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Structured Products

Financial Markets Education


Table of contents

SECTION 1 Performance Certificates 14


SECTION 2 Warrants 32
SECTION 3 Classic Structured Products – Yield Enhancement 37
SECTION 4 Classic Structured Products – Capital Protection 59
SECTION 5 Protection via Portfolio Insurance Techniques 72
SECTION 6 Bonus Certificates - A Softer Protection 86
SECTION 7 Interest Rate Structured Products 99
7.A Motivation
7.B Reverse Floaters
7.C CDRAN
7.D Flatteners and Steepeners
7.E The PRDC
SECTION 8 Basket Products 129
SECTION 9 Summary 137

APPENDIX A Strategy Certificates & Cliquet PPN 139

Financial Markets Education 1


Where it all starts - the investor

♦ Investors demand tailored investment solutions


– good allocation of risk
– wealth preservation
– tax efficiency
– asymmetric risk-return profiles

♦ Classic investments in Bonds, Equities, Foreign Currencies can only partially


meet these requirements
♦ Structured Products can meet specific investment objectives
– Small investment amounts
– Easy to understand
– Easy to trade
– low cost

Financial Markets Education 2


Risk management products

♦ Many products have been developed to


– access specific market segments
– extract and decompose risk-return profiles of classic investments
– tailor the risk-return profiles to specific needs

♦ 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

Financial Markets Education 3


Structured products

♦ Securities issued by financial institutions to meet investment objectives of


individual clients
– Client driven economic structures

♦ Huge range of potential economic structures


– Limitation: purchaser cannot be obliged to issuer (transferable security)

♦ Investor exposed to credit quality of the issuer


– Payments are guaranteed by issuing financial institution
– Investors are not the beneficial owner of the underlying asset
– Not a ‘pass-through’ product as Depositary Receipts or Investment Fund

Financial Markets Education 4


Risk and Reward

♦ Investor: how do you enhance the yield (expected return) of your investment?
– Alpha: arbitrage, mispricing…
– Risk premium

♦ Issuer: how do you lower the cost of funding?


♦ Investment banks act as intermediaries to package risk

Financial Markets Education 5


Type of Structured Products

Financial Markets Education 6


Structured Products now?

♦ 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

Financial Markets Education 7


USD swap and government yield curves 9 Mar 09

Financial Markets Education 8


GBP swap and government yield curves 9 Mar 09

Financial Markets Education 9


Market Timing?

Financial Markets Education 10


Not an easy market

Financial Markets Education 11


What is being issued in the current market (Early 2009)?

Financial Markets Education 12


Fundamental Principles

♦ The fundamental construction is still the same


♦ But need to find different themes (e.g. long short, inflation protection, look
back)
♦ Or use different underlying (e.g. commodities)
♦ And we have it all in store for you here…

Financial Markets Education 13


SECTION 1

Performance Certificates
Performance
Certificates

♦ Redemption amount equal to spot price of


underlying at maturity
– One for one exposure
– Tracks the performance of an asset or strategy

♦ Usually, no coupons are paid to holder


♦ Cost-efficient way to execute investment strategy not easily achieved with
traditional investments
♦ Wholesale and retail investor dealing sizes
♦ Certificates are usually cash settled
– Cash settled at the price of the underlying on expiry
– No stamp duty in UK, Switzerland, Germany

Financial Markets Education 15


Performance
Certificates

♦ Fixed maturity or open ended


– Fixed term usually 3-5 years
– Issuer has the right to stipulate expiry of open-end certificates once a year

♦ Often listed on stock exchanges


– Fast and transparent exposure to investment products
– Simple execution similar to share dealing
– Traded through stockbroker
– Liquid (market making is required by exchange)
– Low cost, minimal bid/offer spread

♦ UBS calls these products PERLES (PERformance Linked to Equity Securities)


– Other names are “Tracker Certificates” or “Benchmark Certificates”

Financial Markets Education 16


Performance
Open-end Certificate on DAX
Deutsche Börse: Certificate

Deutsche Börse: DAX

Financial Markets Education 17


Performance
Diverse range of underlings

♦ Country Index
– DAX, CAC40, FTSE, S&P500, Nasdaq,…

♦ Multinational Index PERLES


– DJ Euro, Stoxx 50, DJ GlobalTitans, …

♦ Sector Certificates
– DJ Stoxx sectors, FTSE Global sectors, …
– Biotech basket, fuel cell basket, data highway basket, EU enlargement basket

♦ Pre-determined investment strategy


– Issuer acts as calculation agent
– Clear investment policy, non manager reliant
– Growth, Value, PEG
– Long/short

Financial Markets Education 18


Performance
Diverse investment strategies
“The Euro PEG 20 Certificate has a clearly defined and disciplined
investment strategy…
Every quarter, 20 companies with the lowest Price-Earnings-to-growth
(PEG-ratio) from DJ STOXX Index are selected.”

DJ Islamic Market Titans 100 Index Open End Certificate


“The Dow Jones Islamic Market Indexes were created for people who
wish to invest according to Islamic investment guidelines. The
indexes track Shari`ah compliant stocks from around the world,
providing Islamic investors with comprehensive tools based on a
truly global investing perspective.”

Open End Certificate on FTSE4GOOD EUR 50


“The FTSE4Good Europe 50 is a price-index for socially responsible
investment. The criteria for the relevant selection are the
environmental sustainability, social issues and human rights. The
FTSE4Good Europe 50 Index is designed with the support of UNICEF,
the United Nations Childrens’s Fund, and uses data provided by
EIRIS, the Ethical Investment Research Service. Index Reviews occur
on a semi-annually basis in March and September.”

