Structured Products (SP) - UZH · 2016-02-22 · Prof. Vanini / Structured Products / FINRSIK at...

Structured Products (SP)

FINRISK Meeting

January, 26 2006 at SWX

Prof. Paolo Vanini

University of Zurich

and

Zürcher Kantonalbank

Prof. Vanini / Structured Products / FINRSIK at

SWX

2 January, 2006

Contents

•Market Practice of Structured

Products (SP)

•Behavioral Finance Approach to SP

•Pricing and Hedging of SP


SWX

3 January, 2006

SWX Classification of SP

Warrants

Plain-Vanilla

Knock-Out/ -in

Spread

Capital Protection

Discount Products Reverse Convertibles Outperformance

Maximum Return

Static Dynamic

Certificates

Structured Products

Derivatives


SWX

4 January, 2006

UBS Definition: BLOC

BLOCs stands for Buy Low Or Cash

Warrants

Plain-Vanilla

Knock-Out/ -in

Spread

Capital Protection

Discount Products Reverse Convertibles Outperformance

Maximum Return

Static Dynamic

Certificates

Structured Products

Derivatives


SWX

5 January, 2006

BLOC: Liability and Hedge

BLOC

Structured Product Payoff

Payoff

Underlying

Payoff

Short Call Option

K

K

+=

Payoff of the Client Payoff of Bank's Liability (Hedge) =

� Zero Risk for the Bank

� Price of the Hedge Instruments? Price of the Structured Product?

See below

� Decomposition Principle of SP in standard products

+


SWX

6 January, 2006

Same Products, Different Names

WARRANTS

KO WARRANTS

WARRANTS

KO WARRANTS

WARRANTS

OPTIONS

FUTURES

Leverage

SECTOR/ BASKET

CERTIFICATES ,

CERTIFICATES

PLUS, OPEN END

CERTIFICATES

PROPER TRACKERPERFORMANCE

CERT., PERLES,

SHORTY

Performance

TORO, REVEXUS,

TORERO

RUNNER CASUAL

BOOSTER

SPEEDER, BLOCs,

GOALsMaximal Return

CPUPROTEIN, BONUS-

PROTEIN

GROI (PIP, PEP),

POP Capital

Protection

CSGZKBUBS


SWX

7 January, 2006

Summary Market Practice, I

Banks and SWX follow same classification logic.

Derivatives turnover at SWX 2005 comparable to 1996 with a

burst bubble around 2000.

Listed derivatives at SWX up from 500 in 1995 to more than

6'000 by the end of 2005 – 2'000 of them are SP.

Fancy and bank specific SP names. Branding or vanity? In

any case, not meaningful from a client's view.


SWX

8 January, 2006

Summary Market Practice, II

SP are particularly well documented by the larger banks on

the internet.

This information pays more attention to risks, earnings and

suitability than the one for other products, such as mortgages

for example.

SP are combinations of standard products, such as stocks,

warrants, bonds (Lego-Principle).


SWX

9 January, 2006

Summary Market Practice, III

EBK

•admits lacks of consistency between the structured products

and funds regulation in some parts,

•discusses whether some structured products should be

regulated under the Anlagefondsgesetz.

Next steps are not defined yet.

Market Practice of SP is close to a behavioral finance

approach. To see this, we consider …


SWX

10 January, 2006

… Payoff View of SP

Symmetric

Diversification

No Options ��Funds

Anti-symmetric

Loss/Diversification/Gamble

Options needed �� SP

Return Return

Fre

quency


SWX

11 January, 2006

Behavioral Finance (BF) Approach

BF: Clients buy a SP if they are motivated to do so.

Motivations are often triggerd by emotions:

•People are familiar with emotions (fear, greed, protection,

gambling)

•People are not familiar to deal with a 20x20 correlation

matrix in standard portfolio theory.

SP are based on motivations. Additionally, the Lego-Principle

used to design products gives also a personal touch.


SWX

12 January, 2006

BF: Risk & Return Motivations

• Risk Aversion

� Fear Market Volatility

• Loss Aversion

� Fear Market Crash

• Chance

� Search for Lottery-Gain

• Diversification

� Don't put all eggs in the same bag

These motivations are common to all clients – wealthy and less wealthy ones,

highly educated and less educated.


