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♦ Many products & techniques have been developed for the professional market
♦ For individuals it is difficult to use these merits
♦ Structured products package professional risk-managed products and
techniques into simple structures that meet specific investor needs
– Simple to understand
– Ready-to-use product
– Cost efficient
♦ Investor: how do you enhance the yield (expected return) of your investment?
– Alpha: arbitrage, mispricing…
– Risk premium
♦ Issuers
– Need to raise funding
– Need to limit the size of the balance sheet
♦ Investors
– Need to assess credit risk to the issuer
– Higher spread leads to more money for risk participation
– But what kind of risk?
♦ Market
– Yield curve is steep and thus encompasses attractive risk premium
– Difficult to pick equity market
– Cash is king: need protection, but option premium is high
– Selling options is risky in highly uncertain time
– However with good risk management, there are many opportunities in times of crisis
Performance Certificates
Performance
Certificates
♦ Country Index
– DAX, CAC40, FTSE, S&P500, Nasdaq,…
♦ Sector Certificates
– DJ Stoxx sectors, FTSE Global sectors, …
– Biotech basket, fuel cell basket, data highway basket, EU enlargement basket
♦ Single stock
– Security borrowing/lending is obscure
wholesale OTC market
– Short position pays manufactured dividend
– Fully collateralised, daily variation margin
“Initial Margin”
“Trade is
closed when
this level is
reached”
Short Term:
No asset premium
to collect
♦ Systematic versus company specific risk ♦ Returns will be correlated to the market
only because of the “non-hedged”
exposure
♦ Likely to under-perform in strong bull
markets
♦ For each product in the “Early 2009 Product” series in this class
♦ Read through the term sheet excerpts
♦ Briefly describe the rationale for the structure
♦ Briefly describe how the structure can be achieved, for example, what kind of
option is embedded in the structure
– It is sufficient to describe the potential upside or downside that has been bought or
sold, or the protection that has been put in place
♦ Investor wants exposure to the Nikkei ♦ Quanto Certificate tracks a basket whose
value in USD always equals the level of
♦ Investor does not believe in the the Nikkei
attractiveness of the JPY
♦ “Quanto basket”
♦ The Quanto Certificate eliminates the
exposure to the foreign currency Long Basket of earn Nikkei
Nikkei stocks dividend yield
earn USD
Long USD
interest rate
pay JPY
Short JPY
NIK interest rate
Warrants
Leverage
What are Warrants?
Optimisation Protection
Yield Short Long Upside
Enhancement Options Options Participation
♦ Alternatively, you could buy the Discount Certificate for GBp 123
♦ With the Discount certificate you will get back in 12 months
– 1 VOD Share if VOD trades below GBp 140
– GBp 140 if VOD trades above GBp 140
12 Months 12 Months
133.46 123
137
Buy
+ Sell Call - Dividend = DC
Share
Spot = 137 Strike = 140
♦ In the end the package has to make sense for the investor, not the individual
bricks!
30
20
10
Profit & Loss
0
110 116 123 129 135 141 148 154 160
-10 Stock Price at Expiration
Discount Certificate Stock
-20
-30
Do you really
want to be
100
exposed to these? How much do
you believe in
those?