Financial Markets Education 19


Performance
Not necessarily long the underlying

♦ Going short an underlying is difficult to ♦ Open-End FTSE 100 Reverse Tracker


operate certificate (SocGen)

♦ Futures are traded on major indices


– Administrative burden
– Mark to market
– Initial margin
– Variation margin

♦ Single stock
– Security borrowing/lending is obscure
wholesale OTC market
– Short position pays manufactured dividend
– Fully collateralised, daily variation margin

♦ Perpetual American Put Warrant


♦ You need to invest GBP 5,174 (10
certificates) to go short 1 FTSE

Financial Markets Education 20


Performance
UBS Shorty

♦ Similar to short SMI future ♦ Speculate on a decline in the index


– Fixed notional
♦ Add to a portfolio to effective way to
– Leverage about 5.5 at issuance hedge against market weakness
– Easy and transparent

“Initial Margin”

“Trade is
closed when
this level is
reached”

Short Term:
No asset premium
to collect

Financial Markets Education 21


Long Google / short Yahoo

♦ 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

Financial Markets Education 22


Long Google Short Yahoo - Redemption

Financial Markets Education 23


Exercises

♦ 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

♦ Your opinion of whether the product will be a successful investment given


what has happened in 2008 leading up to 2009 and the outlook going
forward

Financial Markets Education 24


Early 2009 Product 1: Long Short CMCI vs. GSCI

Financial Markets Education 25


Long CMCI Short GSCI

Financial Markets Education 26


Product Description

♦ For each rebalancing period the multiplier =

{100% + levfactor * FX * [wt1 * (CMCIcomm1return − GSCIcomm1return ) + ...]}* (100% − mgmtfee)

Financial Markets Education 27


Constant Maturity Commodity Index

♦ It eases into a roll more gradually than a traditional index


– It saves on roll cost in contango
– It foregoes positive convenience yield pick up in backwardation

♦ Also it holds contracts along the term structure of futures


♦ It is claimed to show lower tracking error of realized return compared to
underlying price index, and outperform traditional index on average

Financial Markets Education 28


Performance
Equity Certificates & dividends

♦ Certificates usually do not pay the underlying dividend


♦ Fixed term certificates trade at a discount to underlying price
– Dividend risk with issuer
– Estimated dividend
– Tax implications

♦ 1-year FTSE 100 Certificate


– Implied dividend yield
– Expected dividend yield

Swiss Tax information


For private persons with tax
domicile in Switzerland, the
discount to the Initial Underlying
Level (2.1%) represents taxable
income on the Redemption Date.

Financial Markets Education 29


Performance
Quanto Certificates on Nikkei 225

♦ Fixed term Certificate


♦ Underlying is Nikkei 225
♦ Discount to Nikkei spot is 7.39%
♦ Implied dividend yield?
♦ Estimated Nikkei dividend
yield?
♦ What is wrong?

Financial Markets Education 30


Performance
The Quanto feature

♦ 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

♦ This “Quanto basket” needs continuous


USD rebalancing
– Expensive
– Constant monitoring
JPY
– Investor in PERLE invests in a strategy

Financial Markets Education 31


SECTION 2

Warrants
Leverage
What are Warrants?

♦ Economically similar to vanilla OTC and exchange traded options


– Investment with leverage
– Benefiting from market development with small capital outlay
– Substantial earnings potential while at the same time limiting the risk to the capital
invested

♦ Securitized call or put options


– large range of strike prices and maturity
– Issued on just about any underlying
– Often traded on an exchange

Financial Markets Education 33


Covered warrants versus subscription warrants

♦ Covered Warrants are issued by third party unrelated to underlying equity


– Client driven economic structures
– Diverse range of underlying (Equity, Baskets, Indices, Swap rates etc)

♦ Subscription Warrants are issued together with a bond or preferred stock to


allows the holder to buy a common stock
– Equity warrants
– Same issuer as underlying shares
– Driven by financing requirement of the issuer
– Also called Conventional Warrants

Financial Markets Education 34


Leverage
Call Warrant on Nestlé

Financial Markets Education 35


Leverage
Buying Warrants

♦ Buying Call Warrants


– Alternative to buying underlying
– Upside exposure with hedge against falling prices
– Maximum loss is the Warrant premium
– A call can be thought of as a “long underlying plus insurance”

♦ Buying Put Warrants


– Alternative to selling underlying short
– Downside exposure with hedge against rising prices
– Maximum loss is the Warrant premium
– A put can be thought of as a “short underlying plus insurance”

Financial Markets Education 36


SECTION 3

Classic Structured Products – Yield


Enhancement
Yield Enhancement versus Capital Protection

Objectives Views Regrets


Needs Return
Desires Risk
Limitations Time

Optimisation Protection
Yield Short Long Upside
Enhancement Options Options Participation

Financial Markets Education 38


Optimisation
Discount Certificate (BLOC) on Vodafone

♦ Today is October 11, 2004


♦ Vodafone (VOD) is trading at GBp 137
♦ You think about buying VOD
– you are not sure
– It is not that cheap

♦ 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

♦ UBS calls these investments BLOCs (Buy Low Or Cash)


♦ Which investment would you choose? Why?

Financial Markets Education 39


Equity or a money-market product?

Zero Coupon Bond 140 Discount Certificate


1 Share or
4.9% Today 140 Cash
Today

12 Months 12 Months

133.46 123

Share 1 Share ♦ Likelihood of getting stock in


Dividend one year?
Today ♦ Likelihood of getting cash in one
year?
12 Months
♦ What drives this likelihood?

137

Financial Markets Education 40


Optimisation
From Debt to Equity

♦ Investors have traditionally managed their investments by balancing debt and


equity
♦ Structured Products can meet conservative as well as aggressive risk-reward
profiles
♦ This product caps your return
– Maximum return Discount Certificate: 13.8%

Structured Investment Zone


DEBT
Zero
EQUITY
Coupon Low cap High cap
Bond
Discount Certificate

Financial Markets Education 41


Optimisation
The LEGO game – Discount Certificate

♦ How the equity investor could think of the package

Buy
+ Sell Call - Dividend = DC
Share
Spot = 137 Strike = 140

♦ How the Fixed Income investor thinks of the package?

Buy ZCB + Sell Put = DC


Face = 140 Strike = 140

♦ In the end the package has to make sense for the investor, not the individual
bricks!

