structured products8

Structured Products – Part 3: All About Structured Products

(Part of Master Thesis: Kocyigit, Eren, “The Use Of Retail Structured Products And Their Applications In Turkey”, Istanbul Bilgi University, 2010)

3. STRUCTURED PRODUCTS

3.1. Definition of Structured Products

Structured products are ‘tailor-made’ products which aim to provide the best solution to the investors with this ‘tailoring process’ (Kat 2001). There is not a single definition for structured products. Different definitions can be found in different sources.

• Definitions of structured products from web;

Web site (http://www.wikipedia.org/) defined structured product as ‘‘A structured product is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuances and/or foreign currencies, and to a lesser extent, swaps.’’

Web site (http://www.hedgefund-index.com) defined structured product as ‘‘structured products are synthetic investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets.’’

• Definitions of structured products from well-known institutions;

Definition of SSPA (Swiss Structured Products Association) is ‘‘structured products are investment products available to the public whose repayment value derives from the development of one or several underlying assets.’’

Definition of (http://www.structuredretailproducts.com ) is ‘‘structured products are investment products that generate a pre-defined return linked to one or more underlying financial prices, rates or indices.’’

• Definitions of structured products from books;

Structured products are defined as ‘‘structured products refer to combinations of individual financial instruments, such as bonds, stocks and derivatives.’’ by Oesterreichische Nationalbank (Structured Products Handbook 2004)

According to Chorafas D.N (2007) ‘‘Structured products are securities that provide investors with a redemption amount, which may be with either full or partial capital protection, and a certain type of return.’’

Das (2000) defined them as ‘‘combinations of derivatives and underlying financial instruments which exhibit structures with special risk/return profiles.’’

As it can be realized from all these definitions; although there is not a single definition for structured products, there are some certain features that can be mentioned for the structured products like;

Mostly they consist of at least 2 products; a common bond or a deposit, plus a derivative.

The payoffs of the structured products depend on one or more underlying assets.

According to these features it can be told that;

Structured Products are tailor made financial instruments that are composed of mostly more than one product and have a performance depending on one or more underlying assets.

3.2. Composition & Design of Structured Products

Most of the structured products consist of 2 components; basic financial instrument (BFI) component and derivative component (See figure 3.1). The payoff, risk-level and general characteristics of a structured product can be determined from these 2 components.

Screen Shot 2015-02-07 at 02.05.47

Figure 3.1: Composition of a Basic Structured Product

In BFI component, products like bonds, notes and deposits can be located. This component generates a fixed return to the structured product in most types of structured products.

In derivative component mostly options with different kinds of underlying instruments and different strategies are located. Options in this component can be linked to different instruments like equities (stocks, indices), commodities, foreign exchanges and interest rates. They can be linked to a single type of instrument or more than one instrument as a hybrid design. Options in derivative component can be in different types like call & put, vanilla & exotic options (barrier, lookback, asian and etc… (See Appendix A for most popular types of exotic options that are used in structured products) and these options can be in different strategies like bearish, bullish and neutral.

All the characteristics of a structured product like payoff, maturity, underlying instrument and its risk level can be determined according to;

The type, maturity and payoff features of the instrument(s) that is located in BFI component. (e.g. if it is a bond; type of this bond (government or corporate & zero or coupon) , its interest rate and maturity affects the structured products payoff & risk level)

The type, maturity and payoff features of the instrument(s) that is located in derivative component. (e.g. if it is an option, its underlying asset (fx, equity, interest rate, commodity or hybrid), its type (call & put, vanilla & exotic), its strategy (bearish, bullish, neutral) and its maturity affects the structured products payoff & risk level)

The weight of these components.

Screen Shot 2015-02-12 at 22.21.17

 

Figure 3.2 illustrates structured products on risk-return graph.

As it can be realized from that graph a typical structured product locates between bonds and options on risk-return graph. In other words structured product is more risky than government bonds and less risky then options.

According to the types, characteristics and ratios of structured products’ components, risk level of the structured products can move between the risk level of government bonds and options.

In order to move a structured product’s risk level between the risk level of government bonds and options, components and their weight should be re-structured.

  • With the identical components of 2 different structured products; the weight of these components affects the risk level of these structured products. Greater weight of bond component moves the structured product through government bond risk level, greater weight of derivative component moves the structured product through options risk level.
  • With the same weight and identical BFI components of 2 different structured products, the risk level of derivative components effect the risk level of these structured products. Riskier option component moves the structured product through options risk level, less risky option component moves the structured product through government bond risk level.
  • With the same weight and identical option components of 2 different structured products, the risk level of BFI components affect the risk level of these structured products. Riskier BFI component moves the structured product through options risk level, less risky BFI component moves the structured product through government bond risk level.

3.3. Types of Structured Products

Until this section we analyzed the definition and the composition of the structured products. In this section types of the structured products will be analyzed according to;

  • The market that they bought & sold
  • Their underlying asset
  • Their risk level

3.3.1. Structured Products and Their Market

Structured products are financial instruments so they should have a market to be bought or sold. According to their trading markets they can be divided into 2 categories;

3.3.1.1. Structured Products in OTC markets

These types of structured products don’t have an organized market and mostly traded between two different parties. There is not an organizer of these transactions and the parties are responsible to each other for all the liabilities that come along with the product.

For example; Dual Currency Deposit (DCD) which will be analyzed in Chapter 5, can be count as a structured product whose transaction occurs in OTC markets. In the transaction of a DCD product there are two different parties and one structured product whose specifications (maturity, strike price, underlying asset and etc…) are determined and fixed by these two parties. The possible outcomes and liabilities will be faced by these two parties only; not by another third party.

3.3.1.2. Structured Products in Organized Markets

These kind of structured products are bought and sold in organized markets, that is to say transactions of the products occur under the control of an authority and its set of rules and regulations.

The best examples of this category are the structured products which are traded in Scoach1. Unlike the structured products traded on OTC markets, these kinds of products bought and sold in an organized market.

3.3.2. Structured Products and Their Underlying Instrument

Another categorization of the structured products is according to their underlying instrument. Although there are unlimited strategies to compose a structured product there are some main instruments that can be considered as underlying assets when we analyze structured products.

