Structured_Products

Financial Markets Education

Structured Products

Financial Markets Education 1

Table of contents

SECTION 1 Performance Certificates 14

SECTION 2 Warrants 32

SECTION 3 Classic Structured Products – Yield Enhancement 37

SECTION 4 Classic Structured Products – Capital Protection 59

SECTION 5 Protection via Portfolio Insurance Techniques 72

SECTION 6 Bonus Certificates - A Softer Protection 86

SECTION 7 Interest Rate Structured Products 99

7.A Motivation

7.B Reverse Floaters

7.C CDRAN

7.D Flatteners and Steepeners

7.E The PRDC

SECTION 8 Basket Products 129

SECTION 9 Summary 137

APPENDIX A Strategy Certificates & Cliquet PPN 139


Where it all starts - the investor

♦ Investors demand tailored investment solutions

– good allocation of risk

– wealth preservation

– tax efficiency

– asymmetric risk-return profiles

♦ Classic investments in Bonds, Equities, Foreign Currencies can only partially meet these requirements

♦ Structured Products can meet specific investment objectives

– Small investment amounts

– Easy to understand

– Easy to trade

– low cost


Risk management products

♦ Many products have been developed to

– access specific market segments

– extract and decompose risk-return profiles of classic investments

– tailor the risk-return profiles to specific needs

♦ Many products & techniques have been developed for the professional market

♦ For individuals it is difficult to use these merits

♦ Structured products package professional risk-managed products and techniques into simple structures that meet specific investor needs

– Simple to understand

– Ready-to-use product

– Cost efficient


Structured products

♦ Securities issued by financial institutions to meet investment objectives of individual clients

– Client driven economic structures

♦ Huge range of potential economic structures

– Limitation: purchaser cannot be obliged to issuer (transferable security)

♦ Investor exposed to credit quality of the issuer

– Payments are guaranteed by issuing financial institution

– Investors are not the beneficial owner of the underlying asset

– Not a ‘pass-through’ product as Depositary Receipts or Investment Fund


Risk and Reward

♦ Investor: how do you enhance the yield (expected return) of your investment?

– Alpha: arbitrage, mispricing…

– Risk premium

♦ Issuer: how do you lower the cost of funding?

♦ Investment banks act as intermediaries to package risk


Type of Structured Products


Structured Products now?

♦ Issuers

– Need to raise funding

– Need to limit the size of the balance sheet

♦ Investors

– Need to assess credit risk to the issuer

– Higher spread leads to more money for risk participation

– But what kind of risk?

♦ Market

– Yield curve is steep and thus encompasses attractive risk premium

– Difficult to pick equity market

– Cash is king: need protection, but option premium is high

– Selling options is risky in highly uncertain time

– However with good risk management, there are many opportunities in times of crisis


USD swap and government yield curves 9 Mar 09


GBP swap and government yield curves 9 Mar 09


Market Timing?


Not an easy market


What is being issued in the current market (Early 2009)?


Fundamental Principles

♦ The fundamental construction is still the same

♦ But need to find different themes (e.g. long short, inflation protection, look back)

♦ Or use different underlying (e.g. commodities)

♦ And we have it all in store for you here…

SECTION 1

Performance Certificates


♦ Redemption amount equal to spot price of underlying at maturity

– One for one exposure

– Tracks the performance of an asset or strategy

♦ Usually, no coupons are paid to holder

♦ Cost-efficient way to execute investment strategy not easily achieved with traditional investments

♦ Wholesale and retail investor dealing sizes

♦ Certificates are usually cash settled

– Cash settled at the price of the underlying on expiry

– No stamp duty in UK, Switzerland, Germany

Certificates Performance


Certificates

♦ Fixed maturity or open ended

– Fixed term usually 3-5 years

– Issuer has the right to stipulate expiry of open-end certificates once a year

♦ Often listed on stock exchanges

– Fast and transparent exposure to investment products

– Simple execution similar to share dealing

– Traded through stockbroker

– Liquid (market making is required by exchange)

– Low cost, minimal bid/offer spread

♦ UBS calls these products PERLES (PERformance Linked to Equity Securities)

– Other names are “Tracker Certificates” or “Benchmark Certificates”

