected investment is the number one priority. As long as investors are aware that all protection carries a cost but represents a decision they wish to make then they ought to understand that there is some opportunity cost if markets perform strongly and that the protection with hindsight proves unnecessary. The Cost of Protection To study the typical cost and implications of purchasing capital protection, we compare a capital protected FTSE-1 linked structured product with a direct investment into the equity market of a FTSE-1 tracker fund or ETF. Apart from the fact that only the structured product offers capital protection the two investments differ in that dividends are received by the fund. If the FTSE-1 shows a fall in capital terms over the investment horizon, the structured product will still return full capital at maturity. However a tracker fund would show a capital loss offset in full or part by the dividend income. If the size of the market fall exceeded the value of the dividends then it is possible for a tracker fund to show a significant loss in value. Over the last ten years there have been several cycles where the decline of the FTSE-1 would easily justify the premium implicitly paid. Although the price paid for capital protection is a fair market value for what is being offered it does nonetheless represent a significant cost. Therefore, if capital protection is not required by an investor it makes no sense to seek a product which provides it. However, if the client requires capital protection but also seeks the opportunity of equity linked returns rather than interest then a capital protected structured product may be the best choice. FVC Structured Products Handbook 15

16 1 Different Pricing Regimes Structured products are a popular and an important investment class in just about every set of market conditions. However, the different points in the economic cycle affect individual structured product constructions in different ways, just as they differ in their consequences for equities, bonds, cash and any other investment sector. There are two main factors of the economic environment which affect the pricing and suitability of structured products at any given time. The first are simple market conditions whether equity markets can be said to be bull, bear, or range-bound. Also of key importance is the level of interest rates which has a bearing on the relative attractiveness of equity and cash or bonds. The second factor is the level of the different pricing parameters which affect structured products. The most important of these are levels of volatility, but dividend levels are also significant as well as the shape of the interest rate yield curve over different maturities. Issuer funding levels and credit risk has also significantly affected pricing conditions since 27. We shall concentrate on the effects of the levels of interest rates and volatility. For any market environment there are usually two opposing considerations. The first is the perceived attractiveness of any product that can be constructed in terms of participation rates, income levels etc. The second is the likely future performance and prospects of the product in such an environment. There is a natural conflict between these two which shall now be explained. We will consider markets with high and low volatility levels. High Volatility Markets The case of high volatility combined with high interest rates arguably favours reverse convertible products. mean that the investor (who is effectively selling a put option) generates a healthy extra coupon and so the product is a high yielding investment. However, although the income looks attractive, it should be remembered that the high levels of volatility indicate the market s pricing of a sizeable amount of risk and therefore the income offered is far from risk-free. If however interest rates are low this is usually the best situation for auto-call products. In such situations the fixed return available in the case of product calling looks attractive, benefiting from the downside risk taken in the event of kick-out not occurring. Low Volatility Markets The case of low market volatility tends to favour other types of structured products. If volatility levels are low and interest rates are high, capital protected products make the most sense. This is because the high levels of interest rates allow for a favourable swap of interest payments for an option related return and the low levels of volatility mean that options prices are relatively low. Participation rates are high and may even exceed 1%. When low volatility is coupled with low interest rates this favours accelerated products because they are in fact relatively invariant to changes in both interest rates and volatility levels due to the combination of options that they purchase and therefore look attractive compared to cash or direct equities. In such situations the fixed coupon looks attractive, benefiting from both high interest rates and the downside risk taken which increases in high volatility markets. The high levels of volatility 16 FVC Structured Products Handbook

17 11 Bringing Products to Market A structured product goes through a series of stages from its initial concept and design to its strike date. Structured product providers and structurers carry out extensive research and analysis to enable them to design a product to meet the needs of their target investors. Once the structured product design has been decided the structurer or product provider will seek to confirm indicative or final terms. Sometimes this is an open market process involving several issuers, sometimes more than one for each offer. Typically a provider would then agree a deal for the product to be hedged with a particular bank, either based on indicative terms or fixed terms based on expected sales volumes. The product structurer would normally organise the trade directly with the bank or banks selected, with no offering period needed. Securities Securitised products are either privately placed or publicly offered. They can either be listed on an exchange or the issuing entity provides two way pricing. The terms for products that are to be listed on an exchange platform are confirmed closer to the strike date. In this case the product can usually become available as soon as the product terms are hedged, and is listed on an exchange where it can be traded like a stock or a fund. Unlike plan based retail products, there is no offer period and the product can be bought and sold daily throughout its life up to maturity. One of the great benefits of the fund route is the ease of dealing in the secondary market, both selling and buying, allowing investors to take advantage of changing views on market expectations, as well as being able to use the same product across a number of client portfolios. Plans In the case of plans that are to be distributed in the retail market, the bank usually fixes the terms around six weeks before the strike date. Once the product has been hedged, a brochure detailing the features of the product is produced. During this time, providers attempt to promote the product to groups of advisers. The product goes on sale during the offer period during which time the advisers research on products to fit their clients portfolios. The offer period of a structured product refers to the time the product is offered for sale to the public. The sales period usually lasts between six to eight weeks. Funds Some structured products are now offered within UCITS funds and are available both for direct investment (like a Plan) and via platforms, insurance bonds and other arrangements. Although the cost of delivering a product in this format can be high, the additional flexibility they afford can be critical to some investors. FVC Structured Products Handbook 17