Financial Markets Education 42


Optimisation
Break-even graph

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

Financial Markets Education 43


What is your risk capacity?
Which part (shape)
250 of the distribution
are you willing to
Do you need to cap accept
negative returns
200 (bankruptcy)? Are you willing to
accept a cap on the
positive returns
(Regret)?
150

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%

Financial Markets Education 44


Risk and Structured Products

♦ Investing is trading expected return versus risk


– it all starts a with a view
– But there is not much to earn without taking risk

♦ Risk is in general complicated to understand and communicate


♦ Structured products can be designed with risk aspects easy to visualise
– Maximum Loss
– Maximum Gain Bonds
Interest rate risk
♦ An investment not only has Credit risk
expected risk and expected return Foreign Exchange
Long term: economic risk
♦ An investment is a “probability
Short medium term more
distribution” behavioural
Equity
Market Risk
Company specific risk

Financial Markets Education 45


Optimisation
Dual Currency Deposit (DCD)

♦ January 17, 2005


♦ GBP|CHF spot trades at 2.1965
♦ Swiss money market yield: 0.69%
♦ Client invests CHF 100,000
♦ In 6 months he gets back
– CHF 102,218.4 if GBP|CHF above 2.1571
– GBP 47,387.0 if GBP|CHF below 2.1571

♦ What did the client actually do?


– Is there an option involved?
– What strike?
– How to choose the strike?

Financial Markets Education 46


Optimisation
DCD analysis

♦ Dual Currency Deposit is the FX version of


a “Discount Certificate”
♦ Breakeven
– Money market investment pays back
100,346.9 ZCB
– Minimum value DCD in Face CHF 102,218.4
6 months: GBP 47,387
– Break-even exchange rate: 2.1176

Redemption: Redemption:
102,218 CHF
Sell GBP|CHF put
47,387 GBP
Face GBP 47,387
4.41%
Strike 2.1571

Money Market Rate


0.69%

2.1176 2.1571 2.1965


GBPCHF

Financial Markets Education 47


Update…

Financial Markets Education 48


Optimisation
Reverse Convertible on BT Group

♦ June 2004. BT Group is trading at GBp 182.5


♦ You are a bond investor
– Not a good time these days
– You could invest in a 31 months par bond paying a low 5.3% coupon
– You are not a equity investor, but you think that BT is low risk

♦ You could buy a 10.2% coupon Reverse Convertible at par


– Notional is GBP 1,000
– The Reverse Convertible pays a coupon of GBP 51 every 6 months

♦ The Reverse Convertible pays in 31 months a redemption of


– GBP 1,000 if BT trades above GBp 182.50
– 548 BT shares if BT trades below GBp 182.50

♦ The UBS name GOAL stands for ”Geld Oder Aktien Lieferung” (Cash or Share
delivery)

Financial Markets Education 49


Share or Bond?

♦ Is the strike chosen wisely for a typical Fixed Income investor?


♦ How much does he want to become a share holder?
♦ Are there other means to make share delivery less likely?

BOND 1000 Reverse 1000 or


Convertible 548 shares
30.9 26.5 26.5 26.5 26.5
59.5 51 51 51 51
Jun04
Jun04
Jan05 Jan06 Jan07
Jan05 Jan06 Jan07

1000
1000

Financial Markets Education 50


Early 2009 Product 2: Kick-In Goal

Financial Markets Education 51


Early 2009 Product 2: Kick-In Goal

Financial Markets Education 52


Window Barrier Option

Financial Markets Education 53


Risk Mitigation?

♦ Low rate regime but high risk environment


– Yield enhancement with confined risk exposure

♦ 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

Financial Markets Education 54


Optimisation
How to spend a option premium

♦ The use of the option premium


– BLOC: the option premium is used to lower the price of the investment
– GOAL: the option premium is used to boost the coupon
– Many other ways how to use the premium

♦ We can use the premium to "boost" small returns


♦ Example
– Today is July 30, 2004
– Gold spot is trading at 391
– You think that Gold spot will increase slightly over the next 6 months
– You do not think that gold will trade above 414 in 6 months
– How can you accurately express your view?

Financial Markets Education 55


Optimisation
Speeder on Gold

♦ July 21, 2004: Gold is trading at USD 391


♦ Speeder is issued for same price as underlying: USD 391
♦ On Feb 11, 2005 the Speeder pays a USD cash redemption equal to
– Gold spot if Gold closes lower than 391
– 391 + 2 x (Gold spot – 391) if Gold closes between 391 and 414
– 437 if Gold closes above 414

If the underlying is a share you


receive the physical share if spot
trades below the lower strike

Speeder is also called sprint-


certificate
Goldman Sachs calls such structures
IMPACT:"Increased Market
Performance At Capped Target“

Financial Markets Education 56


Optimisation
Speeder LEGO – the debt focus

♦ The option strategy cannot be detached from the Speeder


– Without the debt part the option strategy might oblige the investor to make
payments to the Issuer

Sell
Buy Sell
Put Spread
ZCB Put
Buy 391 Put
Face 437 Strike 414
Sell 414 Put

Put spread 50
Option Strategy
40

30

Profit & Loss


20
10
0
370 381 391 402 412 423 433
-10
-20 Gold Price at Expiration
-30

Financial Markets Education 57


Optimisation
Speeder LEGO – the Gold focus

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

Profit & Loss


Profit & Loss

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

Financial Markets Education 58


SECTION 4

Classic Structured Products – Capital


Protection
Capital guaranteed products

♦ 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

♦ Products protecting investments at a future point in time are (directly or


indirectly) based on Zero-Coupon Bonds

Zero Coupon Bond


1000

Today 4.83%

2 Years

910

Financial Markets Education 60


Protection
Principal Protected Note on FTSE100

♦ You have GBP1,000 to invest


♦ You need a guaranteed GBP1,000 cash redemption in 2 years
♦ You invest GBP 910 in ZCB
♦ You can invest the remaining GBP 90 in risky instruments
– You believe that the broad UK Equity market will outperform Bonds
– You might invest the GBP 90 in UK Certificates
– FTSE100 trades at 4790 today
– You will participate 9% in the FTSE performance

♦ Alternatively, you could invest in the FTSE100 PPN


– Guarantees a redemption of GBP 1,000 in 2 years
– Additionally, you get 100% of the positive FTSE performance
– You do not participate in the negative FTSE performance at maturity