SWX

13 January, 2006

BF: Other Motivations

• Limited Access to Financial Markets (OTC)

� A desired asymmetric payoff profile can not be constructed by the

client itself

• Knowledge and Opportunity Costs

• Realization of Investment Goals with a Limited Amount of

Money

• Tax


SWX

14 January, 2006

Proposal to Classify SP

Diversifikation & Capital Protection &

Chance

Diversifikation & Capital Protection

Sustain./Real

Estate

Commoditie

s

Chance & Diversification

Chance & Capital Protection

Diversifikation

ChanceFX

Pro

tei

n

SharesForeign

InterestRate

Limited Capital Protection

Pro

tei

n

100% Capital Protection

Shares CH

Investment Topics

Investment Motivations

•Where to invest? Investment topics: Stocks, Oil, Interest Rates, Electricity,

Currencies ...

•How to invest? Investment preferences: Risk, Losses, Gambling, Profit&Loss

Sharing


SWX

15 January, 2006

Risks related to SP

Banks

•bear model risk

•bear market liquidity risk (dynamic hedge)

Client

•Overconfidence and temptation

•Subjective misjudgement about the chance

(probability) to get the payoff.


SWX

16 January, 2006

Importance of BF – A Case Study

I. Collect survey data from 40 employees at ZKB to reveal preferences and

test for relevance:

•Motivations: Loss aversion, risk aversion and chance

•Investment topics

II. Derivation of 3 SP using BF-Theory and calibration of the model to data I.

III. Employee make an investment decision on 3 SP & money market

product.

Case study was carried out together with Prof. T. Hens und Dr. P.

Wöhrmann, ISB, University of Zurich


SWX

17 January, 2006

Result: Estimation of Client's Preferences (I)

Average Values

=

Average Values

found in the

academic

literature

Risk - , Loss - a nd Gambling Pa rameter

0

0.5

1

1.5

2

2.5

3

3.5

1 4 7

10

13

16

19

22 2

28

31

34

37

Employees

Parameter Values

Risikaversion Lossaversion gambling

Average Risikaversion Average Lossaversion Average Gambling


SWX

18 January, 2006

Result: Estimation of Client's Preferences (II)

• People are heterogeneous in loss aversion and gambling

motivation.

• Both motivations are missing in traditional asset allocation

models such as Markowitz-model.

• Risk aversion – which is the most regular one – is the only

parameter which matters in classical finance decision

making!


SWX

19 January, 2006

Result: Chosen investment Topics in the

Survey (I)

23%

16%

18%

15%

2%

3%

1%

6%

2%

2%

Anlage:

CH Aktien

Anlage:

Fremdwährung

Anlage:

Erdöl

Anlage:

Zinsprodukte

Emerging Markets Ausländische

Aktien

Inflation of Topics


SWX

20 January, 2006

Result: Chosen investment Topics in the

Survey (II)

The bank has to propose the investment topics,

since

•the possibility to select topics by the clients leads to

an inflation,

•topics are changing over time.


SWX

21 January, 2006

Result: Client Segmentation

Increasing Loss Aversion

Incre

asin

g G

am

blin

g B

ehavio

r

Young &

Female

Experienced in SP &

Male


SWX

22 January, 2006

Optimal Product Design

Prospect Theory of Kahnemann and Tversky, calibrated to the

internal data.

( )

,

,

, ,

, ,

Max ( ( ) ) ( ( ; , ))

. . ( )

s.t. (1) ( ( ) ) ( ( ; , )) ( ) ( ( ; , ))

(2) ( ( ) ) ( ( ; , )) (1 )

where r is the risk free rate

w o

u o wx RP dT N x

s t w h o

u o wx RP dT N x u wx RP dT N x

u o wx RP dT N x u w r RP

α β γ

α β γ α β γ

α β γ α β

µ σ

µ σ µ σ

µ σ

−

≥

− ≥ −

− ≥ + −

∫

∫ ∫∫

,

, is the wealth invested, are the returns of the

underlying per unit invested ( ) are the hedge costs of the structured product . is the prospect theory

value function risk aversion paramete

w x

h o o uα β

r and loss aversion parameter .

is the distortion of the cumulative distribution function with parameter .Tγ

α β

γ

Using this program, 3 SP were designed and submitted to the

employees to make a buy decision.


