(Part of Master Thesis: Kocyigit, Eren, “The Use Of Retail Structured Products And Their Applications In Turkey”, Istanbul Bilgi University, 2010)
2. STRUCTURED PRODUCTS LITERATURE REVIEW
In this chapter academic studies that were made in the past will be analyzed. Within the chapter these studies will be examined in 2 parts; studies made for specific markets and studies made for structured products in general.
In both parts; it can be realized that most of the academic literature deal with the pricing (valuation) of structured products. In these studies; researches were carried out in the areas of pricing and back testing of structured products in the primary and secondary markets. In this literature review, different types of products are taken into account, like discount certificates, reverse convertibles, equity linked certificates, market index certificates, index notes and etc…
Chapter will start by examining the studies that were made about some specific markets.
2.1. Studies About Regional Structured Products Markets
In this section studies that were made about different markets will be examined. Most of the studies were made about 2 regions; North America and Europe.
From North America most of the studies were made about US and Canada. From Europe most of the studies were made about Germany, Switzerland and Holland.
Until now there is not an academic study that was made about Turkish market.
2.1.1. North American Markets
188.8.131.52. US Market
Although the first structured product was seen in US market back in 1987, there are not much academic studies made for this market. Also most of the studies that are exist in the literature go back to a time when these structured products first launched. (Wohlwend et al, 2003).
Chen/Kensinger (1990) investigated Market Index Certificates of Deposit (MICD) for 2 months period in 1988 and 1989 in the US market. Structured product that they deal in their study was MICD which has characteristics of paying a guaranteed minimum interest and a variable interest that is linked to the performance of the S&P 500. In their study they used a sample of 18 MICD issued in January 1988 and 25 MICD issued in January 1989 by Chase Manhattan and Murray Savings.
After they compared the implied volatility of S&P 500 option and option component of the MICDs, they found out that; there are inconsistencies between the pricing of the same type of MICDs among issuers and there are also inconsistencies between the pricing of different types of MICDs offered by the same issuer.
Chen/Sears (1990) investigated S&P 500 Index Note (SPIN) issued by Salomon Brothers in US market. SPIN which they are investigated can be told as a similar product to the MICDs, but exchange-traded. This product is a %2 coupon bond with 4 year maturity which pays to its holder at maturity; (the principal amount + accrued interest + (((S&P 500 first level – S&P 500 last level) / (S&P 500 first level)) * Predetermined Multiplier)). In other words despite the principal and accrued interest paid by the product; this product also provides participation to its investor into the performance of S&P 500 index by a predetermined ratio. From this payoff characteristics of the product it can be told that; this product is consisting of a low coupon bond plus long-term plain-vanilla call option on the S&P 500.
Chen/Sears (1990) focused on the market and theoretical prices of this product over three sub periods between September 1986 and December 1987. In their investigation they used ex-post, average implied and long term implied volatility and found out that; product was overpriced about %5 in the first sub period, in the second and third sub periods the product was underpriced. These results were commented by Chen/Sears (1990) as the market was going through a learning process in pricing this unique and new type of security.
Baubonis/Gastineau/Purcell (1993) investigated Equity-Linked Certificates of Deposit (ELCD) in US market which is a similar product to the MICD which was investigated by Chen/Kensinger (1990). However, unlike Chen/Kensinger (1990) and Chen/Sears (1990), they didn’t deal with the pricing of the structured products. They are focused on the performance of ELCD comparing with alternative investments. In their study they compared 5 year maturity ELCD performance with S&P 500 and treasury note performances. They determined the performance of ELCD as the average return of 4 guaranteed, 1 protected product in US market. They determined S&P 500 and treasury note performances from market data relating to the 5-year overlapping periods between 1948 and 1993.
Baubonis/Gastineau/Purcell (1993) found that; 5 year ELCD have a return of %8.33, 5 year investment in S&P has a return of %9.93 and 5 year investment in a treasury note has an average annual return of %5.42. After these results, they told that structured products are more profitable than riskless products and less profitable than a direct market instrument investment. However, after examining the 5-year investment in structured products, Baubonis, Gastineau and Purcell (1993) conclude that these types of products don’t involve the best investment solution for an investor because an investor would almost always have been better off with either a straight equity investment or with a straight fixed-income investment.
