Structured Products Overview
What are Structured Products:
- Structured products refer to combinations of individual financial instruments, such as bonds, stocks and derivatives. At first glance, most of these composite products are very similar to plain vanilla coupon bonds.
- Structured products tend to involve periodical interest payments and redemption at maturity. What sets them apart from bonds is that both interest payments and redemption amounts depend in a rather complicated fashion on the movement of stock prices, indices, exchange rates or future interest rates.
- Since structured products are made up of simpler components, we usually break them down into their integral parts when we need to value them or assess their risk profile and any hedging strategies. This should facilitate the analysis and pricing of the individual components.
- While breaking down structured products into simpler components is possible in many cases, replication need not automatically entail a considerable simplification.
- Additionally, no uniform naming conventions exist for structured products, and even where such conventions exist, some issuers will use alternative names. In this overview, we use the SSPA denominations, however it is not possible to categorize and valuate a product on this basis alone. The valuation of structured products is only possible on the basis of the instrument's cash flow structure.
The products are presented as follows:
- First, the General Description provides an in-depth discussion of the specific features of each product as well as a straightforward example.
- Under the Replication heading, you will find techniques, neatly presented in a decomposition table, for mapping a product into its simpler components.
- Finally, the Valuation section describes how to determine the fair value of a product. The Annex of each part comprises a synoptic table which summarizes the replication of the products described in this overview.
At the end of the overview a glossary of the most important concepts and references are included. The replication techniques presented here are designed to serve as examples for treating composite products
Introduction
- For the purpose of valuation, structured products are generally replicated with simpler instruments. The portfolio of these simpler products must have the same payoff profile as the structured product and, given the absence of arbitrage opportunities in financial markets, must thus also have the same market value. The merits of this approach are that, first, simple valuation rules can be used to calculate fair market prices for the simpler products. Second, risk control is more efficient since the replicated parts either are directly tradable or may be hedged more easily. Yet,it is not possible to break all products down into simple components. In cases where the structured product has to be depicted as a combination of instruments which are themselves complex in nature and thus difficult to valuate and to hedge on the capital market, numerical procedures have to be employed in order to valuate the products and assess the risks involved.
- Underlying assets: Advanced term structure models are required to capture the stochastic developments of the yield curve over time. Multiple models coexist and differ both in the number of stochastic factors and on the assume dynamic pattern of the underlying asset (i.e. interest rates' term structure). In one-factor models, the short-term rate usually serves as the stochastic factor driving the term structure. The short rate is assumed to follow a stochastic process. With multi-factor models, several sources of uncertainty are accounted for and it is possible not only to adjust the model to the current term structure, but also to capture the current volatility structure(i.e. Longstaff and Schwartz, Duffie and Kan). Under the approach developed by Heath, Jarrow and Morton, any number of stochastic terms may be considered. Multi-factor models have two drawbacks, however. First, it is necessary to precisely calibrate the models to the current market conditions (term and volatility structures) before valuing structured products. Second, they require an enormous computational effort since the valuation must in most cases be based on Monte Carlo simulations. Going forward, the Hull-White model will be our model of choice as it sensibly combines precision and computational/calibration effort.
- Valuation models: Valuation formulas used for embedded options are based on the Black-Scholes model, which makes the following central assumptions:
- Changes in the price of the underlying products (stock, index) follow geometric Brownian motions, with volatility constant over time.
- Trading is continuous.
- No market participant has market power. All participants are price takers, which means that no one can influence an instrument's price.
- The short selling of securities is permitted without restriction.
- There are no transaction costs or taxes.
- The market offers no arbitrage opportunities.
- The risk-free interest rate is constant over time.
- Callability/Putability: Optimum exercise strategies affect the value of all call/put features associated with a structured product, and the path dependency borne by these provisions (Bermudan-style options) complicates greatly the valuation exercise. In practice, a multitude of methods is used to determine the fair value of such sophisticated products. Simple valuation models are applied even if they are not really appropriate or attempts may be made to replicate structured products in the form of portfolios of simple products which at any time pay off at least as much as the respective structure. In such cases, the price of the structured product is at most as high as the value of the replicating portfolio.
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