Foreign Exchange (FX) Linked Structured Products: The payoffs of these kinds of structured products depend on the performance of the currency which is underlying. Products can be linked to one single currency pair or a basket of currency pairs. Most popular types of currency pairs can be formed between USD, JPY, EUR, CHF, GBP, CAD and AUD (Wystup 2006)

Commodity Linked Structured Products: The underlying assets of these kinds of structured products are commodities. Underlying asset can be a single commodity or a basket of commodities. Some popular types of commodities are gold, silver, oil and etc…

Equity-Linked Structured Products: They are promoted as an alternative to directly investing in equities since the underlying assets of these kinds of structured products are equities (Chorafas 2007). There are 2 main types of equity linked structured products: Share linked and Index linked structured products. Share linked structured products can be composed of a single share or a basket of shares. Some popular types of shares are Deutsche Bank, Allianz, Bayer and etc… Index linked structured products can be composed of a single index or a basket of indices. Some popular types of indices are DJ Eurostoxx50, DAX, FTSE100 and etc…

Interest Rate Linked Structured Products: The underlying assets of these kinds of structured products are interest rates. Products can be linked to one single interest rate or a basket of interest rates. Some popular types of interest rates are LIBOR, EURIBOR and etc…

Hybrid-Linked Structured Products: In these kind, different types of underlying instruments comes together in a structured product. For example if a product has currency, commodity and equity as underlying at the same time, this structured product can be evaluated as hybrid-linked structured product.

These 5 types of underlying instruments can be classified as the major types, despite them there are other types of underlying instruments such as;

  • Credit Linked Structured Products: In this kind, the underlying asset is mostly a pool of debt instruments. So the performance of the structured product linked to these debt instruments. (e.g. Asset Backed Securities, Credit Default Obligations and etc…)
  • Fund Linked Structured Products: In this kind the product and its payoff is linked to the performance of a fund. Most popular type is hedge fund linked products. They provide their investors, easy and less costly participation to the hedge funds.
  •  Inflation Linked Structured Products: In this kind, the product is linked to a single inflation rate of a specific country or a zone or basket of inflation rates. Most of them target to protect investors from resurgence in inflation (Chorafas 2007).

3.3.3. Structured Products and Their Risk Level

In this section structured products will be categorized according to their risk levels. Figure 3.3 shows main types of structured products when their risk levels are considered;

Screen Shot 2015-02-12 at 22.27.07

Figure 3.3: Structured Products and Their Risk Levels

As can be seen from figure 3.3; there are 4 main types of structured products according to their risk levels and they can be lined up from less risky to the riskier as following:

  1. Capital protected products
  2. Yield enhancement products
  3. Participation products
  4. Leverage products

At this section the categorization of structured products are made according to the classification of structured products made by Swiss Structured Products Association (SSPA) and European Structured Investment Products Association (EUSIPA). Within the following sections most popular types of products will be analyzed. (See Appendix C for all types of structured products according to SSPA and EUSIPA structured products categorization model.)

3.3.3.1. Capital Protected Products

Capital protected products are structured products which protect the initial investment at the maturity. These products can also generate a return to their investors above their initial investment. These kinds of products mostly consist of a traditional bond (the part which protects the initial investment at the maturity), plus a derivative (the part which may generate a return above initial investment – mostly option.)

In these kinds of products; return of the product above the initial investment is determined by option’s performance multiplied by participation rate. Participation rate is determined by dividing the remaining capital after investing in traditional bond to the price of derivative that is used to structure this capital protected product.

In capital protected products; mostly issuers set the capital protection level at 100%, but they can also set it higher or lower. In Europe today’s low interest rates make it harder to provide %100 capital protection to the investors while structuring attractive products that’s why %70 – %80 capitalprotection started to used in most of European capital protected products. (Marray 2009)

Figure 3.4 shows composition and operating process of a basic capital protected product.

structured products

Figure 3.4: Composition of Capital Protected Products

In Figure 3.4; Y refers to value of a derivative, X refers to value of a bond. At the maturity the value of bond will reach the initial investment which is X+Y. So the capital is protected by this way. At this example Z refers to an extra yield that is generated by the option.

At the maturity X+Y generated independent from the option’s performance. On the contrary, Z which represents the yield above the initial investment is dependent to the option’s performance and participation rate.

Figure 3.5 shows a numerical example of a capital protected product from JP Morgan Structured Investments Solution Catalogue (2007). In this figure return of a $1000 investment to a capital protected product linked to the S&P 500 Index with a 90% participation rate is shown in 2 different scenarios.

structured products

Figure 3.5: A Capital Protected Product Example

In the first scenario; if the S&P 500 Index rises to %20, then the investors receives at the maturity; initial investment * S&P performance * participation rate = 1000 * 0,20 * 0,90 = $180

In the second scenario; if the S&P 500 Index falls to %20, then the investor receives at the maturity his/her initial investment which is equal to $1000. In this scenario rather than incurring a $200 loss in the initial investment, investor receives his/her principal back at the maturity.

Capital protected products can be considered as transition products for the structured products market. As can be seen their place on risk return graph from Figure 3.3, retail investors who didn’t invest in structured products before mostly choose these kinds of products if they want to try investing in structured products for the first time. In other words, it can be told that; capital protected products are the middle term between the phrases of being a conservative investor and sophisticated investor. Because of this reason as Roger (2008) reported in his study; most of the banks offer their customers these types of structured products by assuming that most of their customers are loss averse investors. Before investing in more risky structured products, loss averse investors firstly chooses capital protected structured products.

3.3.3.2. Yield Enhancement Products

Yield Enhancement products are kind of structured products which are desirable to the investors when markets are stable or moving sideways. They offer returns above the traditional bonds if the underlying assets’ prices move sideways or go up (Barlocher 2009). If investors invest in these types of products their yield can be above market; however, their capital may be at risk. In these kinds of products the risk of the investor occurs when the prices of underlying assets go down. Mostly these products have a predetermined limit on the return (cap). Investors who invest in yield enhancement products mostly have following market expectations (‘SSPA Swiss Derivative Map’ 2009);

  • Sideways market (flat market; prices of instruments are moving sideways) of underlying
  • Falling volatility.

There are two main types of yield enhancement products; Discount Certificates and Reverse Convertibles. Reverse convertibles have coupon payments which are above the coupon payments of traditional bonds; however, discount certificates have no coupon payments, they are sold at prices below their underlying assets’ market price (Barlocher 2009).

a. Discount Certificates

Discount Certificates (DCs) are structured products which allow investors to invest to an index, basket of securities or a certain security with a price which is lower than the market price. (That’s why they known as ‘discount’ certificates). This discount is given to the investor in exchange for a fixed maximum return which should be accepted by the investor. This fixed maximum return is known as predetermined cap.

Each DC has its own underlying security and a maximum price which is called cap strike. At the certificate’s maturity, if the price of the underlying is lower than the cap, the investor receives physical form of the underlying (if the underlying is a share). Instead of physical delivery of the underlying, for DCs that are consisted of non-traded assets like indices, cash settlement is also possible (Wilkens, Erner and Roder 2003). On the other hand, if the price of the underlying is higher or equal to the cap, the investor receives the maximum amount which is equivalent to the cap.

In Figure 3.6 an example from Deutsche Bank AG Discount Certificates Product Brochure (2006) can be found. In Figure 3.6 x axis shows the prices of underlying ABC share and y axis of the graph shows the payoff amount of discount certificate at different prices.

discount certificate

Figure 3.6: A Discount Certificate Example

In this example it is assumed that; ABC share is trading at $5. A 1- month Discount Certificate on ABC with a cap strike at $4.86 costs $4.76. Investors may get the share at a discount of % 4.8 (of the initial share price) but in return, they have to accept a maximum payout of $4.86 which will give a maximum return of 2.1%.