Chen and Chen (1995) investigated the valuation of one structured product on the secondary market with no capital protection and offering investors high interest payments in exchange for a cap on the underlying stock’s growth.
Chen and Chen (1995) found that this product is overvalued at some 5 percent.
Edwards and Swidler (2005) investigated Equity-Linked Certificates of Deposit (ELCD) in US market like Baubonis/Gastineau/Purcell (1993). They also focused on the performance of ELCD comparing with alternative investments. In their study they compared the returns of the ELCD with the returns of the S&P 500 index, the 5 year treasury note and the Index Powered Certificate of Deposit (IPCD). They calculated the return distribution of these instruments by using Monte Carlo Simulation over a period of 1981 to 2004.
Edwards and Swidler (2005) found that; investing in IPCD is better than investing in 5-year Treasury note, investing in ELCD is better than investing in IPCD for the investors. They also found that investing in ELCD do not give equity like returns, that means investing in S&P 500 index is better than investing in ELCD for the investors.
Benet, Giannetti, and Pissaris (2006) investigated Reverse- Exchangeable Securities (RES) in US market. In their study they examined the pricing of 31 RES that are outstanding in 2003. They aimed to find the right premium in terms of coupon spread in order to obtain the fair value of product. Benet, Giannetti, and Pissaris (2006) found the coupon spread ranging from 4% to 6% and tried to explain this spread in terms of credit risk. Also they argued that RES holders are less exposed to the issuer’s credit risk then the bondholders. However, at the end of their study this explanation seemed incompatible when issuer bank ABN Amro with AAA rating is analyzed because the corresponding credit spread was too low to have a significant influence on the fair values of the RES under their study.
184.108.40.206. Canadian Market
Milevsky and Kim (1997) investigated capped structured products and participating structured products in Canadian market. In their study they compared the pricing of these structured products. They explained capped structured products as the products that provide their investors to participate in any upward movement in the underlying up to a pre-specified cap, participating structured products as the products that provide their investors to participate in any upward movement in the underlying without any pre- specified cap.
Milevsky and Kim (1997) found that for short term maturities participating products are preferable to capped structured products, for long term maturities capped structured products are preferable to participating structured products. They also found that both type of products are unfairly priced for customers.
2.1.2. European Markets
220.127.116.11. Swiss Market
There have been three important studies conducted in the Swiss market so far. Schenk and Wasserfallen (1996), Burth, Kraus and Wohlwend (2001) and Grunbichler and Wohlwend (2005) Wasserfallen/Schenk (1996) investigated 13 structured products (10 guaranteed, 3 capital protected) issued in Swiss Market between January 1991 and April 1992. In their study they examined the pricing behavior of these 13 structured products within a period of trading days spanning from 21 to 80 days. Examination of these products’ valuation based on the historical and implied volatility in their study.
Wasserfallen/Schenk (1996) found that these products tend to be overvalued in primary, undervalued in secondary markets. In other words these products are sold over their theoretical values at issue and have a tendency to be undervalued then their theoretical price in the secondary market. They told that the difference between the value at issue and theoretical value corresponds to the gain of the issuing bank. In their study they also found that with relative errors generally below 10 %, these products are generally fairly priced.
Burth, Kraus and Wohlwend (2001) investigated 275 structured products (199 reverse convertibles and 76 discount certificates) without capital protection, issued in Swiss Market that was outstanding at August 1, 1999. In their study; structured products with concave payoff function (short position in a call option on same asset) analyzed for the first time. Their study depended on testing the price of these structured products.
Burth, Kraus and Wohlwend (2001) found such results from their examinations;
At all conventional levels of confidence price differences of issuing institutions (15 issuers) are found approximately 1.91% significant
%84 of the total products examined are found as overpriced, %16 of them as underpriced.
Their investigations also show that these different valuations caused by depending on the issuing institution, the product category and the management of the products.
For the product category; mispricing can be seen in structured products without a coupon payment rather than those with a coupon.
A significant statistical bias was seen in the products price in favour of the issuing institutions.