Performance


Open-end Certificate on DAX

Deutsche Börse: Certificate

Deutsche Börse: DAX

Performance


Diverse range of underlings

♦ Country Index

– DAX, CAC40, FTSE, S&P500, Nasdaq,…

♦ Multinational Index PERLES

– DJ Euro, Stoxx 50, DJ GlobalTitans, …

♦ Sector Certificates

– DJ Stoxx sectors, FTSE Global sectors, …

– Biotech basket, fuel cell basket, data highway basket, EU enlargement basket

♦ Pre-determined investment strategy

– Issuer acts as calculation agent

– Clear investment policy, non manager reliant

– Growth, Value, PEG

– Long/short

Performance


Diverse investment strategies

“The Euro PEG 20 Certificate has a clearly defined and disciplined investment strategy…Every quarter, 20 companies with the lowest Price-Earnings-to-growth (PEG-ratio) from DJ STOXX Index are selected.”

DJ Islamic Market Titans 100 Index Open End Certificate

“The Dow Jones Islamic Market Indexes were created for people whowish to invest according to Islamic investment guidelines. The indexes track Shari`ah compliant stocks from around the world, providing Islamic investors with comprehensive tools based on a truly global investing perspective.”

Open End Certificate on FTSE4GOOD EUR 50

“The FTSE4Good Europe 50 is a price-index for socially responsible investment. The criteria for the relevant selection are theenvironmental sustainability, social issues and human rights. The FTSE4Good Europe 50 Index is designed with the support of UNICEF, the United Nations Childrens’s Fund, and uses data provided by EIRIS, the Ethical Investment Research Service. Index Reviews occur on a semi-annually basis in March and September.”

Performance


Not necessarily long the underlying

♦ Going short an underlying is difficult to operate

♦ Futures are traded on major indices– Administrative burden

– Mark to market

– Initial margin

– Variation margin

♦ Single stock– Security borrowing/lending is obscure

wholesale OTC market

– Short position pays manufactured dividend

– Fully collateralised, daily variation margin

♦ Open-End FTSE 100 Reverse Tracker certificate (SocGen)

♦ Perpetual American Put Warrant

♦ You need to invest GBP 5,174 (10 certificates) to go short 1 FTSE

Performance


UBS Shorty

♦ Similar to short SMI future– Fixed notional

– Leverage about 5.5 at issuance

– Easy and transparent

♦ Speculate on a decline in the index

♦ Add to a portfolio to effective way to hedge against market weakness

“Initial Margin”

“Trade is closed when this level is reached”

Short Term: No asset premium

to collect

Performance


Long Google / short Yahoo

♦ Systematic versus company specific risk ♦ Returns will be correlated to the market only because of the “non-hedged”exposure

♦ Likely to under-perform in strong bull markets


Long Google Short Yahoo - Redemption


Exercises

♦ For each product in the “Early 2009 Product” series in this class

♦ Read through the term sheet excerpts

♦ Briefly describe the rationale for the structure

♦ Briefly describe how the structure can be achieved, for example, what kind of option is embedded in the structure

– It is sufficient to describe the potential upside or downside that has been bought or sold, or the protection that has been put in place

♦ Your opinion of whether the product will be a successful investment given what has happened in 2008 leading up to 2009 and the outlook going forward


Early 2009 Product 1: Long Short CMCI vs. GSCI


Long CMCI Short GSCI


Product Description

♦ For each rebalancing period the multiplier =

( )[ ]{ } )%100(*...***%100 111 mgmtfeeGSCICMCIFXlevfactor −+−+ returncommreturncommwt


Constant Maturity Commodity Index

♦ It eases into a roll more gradually than a traditional index

– It saves on roll cost in contango

– It foregoes positive convenience yield pick up in backwardation

♦ Also it holds contracts along the term structure of futures

♦ It is claimed to show lower tracking error of realized return compared to underlying price index, and outperform traditional index on average


Equity Certificates & dividends

♦ Certificates usually do not pay the underlying dividend

♦ Fixed term certificates trade at a discount to underlying price

– Dividend risk with issuer

– Estimated dividend

– Tax implications

♦ 1-year FTSE 100 Certificate

– Implied dividend yield

– Expected dividend yield

Swiss Tax informationFor private persons with tax domicile in Switzerland, the discount to the Initial Underlying Level (2.1%) represents taxable income on the Redemption Date.