Till maturity; DC’s price will be depended on the ABC share but not reflect precisely. The DC tracks upward movements to the cap strike, on the other hand when the price of the share falls, the DC price also falls.

At the maturity; such possible scenarios could occur:

  • Scenario 1: The underlying share is trading at or above the cap strike. Then the DC pays the cap strike of $4.86.
  • Scenario 2: The underlying share is trading below the cap strike and higher than the original invested amount. Then the investor will get one underlying share. In total investor receives a return since current price of the share is higher than the original investment amount.
  • Scenario 3: The underlying share is trading below the cap strike and the original invested amount. The investor will get one underlying share. The investor receives a loss in total since current price of the share is lower than the original investment amount. But this loss will always be lower than a direct investment on the underlying share.

b. Reverse Convertibles

Reverse Convertibles (RCs) are securities that are linked to an underlying stock and pay above market coupons. In return for this coupon, there is no guarantee that investors will recover the full amount of invested capital and unlike direct investment in a stock or bond, upside potential of a RC is limited to this coupon amount. (‘JP Morgan Structured Investments Solution Series Volume III: Reverse Exchangeables’ 2007). They are also known in the market as Reverse Exchangeable Securities (RES) and described by Benet, Giannetti and Pissaris (2003) as interest-paying, non- principal-protected structured products, offering a fixed interest rate that is higher than conventional debt securities.

At maturity the price of underlying is compared to the price at the time of issue. So the investor gets coupon payment + principal investment if the price at the maturity is equal to or greater than the initial price of the underlying. If the price at the maturity is less than the price at the time of issue then the investor gets number of shares that is found by dividing the principal investment by the share price at the time of issue.

Figure 3.7 shows payoff graph of a RC. In this figure the line which is thin represents the price change of underlying asset and the line which is thick represents the payoff of a discount certificate according to the price changes of the underlying asset. x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of RC at different prices.

Reverse Convertible

Figure 3.7: Payoff Graph of a Reverse Convertible

As can be seen from Figure 3.7; at the prices that are above the strike price, RC pays a fixed amount of return to the investor. In the figure this amount is shown as ‘cap’. At the prices that are below the strike price, payoff of RC will be affected 1 to 1 by the performance of underlying share. In other words if underlying share price will fall %a, the price of RC that is linked to this share will fall %a.

To explain how RCs work; following example is given:

Let’s assume; an investor purchases $1,000 of a one-year reverse convertible linked to the price of XYZ share, price of XYZ share at issuance is $10 (strike & initial price) and the coupon rate is %10

At the maturity If the price of XYZ share is $10 or greater; investor will receive $100 (cap) in interest and the return of his principal, for a total of $1,100. If the price of XYZ share is less than $10 let’s say $5, the investor receives $100 interest plus 100 shares (1,000 divided by 10) of XYZ share.

To compare investing in XYZ share directly and investing RC linked to XYZ, Table 3.2 is designed. In this table 4 different scenarios are considered as the XYZ share’s price will be EUR 12, 10.8, 9 or 7 at the maturity. According to these scenarios; comparisons are made in order to show the advantages & disadvantages of investing in RC in different prices at the maturity.

Table 3.1: Direct Investment – Reverse Convertible Comparison

Price at Maturity

Direct investment in XYZ share

Reverse Exchangeable on XYZ share

Scenario 1

EUR 12

Profit of 20%

Profit of 10% (coupon)

Scenario 2

EUR 10.8

Profit of 8%

Profit of 10% (coupon)

Scenario 3

EUR 9

Loss of 10%

Profit/loss of 0 (10% loss on share price 10% profit from coupon)

Scenario 4

EUR 7

Loss of 30%

Loss of 20% (30% loss on share 10% profit from coupon)

As can be seen from Table 3.1;

In scenario 1; at the maturity the price of XYZ share is EUR 12, direct investment to the XYZ share will lead a 20% profit for investor while investing in RC linked to XYZ share will lead a profit of %10 that is equal to the coupon amount.

In scenario 2; at the maturity the price of XYZ share is EUR 10.8, direct investment to the XYZ share will lead a 8% profit for investor while investing in RC linked to XYZ share will lead a profit of %10 that is equal to the coupon amount.

In scenario 3; at the maturity the price of XYZ share is EUR 9, direct investment to the XYZ share will lead a 10% loss for investor while investing in RC linked to XYZ share will not lead any profit or loss to the investor.

In scenario 4; at the maturity the price of XYZ share is EUR 7, direct investment to the XYZ share will lead a 30% loss for investor while investing in RC linked to XYZ share will lead 20% loss to the investor.

3.3.3.3. Participation Products

Participation products are kind of structured products can be one to one with the prices of the underlying assets, or with some leverage and certain discontinuities. The basic difference between participation products and yield enhancement & capital protected products is; there is not a cap level in participation products (Barlocher 2009).

Most common types of participation products that are traded in the market are; Open End Certificates, Outperformance Certificates, Bonus Certificates and Outperformance Bonus Certificates.

a. Open End Certificates

They are also known as ‘Tracker Certificates’ in the market. Open End Certificates (OECs) are suitable for investors who want to benefit from the performance of an index, a sector, a commodity or interest rates. OECs don’t have fixed expiry dates, meaning that investors can pursue an investment goal of their choice for as long as they please.

According to their underlying instrument they can be classified as Open End Index Certificates, Open End Commodity Certificates and Open End Interest Rate Certificates. According to their design and market expectation they can be classified as Bull Certificates (long-tracker certificates: they are suitable for the investors whose market expectations are rising underlying) and Bear Certificates (short-tracker certificates: they are suitable for the investors whose market expectations are falling underlying.)

Figure 3.8 shows the payoff graph of an OEC. In this figure the line which is thin represents the price change of underlying asset and the lines which are thick represent the payoff of Bear and Bull Certificates. x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of Bear and Bull Certificates at different prices.

Open End Certificate

Figure 3.8: Payoff Graph of an Open End Certificate

As can be seen from Figure 3.8, payoffs of Bear and Bull Certificates are affected 1 to 1 (without leverage) from the underlying assets’ price movements. Also these certificates provide %100 and unlimited participation to the underlying assets’ price movements both in upside and downside. Unlike discount certificates; they are traded without any discount.

To explain how OECs work; following example is given;

oec

Most OECs have an exchange ratio which converts the index level into an OEC price. In this example it is assumed that exchange ratio is 0,01; that’s why current price of the OEC is 12 USD when the S&P 500 Index level is 1.200.