Financial Markets Education 61


Protection
A Zero Coupon Bond plus Call Warrant

♦ 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

♦ Current yield environment is unfavourable for Capital Protection


– A lot of money goes into ZCB

♦ Can increase participation rate by


– A Floor instead of full protection
– Guarantee 950 minimum redemption instead of 1,000
– The longer the term, the higher the participation rate
– Cap the maximum return
– Use a ‘cheaper’ option (Averaging, Quanto, Barrier)
– Use a different underling (Less volatile, Lower dividend yield)

DEBT High Protection Low Protection


Zero Low participation High Participation
EQUITY
Coupon
Bond PPN

Financial Markets Education 63


Protection versus optimisation

♦ Equity Investor

Buy -
+ Sell Call Dividend = DC
Share
Buy Unlimited
+ Buy Put - Dividend = PPN
Share
♦ Fixed Income Investor

Buy ZCB + Sell Put = DC

Unlimited
Buy ZCB + Buy Call = PPN

♦ This analogy is called Put-Call Parity

Financial Markets Education 64


Protection
Limited Principal Protected Note

♦ PPNs with limited earning potential


– Participates in the uptrend between two strikes.
– Get maximum return if spot exceeds upper strike
– Call spread is a ‘cheaper’ option
– Higher participation rate between the strikes

Unlimited
Advantage
of Limited Limited
PPNs

Lower Strike
Higher Strike

Guaranteed Capital
Price of Underlying Spot
Financial Markets Education 65
The usual lists

♦ Remember that “an investment is a distribution”


♦ Taking risk leads to higher EXPECTED return
♦ Remember that options are not priced based on expected return
– The expected return in excess of risk free return belongs to the investor (the risk
taker)
– The bank’s role is to manage the uncertainty of settlement (exercise of options, i.e.
volatility) and the cost is covered by the option premium
– Options are used to alter the distribution to cater for the risk capacity of the investor

♦ The degree of leverage often determines the options to be used

Financial Markets Education 66


Early 2009 Product 3: Kick Out GROI

Financial Markets Education 67


Redemption terms

Financial Markets Education 68


Fit the time…

♦ Principle preservation is important


♦ Low rate regime means less money for risk participation: need to make the
option cheaper by using the kick out feature
♦ Rebate makes the potential give up of the parity due to the barrier event
easier to take

Financial Markets Education 69


Range GROI: Wedding Cake structure

♦ Investors forego the interest on their investment and use it to purchase


double lock outs

Financial Markets Education 70


An Equity Example – Range Barrier Notes

♦ 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

Financial Markets Education 71


SECTION 5

Protection via Portfolio Insurance


Techniques
Another form of protection

♦ You have GBP 1000 to invest for 3 years


♦ You need a minimum redemption of GBP1000
♦ A zero coupon bond with GBP 1000 face costs 868
♦ The FTSE100 index trades at 4790 today
♦ You believe that equity market outperforms bond market
♦ You decide to invest GBP500 in FTSE100 and GBP 500 in ZCB
♦ This is somehow risky given your needs
♦ You will have to rethink your portfolio split if markets move
– What will you do if FTSE trades at 5750 in 1 month
– What will you do if FTSE trades at 3750 in 1 month

Financial Markets Education 73


Protection
Portfolio Insurance

PPN Portfolio Insurance


♦ Zero Coupon Bond (ZCB) provides capital ♦ Dynamically managed portfolio
protection
♦ A combination of ZCB and ‘risky assets’
♦ Call option links structure to the upside
of ‘risky asset’ ♦ participation is adjusted in accordance to
predefined rules
♦ Structure does not need to be rebalanced

Deleverage, if market
moves down
Product
value

ZCB Risky
Call Assets Bond
Option

Equity Return Releverage


if market goes up

Financial Markets Education 74


Protection
Portfolio Insurance – the strategy

♦ The bond floor is GBP 868 today


– A portfolio with this value can be switched into a ZCB guaranteeing your minimum
return

♦ 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

♦ The technique to protect the portfolio value is called ‘Constant Proportion


Portfolio Insurance’
– UBS calls it ‘Constant Proportion Portfolio Technique’ (Compliance)

♦ The technique only works if you got your assumptions right

Financial Markets Education 75


Protection
Optimal equity exposure
200%

♦ Maximum ‘supportable’ loss in risky assets Portfolio


(‘Cushion’) is Portfolio Value - Bond 180% Value
Floor
♦ Maximum ‘supportable’ %-fall in share 160%
price is called the ‘Gap’
140%

Portfolio Value − Bond Floor


Gap = 120%
Equity Value
‘Cushion’
100%
Bond
♦ The Portfolio is perfectly balanced with Floor
the Gap exactly equal to the Crash Size 80%

60%

Financial Markets Education 76


Portfolio Insurance – a simulation

♦ You have 100 to invest for 2 years


♦ A 2-year Zero coupon Bond with face 100 costs 95.12 (2.50%)
♦ You rebalance your portfolio quarterly
– Protection: 100%
– Crash Size = Leverage Trigger = Deleverage Trigger = 20%
– Minimum exposure (Equity): 0%
– Maximum exposure (Equity): 150%

♦ We investigate the following scenarios


– Stock tanks
– Stock soars
– Stock wobbles

Financial Markets Education 77


CPPT – stock tanks
Time Equity Equity Equity Bond ZCB ZCB Portfolio
(years) Price Value Weight Floor Value Weight Gap Value
0 100 24.39 24% 95.12 75.61 76% 20.0% 100
1/4 92 22.43 23% 95.72 76.09 77% 12% 98.52
1/4 92 14.02 14% 95.72 84.50 86% 20% 98.52 Rebalanced
1/2 84 12.80 13% 96.32 85.03 87% 12% 97.83
1/2 84 7.57 8% 96.32 90.26 92% 20% 97.83 Rebalanced
3/4 76 6.85 7% 96.92 90.83 93% 11% 97.68
3/4 76 3.78 4% 96.92 93.90 96% 20% 97.68 Rebalanced
1 68 3.38 3% 97.53 94.49 97% 10% 97.87
1 68 1.69 2% 97.53 96.18 98% 20% 97.87 Rebalanced
1 1/4 60 1.49 2% 98.14 96.78 98% 9% 98.27
1 1/4 60 0.66 1% 98.14 97.62 99% 20% 98.27 Rebalanced
1 1/2 52 0.57 1% 98.76 98.23 99% 7% 98.80
1 1/2 52 0.20 0% 98.76 98.60 100% 20% 98.80 Rebalanced
1 3/4 44 0.17 0% 99.38 99.21 100% 5% 99.39
1 3/4 44 0.04 0% 99.38 99.34 100% 20% 99.39 Rebalanced
2 36 0.03 0% 100.00 99.97 100% 2% 100.00