Performance


Quanto Certificates on Nikkei 225

♦ Fixed term Certificate

♦ Underlying is Nikkei 225

♦ Discount to Nikkei spot is 7.39%

♦ Implied dividend yield?

♦ Estimated Nikkei dividend yield?

♦ What is wrong?

Performance


The Quanto feature

♦ Investor wants exposure to the Nikkei

♦ Investor does not believe in the attractiveness of the JPY

♦ The Quanto Certificate eliminates the exposure to the foreign currency

♦ Quanto Certificate tracks a basket whose value in USD always equals the level of the Nikkei

♦ “Quanto basket”

♦ This “Quanto basket” needs continuous rebalancing– Expensive

– Constant monitoring

– Investor in PERLE invests in a strategyJPY

NIK

USD

Long USD

Short JPY

Long Basket of Nikkei stocks

earn Nikkei dividend yield

pay JPY interest rate

earn USD interest rate

Performance

SECTION 2

Warrants


What are Warrants?

♦ Economically similar to vanilla OTC and exchange traded options

– Investment with leverage

– Benefiting from market development with small capital outlay

– Substantial earnings potential while at the same time limiting the risk to the capital invested

♦ Securitized call or put options

– large range of strike prices and maturity

– Issued on just about any underlying

– Often traded on an exchange

Leverage


Covered warrants versus subscription warrants

♦ Covered Warrants are issued by third party unrelated to underlying equity

– Client driven economic structures

– Diverse range of underlying (Equity, Baskets, Indices, Swap rates etc)

♦ Subscription Warrants are issued together with a bond or preferred stock to allows the holder to buy a common stock

– Equity warrants

– Same issuer as underlying shares

– Driven by financing requirement of the issuer

– Also called Conventional Warrants


Call Warrant on NestléLeverage


Buying Warrants

♦ Buying Call Warrants

– Alternative to buying underlying

– Upside exposure with hedge against falling prices

– Maximum loss is the Warrant premium

– A call can be thought of as a “long underlying plus insurance”

♦ Buying Put Warrants

– Alternative to selling underlying short

– Downside exposure with hedge against rising prices

– Maximum loss is the Warrant premium

– A put can be thought of as a “short underlying plus insurance”

Leverage

SECTION 3

Classic Structured Products – Yield Enhancement


Optimisation

Yield

Enhancement

Protection

Upside

Participation

Yield Enhancement versus Capital Protection

Long Options

Short Options

Objectives Needs

Desires

Limitations

Views Return

Risk

Time

Regrets


Discount Certificate (BLOC) on Vodafone

♦ Today is October 11, 2004

♦ Vodafone (VOD) is trading at GBp 137

♦ You think about buying VOD– you are not sure

– It is not that cheap

♦ Alternatively, you could buy the Discount Certificate for GBp 123

♦ With the Discount certificate you will get back in 12 months– 1 VOD Share if VOD trades below GBp 140

– GBp 140 if VOD trades above GBp 140

♦ UBS calls these investments BLOCs (Buy Low Or Cash)

♦ Which investment would you choose? Why?

Optimisation


Equity or a money-market product?

Today

12 Months

133.46

140

4.9%

Zero Coupon Bond

Today

137

1 Share

Dividend

Share

Discount Certificate

Today

12 Months

123

1 Share or140 Cash

♦ Likelihood of getting stock in one year?

♦ Likelihood of getting cash in one year?

♦ What drives this likelihood?12 Months


From Debt to Equity

♦ Investors have traditionally managed their investments by balancing debt and equity

♦ Structured Products can meet conservative as well as aggressive risk-reward profiles

♦ This product caps your return

– Maximum return Discount Certificate: 13.8%

DEBTZero

CouponBond

EQUITY

Structured Investment Zone

Low cap High cap

Discount Certificate

Optimisation


The LEGO game – Discount Certificate

♦ How the equity investor could think of the package

♦ How the Fixed Income investor thinks of the package?

