Advances in Financial Assets Pricing
Introduction
Lecture One to Financial
Assets
Definition of Structured Products
LSE (London Stock Exchange):
Structured products are simply financial instruments issued by banks with varying terms, pay-outs
and risk profiles.
It tracks the performance of an underlying asset which can be: equity, index, commodity, currency
or a basket.
There are no standardised structured products, the terms, pay-out and risk profile of each
instrument is bespoke and determined at the time of issue by the issuing bank. It is therefore
important for investors to understand what a particular product will do and how it will behave if
certain conditions are met, before investing.
FCA (Financial Conduct Authority): Structured products are generally a type of fixed-term
investment where the amount you earn depends on the performance of a specific market (such as the
FTSE 100) or specific assets (such as shares in individual companies).
Main Families
of Structured
Investment
Products:
Structuring investment products with derivatives allows the tailoring of
products to different investor market views.
Based on the underlying assets:
Types of Credit products
Structured
Equity Products
Products
Interest rate products
Other
Structured Credit Products
• For investors who are willing to take corporate or sovereign credit risk in an attempt to boost income or in some
cases provide capital gain.
A nation is a sovereign entity.
Any risk arising from a government failing to make debt repayments or not honoring a loan agreement is a
sovereign risk.
• Appeal to institutions, HNW (High Net Worth) and increasingly to retail investors.
• Capital protected products are also common when underlying assets are more risky.
These include: Corporate Credit Default Swaps (CDS), Sovereign CDS…etc
Example of Sovereign Credit Risk
The 2012–2013 Cypriot financial crisis involved the exposure of Cypriot banks with excessive
levels of leverage.
The Cypriot financial sector was affected by the Greek government-debt crisis and the downgrading
of local Cypriot government bond credit rating to junk.
On 25 March 2013, a €10 billion international bailout by the Eurogroup, European Commission
(EC), European Central Bank (ECB) and International Monetary Fund (IMF) was announced.
In exchange, Cyprus agreed to close the country's second-largest bank, the Cyprus Popular Bank
(also known as Laiki Bank).
Interest-rate products
Interest-rate products include all those products whose income and valuation
depends on an interest-rate that fluctuate depending from market rates.
The associated risk is an interest-rate risk (market risk).
Interest-rate products
Derivative products whose underlying asset is interest-rate sensitive, include: interest-rate swaps, interest-rate futures,
interest-rate options.
• Interest Rate Swap: the exchange of a fixed interest rate for a floating rate
• interest rate future is a future contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset (e.g. yield on a 10-Year
Treasury Note)
• An interest-rate options is an option contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset (e.g. yield on a 10-
Year Treasury Note)
Could also be on a Bond given that its value depends from fluctuation in interest rates
Repos: dealer sells the government securities to investors, usually on an overnight basis to buy it back the next day.
• The buyer is as a short-term lender and the seller is the short-term borrower.
• The security which is sold is the collateral.
• The objective for both parties is to secure funding and liquidity
Forward Rate Agreement (FRA): an over-the-counter contract that determines the rate of interest, or the currency exchange
Structured interest rate products
Mainly favored by institutional investors who are looking for low-risk and low-
yield enhancement.
Mostly are capital guaranteed since the investors do not generally want to put
capital at risk and are only willing to risk coupon payments.
Coupons can be capped, linked to barriers and ranges or issuer calls to provide
moderate increases in yields.
Equity-Linked Product
A security that is backed by an instrument that does not pay a fixed interest rate.
Instead, it is tied to the performance of a single security, a basket of securities, or
a broader market index.
Principal Protected Notes (PPN):
As a result of the volatile market conditions that prevailed in early 2000s,
investors were looking for new approaches to invest.
They wanted security and higher profits. This is the reason why principal
protected notes were initially introduced
Principal Protected Notes (PPN) are therefore used by investors to gain exposure
to an asset class while at the same time providing principal protection at
maturity.
Equity-Linked Product
o Due to the volatile nature of equity, often provide the highest risk and return of any
structured products.
o Appeal to retail and high net worth investor who are looking to outperform the return
of their regular cash bank deposits
o They are usually either designed for income or capital gain and structured on single
underlying (index or individual equities) or baskets of stocks or indices.
Equity-Linked Product: Principal Protected Note (PPN)
o A principal protected note (PPN) is a structured product that guarantees a rate of return of at
least the principal amount invested, only if the note is held to maturity.
o A PPN could be structured as a zero-coupon bond (which is a bond that makes no interest
payment until it matures, sold at discount) + an option with a payoff that is linked to an
underlying asset, index, or benchmark.
o E.g. Zero coupon bond + option linked to a stock
o The payoff will fluctuate depending on the performance of the underlining asset, index or
benchmark.