Since OEC reflects the performance of underlying index 1 to 1;

  • At maturity the price of the OEC will be determined by (Index Level at maturity) * (Exchange Ratio)
  • Holder of OEC will gain or lose;

(Current Index Level – Index Level at maturity) * (Exchange Ratio)

If at maturity S&P 500 Index closes at 1.320 (representing a %10 increase), holder of this OEC will gain (1.320 – 1.200) * (0,01) = USD 1,2 and gets USD13,2 at maturity (a return on investment of %10)

If at maturity S&P 500 Index closes at 1.080 (representing a %10 increase), holder of this OEC will lose (1.200 – 1080) * (0,01) = USD 1,2 and gets USD 10,8 at maturity (a loss on investment of %10)

The question is; why investors invest in OECs instead of investing the underlying instrument directly; although they don’t have capital protection and they reflect the underlying instruments’ performance 1 to 1?

The answer is; OECs provide investors spreading the risks by investing inexpensively in a broadly diversified product. In other words they provide easy access for the investors to a large variety of alternative investments. For example it can be so expensive to invest in S&P 500 by purchasing each stock individually, but by investing to an open-end certificate which is linked to S&P 500 index, investor can reach S&P 500 index’s performance with low transaction costs and transparent fees. Also if an investor tries to invest in each S&P 500 stock individually it will be hard to follow the performance of the whole portfolio. But by investing in an OEC which is linked to S&P 500 provides the investor to track the performance of the investment anytime.

The risks that can be mentioned about these types of products are comparable to a direct investment in the underlying. In other words; if the underlying of the OEC decreases, the value of the OEC decreases. As the worst scenario, the investor can lose their entire investment. Also the OECs that are issued on international currency carry currency risk. However, there are some types of certificates that are called ‘Quanto Certificates’ which enable the investor to participate the product in his/her own local currency. When the certificates are ‘Quanto’, investors don’t participate in risks or opportunities that are arising from exchange rate movements between the currencies of underlying and certificate. (‘Goldman Sachs 2 Year Quanto SGD 100% Capital Protected Certificate on an Asian FX Basket Product Brochure’ 2009) Unlike OEC’s Quanto Certificates do have a participation ratio and provide the investors a pre-determined participation rate to the underlying performance.

b. Outperformance Certificates

Outperformance Certificates (OCs) are also known in the market as Sprint Certificates, Accelerator Certificates, or Speeders. Their payoffs are depending on tracking the underlying instrument. Unlike OECs, OCs tracks the underlying 1 to 1 till the strike price and disproportional on the prices that are above the strike price. In other words on the prices that are above the strike price OCs offers disproportional participation to the underlying’s performance. This proportional participation is determined by pre-specified multiple (known as performance factor) times the return on the underlying asset (Hernandez, Lee & Liu 2007). This performance factors is always above %100 that’s why these products are known as ‘outperformance’ certificates.

Figure 3.9 shows the payoff graph of an OC. In this figure the line which is thin represents the price change of underlying asset and the line which is thick represents the payoff of an OC according to the price changes of the underlying asset. x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of OC at different prices.

Outperformance Certificate

Figure 3.9: Payoff Graph of an Outperformance Certificate

As can be seen from the graph till strike price holder of OC will participate to the underlying asset’s performance %100 and at the prices above the strike price participation of the OC holder to the asset performance will be above %100.

To explain how OCs work; following example is given;

Screen Shot 2015-02-12 at 22.47.35

Above the strike price of EUR 300, OC will give a return of (%150) * {XYZ (beginning) – XYZ (maturity)}

If at maturity stock closes at EUR 330 (representing a %10 increase), holder of this OC will gain (%150) * (330-300) = EUR 45 and gets EUR 345 at maturity (a return on investment of close to %15).

Below the strike price of EUR 300, holder of OC participates 1 to 1 in the losses on the stocks.

If at maturity stock closes at EUR 270 (representing a %10 decrease), holder of OC also loses EUR 30 and gets EUR 270 at maturity.

Hernandez, Lee and Liu (2007) also declared in their study that; holders of OCs don’t receive cash dividends of underlying assets even the underlying assets pay dividends during OC maturity.

The investors who invest in OCs expect a rise on the underlying’s price and also a rise in the volatility. The risk that can be mentioned for the investor when they purchase OCs is similar to the risk if investor invests to the underlying directly.

According to Hernandez, Lee & Liu (2007) returns of OCs can be divided into 2 as; capped certificates (if the returns on the certificates are subject to a maximum limit) and uncapped certificates (if the returns on the certificates are not subject to a maximum limit).

c. Bonus Certificates

Bonus Certificates (BCs) are types of participation products that are also known by the names of Bonus Protect Certificates, Step Up Bonus Certificate, Bonus Certificates Pro, or Certificates Plus in the market. They can be considered as a second generation of OECs with a conditional capital protection feature. This capital protection feature dependent on the underlying asset’s price and as long as the underlying asset’s price doesn’t cross a predefined barrier, capital protection occurs (Hernandez, Brusa & Liu 2007).

Figure 3.10 shows payoff graph of a BC.

Bonus Certificate

Figure 3.10: Payoff Graph of a Bonus Certificate

In this figure the line which is thin represents the price change of underlying asset and the line which is thick represents the payoff of a BC according to the price changes of the underlying asset. x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of BC at different prices. Dotted line represents possible payoff of a BC if the barrier is breached downward.

As can be seen from Figure 3.10; if the barrier is never breached; at the prices between barrier and strike, the product gives a predefined ‘bonus’ to the investor. This bonus is equal to the amount in the y axis which is corresponded to the intersection of barrier and BC payoff line above the x axis. At the prices that are above the strike, the product becomes an OEC and reflects the underlying’s performance 1 to 1. At the prices below the barrier in other words, if the barrier is breached downward then the product reflects 1 to 1 underlying’s performance.

To explain how BCs work; following example is given;

Screen Shot 2015-02-12 at 22.48.47

If during 2 years ABC is never traded at or below EUR 24 (barrier);

Above the strike price of EUR 33, BC will pay 1 to 1 in the increase of the stocks to the investor.

If at maturity stock closes at EUR 36 (representing a %20 increase), holder of BC will get EUR 36 at maturity.

Between strike price (EUR 33) and barrier (EUR 24), BC will pay EUR 33 which is ‘bonus level’ in this BC.

If at maturity stock closes at EUR 31,5 (representing a %5 increase), holder of BC will get EUR 33 at maturity.

If at maturity stock closes at EUR 27 (representing a %10 decrease), holder of BC will get EUR 33 at maturity.

If during 2 years barrier is breached in other words ABC is traded at or below EUR 24 (barrier);

At this time; investor gets the current market value of ABC stock at the maturity.

If at maturity stock closes at EUR 31,5 (representing a %5 increase), holder of BC will get EUR 33 at maturity. Investor will gain a profit in total.

If at maturity stock closes at EUR 27 (representing a %10 decrease), holder of BC will get EUR 33 at maturity. Investor will suffer a loss in total. .

