In Part 1 of this series, we have mentioned that Structured Notes are highly customizable. This diversity can lead to financial hazards if the risks of these products are not well understood by the investor.
When an investor is looking at the prospectus of a new type of Structured note, the first challenge is to understand the features of the payoff, how the product behaves in different market scenarios, and what the main risk factors are. Even simple products can reveal a high level of complexity.
Let’s look again at the example described in Part 1 of this series….
Tenor: 3 months
Underlying: Stock ABC
Reference Price: Stock ABC $10
Strike Price: $8
Coupon: 12% p.a.
Recall the two scenarios at maturity for this structured note:
Scenario 1: If ABC falls below the Strike Price of $8, you will get a coupon of 12% p.a. (which works out to be 3% for a 3 month structured note) and you have to buy $10,000 worth of that stock at $8 regardless of where the stock is trading at.
Scenario 2: If ABC closes above the Strike Price of $8, you will get your $10,000 back plus a coupon of 12% p.a. (which works out to be 3% for a 3 month structured note) of $10,000, totaling $10,300.
If we were to break this down further, this product can be replicated by having the following in a portfolio:
- Buy a 3 months bond and
- Sell a 3 months put option on ABC with a strike at $8.
Why is the coupon paid by ELN higher than that of a typical bond or deposit with the same issuer and maturity? By replicating the portfolio, we can see that the investor is, in fact, selling a put option on ABC stock to the note issuer, and is compensated for the risk by receiving a higher “premium”.
Given two scenarios...
If ABC falls below the Strike Price of $8, from a) you receive $10,000 from the maturity of the bond. But for b) you have to buy $10,000 worth of that stock at $8 regardless of where the stock is trading at as the counterparty will exercise the in-the-money put option.
If ABC closes above the Strike Price of $8, from a) you receive $10,000 from the maturity of the bond. On the other hand, from b) you would have already received the premium from the moment you sell the put option. You’d have received $299 and put it into the bank for a 3-month deposit @ 1.3% p.a. To sum up, after 3 months you will get your $10,000 back from a) and $300 from b), totaling $10,300.
Going one step further, an ELN can be seen as a hybrid product, combining an equity component (the put option) and a fixed income component (the bond), within the same note.
The next important factor for the investor to decide is whether the product would fit the objectives of his or her portfolio. Total risk exposure, stress scenarios, and performance backtesting are common analysis used to monitor the different risks of a portfolio. To calculate these numbers, it requires a multi-asset portfolio management system, further integrated with a derivatives pricing engine, which are technologies generally only available to institutional investors.
Access to the models and technologies mentioned above can provide investors with better insights and clarity on their investment decisions.
At Prive Technologies, we hear the challenges which investors of structured products have highlighted and have built an innovative solution that aims to provide transparency and accessibility to both advisors and investors. With the right access to information, structured products can be a real value-add to one’s portfolio, and no investor should be deprived of that.