Exotic Options - Advanced

8/9/2019 Exotic Options - Advanced

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EXOTIC OPTIONSEXOTIC OPTIONS Although options have been around for a

long time, they are still evolving

continuously. New combinations of optionsstructures are always being developed.These complex options are sometimesknown as exotic options.

Exotic options include options on currencies,equities, debt instruments, precious metals,commodities, energy and new assets thatmay be created in the future.


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EXOTIC OPTIONSEXOTIC OPTIONS

The main purpose for the existence of exoticoptions is to create more trading instrumentsfor investors to hedge their investment

portfolio risks and also to modify theirportfolio risk and returns. However, the

market for the exotic option is still relativelysmall as compared to the market for a normaloption.


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Why Exotic Options?Why Exotic Options?

What makes exotic options attractive is theability to tailor them to fit an individuals

particular market view. The characteristics ofthe exotic options are as follows:


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CharacteristicsCharacteristics

Provide new opportunities to manageexposures

Create new risk profiles Act as new tools for yield enhancement Provide flexibility

Option cost structure can be altered basedon the unique risk and return profile of theoption


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SomeoftheExoticOption

StructuresAvailableintheMarket

SomeoftheExoticOption

StructuresAvailableintheMarket

Barrier optionsTwo typical types of barrier options; knockoutsand knockins. These types of options lapse (inthe case of knockouts) or take effect (in the case

of knockins) when a predetermined trigger pointis reached during the specified observation time.


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INVESTMENTS

High Risk

Potential forHigh Return

DEPOSITS

Low Risk

LowReturn

B R I D G E

StructuredStructured ProductsProducts ooffers complete

spectrum of :

Low Risk -> High Risk

Short Term -> Long Term

Simple -> Complex

On Balance Sheet -> Off BalanceSheet

CONCEPT OF STRUCTURED PRODUCTS


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WHYSTRUCTURED PRODUCTS?

Flexibility & customization allowed.

Issuer (AA- and above)

Tenors (Short/Long Term)

Coupon (Min, Max, Fixed, Float, Flipper, Cap, Floor)Underlying Assets (Libor, Swaps, Quanto etc)

No risk to the capital invested assuming that theproduct is held to maturity (if 100% principalprotected)

Medium-term capital appreciation and/or portfoliodiversification

Potentially higher return on the investment compared


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STRUCTURED NOTES

INVESTORS

BANKINVESTMENT BANK

(Goldman, Lehman, Merrill etc)

Issuer(Lloyds, BNP, CBA)

US$10 MM

US$10MM

US$10MM

Funding Cost:

Libor 25bps

StructuredCoupon with

Potential

Higher Yield

Structured

Coupon with

Potential

Higher Yield Option RiskManagement

Swap

Activities

Funding for Banking

Activities: Mortagage, Credit

Card, Lending, CarLoan etc

Distribution

Agent

Fee

Income

Seek

Potential

higher

returns

Willing to

assume

some level

of risk


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STRUCTURED NOTES FEATURES

Typically 100% principal protection when held untilmaturity

Currency: EUR, USD, GBP

, local currencies, etc. Tenor: 110 years Issue price 100% when issued at par Secondary market liquidity typically less liquid

compared to vanilla bonds Off-balance sheet item, however included as AUM

for the bank


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STRUCTURED DEPOSITS

INVESTORS

BANKINVESTMENT BANK

(Goldman, Lehman, Merrill etc)

OptionsPremium

US$10MM

Principal Protectionat Maturity

Potential for higher

return by participation

in underlying asset

class

*Options Option RiskManagement

Built

Liability

Spread

Earned

Seek

Higher

Returns

Willing to

assume

some level

of risk

* Options

Participation?

Higher Coupon, lower participation

Reference Point comparison:

Multiple points, higher

participation

Single point to point (Initial vs

Maturity), lower participation

Underlying asset performance payoff

Callable (if any)

Payout method? Caps/Floors? (if any)


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Credit RiskInvestors assume full credit risk of ISSUER for the case of Structured Notes

GUARANTOR (if any) BANK for Structured Deposits.

Interest Rate RiskA rise in interest rates during its lifetime may result

in a reduced value of the note and vice versa.