Principal protected Notes
o Can be created by a zero-coupon bond and an option
o “Principal protected” means that the principal investment in the notes will be returned to
the investor if the notes are held until maturity.
o This is regardless of the performance of the underlying Index over the term of the notes.
o However, because the notes are not principal protected prior to maturity, the investor
may receive less than his initial investment if he sells the notes in the secondary market
prior to maturity.
Principal protected Notes
o Principal protected notes could guarantee 100% of invested capital, as long as the note is held
until maturity.
o Therefore, regardless of market conditions, investors receive back all money they invested.
o As such, upon maturity, the payout on the Note is the original principal plus any appreciation
from the underlying assets.
o The underlying asset could include an index or basket of equities or commodities, among other
possible underlying products.
Difference between a Treasury Bond and a Treasury Note:
o The difference between T-Bond and T-Note is mainly the maturity factor.
o T-bonds have the longest maturities of all government-issued securities.
o Issues are offered to investors with either a 20- or 30-year maturity.
o Investors get an interest payment semi-annually per the terms of the bond issue.
o Given that T-bonds have the longest time to maturity, their prices tend to fluctuate more than T-notes or T-
bills.
Difference between a Treasury Bond and a Treasury Note:
o T-notes are issued with shorter maturities than T-bonds, typically offered
to investors with one-, five-, seven- or 10-year terms.
o As the maturity is short, interest rates are lower than those offered to T-
bond investors (because of smaller risk).
o Prices on T-notes fluctuate less than T-bonds.
Fixed v Floating Rate Note
o A fixed-rate note pays the same interest rate for its entire maturity.
o A floating-rate note typically pays lower interest than a fixed-rate note
of the same maturity (referring to coupon).
o Because the floating-rate notes are based on short-term interest rates,
these are usually lower than long-term rates.
Interest rate products: Floating Rate Note (FRN)
o Some bonds do not carry a fixed interest rate.
o An example is the Floating-Rate Note (FRN)
o A floater or FRN, is a debt instrument with a variable interest rate plus a quoted fixed spread.
o It affects the coupon of the bond or note.
o A floating rate note’s interest rate, is not fixed and is linked to a benchmark such as the T-bill rate,
LIBOR or the base rate.
o In most of the cases, the issuers are financial institutions and governments, and they typically have a
two- to five-year term to maturity.
o It allows investors to take advantages of increasing interest rates.
o This is because the rate of the floater are adjusted to the market rate on regular basis.
FRN: Example 1
o For example, a floating-rate note might be issued with a maturity of two years and an
interest rate that resets quarterly based on the three-month LIBOR rate plus 0.15%.
o Let us assume that the three-month LIBOR rate is 0.33%.
o This implies that the note would pay 0.48% for its first quarter after its issuance.
o If the three-month LIBOR were to rise to 1% after one quarter has passed, then the note's
interest rate would reset to 1.15%.
FRN: Example 2
o Investors would prefer floating-rate notes to minimize their interest rate risk.
o If there is a choice between two securities;
o 2-year T-Note with a fixed 0.6% interest rate, or
o 2-year floating-rate T-Note that currently pays 0.5% but is based on the 10-week Treasury- bill rate plus 0.3%.
o If interest rates spike later this year, the fixed-rate Treasury note will still be paying 0.6%. However, if
the 10-week Treasury rate rises to 1%, then the floating-rate note would pay 1.3%.
o Therefore, Investors could potentially accept a lower initial rate in exchange for the possibility of a
higher rate if market rates increase.
o This is a particularly appealing advantage especially given the current low-interest rate environment.
Floating Rate Note (FRN):
o Interest is quoted as a premium or discount to a reference rate, e.g. LIBOR +
margin
o Example: FRN pays LIBOR +0.6%
o A variable-rate note has a margin above the reference which is not fixed.
o Coupons may have a “cap”, rate cannot go above a specified ceiling or below a
specified threshold “floor”.
A Capped Floating Rate Note: Example
o For instance, consider a EURO capped floating rate note
o Coupon: 6-month EURIBOR+0.5%
o Coupon cap: coupon cannot exceed 7%
o If the EURIBOR 7%, the investor still gets 7%. If the EURIBOR is 6%,
the investor will get 6.5%
Floating and Fixed Rate Notes:
o Both Fixed-rate notes, floating-rate notes can be callable or non-callable,
o The issuer could have the possibility to repay the principal before the maturity
date is reached.
o Floating-rate notes could also have a "cap" or "floor."
o A cap is a maximum interest rate the note can pay, unrelatedly to how high the
benchmark rate increases,
o
Example of a Structured Product:
Protected and Unprotected Bull Note:
o Unprotected Bull notes put the principal of the investor at risk which can significantly
limit the investors who are eligible to purchase these products.
o The unprotected bull note is equivalent to a zero coupon note plus a forward contract on the reference
equity.
o To make it more lucrative, a principal protection feature can be added, resulting in a
protected bull note.
o Instead of a zero coupon note and a forward, the protected bull note is now equivalent
to a zero coupon note and a call option.