Hernandez, Brusa and Liu (2007) also declared in their study that; holders of BCs don’t receive cash dividends of underlying assets even the underlying assets pay dividends during BC maturity.

BCs are suitable products for the investors who expect the underlying’s price rises or moves sideways, also doesn’t breach the barrier. Risks of BCs can be mentioned as lower than investing directly to the underlying because of the conditional capital protection.

According to Hernandez, Brusa & Liu (2007) returns of BCs can be divided into 2 as; capped certificates (if the returns on the certificates are subject to a maximum limit) and uncapped certificates (if the returns on the certificates are not subject to a maximum limit).)

d. Outperformance Bonus Certificates

Outperformance Bonus Certificates (OBCs) are participation products that are formed by combination of OCs and BCs. They can be considered as a second generation of OCs with a conditional capital protection feature. This capital protection feature depends on the underlying asset’s price and as long as the underlying asset’s price doesn’t cross a predefined barrier, capital protection occurs. Above strike price; this proportional participation is determined by pre-specified multiple (known as performance factor) times the return on the underlying asset. (Hernandez, Brusa & Liu 2007).

Figure 3.11 shows payoff graph of an OBC

Outperformance Bonus Certificate

Figure 3.11: Payoff Graph of an Outperformance Bonus Certificate

In this figure the line which is thin represents the price change of underlying asset and the line which is thick represents the payoff of an OBC according to the price changes of the underlying asset. x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of OBC at different prices. Dotted line represents possible payoff of an OBC if the barrier is breached downward.

As can be seen from figure 3.11 there is a predetermined barrier like BCs and disproportional participation at the prices that are above strike price like OCs. In other words; if the barrier is never breached; at the prices between barrier and strike, the product gives a predefined ‘bonus’ to the investor. This bonus is equal to the amount in the y axis which is corresponded to the intersection of barrier and OBC payoff line above the x axis. At the prices that are above the strike, the product becomes an OC and provides disproportional participation to the underlying’s performance. If the barrier is breached downward then the product reflects 1 to 1 underlying’s performance below strike.

To explain how OBCs work; following example is given;

Screen Shot 2015-02-12 at 22.49.03

never traded at or below EUR 68 (barrier);

Above the strike price of EUR 80, OBC will pay 1.5 to 1 (because of %150 performance factor) in the increase of the stocks to the investor. At maturity investor will get; (%150) * {abc (beginning) – abc (maturity)}

If at maturity stock closes at EUR 88 (representing a %10 increase), holder of this OBC will gain (%150) * (88-80) = EUR 12 and gets EUR 92 at maturity (a return on investment of %15).

Between strike price (EUR 80) and barrier (EUR 68), BC will pay EUR 80 which is ‘bonus level’ in this OBC.

If at maturity stock closes at EUR 76 (representing a %5 decrease), holder of this OBC will get EUR 80 at maturity.

If at maturity stock closes at EUR 72 (representing a %10 decrease), holder of this OBC will get EUR 80 at maturity.

If during 2 years barrier is breached in other words abc is traded at or below EUR 68 (barrier);

At this time; investor gets the current market value of abc stock at the prices below strike.

If at maturity stock closes at EUR 64 (representing a %20 increase), holder of this OBC will get EUR 64 at maturity. Investor will suffer a loss of 80 – 64 = 16 in total

Above strike, OBC pays; (abc performance) * (performance factor)

If at maturity stock closes at EUR 88 (representing a %10 increase), holder of this OBC will gain (%150) * (88-80) = EUR 12 and gets EUR 92 at maturity (a return on investment of %15).

The disproportionate participation rate of OBC is usually lower than disproportionate participation rate of OC. Also because of this disproportionate participation OBC’s downside protection level is more modest than BC.

The investor of OBCs expects the underlying’s price will rise and won’t breach the barrier. Like BCs, OBCs involves a risk that is lower than

investing directly to the underlying because of the conditional capital protection.

According to their returns OBCs can be divided into 2 as; capped OBCs (if the returns on the certificates are subject to a maximum limit) and uncapped OBCs (if the returns on the certificates are not subject to a maximum limit). Holders of OBCs don’t receive cash dividends of underlying assets even the underlying assets pay dividends during OBC maturity (Hernandez, Brusa & Liu 2007).

3.3.3.4. Leverage Products

Leverage products are types of structured products that magnify the price movements of the underlying instruments. This magnification is known in financial world as ‘leverage’. In leverage products like the other structured products underlying instruments can be shares, indices, currencies, commodities and etc…

In these types of products investor can obtain an outsized gain with a low capital by the leverage effect. But also the same leverage effect can lead big losses if the expectation of the investor doesn’t come true. The main type of leverage products that is traded in the market and issued by popular banks is warrants.

a. Warrants

Warrants are leverage products which give their holder, buying or selling right of an underlying share at a predetermined price. Warrants give their holders the right but not the obligation. They are written by a company on its own stock (Hull 1997). In financial terms, their characteristics are confused with options mostly. The main differences between options and warrants are (Ross, Westerfield & Jaffe 2005);

  • Warrants are issued by the firms when options are issued by individuals.
  • In order to talk about maturity, exercise period of a warrant is usually several years but exercise period of an option is usually several months.
  • If an option is exercised the firm receives the exercise price from the investor and the firm simultaneously issues new shares when a warrant is exercised, a firm must issue new shares of stock.

The most important factor that attracts investors to invest in warrants is ‘leverage effect’. To illustrate the meaning of leverage effect an example that is out of the financial markets can be used:

Some big burger companies like Burger King, Mc Donald’s give coupons which give discounts till a predetermined date to their customers. Let’s say Burger King gives a customer a coupon which enables he/she to buy a whooper menu for 5 TL instead of 8 TL till 31.12.2010 (expiry date). At this point: his/her coupon worth 3 TL (this is called intrinsic value). Let’s assume Burger King decides to increase whooper menu prices to 10 TL next month. That means a %25 increase in whooper menu prices. However, he/she can still buy a whooper menu with his/her coupon for 5 TL that means now his/her coupon worth 5 TL. That means the value of his/her coupon increases about %66 while the price of whooper menu increases only %25. This is called ‘leverage effect’. Besides intrinsic value, this coupon has a ‘time value’ which expresses the probability of this coupon’s value increasing before the expiry date (Scoach Europa AG: Leverage Products – Warrants and Knock-outs 2009).

There are 2 typical types of warrants that are designed for the investors who have an expectation on the trend of any underlying;

• Call Warrants; for the investors who expect a rise of the underlying 51

• Put Warrants; for the investors who expect a fall of the underlying. aa. Call Warrants

A call warrant is an instrument which gives its holder the right but not the obligation to buy a certain underlying asset at a fixed price (mostly called strike or exercise price), in a certain quantity, till a certain date (expiry date).