Grunbichler and Wohlwend (2005) investigated 192 structured products without capital protection, issued in Swiss Market. In their examination they made a comparison between EUREX options and structured products that are linked to EUREX options.
Grunbichler and Wohlwend (2005) found that in primary market structured products are overvalued about %4.25, in secondary market they are overvalued about %1.65. They also found the misevaluation of these products led to the investor’s disadvantage and a significant decline during the lifetime of these products.
18.104.22.168. German Market
Wilkens, Röder, and Erner (2003) investigated 906 structured products in German Market. In their examination they focused on mainly discount certificates and reverse convertibles that were linked to DAX and NEMAX stock indices and their pricing during a timeframe of 22 days.
Wilkens, Röder, and Erner (2003) found that according to the risk of redemption of shares that is given by the moneyless of the option and the lifetime of the product, issuers are orienting their pricing. The misevaluation of the products are increasing with the moneyless of the option and decreasing with time to maturity. They concluded as the differences of the pricing of structured products can mostly be interpreted because of the issuer.
Stoimenov and Wilkens (2005) investigated plain-vanilla structured products in German Market. In their examination they focused on mainly discount certificates and reverse convertibles and their pricing. In their study they also examined the structured products embedded to barrier or rainbow options where the underlying asset is DAX index or DAX stocks.
Stoimenov and Wilkens (2005) found such results from their examinations;
In the most of the products they found out that issuing banks charge large implicit premiums in the primary market.
Product life cycle is determined as an important parameter for secondary market pricing according to their study.
Structured products with exotic options generate higher premiums compared to the classic products; in other words more complex products provide more premiums.
They conclude that because of their underlying equity the structured products on average overpriced on primary and secondary markets
Baule, Entrop and Wilkens (2006) investigated exchange traded structured products in German Market. In their examination they focused on mainly discount certificates and their pricing. They divided their study into 2 parts as; empirical and theoretical parts. In theoretical part they evaluate the pricing of discount certificates by taking the issuer’s credit risk into account. In empirical part they investigated 5 major issuers’ quoted prices of discount certificates on the DAX stocks.
Baule, Entrop and Wilkens (2006) found that because of the credit risk of the issuer is a material part of total margin, compared to earlier studies (conducted for discount certificates in Germany) in their studies total margins were found lower. According to them the reason of this decline in total margin can be explained by the rising competition among the issuer institutions.
Entrop, Scholz and Wilkens (2007) investigated exchange traded structured products in German Market. In their examination they focused on mainly open-end leverage certificates and their pricing. In their study they didn’t rely on the prices from primary and secondary markets because they thought these prices are determined by the issuers by applying already agreed price-setting formulas. In other words the issuers influence the market price by communicating with each other and determining a price setting formula and announcing this ex-ante formula continuously.
Entrop, Scholz and Wilkens (2007) found such results from their examinations;
In the course of the product lifetimes, profits of the issuers are increasing.
The price setting formula favours the issuers strongly.
The issuers can hedge these certificates easily.
Funding rate spread and the volatility of the underlying can be determined as key factors leading to misevaluation, compared to them interest rates and their dynamics were found negligible.
Wilkens and Stoimenov (2007) investigated leverage structured products in German Market. In their examination they focused on mainly leverage structured products on the DAX and their pricing. They divided their study into 2 parts as; empirical and theoretical parts. In theoretical part they determined the price of leverage products from model values. In empirical part they determined the price of leverage products from issuer quotes.
Wilkens and Stoimenov (2007) found such results from their examinations;
Value of long and short certificates exceeds theoretical values.
The profit of issuers can be almost risk free if they have suitable conditions for hedging
If long and short leverage products are compared, short leverage products generate higher premiums and they require more risky super hedging strategy.
22.214.171.124. Dutch Market
Szymanowska, Ter Horst and Veld (2003) investigated the pricing of 75 reverse convertibles issued between January 1999 and December 2002 on the Dutch market.
Szymanowska, Ter Horst and Veld (2003) found that Dutch reverse convertibles that were examined in their study were overpriced on average about %23. This overvaluation was determined by the difference between the market value of the product and the model value relative to the model value.