50
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.05
0.15
0.25
0.35
0.45
0.55
0.65
0.75
0
More
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
-0.55
-0.45
-0.35
-0.25
-0.15
-0.05
2000 simulations
Investors expected stock return is 8%
Volatility: 20%
Redemption: Redemption:
102,218 CHF
Sell GBP|CHF put
47,387 GBP
Face GBP 47,387
4.41%
Strike 2.1571
♦ The UBS name GOAL stands for ”Geld Oder Aktien Lieferung” (Cash or Share
delivery)
1000
1000
♦ No risk of ending up with stock unless the stock is severely depressed from
current level at expiration
♦ Need to pick stock that works
♦ The view is that the market, at least this name, will recover by expiration in
March 2010 – 1 year from now
♦ Barrier is only active at expiration; but high volatility provides high enough
premium for the yield pick up in the product
Sell
Buy Sell
Put Spread
ZCB Put
Buy 391 Put
Face 437 Strike 414
Sell 414 Put
Put spread 50
Option Strategy
40
30
Buy
Buy Sell
Call Spread
Gold Call Lend Gold
Buy 391 Call
Spot 391 Strike 414
Sell 414 Call
15 Call spread 25
Option Strategy
10 20
15
5
10
0 5
370 381 391 402 412 423 433
-5 0
-5 380 390 400 410 421 431 441
-10
Gold Price at Expiration -10 Gold Price at Expiration
-15 -15
♦ Today’s price of a Zero-Coupon Bond (ZCB) is the market price for receiving
money in the future
– a fixed redemption amount
– At a fixed point in time
Today 4.83%
2 Years
910
♦ The PPN uses a call on FTSE to link the ZCB with the FTSE upside
– Strike determines the point where the investor starts to participate
in the increase of the underlying
– Investor wants to participate now (strike is ATM spot)
♦ Unlimited PPNs
– 100% capital protection only at maturity
– Unlimited upside potential
– The call warrant might be detachable
1100
♦ UBS calls this product Call adds upside of
risky market
– PIP (Protected Index Participation)
1000
– GROI (Guaranteed Return
On Investment note) Redemption Bond with GBP 1,000
in 2 years Face to protect the
capital
4790 5269
Index Level in 2 years
Financial Markets Education 62
Protection
Participation rate
♦ Equity Investor
Buy -
+ Sell Call Dividend = DC
Share
Buy Unlimited
+ Buy Put - Dividend = PPN
Share
♦ Fixed Income Investor
Unlimited
Buy ZCB + Buy Call = PPN
Unlimited
Advantage
of Limited Limited
PPNs
Lower Strike
Higher Strike
Guaranteed Capital
Price of Underlying Spot
Financial Markets Education 65
The usual lists
♦ Tenor: 3 years
Coupon Rate
♦ Underlying: DJIA index
♦ Coupons
– 8% if DJIA traded at or beyond 35% on 8%
either side of the beginning level of the
interest period within the interest period
– 4% if condition 1 is not fulfilled and DJIA
traded at or beyond 25% on either side of
the beginning level of the interest period 4%
within the interest period
– 1% if both conditions 1 and 2 are not 1%
fulfilled
-35% -25% 0% 25% 35%
Index return
Deleverage, if market
moves down
Product
value
ZCB Risky
Call Assets Bond
Option
♦ You have to prevent the portfolio value from falling below the bond floor at
any time before maturity
♦ You expect a maximum fall in FTSE of 20% between rebalancing points
– This is called the ‘Crash Size’
– The Size of the ‘Crash Size’ is an investment view
– Is your portfolio correctly balanced
60%
♦ Before maturity, the value of the portfolio can fall below the protected
amount
♦ The better the index performs the more participation in stock
950
850
750
Jan-00 Sep-00 May-01 Jan-02 Sep-02 May-03
1200
1150
1100
1050
1000
950
Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05
Buy Unlimited
+ Buy Put - Dividend = PPN
Share
Buy Buy Kick- Bonus
+ - Dividend =
Share Out-Put Certificate
Kick-Out-Put
♦ Fully exposed to the downside risk
once the barrier has been touched 993.3 Spot
2
551.29
Kick Out
121%
“A Kick-out Event shall be deemed to have
occurred if at any time during the period from
the Start of Term of the Certificate until and
75%
including the Expiration Date the Level of the
Underlying as continuously calculated and
published, trades at or below the Kick-out level” 75% 121%
100%
75%
yield curve
7.00%
6.00%
5.00%
4.00%
rate
3.00%
2.00%
1.00%
0.00%
1 2 3 4 5 6 7 8 9 10
year
♦ If you think that the curve will be the same in a year time
– What trades would you do?
– What is the risk and are you paid for taking that risk?