At expiry date, if the price of underlying asset is higher than the warrant’s exercise price; then the holder of warrant will receive cash that is equal to;
{(Price of underlying asset at maturity) – (Exercise price of the warrant)} * (conversion ratio)

To explain how call warrants work; following example is given; (http://www.dbs.com)

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Scenario 1: In the money

If share price on the expiry date is $14.50, then this warrant holder will get (14.50 – 11.50) * 0.1 = $0.30 and make a profit of 0.30 – 0.20 = $0.10 per one warrant. This means %50 profit for the warrant holder although the share price increases 2.50/12.00 = %20.8

Scenario 2: Out of money

If the share price trades at or below $11.50 (exercise price) on the expiry date, the warrant and the investment will be worth nothing. Investor’s total loss will be equal to the amount he/she paid for the warrant. ($0.20 per warrant in this example)

Scenario 3: Breakeven Price (Point)

The breakeven price of a call warrant can be calculated by;
{(purchase price of the warrant) / (conversion ratio)} + (the exercise price)

$(0.20 / 0.1) + $11.50 = $13.50 is the breakeven price (point) of this example’s call warrant.

Figure 3.12 shows payoff graph of a call warrant.

Call Warrant

Figure 3.12: Payoff Graph of a Call Warrant

In this graph payoff feature of a call warrant is shown corresponding to the different prices of the underlying stock. In this figure x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of a call warrant at different prices.

As can be seen from Figure 3.12; holder of a call warrant will be suffering a loss till the breakeven point which has been described in the example above. At the prices that are above the breakeven price, the holder of call warrant will be making profit that will be equal to the difference between current underlying asset’s price and exercise price of call warrant.

This payoff scheme shows the call warrant investor’s profit – loss position at all the prices of the underlying by taking into account the predetermined exercise price. But in reality most of the investors buy call warrants in order to sell these call warrants at a higher price instead of waiting for these call warrants’ expiry dates. That’s why a call warrant’s investor monitors the call warrant’s prices in the secondary markets in order sell their call warrant at the prices they want. That also shows call warrants can be considered as a short term trading instruments since their holders do not need to hold them until their maturity.

ab. Put Warrants

A put warrant is an instrument which gives its holder the right but not the obligation to sell a certain underlying asset at a fixed price (mostly called strike or exercise price), in a certain quantity, till a certain date (expiry date).

At expiry date, if the price of underlying asset is lower than the warrant’s exercise price; then the holder of warrant will receive cash that is equal to;
{(Exercise price of the warrant) – (Price of underlying asset at maturity)} * (conversion ratio)

To explain how put warrants work; following example is given; (http://www.dbs.com)

Screen Shot 2015-02-12 at 22.58.51

Scenario 1: In the money

If share price on the expiry date is $8.50, then this warrant holder will get (10.50 – 8.50) * 0.1 = $0.20 and make a profit of 0.20 – 0.15 = $0.05 per one warrant. This means %33 profit for the warrant holder although the share price increases 1.50/10.00 = %15

Scenario 2: Out of money

If the share price trades at or above $10.50 (exercise price) on the expiry date, the warrant and the investment will be worth nothing. Investor’s total loss will be equal to the amount he/she paid for the warrant. ($0.15 per warrant in this example)

Scenario 3: Breakeven Price (Point)

The breakeven price of a put warrant can be calculated by;
(the exercise price) – {(purchase price of the warrant) / (conversion ratio)}

$10.50 – $(0.15 / 0.1) + = $9.00 is the breakeven price (point) of this example’s put warrant.

Figure 3.13 shows payoff graph of a put warrant.

Put Warrant

Figure 3.13: Payoff Graph of a Put Warrant

In this graph payoff feature of a put warrant is shown corresponding to the different prices of the underlying stock. In this figure x axis shows the prices of underlying asset and y axis of the graph shows the payoff amount of a put warrant at different prices.

As can be seen from Figure 3.13; holder of a put warrant will be suffering a loss at the prices above breakeven price. At the prices that are below the breakeven price, the holder of put warrant will be making profit that will be equal to the difference between exercise price of put warrant and current underlying asset’s price.

This payoff scheme shows the put warrant investor’s profit – loss position at all the prices of the underlying by taking into account the predetermined exercise price. But in reality most of the investors buy put warrant in order to sell these put warrants at a higher price instead of waiting for these put warrants’ expiry dates. That’s why a put warrant’s investor monitors the put warrant’s prices in the secondary markets in order to sell their put warrants at the prices they want. That also shows put warrants can be considered as a short term trading instruments since their holders do not need to hold them until their maturity.

Knop (2002) divided call and put warrants into 4 categories as European, American, Bermudan and Asian warrants. Also there are some different types of warrants in the market that are designed with more or less leverage and with different features like barriers (knock out levels). Knock out call – put warrants and turbo warrants are some of the examples to these kinds of warrants.

Warrants are suitable for the investors who want to benefit from leverage effect in their investments. As the leverage effect works for both sides; the investors’ risk appetite also should be higher than risk averse investors. Maximum risk for the investor of a warrant is limited to the price that is paid to buy this warrant (Knop 2002). That means in the worst scenario; the investor of a warrant loses the all amount of money that is invested in that warrant.

3.4. Pricing of Structured Products

As can be seen from 3.3 section, there is not a single type of structured products and they can be composed from different kinds of instruments. That’s because they don’t have a single pricing method or formula. In other words each structured product has its own pricing formula which is determined by the components of this structured product.

As it is explained in section 3.2; structured products are composed of 2 components;

  • BFI component that consists of mostly fixed income securities like zero coupon bond, coupon bearing bond, deposit and etc…
  • Derivative component that consists of mostly options like call index option, put FX option, asian option and etc…

Mostly payment feature of structured products is designed by replacing the payment feature of a basic financial instrument (e.g. government bond) with payment feature of a derivative (e.g. option) that is linked to an underlying asset. In other words structured products pay to their investors according to their underlying assets’ performances. That’s why valuation of structured products is closely relating to option valuation. Option valuation can be made in many different methods and approaches. In most of the structured products’ valuation Black & Scholes option pricing method is chosen by the market players since this model can easily be modified to any underlying asset like share, index, FX, interest rate and etc… (Choudhry 2005). That’s why in this study Black & Scholes option pricing method will be firstly analyzed and then used in order to value some structured products like reverse convertibles, discount certificates and outperformance certificates.

3.4.1. Black & Scholes Option Pricing Method

This model is developed by Fisher Black and Myron Scholes in the beginning of 1970 and since then it is used as the most popular option pricing method among market players to value European options (option that can only be exercised at its maturity). This model has some main assumptions like; (Knop 2002, Stigum 1990)

  • Underlying asset of the option has a lognormal distribution.
  • Short term risk-free interest rate is constant and known rate.
  • The investors may lend and owe at risk-free interest rate.
  • No dividends or coupons are paid by the underlying asset
  • Markets are liquid enough to buy or sell any amount of stock or options anytime.
  • Markets operate without transaction costs or taxes.
  • There is no risk-free arbitrage opportunity.