2.2. Studies About Structured Products in General
2.2.1. Studies About Anatomy of Structured Products
Wolfgang Breuer and Achim Perst (2005) investigated Discount Reverse Convertibles (DRCs) and Reverse Convertible Bonds (RCBs) as important examples of structured products.
Wolfgang Breuer and Achim Perst (2005) found that DRC and RCBs benefit from low volatility estimates and medium-level return expectation estimates by investors. Both expected utility theory and cumulative prospect theory come to the same qualitative conclusion for these products. Also they concluded as the demand for RCBs by individual investors can only be understood against the background of hedonic framing theory.
Carole Bernard, Phelim Boyle, and Weidong Tian (2007) investigated customer’s wishes so they focus in the design of structured products which meets these investors’ demands rather the pricing of these products. They also declared many investors want both downside protection in bear markets and upside participation in bull markets and there is a wide variety of structured investment products that cater to such investors.
Carole Bernard, Phelim Boyle, and Weidong Tian (2007) found that optimal design of a structured product with capital protection depends on the issuer’s utility function rather than the issuer’s risk preferences.
Brian J. Henderson and Neil D. Pearson (2007) investigated Structured Equity Products (SEP). In their study they focused on type of SEPs which are medium-term notes with payoffs based on the prices of common stocks, baskets of stocks, or stock indices. They investigated equity-linked products which are linked to common stocks, equity indices, or multiple stocks or indices volume of over $50 billion from 1994 through the end of 2005.
Brian J. Henderson and Neil D. Pearson (2007) found that products linked to individual stocks mostly have concave payoff functions whereas products linked to equity indices mostly have convex payoff functions.
Daniel Bergstresser (2008) investigated structured notes. Unlike the earlier studies, he investigated issuance and performance patterns, using a broad sample based on more than 1,000,000 notes.
Daniel Bergstresser (2008) found that investors are looking for performance while issuers prefer to issue notes whose underlying risks are easier to hedge. Also he found out in this market, investors were getting a negative alpha over the period since 2000 (approximately 100 basis points per month).
Carole Bernard and Phelim Boyle (2008) investigated a particular design of a structural product where the investor’s return is capped periodically and there is also a guaranteed minimum at maturity.
Also they examined which type of contract investor should choose. They discussed the puzzle of investor choice from simple or complex products through their investigations.
Carole Bernard and Phelim Boyle (2008) found that although the structured products are very costly for the retail investors because of pre- packaged solutions, these instruments are still attracting the investors. By the way they showed that some of the consumer choices made in this market are very puzzling from the perspective of standard finance theory. They couldn’t understand why the consumers select a complex contract when a simpler one would appear preferable. Because of these 2 puzzles they come face to face with the fact that the most complicated products are the most overpriced and carry the highest sales commissions.
Nicole Branger and Beate Breuer (2008) investigated the possible solutions for retail investors with different demands. In their study they determined investment certificates as a potential solution for these retail investors. (Especially for the investors who hold their portfolio for 1 year). So they analyzed different certificates and compared them with each other.
Nicole Branger and Beate Breuer (2008) found that simple discount certificates perform better than the more complicated ones with knock-in knock-out features. So they concluded as retail derivatives with a more sophisticated payoff structure are less attractive for the investors.
Patrick Roger (2008) investigated Capital Protected Notes (CPNs) which are very popular structured products since the internet bubble burst in 2000. In his study he also examined the convenience of these types of products to the loss averse investors.
Patrick Roger (2008) found that CPNs are attractive for loss-averse investors. However, using a simple version of cumulative prospect theory, he showed that these products are not attractive to the investors if the investor takes either the underlying index or the risk-free instrument to invest. In other words loss-averse investors never find it optimal to invest in a CPN when their reference return depends on either the underlying or the risk-free asset.
2.2.2. Studies About Pricing of Structured Products
K.C. Chen and Lifan Wu (2007) investigated equity-linked structured notes. In their study they especially focused on the pricing of Bullish Underlying Linked Securities (BULS).
K.C. Chen and Lifan Wu (2007) found that valuation of BULS was overpriced at issue according to the model they used during the seasoning period with a mean pricing error of 2.40%. However, they found also out, this overpricing was soon corrected in the following year with a mean pricing error of −0.16%, which is statistically insignificant.