– Try this
– A 4-year par bond at 4.75%
– A 1-year deposit at 3%
– Which one do you prefer?
yield curve
7.00%
6.00%
5.00%
4.00%
rate
3.00%
2.00%
1.00%
0.00%
1 2 3 4 5 6 7 8 9 10
year
Financial Markets Education 104
It happens in FX too
♦ The reverse floater: investor pays 100 and receives coupon of “fixed rate – n
times LIBOR”. For example 13.5% - 2 x LIBOR
♦ Minimum coupon is zero
♦ At pricing
– Investor receives fixed interest for his investment less the premium for the cap to
protect against negative coupons
– Investor leverages up his exposure n times by entering into a swap receiving fixed
0.0%
4 5 6 7 8 9 0 1 2 3
u g-0 ug-0 ug-0 ug- 0 ug-0 ug-0 ug- 1 ug-1 ug- 1 ug-1
A A A A A A A A A A
♦ Steepeners’ value comes from the Forwards: the backend of the yield curve
tends to be flat
♦ Forward curves imply that the yield curves are going to invert in the future
(e.g. EUR 10y-2y spread is predicted to become negative in January 2018).
However
– This only happened once in the past, after the German reunification
– There is no strong economical reason for the curve not to remain upward sloping in
the future (risk premium)
4
%
(2)
Sep-88 Sep-93 Sep-98 Sep-03 Sep-08 Sep-13 Sep-18 Sep-23 Sep-28 Sep-33
EUR10yCMS EUR2yCMS Spread
♦ Like the reverse floater, investor enters into a CMS swap leveraged at a certain
number of times the note notional, receiving long end and pays short end
♦ If the structure is not callable, investor enjoys large coupon if the curve does
not flatten as the forward predicts
♦ If the structure is callable, investor sells option on the potential upside and
collects premium to enhance the guaranteed initial coupon
♦ Risk: if the yield curve flattens more than the forward and the realized barbell
spread is low, then the investor will be stuck with a note paying low coupons.
And of low mark to market value
♦ Dual currency note: investment and coupons in low interest rate currency,
redemption in high interest rate currency
♦ Reverse dual currency note: investment and redemption in low interest rate
currency, coupons in high interest rate currency
♦ Power (hyper) reverse dual currency note: all cash flows in low interest rate
currency, but the coupon is linked to FX with a high interest rate currency; e.g.
♦ During the days when the PRDC was popular in Japan, USDJPY rate
differential was large (highly negative), so long dated forward was very low
(i.e. the forward predicted that USD will weaken against JPY significantly)
♦ USDJPY was not perceived to follow the forward
♦ Dual currency note: investor enters into a JPY funded long USD forward
♦ Reverse dual currency note: investor enters into a cross currency coupon swap
receiving USD coupons instead of JPY coupons
♦ PRDC: similar to the reverse dual currency note on the one hand and similar to
the reverse floater note on the other hand
– Investor enters into a cross currency coupon swap receiving USD coupons paying JPY
coupons at a certain number of times of leverage
– Investor realizes the USD coupons in JPY at the FX at reset dates
– Investor buys protection against negative coupons
♦ Investor can further risk the principal amount by incorporating the risk from
the dual currency note
♦ Reward: in general the underlying exposure is a long dollar short yen position.
Investors sells option on the potential upside and so short ATM FX volatility
and long FX volatility at lower strikes. The note can achieve higher valuation,
and thus will be called if
– Dollar strengthens against yen
– Yen rate rises
– Dollar rate falls
– ATM volatility comes in
♦ Risk: the main risk is if dollar weakens more than the forward, the investor
will be stuck with the note and realize low coupons
Basket Products
Relationships
♦ By using the pricing of correlation in the market relative to the view about
correlation of the investor, one can increase the leverage in structures
♦ Get paid 1 if both A and B are equal or more than 3, else nothing
♦ If the correlation is much less than 1, what is the chance of getting a payout?
♦ If your view is
that the market 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.0 1.0 1.0
is going to go up 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.0 1.0 1.0
anyway, what is
your trade? 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.0 1.0 1.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
♦ Worst of A and B
♦ If the correlation is less than 1, what is the chance that you have a positive
score?