Example 1: zero coupon bond + FTSE100 call option
o Step 1: Assume an investor investing in a 5-year GBP zero-coupon bond which costs
75p. Upon maturity he receives back 100p.
o This means that the investor has used up 75p of his 100p to guarantee the bond, and
therefore has 25p left to buy something else.
Example 1: zero coupon bond + FTSE100 call option
o Step 2 - Let us assume that it costs 1.5% to put a structured product together. In this case, therefore, 1.5p of the
remaining 25p would be used up, leaving 23.5p to buy some upside in an asset.
o Step 3 – The final step is to decide what will be bought with the remaining 23.5p.
o If one 5-year option on the FTSE100 were to cost 23.5p, then one of these options could be bought with the
remaining 23.5p.
o The Final Product implies putting the zero-coupon bond together with the FTSE call option above creating a
structured product that guarantees the customer all of his capital back at maturity and also 1:1 in any increase in the
FTSE100.
o If the FTSE falls over the term of the trade then the investor does not suffer any significant loss (apart from 1.5p).
Example 1:
• Amount to spend = 100p
• Zero coupon bond cost = 75p
• Cost of structuring the product = 1.5p
• Therefore cash remaining to spend = 100p – 75p – 1.5p = 23.5p
• Cost of one FTSE call option = 23.5p
• Therefore structured product is 1 x ZCB (zero coupon bond)+ 1 x FTSE call
Example 2 of how to create a structured product?
Let us take the example of a EUR Protected Bull Note on DJ EUROSTOXX 50
• Issuer: A rated issuer
• Currency: Euro
• Notional: 10mm
• Maturity: 7 years
• Issue price: 100%
• Underlying: Dow Jones Eurostoxx 50
• Coupon: Zero coupon
• Participation: 80%
This represents a “term sheet”, which is designed to include the most important terms of the transaction for investors.
Example 2 of how to create a structured product?
Redemption:
Each note will be redeemed at maturity at an amount depending on the EUROSTOXX final, the
closing price of the underlying, 3 business days before the maturity date.
The redemption amount will be equal to:
100% + participation x Max [(EUROSTOXX final/EUROSTOXX initial) – 100%, 0]
Where: EUROSTOXX initial is the opening price of the underlying on the issue date
Explanation:
o The investor invested in EUR Protected Bull Note on DJ EUROSTOXX 50.
o In this instance, this represents a protected bull note which is equivalent to a zero coupon note and a
call option.
o Let us assume that the zero-coupon note is sold at £80.
o The issuer (let us assume Tesco) gives the investor a promissory note confirming that upon maturity he/she will receive the face
value back (i.e. £100).
o With the £20 the investor has, he/she decides to get an option linked to an equity index, in this case, the DJ EUROSTOXX 50.
o Investor asks the issuer to proceed.
o The issuer (Tesco) passes this on structurer (let us assume HSBC).
Further Explanation:
o HSBC issues the option on the index (DJ EUROSTOXX 50).
o Upon maturity, in the case the index makes a 50% appreciation (i.e. £50), with a participation rate of 80%, the
investor does not get the full £50, instead he gets only £40 (80% of £50 which is the appreciation of the index).
o Investor now gets the following pay-out: £100 of notional value + £40 =£140.
o HSBC returns this to Tesco and along with the face value, this is then given to the investor.
o Therefore, whatever Tesco gives to the investor, he/she will get it back upon maturity.
o To structure the deal, Tesco can give the funding to HSBC as several instalments.
o For Tesco, there is no risk (apart from credit default risk of HSBC).
o Market risk remains only with HSBC for structuring the deal.
Who can act as a swap provider (structure the deal)?
o Equity providers include: Societe Generale, JP Morgan, BNP
Paribas, UBS, Deutsche Bank and Goldman Sachs.
o Interest rate providers: JP Morgan, Barclays, UBS and BNP
Paribas,
o Credit providers: JP Morgan, Morgan Stanley, Deutsche Bank,
Goldman, and Barclays.
Who are the main issuers of structured products?
1. Financial and corporation issuers: Highly rated financial institutions or
corporations
o Advantageous financial level
o The role of an arranger
E.g., Santander, Barclays, Deutsche Bank, etc.
2. Special purpose vehicles (SPVs): An alternative to a financial issuer is to
use a special purpose vehicle (SPV)
Special Purpose Vehicle (SPV):
o SPVs are companies incorporated in tax favourable jurisdictions, who
have a:
o Trustee,
o An administrator,
o Does not have personnel except a board of directors,
o A tax exempt shareholder ( who is usually a resisted charity) and possess no assets except investments
of proceeds of the note issuance and swap contract that may be entered into.
o SPV will be discussed a lot more in during the next lecture.