Rodrigo Hernández, Wayne Y. Lee and Pu Liu (2007) investigated Reverse Exchangeable Securities (RES). In their study they used a detailed survey of the $ 45 billion US dollar-denominated market for 7,426 issues of bonds issued between May 1998 and February 2007. They developed pricing models for four different bonds to examine the profits.
Rodrigo Hernández, Wayne Y. Lee and Pu Liu (2007) found that result of the survey suggest significant positive profits for the issuing financial institutions. They also showed that a perfect hedge can be obtained with RES and issuing of the certificates is a profitable business. In their study they examined the design, the payoff, the market, the pricing, the profitability, and the realized returns of expired issues of the RES.
Rodrigo Hernández, Wayne Y. Lee and Pu Liu (2007) investigated OCs. In their investigations they studied €43 billion market by examining 1,507 issues of the certificates issued by banks in Europe. They also developed pricing formulas to value the certificates and empirically examine the profits in the primary market for issuing the certificates.
Rodrigo Hernández, Wayne Y. Lee and Pu Liu (2007) found that the dividend yields and ex-dividend dates play an important role in the profitability of the certificates. As a further study they developed pricing models for two types of certificates ‘uncapped and capped certificates’ and they found out that issuance of the certificates is profitable for the issuers in their sample.
Jos van Bommel, Silvia Rossetto (2008) investigated Endless Leverage Certificates (ELC). In their study they explained ELC as structured products which are long or short positions in an underlying that are partly financed with a loan from an issuing bank.
Jos van Bommel, Silvia Rossetto (2008) found that the value of an ELC is virtually independent of the volatility of the underlying, and is at most 0.3% higher than its intrinsic value. They found that ELCs are competitively priced and traded, and on average, ELC longs and shorts are overpriced by 0.51% and 1.01% respectively relative to their intrinsic values. Also in their study they found desirable properties of ELCs. First, the lower bound value of the product, the intrinsic value, is easy to ascertain and compare with market prices. Second, bid-ask spreads in the secondary market are narrow. ELCs also have desirable ‘behavioral’ properties.
2.2.3. Studies About Regulation of Structured Products
Jennifer Bethel and Allen Ferrell (2006) investigated possible risks that can be involved by the usage of structured products.
Jennifer Bethel and Allen Ferrell (2006) found that first of all there is not an enough regulation for the structured products and investors are buying them at most of the times without understanding them. They suggested several possible approaches for structured products regulation such as classifying investors as accredited and no accredited investors and allow only accredited investors to invest in structured products, restructuring the distribution of structured products (preventing large denominations, enhancing suitability requirements). They suggested these kinds of possible regulations in order to reduce the probability that investors hold inappropriate structured products. They also suggested improved disclosure (containing all explicit fees and best practices) and more accessible information such as web-based memoranda.
Thorsten Hens and Marc Oliver Rieger (2008) investigated optimal design and introduction of structured products to the investors. In their study they used data from Germany and Switzerland. They focused on the reasons why structured products look so attractive for many investors.
Thorsten Hens and Marc Oliver Rieger (2008) found that attractiveness of structured products can arise as a solution for enhancing the performance of a portfolio purposes. Also they found some behavioral factors like loss aversion or probability of misestimation can increase the attractiveness of these products in the eyes of potential investors. They suggested improving the understanding of customer instead of banning structured products completely (as it is discussed in some countries).
2.3. Overview of Literature Review
Studies that were made in the past for structured products showed that most of the studies focused on pricing and performance of the structured products like Certificates of Deposits, Reverse Exchangeable Securities, Discount Certificates, Capital Protected Notes and etc… Researchers investigated these products whether in specific markets or in general.
Findings of the studies are differed from each other. However, it can be told that according to the most of the empirical studies; pricing of these products are in investors’ disadvantage when the prices in primary or secondary markets are testing according to different pricing models like Black & Scholes model. Also when the performance of the structured products are analyzed most of the studies showed that investing in risk free instrument or investing directly to the structured products’ underlying asset could be better for investors.