Market Price Equity Value as % Value of Bonds Supportable %-


of 1 Share of Portfolio Value in Portfolio fall in Share

Value of Equity Value of ZCB Bond Value as % Market Value


in Portfolio with Face 100 of Portfolio Value of Portfolio

Financial Markets Education 78


CPPT – stock soars
Time Equity Equity Equity Bond ZCB ZCB Portfolio
(years) Price Value Weight Floor Value Weight Gap Value
0 100 24.39 24% 95.12 75.61 76% 20% 100
1/4 110 26.82 26% 95.72 76.09 74% 27% 102.91
1/4 110 35.97 35% 95.72 66.95 65% 20% 102.91
1/2 120 39.24 37% 96.32 67.37 63% 26% 106.60
1/2 120 51.41 48% 96.32 55.19 52% 20% 106.60
3/4 130 55.70 50% 96.92 55.54 50% 26% 111.23
3/4 130 71.55 64% 96.92 39.69 36% 20% 111.23
1 140 77.05 66% 97.53 39.94 34% 25% 116.98
1 140 97.27 83% 97.53 19.72 17% 20% 116.98
1 1/4 150 104.22 84% 98.14 19.84 16% 25% 124.06
1 1/4 150 129.57 104% 98.14 -5.51 -4% 20% 124.06
1 1/2 160 138.21 104% 98.76 -5.55 -4% 25% 132.66
1 1/2 160 169.51 128% 98.76 -36.85 -28% 20% 132.66
1 3/4 170 180.10 126% 99.38 -37.08 -26% 24% 143.02
1 3/4 170 214.53 150% 99.38 -71.51 -50% 20% 143.02
2 180 227.15 146% 100.00 -71.96 -46% 24% 155.19

♦ Before maturity, the value of the portfolio can fall below the protected
amount
♦ The better the index performs the more participation in stock

Financial Markets Education 79


CPPT simulation – some volatility
Time Equity Equity Equity Bond ZCB ZCB Portfolio
(years) Price Value Weight Floor Value Weight Gap Value
0 100 24.39 24% 95.12 75.61 76% 20% 100
1/4 95 23.17 23% 95.72 76.09 77% 15% 99.25
1/4 95 17.68 18% 95.72 81.58 82% 20% 99.25
1/2 100 18.61 18% 96.32 82.09 82% 24% 100.70
1/2 100 21.89 22% 96.32 78.81 78% 20% 100.70
3/4 95 20.79 21% 96.92 79.30 79% 15% 100.10
3/4 95 15.87 16% 96.92 84.23 84% 20% 100.10
1 100 16.70 16% 97.53 84.76 84% 24% 101.46
1 100 19.64 19% 97.53 81.82 81% 20% 101.46
1 1/4 95 18.66 18% 98.14 82.33 82% 15% 100.99
1 1/4 95 14.24 14% 98.14 86.75 86% 20% 100.99
1 1/2 100 14.99 15% 98.76 87.29 85% 24% 102.28
1 1/2 100 17.63 17% 98.76 84.65 83% 20% 102.28
1 3/4 95 16.75 16% 99.38 85.18 84% 15% 101.93
1 3/4 95 12.78 13% 99.38 89.15 87% 20% 101.93
2 100 13.45 13% 100.00 89.71 87% 24% 103.16

♦ You buy high and sell low


– How much does a zero coupon bond return?
– Volatility is not good for this strategy
– The trader calls this effect ‘short gamma’

Financial Markets Education 80


CPPT simulation – more volatility
Time Equity Equity Equity Bond ZCB ZCB Portfolio
(years) Price Value Weight Floor Value Weight Gap Value
0 100 24.39 24% 95.12 75.61 76% 20% 100
1/4 84 20.48 21% 95.72 76.09 79% 4% 96.57
1/4 84 4.27 4% 95.72 92.31 96% 20% 96.57
1/2 100 5.08 5% 96.32 92.89 95% 32% 97.96
1/2 100 8.22 8% 96.32 89.74 92% 20% 97.96
3/4 84 6.91 7% 96.92 90.31 93% 4% 97.21
3/4 84 1.44 1% 96.92 95.77 99% 20% 97.21
1 100 1.71 2% 97.53 96.37 98% 32% 98.09
1 100 2.77 3% 97.53 95.31 97% 20% 98.09
1 1/4 84 2.33 2% 98.14 95.91 98% 4% 98.24
1 1/4 84 0.48 0% 98.14 97.75 100% 20% 98.24
1 1/2 100 0.58 1% 98.76 98.37 99% 32% 98.94
1 1/2 100 0.93 1% 98.76 98.01 99% 20% 98.94
1 3/4 84 0.78 1% 99.38 98.62 99% 4% 99.41
1 3/4 84 0.16 0% 99.38 99.25 100% 20% 99.41
2 100 0.19 0% 100.00 99.87 100% 32% 100.06

♦ Unlike a bond-plus-call strategy, your final redemption is path dependent


– Hard to keep track
– Product not so transparent

Financial Markets Education 81


CPPT simulation – disaster strikes
Time Equity Equity Equity Bond ZCB ZCB Portfolio
(years) Price Value Weight Floor Value Weight Gap Value
0 100 24.39 24% 95.12 75.61 76% 20% 100
1/4 110 26.82 26% 95.72 76.09 74% 27% 102.91
1/4 110 35.97 35% 95.72 66.95 65% 20% 102.91
1/2 105 34.33 34% 96.32 67.37 66% 16% 101.70
1/2 105 26.89 26% 96.32 74.81 74% 20% 101.70
3/4 80 20.49 21% 96.92 75.28 79% -6% 95.76
3/4 80 0.00 0% 96.92 95.76 100% NA 95.76
1 90 0.00 0% 97.53 96.36 100% NA 96.36
1 90 0.00 0% 97.53 96.36 100% NA 96.36
1 1/4 100 0.00 0% 98.14 96.97 100% NA 96.97
1 1/4 100 0.00 0% 98.14 96.97 100% NA 96.97
1 1/2 105 0.00 0% 98.76 97.58 100% NA 97.58
1 1/2 105 0.00 0% 98.76 97.58 100% NA 97.58
1 3/4 110 0.00 0% 99.38 98.19 100% NA 98.19
1 3/4 110 0.00 0% 99.38 98.19 100% NA 98.19
2 120 0.00 0% 100.00 98.80 100% NA 98.80