KEYRISKS


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KEYRISKSKEYRISKS

Market RiskThe return on the Note is linked to theperformance of a pre-specified underlying asset.

There is no guarantee that the underlying assetwill appreciate during the tenor of the product

Options RiskThe value of the option, prior to maturity, is

affected by a number of factors including but notlimited to implied underlying asset volatilities interest rates, and

time remaining to maturity


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Early Redemption RiskIn the event of early redemption there is no principal protection for Notes sold prior to

maturity. redemptions may or may not be allowed forStructured Deposits (depending on countryrequirements)

Event Risk

There may be adjustments to the terms of the Notes andDeposits due to events such as Mergers and Disposals,Price Source Disruption, Trading Suspension, MaterialChange in Formula and in Content, and change intaxation laws as defined in the Application Form

KEYRISKS


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Interest Rates ProductRange Accrual (RAN)Target Redemption (ACRN)

Others: Equities / Indices / Commodities /FX

Collared Structure Napoleon Range Accrual Lock-the-Best Option

Barrier Knock-Out / Knock-In CPPI

EXAMPLES STRUCTURES


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RANGEACCRUAL STRUCTURE

Basic Range Accrual Structure:

Investor will receive coupon payments based on the number of daysthat the underlying interest rate falls within a specified range

Coupon Paid:

Where:

n = The number of days when the interest rate fixes between the upperand lower barrier during the relevant calculation period

N = The number of days in the relevant calculation period

NnCouponRate*


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Callable Range Accrual Structure:

Issuer has the option to call the structure at

predetermined dates over the tenor of the structure

When structure is called investor will receive:

Par value of the note (Par Value in most cases =

100%)

Unpaid coupon dependent upon the number of

days the interest rate falls between the upper and

lower barriers during the calculation period



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Example Range Accrual Structure

PrincipalProtection 100% (at maturity) Currency USD Tenor 7 Years

Underlying 6 Month USD Libor Coupon Frequency Semi-annual

Period Range Coupon Rate

Year 1 No Range 3.25%

Year 2 0 3.00% 3.50%

Year 3 0 4.00% 4.00%

Year 4 0 5.00% 4.25%

Year 5 0 5.50% 4.50%

Year 6 0 6.00% 4.75%

Year 7 0 6.50% 5.00%



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0%

2%

4%

6%

8%

2%

0%

7%

5%

3%

1%

3%

1%

Yr

3

Number of Days

Trading Within

Range: 120

Annual Coupon

Payment:

(120/360)*4%=

1.33%

Yr2

Number of

Days Trading

Within Range:

0

Annual Coupon

Payment:

0%Yr4

Number of Days

Trading Within

Range: 275

Annual Coupon

Payment:

(275/360)*4.25%

=

3.25%

* Please note that this structures makes semi-annual coupon payments, however for simplicity purposes the diagram calculates

annual coupon payments.

LIBOR

RatesYr

5

Number of Days

Trading Within

Range:360

Annual Coupon

Payment:

(360/360)*4.5%=

4.50%

Yr

6

Number of

Days Trading

Within Range:

360

Annual Coupon

Payment:

(360/360)*4.75

=

4.75%Yr

7

Number of

Days Trading

Within Range:

5

Annual Coupon

Payment:

(5/360)*5%=

0.07%Yr

1

Annual Coupon

Payment:

3.25%



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Basic Collared Structure: Value of the underlying asset measured at

regular intervals Values are summed or compounded

(depending upon the specific calculationmethodology) to determine potential

additional payoff at maturity

COLLARED STRUCTURE


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-3%

Qtly

Floor

0%

2%

3%

Qtly

Cap

6%

-4%

-6% Q

1

Q

2

Q

3

Q4 Q5

Payout at Maturity: (3.00 - 0.49 -1.07 - 3.00 + 0.25 + . . . ) %

DJ Euro Stoxx 50 Levels

Payout

1%

5%

-1%

-2%

-5%

4%

Q1 Level:

