Case: Private Wealth Management

Designing a Structured Product

Refer ‘Securities Valuation: Applications of Financial Modeling’ Thomas S.Y. Ho and Sang Bin Lee
Ahmed Khan is the vice president of Amina Mansoor Securities Company (AMS) in charge of the
Private Wealth Management group. His clients are individuals with high net worth that exceeds
$20million. His group provides them asset management services, execution of trades, and market
research as well as assistance in tax, estate, and trust planning. Most important of all, he has to
understand his clients’ needs and provide solutions. In building a relationship with each client base,
providing each client a personalised solutions, he can then build a client base for the firm for many
services that the firm provides.
He has a broad range of clients. Many of them are business owners and they often have special
needs. A case in point, today, he met with a new client who asked for “principal preservation”
investment. He would like to invest $2 million with AMS. He would like to take the stock market risk
in the next ten years. But he wanted his $2 million to be safe. Typically, other investors of principal
preservation would want a payoff at the end of the tenth year of at least $2 million. However, this
client says that he needs $1 million in five years and another $1 million in ten years. What should he
do?
After giving it some thought, he decided that the client’s portfolio should consist of a five-year zero-
coupon bond, a ten-year zero-coupon bond, and a call option on the S&P index expiring in ten years.
This way, the portfolio satisfies the client requirements. However, he has to decide on the strike price
of the call option, and he decided to use the at-the-money option. To arrange for a ten-year stock
option could be quite expensive, and so he decided to use a dynamic hedging strategy. He needed to
calculate the hedge ratios of the trade.
Ahmed called Mary Kim, the quantitative analyst at the equity derivative group. “Mary, I need a
favour”. “Yes, Ahmed, shoot.” “My client in essence needs a ten-year at the-money call option on a
hypothetical S&P index that pays no dividends”. “Ahmed, your marketing people are wonderful,
poetic but not precise. What are you talking about---S&P with no dividends?!”. “ I need an underlying
asset that has the volatility of the S&P, and the asset pays no dividends”. “Do you want the historical
volatility or the implied volatility?” “How do we get the long-dated implied volatility for the S&P?
Aren’t the exchange-traded options short-dated?” “We make a market of long-dated S&P options
here. We would be able to sell you something.”
“Mary. You people are great. Can you price the product for me based on a $1 million S&P notional
amount? Remember, no dividends”. “OK.I will work out the price by checking how much it will cost
us to hedge the position. At the moment, our book is quite thin on these options, and we do not have
any offsetting positions. We probably need to dynamic hedge this position for a while to neutralize the
risks.”
Ahmed now turned his attention to determining the investment amount of the option. It would be $2
million net of the two zero-coupon bonds.” Should I buy Treasuries or other bonds with higher yields?
I had better check with the fixed-income people”.
Meanwhile Ahmed started thinking about writing up the proposal to his client.” I need to show him
that the investment is appropriate. How can I explain to him the risk and return of the investments?
How should I start?”