♦ UBS guarantees repayment of notional at maturity


– Additional protection for the Investor
– UBS is taking the loss if assumptions Protection
(Crash Size) were wrong

Financial Markets Education 82


Baring Hong Kong China Fund USD

Financial Markets Education 83


Protection
CPPT on Baring Hong Kong China

Simplified Product Characteristics


Issuer UBS AG, Jersey Branch Capital Protection 100% nominal at
Issue Date 27 October 2003 expiry + Captured Profit

Maturity Date 27 October 2009 Annual Captured Profit 30% of Value


above notional (after fees)
Issue Size USD 25,000,000
Management Fee 1.50% p.a. (0.90% if
Currency USD cash-locked)
Denomination USD 1‘000 Leverage Fee 0.9% p.a. of leveraged
Issue Price 100% of nominal exposure
Underlying Fund Minimum Fund Exposure 0%
Baring Hong Kong China $ Maximal Fund exposure 120%
Initial Basket 75% Fund, 25% ZCB Crash Size 29%
Rebalancing Daily Deleverage Trigger 24%
Releverage Trigger 34%

Financial Markets Education 84


Protection
CPPT GBP Note Linked to Hedge Funds

Simplified Product Characteristics


Issuer UBS AG, Jersey Branch Protected Amount 100% nominal
Issue Date 1 October 2004 Coupon at Maturity
Maturity Date 30 September 2009 Max(0, RBfin – Protected Amount)

Issue Size GBP 15,000,000 RBfin = Value of Basket at Maturity

Currency GBP Contingent Fee 2.45% p.a on basket


value if fund exposure is positive
Denomination GBP 10‘000
Non-Contingent Fee 0.95% p.a. on
Issue Price 100% of Nominal basket value if no fund exposure
Underlying Minimum Fund Exposure 0%
50% GAM Diversity (GBP)
50% UBS O’Connor – Global Alpha Strategy Maximal Fund exposure 150%
Fund (GBP) - institutional
Deleverage Trigger 15%
Initial Basket 100% Fund, 0% ZCB Releverage Trigger 25%
Rebalancing Monthly

Financial Markets Education 85


SECTION 6

Bonus Certificates - A Softer Protection


A historic example (or déjà vu?)

♦ Today is July 18, 2003


♦ Over the last 3 years the S&P500 has fallen by 34%
♦ You think that the worst is over
♦ You think that the future
SPX Daily Closing Prices
will be brighter 1550

♦ But you might be 1450 wrong and


the index 1350
falls another 20%
♦ You need some protection 1250

♦ But you do not want it


1150
to hamper all
your upside 1050

950

850

750
Jan-00 Sep-00 May-01 Jan-02 Sep-02 May-03

Financial Markets Education 87


Performance
A historic example – Bonus Certificate

♦ PPN = Stock + long ATM Put – Dividends


♦ The put is expensive
– You buy full protection against any fall in the underlying price
– Do you need all that protection?
– Do you really think that the index might fall another 40%?
– Might a softer protection be enough protection for you?

♦ The S&P500 (SPX) is trading for 993


♦ You can buy a 5 year Bonus certificate (Certificate Plus) for the same price:
USD 993.23
♦ On July 18, 2008 the certificate pays a USD redemption equal to
– Level of SPX if the index ever traded at or below 551.3
– The greater of SPX Spot and USD 993 if SPX never traded at or below 551.3

Financial Markets Education 88


How the S&P500 performed

1250 SPX Daily Closing Prices

1200

1150

1100

1050

1000

950
Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05

Financial Markets Education 89


PPN versus Bonus Certificate

♦ Bonus Certificates are also called PERLES Plus or Certificates Plus


– Direct, un-leveraged exposure to underlying
– Bonus feature that you get a minimum payout if the underlying never trades at or
beyond a predefined level

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

Financial Markets Education 90


Performance
A product from 2006

Simplified Product Characteristics


Underlying Royal Dutch Shell Redemption Amount
Ratio 1:1 A) No Kick-out Event
Pricing Date 18 August 2006 Max (EUR 33.35, Expiry Price RDS)

Expiration Date 31 July 2009 B) Kick-out Event


Expiry Price RDS
Underlying Price: EUR 27.56
Issue Price EUR 27.56
Bonus Level: EUR 33.35 (121%)
Kick-out Level EUR 20.67 (75%)

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%

Financial Markets Education 91


Kick-out Event

Financial Markets Education 92


Performance
Revival Bonus Certificate on Daimler Chrysler

Simplified Product Characteristics


Underlying Daimler Chrysler Redemption Amount
Ratio 1:1 A) No Kick-out Event:
Pricing Date 21 June 2006 Max (EUR 45.49, Expiry Price DCX)

Expiration Date 19 June 2009 B) Kick-out Event:

Underlying Price: EUR 37.91 Expiration Price lower than Kick-


out Level: Expiration Price DCX
Issue Price EUR 37.91
Expiration Price higher than Kick-
Bonus Level: EUR 45.49 (120%) out Level:
Kick-out Level EUR 28.43 (75%) 28.43 + 2 x (Expiration Price – 28.43)
Recovery Leverage 2

100%

75%

75% 87.5% 100%

Financial Markets Education 93


Hmm…

Financial Markets Education 94


2009 - Back to 2003

♦ In the credit crunch and the global downturn of 2009


♦ Market in long and many times sharp decline
♦ But you don’t want to miss the boat when the recovery happens
– As some people say it will be fast and furious

♦ Many experts tried to call the bottom and got burnt


♦ Timing the market is very difficult
♦ Don’t you want to have the best timing: buy at the lowest price

Financial Markets Education 95


Timing PERLES

Financial Markets Education 96


Fitting the current market

Financial Markets Education 97


Is it behaving as expected?