5.25%

Q5 Levels: -.75%

Q5 Returns: .25%(-.75% + 1.0%)/1.0%

Q2 Level: 2.7%

Q2 Returns: -0.49%,(2.7% -5.25%) / 5.25%

Q1ReturnsCapped at

3%

Q4 Level: -1.0%

Q4 Returns: -4.0%

Floored at 3.0%(-1% + .2%) / 0.2%

Q3 Level: -0.2%

Q3 Returns: -1.07%(-0.2% - 2.7%) / 2.7%

COLLARED STRUCTURE


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NAPOLEON STRUCTURE

Basic Napoleon Structure:

Headline coupon set at launch of product

The return each year is set to the headline coupon plus

the weakest monthly performance of the underlying asset Payoff is equal to the greater of:

The minimum coupon

The headline coupon plus the underlying performance

Payoff may be set at the end of each year or at maturitydepending on the structure

Payoff at the end of each year is more expensive thanpayoff at maturity


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Example Napoleon Structure: PrincipalProtection 100% (at maturity)

Currency USD Tenor 5 Years Underlying S&P500 Minimum Coupon 1%

Headline Coupon 10% Payoff Annually

NAPOLEON STRUCTURE


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ProfitFormula at end of each year: The greater of:

Minimum protected coupon of 1%, OR

10% + Weakest MonthlyPerformance of S&P500

Thus, if the weakest monthly performance of theS&P500 was 3%, the customer will receive 13%

However, if the weakest monthly performance ofthe S&P500 was 11%, the customer wouldreceive the 1% minimum protected coupon

NAPOLEON STRUCTURE


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LOCK-THE-BEST OPTION STRUCTURE Lock-the-Best Option Structure

Linked to an equally weighted basket of indices

At regular observation dates the single best

performance of an index for the observation periodwill be recordedAt each observation date, the best performingindex will be removed from the basket

Payoff at maturity will equal the greater of: Protected minimum coupon The arithmetic average of the best recordedperformances


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Example Lock-the-Best Option Structure

PrincipalProtection 100% (if held until maturity)

Currency USD Tenor 3 Years

Minimum Coupon 1.50%

Observation Intervals Semi-annually

Underlying Indices S&P500 DJIA Eurotop 100

FTSE 100 SMI Nikkei 225

LOCK-THE-BEST OPTION STRUCTURE


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Profit at Maturity = 9.83%Greater than the minimum coupon of 1.50%

ObservationPeriod BestPerformer Performance Remaining Basket

Year 0.5 S&P500 15% DJIA, Eurotop 100, FTSE 100, SMI,Nikkei 225

Year 1.0 Nikkei 225 12% DJIA, Eurotop 100, FTSE 100, SMI

Year 1.5 Eurotop 100 -5% DJIA, FTSE 100, SMI

Year 2.0 DJIA 17% FTSE 100, SMI

Year 2.5 SMI 13% FTSE 100

Year 3.0 FTSE 100 7%

Average 9.83%

LOCK-THE-BEST OPTION STRUCTURE


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BasicBarrier Structure: Linked to a basket of stocks

100%P

articipation in each stocksappreciation up to an upper barrier level Profit Lock-in Feature: In the event that one

of the stocks crosses the upper barrier level(at anytime during the tenor of the product)the returns for that stock will be locked in ata specific level

BARRIER STRUCTURE


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ProfitFormula at Maturity: Minimum Return: 3% Maximum Return: Average of performance ofthe stocks Stock performance used in profit calculation:

Stock never trades above 150%, use actualstock performance Stock trades above 150%, accord 20% asperformance

BARRIER STRUCTURE


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StockPerformance Since

Trade DateEver Traded at or

above 150%? Payout

Pfizer 47% No 47%

Siemens 30% Yes 20%

Intel -15% No -15%

Proctor & Gamble 27% No 27%

Exxon Mobile 38% No 38%

IBM -12% No -12%

Sony -12% Yes 20%

Ford 151% Yes 20%

Toyota 34% No 34%Nokia -75% No -75%

Average 10.4%

Profit at Maturity: 10.4%Significantly greater than minimum protected coupon of 3%