SWX

23 January, 2006

Result: How do Potential Clients React to a BF

Approach?

•They liked it, although the questionary was demanding.

Investment Decision of Employees

1 0%

21%

42%

27%

M oney M a rk et SP1

1 0 0% Capita l Protection

5 0% Pa rtizipa tion

Cap Level SM I 4 0%

SP2

9 7% Capita l Protection

5 0% Pa rtizipa tion

Cap Level SM I 4 0%

SP3

9 0% Capita l Protection

1 0 0% Pa rtizipa tion bup to 3 0% SM I Return

Boost until 6 0% SM I Return

6 0% Ca p Level SM I


SWX

24 January, 2006

Result: Consistency Test of the Whole Approach

Are the preferences derived from the survey compatible with the

chosen optimal designed products?

If this does not hold, SP are offered to the wrong type of clients.

If the trade-off between loss aversion and gambling-seeking parameter θ satisfies

θ(SP1) < θ(SP2) < θ(SP3),

the revealed preferences from the survey and the one from the SP investment

decision are compatible. Average θ(SP) from the Survey

4.5 < 6.6 < 10.4


SWX

25 January, 2006

Pricing and Hedging of SP, Client

Motivation

• 95% Capital Protection

• Bonus Gain

• Issuance at 100, i.e. client pays 100 CHF

Contract Data

• Maturity 5y

• SMI, i.e. Face Value 5'932 CHF as of 30/3/05


SWX

26 January, 2006

Pricing and Hedging of SP, Bank

100 needed for:

• cover 95% Capital

Protection

• finance Options on SMI for Bonus gain

� Need a cap on SMI to share risks. Chosen at 40% Level

SM I Structured N ote - Possib le Design of SP

95%

175%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

-15

.0%

-10

.0%

-5.0

%

0.0

%

5.0

%

10

.0%

15

.0%

20

.0%

25

.0%

30

.0%

35

.0%

40

.0%

45

.0%

50

.0%

SM I Return

SP SMI


SWX

27 January, 2006

Portfolio of hedge instruments Strike Pay-off Price

Zero coupon bond 5'933.9 90.85%

European binary call options 6'229.5 297 1.56%

6'526.2 593 2.58%

6'822.8 593 2.19%

7'119.5 593 1.85%

7'416.1 593 1.56%

7'712.8 593 1.31%

8'009.4 593 1.10%

8'306.1 593 0.93%

Overall price of hedge portfolio 103.92%

Profit for the bank (net of transaction costs) 1.08%

Pricing and Hedging of SP, Is the product worth to be

issued? Price 5y Bonds +

Transaction Costs of 10bp100% Capital

Protection

40% increase of

SMI (Cap Level)

Options Bought by the Bank to Hedge

105-103.92= 1.08 needed to

cover all-in costs (People/Infrastructure)


SWX

28 January, 2006

Pricing and Hedging of Structured Products, Example

Full Capita l Protection + Bonus Gain w ith a

unfavorable risk sharing.

Less of the 100 is needed for the capita l guarantee.

Decreases the price of the options to hedge the SP

3y Maturity insted of 5 y

100% Capita l Protection

instead of 95 %

5Y Sw ap Rate Rises to 2 .2%Volatility increase from

15% to 20 %

-3 .92 % Loss

2 .13% Gain

2 .17% Gain

Benchmark 1 .08% Gain

Varia tions

Impact on Bank 's

profit & loss Reasons

-1 .43 % Loss

To much of the 100 is needed to guarantee capita l

protection.

Design of SP is an iteration on

• motivations and their strengths (demand),

• finding optimal risk sharing,

• desired margins.


SWX

29 January, 2006

Conclusion

• Trends of SP-Markets?

� Any future demand which can be represented by a cash

flow stream – leading banks will offer the corresponding

SP.

• SP are from an economic perspective the product

for any client. They are not a fashion.

• SP have a personal touch, linked to emotions and

flexible to design.

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Structured Products (SP) - UZH · 2016-02-22 · Prof. Vanini / Structured Products / FINRSIK at...

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