Financial Markets Education 98


SECTION 7

Interest Rate Structured Products


SECTION 7.A

Interest Rate Structured Products


Motivation
Have I made money

♦ Stock price is 100


♦ 1-year Interest rate is 5%
♦ Dividend is 1
♦ Stock price in a year is 103
♦ Should I have a celebration?
♦ What is the break even price?

Financial Markets Education 101


Prices in the interest rates world

♦ A common shape of the yield curve

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

♦ Care to explain why it is more often upward sloping?

Financial Markets Education 102


What trades should I do?

♦ 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?

♦ Another way to look at this…


♦ What should the yield curve be in a year time for trades to break even?
– An upward sloping curve prices in a rise in rates

Financial Markets Education 103


Looking forward

♦ Thinking about the forward means incorporating the basis


♦ Basis is cost minus benefit
♦ The 1-year forward yield curve (in other words you are looking at the back
end of the curve)

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

♦ Dollar yen is 116 today


♦ USD 20-year rate is 5.5% (annual compounding)
♦ JPY 20-year rate is 3% (annual compounding)
♦ What is the 20-year forward in dollar yen?
♦ Do you believe that the forward is a good predictor of the spot in 20 years?
♦ If not what trade would you do and what is the risk?

Financial Markets Education 105


Typical plays

♦ Receive fixed for long term


♦ Fund dollar assets by yen
– Heard of the yen carry trade?

♦ Sell options on the potential gains of the above


– Monetize upside into option premium
– Trade terminates if the chance of realizing the upside becomes higher
– Trade terminates if rates go lower or the curve becomes steeper
– Trade terminates if dollar becomes more expensive

♦ Buy options to protect against making a payout


– Protect against interest rates going too high
– Protect against dollar becoming too cheap

Financial Markets Education 106


SECTION 7.B

Interest Rate Structured Products


Reverse Floaters
Reverse floater

♦ 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

♦ Reward: large coupons if rates are realized at low levels


♦ Risk: poor return if rates are realized at high levels. Suffers mark-to-market
losses if yield curve moves higher than the forward yield curve

Financial Markets Education 108


Selling options

♦ If the reverse floater note is callable by the issuer at par


♦ Investor has monetized the potential upside at pricing into a high guaranteed
initial coupon
♦ Reward: if the yield curve moves lower than the forward yield curve causing
the note to be valued beyond par, the note will be called and investor gets
back the principal. If this happens sooner, investor realizes a better return
♦ Risk: yield curve moves higher than the forward yield curve and rates are
realized at high levels. Investor is stuck with the note and receives low
coupons

Financial Markets Education 109


Variable Maturity Note

♦ Also called target redemption note


♦ Redemption occurs as soon as the Aggregate Coupons reach a predetermined
Cap
♦ Aggregate coupon is often floored
– Minimum aggregate coupon floored
– Protection of the sum of all coupon payments
– Guaranteed Total Payout of the Note

♦ More transparent early redemption criteria

Financial Markets Education 110


Variable Maturity Inverse Floater -VMIF

♦ Issue Date: 06 Feb 2004 ♦ Aggregate Coupon Cap and Floor:


12.00%
♦ Min Maturity: 06 Aug 2006
♦ Note redeems at par if cumulative
♦ Max Maturity: 06 Feb 2014 coupon is 12%
♦ Coupons (semi-annual)
– Year 1: 8%, 16.0%
– Years 2-10: 10% - 2*Euribor
14.0%

♦ View that the Euro short term rates will 12%


12.0%
remain stable or only slightly increase Coupon Cap/Floor
10.0%

♦ Based on forwards the Note is expected 8.0% Maturity implied


to redeem in 2.5 years by forwards
6.0%

4.0% Expected Coupons


2.0% Aggregate Coupon

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

Financial Markets Education 111


Value and risk

♦ Essentially the same as the callable reverse floater


♦ Investor sells option on the potential upside beyond the aggregate coupon
level
– It depends more on the short end of the curve

♦ Investor expects to collect the aggregate amount of coupon within the


expected life of the note
♦ If rates are realized at lower levels, investor collects the coupon within a
shorter period of time than expected, realizing a better return

Financial Markets Education 112


SECTION 7.C

Interest Rate Structured Products


CDRAN
CDRAN

♦ Callable Daily Range Accrual Note


♦ Use digital options
♦ Daily expiration
♦ Easy to risk manage as digital risk is small on a daily basis
♦ Looks like a coupon bond for fixed income investors
– Except that the coupon is variable (and may be zero)

♦ Investor sold options to boost guaranteed coupon


– Achieved better return against the guaranteed coupon if the note is called early

Financial Markets Education 114


Early 2009 Product 4: CDRAN

Financial Markets Education 115


CDRAN: good pricing (risk premium) with steep curve

Financial Markets Education 116


SECTION 7.D

Interest Rate Structured Products


Flatteners and Steepeners
Why is the product valuable?

♦ 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)

Financial Markets Education 118


Historical and forward EUR 10y-2y CMS spread

Historical and Forward EUR 10y-2y Spread


10
Historics Market Implied
8

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

Financial Markets Education 119


Historical USD 10y-2y CMS spread

Financial Markets Education 120


Early 2009 Product 5: Steepener

Financial Markets Education 121


Non callable CMS Spread Note

Financial Markets Education 122


Risk and Reward

♦ 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

Financial Markets Education 123


SECTION 7.E

Interest Rate Structured Products


The PRDC
PRDC – Power Reverse Dual Currency

♦ 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.