♦ If your view is (5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0 4.0 5.0
that the market
(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0 4.0 4.0
is going to go up
anyway, what is (5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0 3.0 3.0
your trade? (5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 2.0 2.0 2.0
(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 1.0 1.0 1.0 1.0
(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 0.0 0.0 0.0 0.0 0.0
(5.0) (4.0) (3.0) (2.0) (1.0) (1.0) (1.0) (1.0) (1.0) (1.0) (1.0)
(5.0) (4.0) (3.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0)
(5.0) (4.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0)
(5.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0)
(5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0)
♦ Knock-out wedding cake structure (or knock-out range GROI) on the “and”
basket of USDJPY and N225
Payout
“Price” level
Knock-out
level
Summary
Many more…
♦ Your View is that the DAX will moderately outperform Fixed Income market
– Invest in DAX speeder over and over again
♦ Why not buy all the options today, but set the strikes later at the then current
index levels
– Such an option is called “Cliquet or Rachet option”
– Cliquet options are baskets of forward-start options
Floored monthly
95% performance
NA: Nominal
GM: Guaranteed Minimum Payout
NDXi: Level of the Index close of
business at the resetting 102.373%
date of month i Capped & Floored
95%
monthly Performance
♦ The investor in a Standard Cliquet is confident that the underlying will move
up
– A Cliquet PPN pays the maximum performance in an up-trending market
♦ Cliquet PPNs lock in moves in the underlying that happened during the
lifetime of Product
– The standard Cliquet is an alternative to the ‘Rolling PPN’ strategy
♦ In a volatile market environment Cliquet PPNs ‘filter out’ the positive periodic
performances
– Standard Cliquet offers insurance against the risk of market downside
– With a Standard Cliquet you are long vega
♦ Another strategy would be to sell the periodic downside protection you are
not afraid of
– In a protected form
– This is a Reverse Cliquet PPN
Redemption:
The greater of
the Guaranteed Minimum
Or
Nominal x (Max return – sum of negative monthly performances)
Date Price Monthly Cum Neg Date Price Monthly Cum Neg
30-Apr-02 3574.23 Return Return Return Return
1 30-May-02 3388.44 -5.2% 5.2% 17 30-Sep-03 2395.87 -7.9% 79.1%
2 1-Jul-02 3131.39 -7.6% 12.8% 18 30-Oct-03 2571.51 7.3% 79.1%
3 30-Jul-02 2691.91 -14.0% 26.8% 19 1-Dec-03 2674.62 4.0% 79.1%
4 30-Aug-02 2709.29 0.6% 26.8% 20 30-Dec-03 2750.09 2.8% 79.1%
5 30-Sep-02 2204.39 -18.6% 45.5% 21 30-Jan-04 2839.13 3.2% 79.1%
6 30-Oct-02 2468.8 12.0% 45.5% 22 1-Mar-04 2918.56 2.8% 79.1%
7 2-Dec-02 2662.49 7.8% 45.5% 23 30-Mar-04 2791.58 -4.4% 83.5%
8 30-Dec-02 2386.41 -10.4% 55.8% 24 30-Apr-04 2787.48 -0.1% 83.6%
9 30-Jan-03 2238.19 -6.2% 62.0% 25 1-Jun-04 2713.29 -2.7% 86.3%
10 3-Mar-03 2142.39 -4.3% 66.3% 26 30-Jun-04 2811.08 3.6% 86.3%
11 31-Mar-03 2036.86 -4.9% 71.2% 27 30-Jul-04 2720.05 -3.2% 89.5%
12 30-Apr-03 2324.23 14.1% 71.2% 28 30-Aug-04 2697.05 -0.8% 90.4%
13 30-May-03 2330.06 0.3% 71.2% 29 30-Sep-04 2726.3 1.1% 90.4%
14 30-Jun-03 2419.51 3.8% 71.2% 30 1-Nov-04 2834.03 4.0% 90.4%
15 30-Jul-03 2483.9 2.7% 71.2% 31 30-Nov-04 2876.39 1.5% 90.4%
16 1-Sep-03 2600.9 4.7% 71.2% 32 30-Dec-04 2951.24 2.6% 90.4%
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