What fees do they charge for structured products?
Structured product fess are very nebulous area
o A disadvantage for most investors: Lack of transparency of fees incorporated in different products
1. Distribution fees:
o The distributor fees are charged by the selling agent or intermediary.
o For example the IFA or private bank, who directly market and sell of the product to the retail investor.
o Typically for an equity linked product of say 5 year maturity this might be between 2-5% up
front.
o For Some products per annum fee is charged
What fees do they charge for structured products?
2. Issuance costs:
Depends on the issue size, maturity, credit rating and method of issuance.
o Typically costs might range between 10-50bp per annum
3. Swap provider margins
o The margin taken by the bank is the price at which the derivative is traded relative
to the theoretical model price.
What fees do they charge for structured products?
Swap provider margins
o If possible conservative volatilities and correlations will be used, and for long
dated products where hedging risks are important, large reserves may be taken
which are released into the trading book profit and loss account over several years.
o The overall upfront profit would typically be 2-3% but could range from 0.5% for
short dated, competitive products to 5-6%+ or more for longer dated complex
products which involve large model risk.
Bull Spread with Calls:
o Buy a call a(K1) and sell a call with a higher strike price (K2) (on the same stock )
Bull Spread with Puts:
o Buy a put with a low strike price (k1) and sell a put with a high strike price (K2)
Bull Spread with Puts:
o A bull put spread involves being short a put option and long another put option
with the same expiration but with a lower strike.
o The short put generates income, whereas the long put's main purpose is to offset
risk and protect the investor in case of a sharp move downward.
o This spread generally profits if the stock price holds steady or rises.
A Long Straddle Combination:
Profit
K ST
A Long Straddle Combination:
o A long straddle is a combination of buying a call and buying a put, both with the
same strike price and expiration (with different premium).
o Together, they produce a position that should profit if the stock makes a big move
either up or down.
o Typically, investors buy the straddle because they predict a big price move and/or a
great deal of volatility in the near future.
A Long Straddle Combination:
Max Loss
o The maximum loss is limited to the two premiums paid.
o If at expiration the stock's price is exactly at-the-money, both options will expire worthless, and the entire
premium paid to put on the position will be lost.
Max Gain
o The maximum gain is unlimited.
o The best that can happen is for the stock to make a big move in either direction.
o The profit at expiration will be the difference between the stock's price and the strike price, less the premium
paid for both options.
o There is no limit to profit potential on the upside, and the downside profit potential is limited.
A Strangle Combination:
Profit
K1 K2
ST
A Strangle Combination:
o The investor is looking for a sharp move in the underlying stock, either up or down, during
the life of the options.
o This strategy does best if the stock price moves sharply in either direction during the life of
the options.
o This strategy differs from a straddle in that the call strike is above the put strike (premium
is different for both call and put).
o Strangles are less expensive than straddles.
A Strangle Combination:
o The investor is looking for a sharp move in the underlying stock, either up or down, during
the life of the options.
o This strategy does best if the stock price moves sharply in either direction during the life of
the options.
o This strategy differs from a straddle in that the call strike is above the put strike (premium
is different for both call and put).
o Strangles are less expensive than straddles.
Pay-off and Profit Calculation on options:
Payoff and Profit on Long Call Options:
o Payoff to call option buyer = Max(St – X, 0)
o Profit to call option buyer = Max(St – X, 0) – C
Payoff and Profit on Short Call Option:
o Payoff to call option seller = –Max(St – X, 0)
o Profit to call option seller = C – Max(St – X, 0)
Pay-off and Profit Calculation on options:
Payoff and Profit on Long Put Option:
o Payoff to put option buyer = Max(X – St, 0)
o Profit to put option buyer = Max(X – St, 0) – P
Payoff and Profit on Short Put Option:
o Payoff to put option seller = –Max(X – St, 0)
o Profit to put option seller = P – Max(X – St, 0)
Example of a Long Strangle : Calculation of pay-off and profit for a long strangle spread
o Assume a long strangle spread, composed of one long call and one long put option on a
stock with the same expiry date.
o Long strangle: buying a call and buying a put, both with the same expiration.
o The strike price of the call option is £35 and of the put option is £45.
o The price of both the options is £2.5 each.
o Calculate the pay-off and profit from this strategy.
Example of a Long Strangle : Calculation of pay-off and profit for a
long strangle spread
Stock price Pay-off Profit
S>45 S - 45 S-50
45>S>35 0 -5
35>S 35-S 30-S
The spread will result in loss when stock price is between 30 and 50 on maturity.
Long Strangle Example