Under these assumptions Black & Scholes developed the following model for option pricing (Fabozzi & Modigliani 1996, Chambers 2008).

Screen Shot 2015-02-12 at 23.01.24

where;

S= Underlying asset price X= Strike price

σ2= Variance

r= Continuously compounded risk-free interest rate

t= Time to option maturity and, ln= logarithm

e= A mathematical constant that is equal to 2.7183 N( )= The cumulative normal distribution

N(d1) and N(d2) are the cumulative probabilities from the normal distribution of obtaining d1 and d2. N(d1) is the change in the option price for a given change in the price of the underlying asset. N(d2) is the probability that the option will be exercised (Choudhry 2005).

In these formulas S, T, X and r variables are known; however, only G variable is not known. This variable represents the standard deviation of the underlying asset’s price and also means volatility. In Black & Scholes and other option pricing models this variable is the most important single variable since there are numerous methods for estimating volatility. 2 common types of volatilities that are used within the market players to estimate volatility are; historical volatility and implied volatility2. In historical volatility past price movements of the option’s underlying asset are analyzed and future price movements of this option are being tried to be estimated from these past price movements of underlying asset. However, in implied volatility, the market’s opinion about the volatility of the option through its remaining life are tried to be found in order to estimate the price movements of that option in the future. Market’s opinion about that option’s future volatility are tried to be found by taking the quoted price of the option in the market and working on this price (Wilmott, Howison & Dewynne 1995). According to Hull (1997); implied volatilities can be explained as the volatilities that are implied by option prices which are observed in the market and he said that most of the traders in the markets usually use implied volatility in their option pricing process. Since there are different types of volatilities that can be used in option pricing methods, in pricing of structured products different prices for similar structured products can be found in the market.

A numerical example for Black & Scholes option pricing model can be found below (Choudhry 2005);

The price of a European call option that is written on a non-dividend- paying stock whose current share price is 25$ and whose implied volatility is %23 when the strike price of this option is 21$, its maturity is 3 months and risk-free interest rate is %5 can be calculated according to Black & Scholes formula;

Screen Shot 2015-02-12 at 23.04.57

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As it is told in the beginning of this section, Black & Scholes option pricing method is used in most of the structured products’ valuation since Black & Scholes model can easily be modified to any type of underlying asset. The pricing example which is above shows a non-dividend paying stock, also Black & Scholes model can be applied for different assets like dividend paying stock, equity-index and foreign exchanges.

Black & Scholes model for dividend paying stock options; one of the assumptions of Black & Scholes model is: no dividends are paid by the underlying asset. However, according to Chance (1989); Black & Scholes model can be used also for stocks that pay dividends. Following example shows Black & Scholes model for a dividend paying stock (Chambers 2007);

There is a European call option that is written on a dividend-paying stock whose current share price is 40$, implied volatility is %30. The strike price of this option is 40$, its maturity is 6 months and risk-free interest rate is %9. If the expected dividend payments for this share will be made 2 times (in the second and fifth month) in equal amounts which is 0.50$ then the option price of this share can be calculated as following according to Black & Scholes formula;

Screen Shot 2015-02-12 at 23.09.33

 

Black & Scholes model for equity-index options; In Black & Scholes model for pricing equity-index options, (S) which represents the current price of underlying is changed as (Se-qt) where q represents dividend payment value that is obtained from the entire index. The Black & Scholes Model is formulated as;

Screen Shot 2015-02-12 at 23.10.14

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where;

S= Spot exchange rate that the domestic currency is converted to foreign currency

r£= Risk free interest rate for domestic currency r$= Risk free interest rate for foreign currency

When an option pricing model used in a structured product firstly the option’s underlying and option type that is embedded to this structured product is determined; then the pricing of structured product is formulated according to this option type’s pricing. For example pricing of a structured product that has an exotic option that is written on an equity-index will be different then pricing of another structured product that has a European call option that is written on a currency.

3.4.2. Pricing a Structured Product with Black & Scholes Model

As it is told in this study several times; while pricing a structured product; components of this structured product and their valuation is taken into account to formulate a single model for pricing of this particular structured product. In order to formulate the valuation method of a structured product, it is better to obtain this structured product payoff profile. Payoff profile of a structured product can be obtained by the combinations of the payoff profiles of its components.

To value a structured product it is better to determine the positions that the issuer will hold by structuring this structured product. Following example valuations that are made for reverse convertibles, discount certificates and outperformance certificates are made according to the positions that are being held by the issuer by structuring these products.

3.4.2.1. Pricing a Reverse Convertible (Exchangeable)

The payoff for an investment in one (plain vanilla) reverse exchangeable with face value $1000, C coupon payment, strike price of I0, and a term to maturity T, is exactly the same as the payoff for holding the following three positions (Hernandez, Lee & Liu 2007);

  1. Long position in one zero coupon bond with face value equal to $1,000 and same maturity with reverse exchangeable.
  2. Long position in zero coupon bonds that have the face values same as the reverse exchangeable’s coupons payments and have the same maturity dates with the reverse exchangeable coupon payment dates.
  3. A short position in put option with an exercise price of I0, term to maturity of T, (same strike price, same time to maturity with the reverse exchangeable) and number of options of $1,000/I0.

Reverse exchangeable’s payoff profile can be obtained from the payoff profiles of these 3 positions.

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3.4.2.2. Pricing a Discount Certificate

Discount certificate can be considered as a special case of reverse exchangeable with a zero coupon bond and only one embedded put option (Hernandez, Lee & Liu 2007). So the valuation of it can be formulated as;

Screen Shot 2015-02-12 at 23.13.48Screen Shot 2015-02-12 at 23.14.04

(In this formulation X is used as strike price in order to cover all possible cases);

3.4.2.3. Pricing a Outperformance Certificate

The payoff for an investment in one (uncapped) outperformance certificate with a strike price of I0, term to maturity T, and a performance factor of PF is exactly the same as the payoff for holding the following three positions (Hernandez, Lee & Liu 2007);

  1. Long position in the underlying asset.
  2. Short position in zero coupon bonds of which face values are the cash dividends to be paid by the underlying asset and have the same maturity dates with the exdividend dates of cash dividends;
  3. A long position in call options on the underlying asset with an exercise price of I0, term to maturity of T, (same strike price, same time to maturity with the outperformance certificate). Number of options can be determined by deducting 1 from performance factor and is known as additional performance factor (APF)

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As can be seen from these 3 pricing examples of different structured products; it can be realized that structured products with different components and payoff profiles have different pricing formulas. In order to value a structured product firstly this product’s components should be priced. Since Black & Scholes model is very popular in the financial markets to value options, in this study Black & Scholes method is used while pricing the option component of different structured products. In every kind of structured product, as can be seen from pricing examples of reverse exchangeable, discount certificate and outperformance certificate; after obtaining each component’s value of a specific structured product, these values should be combined in order to derive a single pricing formula for this specific structured product.