BARRIER STRUCTURE


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120%Profit Lock-

in

50

%

170%

210%

10

%

-

30%

150%Barrier

10.4% Payout

100

%

Nokia75%Payout

Siemens20%

Payout

BARRIER STRUCTURE


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KNOCK-OUT STRUCTURE

Basic Knock-Out Structure Payout at maturity linked to the performance

of an underlying asset up to a specific

performance level In the event that the value of the underlying

asset touches or passes a specific level, theinvestor will receive no payout at maturity

The option linked to the underlying assetis knocked-out of the money


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Example Knock-Out Structure: PrincipalProtection 100% ( at maturity) Currency USD

Tenor 6 months Underlying DJIA Minimum Coupon 0% Participation Factor 15% Observation Intervals Daily (Closing levels) Knock-out Level 20%

KNOCK-OUT STRUCTURE


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120%Profit Lock-

in

50

%

130%

10%

100

%

110

%

140%

150%

Payout at Maturity:

Example #1: 15% ParticipationFactor * 17% Performance =2.55%

Example #1

Example#2

Example #2: 0.00%

Exampl

e #3

Example #3:0.00%

KNOCK-OUT STRUCTURE


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CPPI STRUCTURECPPI STRUCTURE

CPPI = ConstantProportion Portfolio Insurance Basic CPPI Structure: Linked to the performance of a cash portfolio

and a portfolio of other investments whichmay include: Basket of Stocks (e.g. Income Plus) Basket of Indices (e.g. Best of )


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CPPI STRUCTURESCPPI STRUCTURES

Dynamic Hedging Leveraging Event:

Allocation of more funds to the portfolio of

investments (i.e. underlying basket etc.)when the portfolio of investments performswell

Example: Maximum leveraged allocation to portfolio

of investments = 150% 150% allocation to portfolio of investments

means that the cash balance is reduced to 0and an additional 50% of the NAV of theportfolio of investments is borrowed


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CPPI STRUCTURESCPPI STRUCTURES

Dynamic Hedging Example:

Customer originally invests $100,000 in

the CPPI structure, while $150,000 isinvested in the portfolio of investments($100,000 original investment + $50,000additional borrowing)

De-leveraging Event:Allocation of more funds to the cash portfolio whenthe portfolio of investments does not perform well


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CPPI STRUCTURES

Traditional Structured Note vs.Vanilla CPPI Structure

TraditionalCapital ProtectedStructured Note

Vanilla CPPIStructure

Zero CouponBond

Option

Portfolio ofInvestment

s

Portfolio ofInvestment

s

Cash


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Income Plus features :

Currency USD PrincipalProtection 100% (at maturity)

Tenor 6 yrs Underlying 30 of the largest companies inthe Dow Jones Global Titans50 Index Initial Allocation 60% Target Coupon 7.00% p.a. (payable Qtrly) Dynamic Hedging Rules150% of the NAV

Target Coupon of 7.00% p.a.

CPPI STRUCTURES INCOME PLUS


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DYNAMICALLOCATION SUMMARIZEDDYNAMICALLOCATION SUMMARIZEDDYNAMICALLOCATION SUMMARIZEDDYNAMICALLOCATION SUMMARIZED

Key components ofDynamic Allocation

Portfolio ofInvestments InterestRates* Leverage

NAV

Allocation

NAV

Allocation

Interest Rates

Allocation

Interest Rates

Allocation

Only when

allocation %

> 100%

*Interest rates are only a component of dynamic allocation for those structures where the bond floor is allowed to

float, i.e. the bond floor changes as interest rates change.


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KEYSELLING POINTS

Protect principal investmentSeek higher potential returns than traditional

savings or money market accountsP

articipate in a potential upswing in the marketInvest principal for a specific time periodPotentially diversify portfolio linked to a broad

array of underlying assets (i.e. equity index, stockbasket, or other assets)

Gain exposure to foreign equity markets throughthe underlying asset without the currency riskassociated with investing in overseas marketsdirect


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KEYSELLING POINTSKEYSELLING POINTS

Adding structured products to an existingportfolio of stocks and bonds can potentiallyenhance returns for a given level of risk

Provide access to multiple asset classes withdiffering levels of capital protection in line withthe customers risk profileCan efficiently provide appropriate surrogates

for cash, bond or equity portion of customersinvestment portfolio


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