Advanced guide to structured products
Pricing structured products
Structured products are a combination of different financial instruments. They commonly have a traditional deposit or bond with derivatives embedded into them, though options are the most common. When capitalising on a structured product, investors are effectively buying a bundle of different components. The price of the product reflects the total price of the different instruments. Similar to structured notes and deposits, the pricing of structured products varies depending on the type of products:
Capital protected products – swapping coupons for upside
At the inception of the structured product market, capital protected notes were the most popular product type. They were attractive because of the simple concept and were made possible by higher interest rates than are seen today.
Capital protected products offer at maturity a minimum return of the initial capital invested, plus a potential upside linked to an equity market. The two basic pricing alternatives are:
a zero coupon bond + option combination; or an interest rate swap + rolling short-term deposits + option combination
We will take the example of a product offering after five years a minimum capital return of 100% plus 100% of any rise in the Eurostoxx 50 over the investment period. The traditional way to build a guaranteed equity product would be to split the money received from the investor into two main building blocks:
- An upfront deposit also known as a zero coupon deposit or zero coupon bond, which is guaranteed (as long as the deposit taker or bond provider do not default on their obligations) to grow to 100% at the maturity date.
- An option premium used to purchase at-the-money call options on the Eurostoxx 50, offering upside exposure. For example, if the Eurostoxx 50 was at a level of 2,500 at the start of the investment and rises to 3,500 after five years, the option will pay out the difference between the strike price (the initial index level of 2,500) and the final index level, resulting in a gain of 1,000 points (3,500 minus 2,500), i.e. the rise in the index over the investment period. Otherwise, if the index falls, the option expires worthless.
Key factors that influence pricing:
They impact the price of structured products in different ways as this is what defines the bond or deposit. This is the most important factor for capital protected products: this is the part of the product which allows the full capital to be returned either at maturity, or if the conditions of the product are met and the plan matures early. A higher interest rate means less needs to be set aside to ensure a full return of capital and leaves more to spend on the options, generally making the investment return more favourable.
This is a statistical measure of dispersion of potential returns around the current market price and is measured via the standard deviation of the underlying asset or market index. Generally, the higher the volatility, the riskier the asset and the more price variance there is likely to be. The volatility of the underlying asset is clearly important in assessing the likelihood of the option being exercised. It is also the one factor that cannot be directly observed. In summary, low volatility makes options cheaper, while high volatility makes them more expensive.
Equity holders, as owners of the company, are generally entitled to a share of the profits, which may be paid to them in the form of dividends. On structured products, the investor is not entitled to receive the dividends that the stock pays. However, the dividend is discounted from the option premium, allowing the option to become cheaper, hence increasing participation or capital protection.
This is the level at which the structured product payoff starts to provide a positive return. Usually, if the strike price is above the underlying price, the option cost decreases as the likelihood of a positive return is lower compared with a strike price below the underlying spot price.
This is the period between the initial date and the maturity date. Usually, the cost of an option increases with the term. Nevertheless, the annualised cost decreases. This is why when interest rates are low, the term of structured products increases to offer the same participation or capital protection.
Yield enhancement products – simple yield enhancement
For traditional investments, yield enhancement is achieved through leverage, often in the form of borrowing to finance additional exposure.
With structured products, yield enhancement can be achieved by limiting performance or accepting some degree (part or all) of capital investment risk.
Many of these strategies are achieved by investors being short volatility, i.e. selling an option strategy, that allow the investors to obtain the corresponding premium to feed back into the structured product.
Simple forms of yield enhancement can be achieved by:
- taking a higher degree of credit exposure to the product issuer;
- capping or limiting the maximum achievable return;
- taking a limited capital investment exposure (e.g. 10%); or
- investing in products with early maturity (autocall) features.
Key factors that influence pricing:
A statistical measure of dispersion of potential returns around the current market price which is measured via the standard deviation of the underlying asset or market index. The higher the volatility, the riskier the asset and the more price variance there is likely to be. The volatility of the underlying asset is clearly important in assessing the likelihood of the option being exercised. It is also the one factor that cannot be directly observed. In summary, high volatility makes the investor obtain a higher yield.
Equity holders, as owners of the company, are generally entitled to a share of the profits, which may be paid in the form of dividends. On structured products, investors are not entitled to receive dividends. However, the dividend is discounted from the option premium, allowing the option to become cheaper, hence increasing participation or capital protection.
This is found in many of longer maturities of yield enhancement products, and allows investors to obtain the capital and coupons before maturity if the underlying is at or above its initial level on a specific observation date. This feature means that the more frequent observation dates are, the lower the potential return to the client.
Leverage products – accelerated returns
Leveraged forms of yield enhancement involve taking an increased degree of capital investment risk.
Leverage products give a higher participation to the underlying asset compared with a direct investment. This is achieved by using the premium derived from the sale of an option strategy, to increase participation.
The underlying products will be similar to the simple capital protected products but will contain additional option or credit exposures embedded within the structured product that enable the potential for enhanced returns, at the risk of capital loss (partial or full).
Leveraged forms of yield enhancement can be achieved by:
- increasing the level of capital investment exposure to 50% or 100%;
- investing in products with barrier features; or
- investing in products with combinations of barrier and early maturity (autocall) features.
Key factors that influence pricing:
A statistical measure of dispersion of potential returns around the current market price, measured via the standard deviation of the underlying asset or market index. The higher the volatility, the riskier the asset and the more price variance there is likely to be. The volatility of the underlying asset is clearly important in assessing the likelihood of the option being exercised. It is also the one factor that cannot be directly observed. In summary, high volatility makes the investor obtain a higher yield.
Following the 2008 financial crisis, the perceived counterparty risk became one of the most important factors for investors and their advisors. The credit rating is generally inversely correlated to the credit spread that issuers pay for cash: as such, the higher the credit spread (i.e. lower rating), the higher the return offered.
Hong Kong SAR Market Review, Q2 2023: issuance down QoQ
Asia Pacific | Market Reviews
Some 7,760 structured products worth HKD170 billion ($21 billion) were issued on the Hong Kong SAR primary market during the second quarter of 2023.
19 Sep 2023 by Violina Kirilova
South Korea Market Review, August 2023: Chinese IB enters the market
Asia Pacific | Market Reviews
There were 1,688 products issued in the retail segment in August.
14 Sep 2023 by Lachezara Tsenova
South Korea Market Review, July 2023: sales up 76% YoY, Hana enters top three
Asia Pacific | Market Reviews
There were 1,908 products issued in the retail segment in July.
08 Sep 2023 by Lachezara Tsenova
South Korea Market Review, June 2023: NH tracks Citi risk premia index
Asia Pacific | Market Reviews
There were 2,303 products issued in the retail segment in June.
21 Aug 2023 by Lachezara Tsenova
Taiwan Market Review, June 2023: DBS Bank most active issuer of H1 2023
Asia Pacific | Market Reviews
Some 3,163 products with estimated sales of TWD300 billion ($9.6 billion) were added to the SRP Taiwan database in June.
14 Aug 2023 by Vanina Kopcheva
Thailand Market Review, Q2 2023: quarter ends with 37% decline in sales
Asia Pacific | Market Reviews
Some 3,947 structured products with worth THB20.4 billion ($0.6 billion) were launched in Thailand during the second quarter of 2023.
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