Coupon = Notional*(9%*FX1/FX2 – 4.5%)

where FX1 is FX at reset dates and FX2 is initial FX


♦ Callable PRDC: investors sells option on the potential upside at pricing,
monetizing that upside into option premium embedding it in an enhanced
guaranteed initial coupon

Financial Markets Education 125


Dollar Yen PRDC

♦ 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

Financial Markets Education 126


A closer look

♦ 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

Financial Markets Education 127


The callable structure

♦ 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

Financial Markets Education 128


SECTION 8

Basket Products
Relationships

♦ You may have a view about how two underlying co-move


♦ USDJPY and EURJPY
♦ USDJPY and AUDJPY
♦ USDJPY and N225
♦ You can trade a derivative on a basket

Financial Markets Education 130


Correlation

♦ Correlation affects the pricing of derivatives on a basket


♦ Correlation affects the pricing of the forward
– If co-movement leads to losses in the hedge, then positive correlation is a cost
– If co-movement leads to profits in the hedge, then positive correlation is a benefit

♦ Correlation affects the pricing of volatility


– If correlation enhances the fluctuation of the return of the basket then the basket
volatility is higher
– If correlation causes cancellation and dampen the fluctuation of the basket then the
basket volatility is lower

♦ 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

Financial Markets Education 131


Basket 1

♦ Half the amount in A and half the amount in B


♦ If the correlation is much less than 1, what is the chance of scoring 5 on the
basket?
♦ If your view is 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0
that the market (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5
is going to go up
anyway, what is (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0
your trade? (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5
(2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0
(2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5
(3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0
(3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5
(4.0) (3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0
(4.5) (4.0) (3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5
(5.0) (4.5) (4.0) (3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0
Financial Markets Education 132
Basket 2

♦ 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

Financial Markets Education 133


Basket 3

♦ 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)

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FX TARN

♦ FX1 is USDJPY, FX2 is AUDJPY


– Indexed rate = (FX1 – 106.41) x 1.00%
– Minimum rate = 0
– Maximum rate = (FX2 – 87.77) x 1.00%
– Structure early terminates if aggregate coupon > 19.20%
– Final redemption USD or AUD whichever cheaper against yen

♦ A “worst of” basket of PRDC on USDJPY and AUDJPY


♦ Investor sells option on the potential upside via target redemption
♦ Final redemption uses a dual currency structure: the exposure is a forward on
the “worst of” basket of USD and AUD
– However the forward is canceled if the note early redeems

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Digital coupon trigger note

♦ Knock-out wedding cake structure (or knock-out range GROI) on the “and”
basket of USDJPY and N225

Payout

“Price” level
Knock-out
level

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SECTION 9

Summary
Many more…

♦ This class discussed the fundamental considerations in product structuring


♦ There are many more variations
♦ Also there are the credit products – if the market has not died out
– Credit Linked Notes
– First-to-default Notes
– Collateralized Debt Obligations

♦ Remember that a successful structure usually arises naturally from needs to


meet investment objectives of the time
♦ More importantly, the success of the product hinges on the choice of the
underlying and the structure that fits the time
– In the early part of the 2000’s there were many innovations in product structures
– But the later part is more about the selection and combination of the underlying
risks, including commodities, rates, equities and FX
– What about in the global downturn?

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APPENDIX A

Strategy Certificates & Cliquet PPN


Strategies

♦ A strategy is a plan that is intended to implement a view


♦ If you don’t have a view, you can’t have a strategy
♦ Structured products
– can implement a view
– can help to tailor risk and return profile
– at known cost
– with a more predictable results

♦ Structured products cannot


– make your view correct
– give you profits when you’re wrong

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Optimisation
A real Sprint – the rolling speeder

♦ Your View is that the DAX will moderately outperform Fixed Income market
– Invest in DAX speeder over and over again

♦ Alternatively, invest in the Germany Rolling Sprint Index


– Open End Certificate on the Germany Rolling Sprint Index
– Management Fee: 75 Basis points per year

♦ Germany Rolling Sprint Index tracks performance of 1-months sprint


certificate (speeder) on the DAX on a rolling basis
– Rolled over every months
– long at-the-money call and short 2 of the 3% out-of-the-money calls
– Option prices calculated at EUREX mid plus 1%

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Protection
Cliquet Options

♦ You have a positive view on the Nasdaq


♦ You feel that you need a product that protects your initial capital
♦ You would also like to lock in the achieved gains, since you fear periodic
downside corrections
♦ Invest in “Rolling PPN Strategy”
– You pay the option premium on the roll-over dates
– The option premium will determine your participation
– Participation will the depend on future option market (future implied volatility)

♦ 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

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Protection
Cliquet PPN on the Nasdaq 100 Index

Underlying Nasdaq Guaranteed Minimum 5,000 at Exp


Nominal USD 5,000 Coupon 2% p.a.
Issue Price 100% of Nominal Monthly CAP 102.375%
Issue Date 6 February 2004 Monthly FLOOR 95%
Maturity Date 6 February 2009 Max Redemption 242% of Nominal

Summing up capped &


floored monthly Redemption Formula:
performances

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

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Protection
Standard Cliquet PPN

♦ 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

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Not afraid of downside moves?

♦ You are somewhat bullish on the market


♦ You believe that the Euro STOXX either trends slowly but constantly up or
stays at its current levels
♦ You do not have a particularly negative view on Euro STOXX
♦ Specially, you do not think that there will be large periodic down-side moves
in the index
♦ One possible strategy is to sell the upside you do not believe in
– Why not invest in ‘Rolling Discount certificates’ explained earlier?

♦ 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

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Protection
Reverse Cliquet PPN

Underlying Euro STOXX 50 Guaranteed Minimum EUR 5,975 at


Nominal EUR 5,000 Expiration (119.5%)

Issue Price 100% of Nominal Max Redemption 190% of Nominal

Issue Date 30 April 2002 Redemption The greater of Formula or


Guaranteed Minimum
Maturity Date 30 April 2007

Redemption:
The greater of
the Guaranteed Minimum
Or
Nominal x (Max return – sum of negative monthly performances)

Max return – sum of negative monthly performances

SX5Ei: Level of the index close at the resetting date of month i

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The Euro STOXX 50 so far

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%

Redemption in 2007 will be EUR 5,975


The product is now a Zero Coupon Bond

Financial Markets Education 147


Contact Information

For further information:


•UBS Internal: Type ‘FME’ into your browser
•UBS External: Email SH-Learning-Americas@UBS.com
SH-Learning-UK@UBS.com

Financial Markets Education 148


Disclaimer

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Financial Markets Education 149


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