Emerging Financial Derivatives

Understanding exotic options and structured products

Jerome Yen, Kin Keung Lai

• Publisher: Routledge
• Year: 2014
• Print ISBN:
  9781138066793
• eBook ISBN:
  9781317638889
• Topic: Business
• Subtopic: Business General
• Index: Business

Exotic options and structured products are two of the most popular financial products over the past ten years and will soon become very important to the emerging markets, especially China. This book first discusses the products' recent development in the world and provides comprehensive overview of the major products. The book also discusses the risks of issuing and buying such products as well as the techniques to price them and to assess the risks. Volatility is the most important factor in determining the return and risk. Therefore, significant part of the book's content discusses how we can measure the volatility by using local and stochastic volatility models — Heston Model and Dupire Model, the volatility surface, the term structure of volatility, variance swaps, and breakeven volatility.

The book introduces a set of dimensions which can be used to describe structured products to help readers to classify them. It also describes the more commonly traded exotic options with details. The book discusses key features of each exotic option which can be used to develop structured products and covers their pricing models and when to issue such products that contain such exotic options. This book contains several case studies about how to use the models or techniques to price and hedge risks. These case analyses are illuminating.

1
Survey and classification of structured products

1.1 Background

Structured products are designed as part of prepackaged investment strategies by financial engineers, often combining elementary financial instruments such as bonds, stocks, futures, and options that are traded independently in spot and futures markets, to offer tailor-made risk return profiles to the investors. These products are designed to help investors pursue a broad range of portfolio and risk management objectives, such as protection, optimization, enhancement of returns, and leverage. They can help diversify portfolios, address various market conditions, or manage risks and taxes.

There are various ways in which structured products can be classified, and we are going to discuss them in detail.

1.2 Literature review

1.2.1 History and product development

In the early 1990s, many investment banks thought up new solutions to attract more investors to equity markets. The idea was to create innovative options (products?) with sophisticated payoffs that would he based on all types of assets such as stocks indices, commodities, foreign exchange, and all kinds of funds. Also, banks were looking for intelligent ways to provide investors with easy access to these innovations by issuing wrappers (medium-term notes, insurance life contracts, and collective funds) in a tax-efficient manner. Moreover, it was important to structure a business that was capable of following an issued financial asset throughout its life. Therefore, structured roles were created to compose complex over the counter products, while quantitative analysts developed pricing models to enable traders to hedge the products until maturity. Banks were also conscious of the importance of providing secondary markets that introduced the liquidity the business needed to expand. (See Exotic Options and Hybrids: A Guide to Structuring, Pricing and Trading by Mohamed Bouzoubaa and Adel Osseiran.)

Another school of thought considers that structured investment products came into being because companies wanted to issue debt, implying fewer opportunity costs to the investors. Traditionally, one of the ways to do this was to issue a convertible bond, i.e., debt that under certain circumstances can be converted into equity. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors were willing to accept lower interest rates. However this trade-off and its actual worth are debatable because the movement of the equity value of the company was unpredictable. Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on convertibility of the stock, or principal protection. These extra features were all based on strategies investors themselves could formulate, using options and other derivatives, but these were prepackaged as one product. The goal was again to give investors more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand, the goal for the investment banks was to increase profit margins because the newer products with added features were harder to value, making it harder for banks’ clients to see how much profit the banks were making from it.

1.3 History and market development

Structured products gained popularity in the United States during the 1980s and were introduced in Europe in the mid-1990s, during years of low interest rates. Though the trend came into being because companies wanted to issue debt more cheaply, first, convertible bonds were issued that under certain circumstances could be converted into equity. In exchange for potential higher returns, investors were ready to accept lower interest rates. Investment banks and financial engineers kept innovating different financial instruments to provide more and more reasons for investors to accept lower interest rates, and features such as increased income in exchange for limits on convertibility of the stock or principal protection were added.

The past two decades have seen a huge growth in structured products globally. The 2000–2003 large drops in stock markets were one of the reasons that motivated investors to look at structured product as an influential alternative investment strategy; the other reason was increased market volatility.

When structured products were first introduced to high net-worth individuals in the early 1990s, the value proposition was focused on innovation, access to capital markets, and potential for enhanced performance. Since then, the structured products market has undergone major changes. The number of private investors using them has increased significantly, and a wider range of standardized products has been introduced.

According to the definition given by Roberto Knop, “a structured product is a financial instrument, and its return depends on the composition of other, simpler products. It consists of a loan, and one or more derivative products. The special feature here will be the conversion of the original risks of each of its compo...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of figures
• List of tables
• Preface
• 1 Survey and classification of structured products
• 2 Tools and methods for pricing exotic options
• 3 Stochastic and local volatility models, volatility surface, term structure, and break-even volatility
• 4 Market view formation
• 5 Structured equity products
• 6 Foreign exchange-linked structured products
• Index