3.5. Advantages and Disadvantages (Risks) of Structured Products

Before this section, at the section 3.3 most common types of structured products, their categories, features, and characteristics were analyzed product by product. However, at this section advantages (by the way attractions) and disadvantages (in other words risks) of structured products will be analyzed as a whole.

3.5.1. Advantages of Structured Products

Structured products became so popular within the retail investors in most of the markets. Main reason of this development is; structured products are attracting the retail investors with their advantages. Main advantages provided by structured products to their investors are;

  • Higher return: Depending on the risk level of a structured product, it is possible to have a higher return than traditional bonds or deposits by investing in a structured product. (Structured products with higher risk levels have higher earning potential)
  • Capital protection: Some of the structured products provide full or partial capital protection. This feature attracts mostly risk averse investors to invest in structured products. The popularity of these products increases when the volatility increases in the market since the investors seek opportunities to reduce risks (Chorafas 2007). These products are mostly popular in the slightly developing structured products markets like Turkey because they provide a transition period for the markets from traditional investment products to structured products. After financial crisis, products with capital protection become more popular among retail investors.
  • Easy access: As can be seen from the section 3.3, structured products can be linked to many different assets. Investing directly to these assets may not be easy or investing in them can be costly for retail investors. Structured products solve this problem by providing customers easy investment at a moderate charge to these kinds of products whose direct investment is hard and costly for retail investors.
  • Tailor-made: Structured products are designed as ‘tailor-made’ products in order to meet investors’ specific demands. In other words, the payoffs of the products can be tailored according to different requirements of the investors. This feature of structured products provides the investors flexibility in their investment decisions and provides diversity of products in the financial markets.
  • Diversification: The ability to customize a variety of assumptions into one instrument is one of the principle attractions of structured products for retail investors because that provides attractive diversification properties to the investors (Lamb 2007). Also combining different types of products in a specific product provides investors spreading the market risk. In other words an investor can participate in a diversified portfolio by buying a structured product that is consisting of many different instruments. According to Hernández, Lee and Liu (2007) this combination of different instruments in structured products enhanced the capital market efficiency which also leads a reduction in transaction costs.
  • Tax benefits: Some of the structured products are designed in order to provide tax benefits to the investors. Especially the structured products which are tailored to private banking customers have this feature.
  • Transparency of Portfolio Management: Investing in structured products is mostly more efficient than investing in a mutual fund when transparency is the issue. While investing in a mutual fund, all the investment decisions are left to the manager of the mutual fund and the performance of the fund can be tracked in total. However, investing in a structured product provides investors to track the performance of the structured product as a whole, or each component separately. That’s why it can be told that investing in structured product provides a more transparent portfolio management than investing a mutual fund.

3.5.2. Disadvantages & Risks of Structured Products

First of all most of the structured products are designed in unique and complex forms when they are compared to other traditional instruments. That’s why their compositions, payoff profile and other unique characteristics cannot be easily understood by ordinary investors. The biggest risk that leads a lot of disadvantages is the meeting of ordinary investors and extraordinary instruments when structured products are the issue.

Other risks that should be considered about structured products are;

Liquidity Risk: Since structured products are tailor-made, they are found in the market as customized products. Most of them are traded in OTC markets so they are lack of secondary markets. That’s also because most of the structured products are seem as buy-and-hold investment vehicles to the investors (Lamb 2007). Addition to that, most of the structured products have longer maturities and this also leads liquidity risk to their investors.

Credit Risk: Structured products are issued by financial institutions. Although their payoff depend on their underlying instrument, their issuer and this issuer’s creditworthiness is also important. That’s because; as a result of the default of the issuer, investor could get nothing from the structured product he/she invested although underlying instrument of that product did well.

Pricing Risk: Another consideration is pricing risk in other words pricing transparency risk. Since there is not a uniform standard for pricing; it is hard to determine the right price for a specific product. According to Katrina Lamb (2007) most of the structured products’ issuers are using their own pricing models and that’s why there is not an explicit fee or other expense to the investor.

As can be seen from Chapter 2 lots of the academic works are made about the pricing subject of the structured products in order to test the pricing models of the different issuers. The aims of these academic papers were in order to find whether the products are fairly priced or not. In most of the studies; authors concluded as the structured products aren’t fairly priced and the pricing is on the disadvantage of the investor. Most of these studies showed that; complexity of the products leads complex valuation methods and these methods resulted as unfavorable prices for the investors. Higher complexity of products leads higher margins in the prices of structured products on investors’ disadvantage (Wilkens, Erner and Roder 2003). Especially after the banking crisis, retail investors started to worry about return of their capital so complexity in pricing became a problem for them. Retail investors started to seek products that can be easily understood by them (Wright 2008).

Entrop, Scholz and Wilkens (2008) are expecting this unfair pricing will be eliminated in the future with the increase in competition between issuers. Since the market depth of secondary markets is not sufficient of it is difficult for the investors to determine the best price for structured products.

Addition to the risks that are mentioned above there are some disadvantages of the structured products such as;

If an investor invests in X share he/she can get dividend payments of that share, but if she/he invests in a structured product whose underlying is that X share, he/she cannot get any dividend payments.

Most of the structured products fees may be much higher than the standard instruments such as mutual funds, bonds and shares. Also their cost and fee rates may be much complex then regular instruments. For example if an investor invests in X share, he/she can easily understand the commission rate because it is paid by the transaction occurs. But if he/she invests in a capital protected structured product whose underlying instrument is that X share, then the commission rate can be differ if the investor buys and holds till the maturity date or sells before the maturity date.

Because of all these risks and disadvantages, these products are subject to different regulations in different countries depending on the products’ characteristics, risk level and tolerance of the country’s regulatory agency. Each country has a regulatory agency or agencies which determine specific regulations about each kind of structured products.

Regulation levels change for the same type of structured products among different countries or for different types of structured products in the same country. For example Switzerland has limited regulatory restrictions for structured products compared to other countries and this leads a considerable freedom to the structurers in Swiss market (Yumusak 2007).

Especially just after Credit Crunch Crises, regulation of these products is tightened in most of the countries and these products were started to be questioning by the regulatory authorities. Even some countries thought to ‘ban’ these products. Instead of banning these products as Hens and Rieger (2008) implied in their study; understanding of investors about these products should be improved to solve the complexity and other related problems.

When advantages, disadvantages and risks of structured products are considered it can be told that; a structured product can bring lots of advantages to an investor although the same structured product can bring lots of disadvantages to another investor. Here the key term for the investors is analyzing all the features and possible risks of the products in detail and choosing the right product for their needs. That means if the match of the investor and the product is right then it is possible talk about lots of advantages of this togetherness, but if not then disadvantages arise. Derivatives are essentially innocent for the right purposes (Chambers 2008), since these derivatives are created structured products; same statement can be valid for also structured products.