18 12 Secondary Markets The intermediate value of a structured product at any time between its launch and its maturity is known as its secondary market value, which is an ongoing valuation of the options and other components of the investment. At the start of any product the level of its market value is the issue price less declared fees and at maturity it will equal the product payoff. The secondary market value during the life of the product is the sum of the value of the individual product components. The value of each component varies continuously during the lifetime of the product and therefore so does the market value of the product. Each component of the product has a sensitivity to market parameters such as underlying spot levels, interest rates, credit spreads and volatility. Fixed income components such as capital repayment and coupons decrease in value when either interest rates or credit spreads increase. Options generally increase in value when volatility increases and call options increase in value when the spot level goes up whereas put options decrease. A secondary market exists when a bank market quotes bid and offer prices on its own product during its lifetime. In most situations we would expect the bank s estimate of fair value to lie between the bid and offer price but supply and demand sometimes mean that this is not the case. Increasingly a secondary market with reasonable bid-offer spreads has become commonplace in retail structured products. Currently, generally only the issuer makes a market in its own products, however in principle structured products could become more widely traded between third parties on the secondary market. Many investors view a structured product as primarily a buy and hold investment. For them the existence of a reasonable secondary market acts as an exit strategy in case the funds are needed urgently. For all investors a meaningful secondary market allows accurate valuations to be made and used in product or portfolio reporting statements during the investment s life. More sophisticated investors or active managers will seek to trade either in or out of a listed structured product. This enables them to choose an appropriate risk profile but potentially also benefit from timing the market in some way. For example an investor who seeks high yield in return for controlled risk through a reverse convertible or auto-callable might sell the investment back before maturity if markets are sufficiently high since most of the yield will have been earned and the product will be trading like cash. They can then re-invest into a longer dated product and seek that yield enhancement again. Products listed on a stock exchange such as the London Stock Exchange are typically more liquid than most retail structured products and in most cases will have continuous trading. Issuers of listed products on an exchange have to adhere to the market making terms of that exchange under normal market conditions. 18 FVC Structured Products Handbook

19 13 Use of Structured Products within a Portfolio Structured products have a place in many investors portfolios. The variety of asset classes and risk profiles on offer mean that they provide solutions to many investors of different risk profiles and investment aims. Structured products can be considered to have three main uses in an investor s portfolio. Core Holdings The first is as a core holding. As structured products are constructed using derivatives, many wealth managers and advisers feel that structured products rank alongside such niche or alternative investments as commodities, property, hedge funds and other complex or illiquid investments. However, one of the most important features of structured products is that they aim to control risk. Therefore a structured product is a natural choice for a lower risk investor who wishes to retain market exposure or income generation opportunities while reducing or eliminating market (and credit) risk as much as possible. For an investor to do this without structured products it would be necessary to convert a large part of the portfolio to cash or bonds and potentially miss out on market returns. Access to New Underlyings The second use of structured products is to allow an investment into a new market or underlying asset with better transparency, diversification, lower costs and typically some risk reduction as well as currency protection. Many investors would not consider any direct holding into some markets or underlyings because of the associated risk yet consider them to offer interesting potential returns. A capital protected structured product linked to an overseas stock market index for example gives a safer way to allocate a few per cent of an investor s portfolio. Improving Risk Profile The third use we consider here is to fundamentally shape the risk profile of an investment to take account of market conditions as well as the investor s risk appetite. Products such as accelerated growth products or kick-outs allow an investor to capture a good return from equities in the event of modestly performing markets. This allows them to keep or increase exposure to their target markets or asset classes but also offers them the opportunity of a greater return than a direct investment in the event of modest market growth. Popular and appealing in recent years have been the auto-calls which seek to generate high fixed returns without requiring any market growth and therefore are the perfect choice for expected range-bound markets. The use of such tactical investments would mimic many active fund managers strategies of core holdings plus specific overlays in order to enhance return. For securitised products the opportunity to buy and sell to take account of changing market conditions or strong performances in the underlying allows extra possibilities to shape risk and boost returns. FVC Structured Products Handbook 19