♦ In the end the package has to make sense for the investor, not the individual bricks!

Buy Share

Sell Call+ = DC- DividendStrike = 140 Spot = 137

Buy ZCB Sell Put+ = DC

Face = 140 Strike = 140

Optimisation


Break-even graph

-30

-20

-10

0

10

20

30

110 116 123 129 135 141 148 154 160

Stock Price at Expiration

Prof

it &

Los

s

Discount Certificate Stock

Optimisation


What is your risk capacity?

0

5 0

1 0 0

1 5 0

2 0 0

2 5 0-0.6

-0.55

-0.5

-0.45

-0.4

-0.35

-0.3

-0.25

-0.2

-0.15

-0.1

-0.05 0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

0.55

0.6

0.65

0.7

0.75

0.8

More

Do you really want to be

exposed to these? How much do you believe in

those?

Are you willing to accept a cap on the positive returns (Regret)?

Which part (shape) of the distribution are you willing to

acceptDo you need to cap negative returns

(bankruptcy)?

2000 simulationsInvestors expected stock return is 8% Volatility: 20%


Risk and Structured Products

♦ Investing is trading expected return versus risk

– it all starts a with a view

– But there is not much to earn without taking risk

♦ Risk is in general complicated to understand and communicate

♦ Structured products can be designed with risk aspects easy to visualise

– Maximum Loss

– Maximum Gain

♦ An investment not only hasexpected risk and expected return

♦ An investment is a “probability distribution”

BondsInterest rate riskCredit risk

Foreign ExchangeLong term: economic riskShort medium term more behavioural

EquityMarket RiskCompany specific risk


Dual Currency Deposit (DCD)

♦ January 17, 2005

♦ GBP|CHF spot trades at 2.1965

♦ Swiss money market yield: 0.69%

♦ Client invests CHF 100,000

♦ In 6 months he gets back

– CHF 102,218.4 if GBP|CHF above 2.1571

– GBP 47,387.0 if GBP|CHF below 2.1571

♦ What did the client actually do?

– Is there an option involved?

– What strike?

– How to choose the strike?

Optimisation


DCD analysis

♦ Dual Currency Deposit is the FX version of a “Discount Certificate”

♦ Breakeven– Money market investment pays back

100,346.9

– Minimum value DCD in 6 months: GBP 47,387

– Break-even exchange rate: 2.1176

4.41%

Money Market Rate

GBPCHF

2.1571

0.69%

2.1176 2.1965

ZCBFace CHF 102,218.4

Sell GBP|CHF putFace GBP 47,387

Strike 2.1571

Optimisation

Redemption:102,218 CHF

Redemption:47,387 GBP


Update…


Reverse Convertible on BT Group

♦ June 2004. BT Group is trading at GBp 182.5

♦ You are a bond investor– Not a good time these days

– You could invest in a 31 months par bond paying a low 5.3% coupon

– You are not a equity investor, but you think that BT is low risk

♦ You could buy a 10.2% coupon Reverse Convertible at par– Notional is GBP 1,000

– The Reverse Convertible pays a coupon of GBP 51 every 6 months

♦ The Reverse Convertible pays in 31 months a redemption of – GBP 1,000 if BT trades above GBp 182.50

– 548 BT shares if BT trades below GBp 182.50

♦ The UBS name GOAL stands for ”Geld Oder Aktien Lieferung” (Cash or Share delivery)

Optimisation


Share or Bond?

♦ Is the strike chosen wisely for a typical Fixed Income investor?

♦ How much does he want to become a share holder?

♦ Are there other means to make share delivery less likely?

BOND ReverseConvertible

1000

1000

1000

1000 or548 shares

Jun04

Jan07

30.9

Jan05 Jan06

26.5 26.526.5 26.5

Jun04

Jan07

59.5

Jan05 Jan06

51 5151 51


Early 2009 Product 2: Kick-In Goal


Early 2009 Product 2: Kick-In Goal


Window Barrier Option


Risk Mitigation?

♦ Low rate regime but high risk environment

– Yield enhancement with confined risk exposure

♦ No risk of ending up with stock unless the stock is severely depressed from current level at expiration

♦ Need to pick stock that works

♦ The view is that the market, at least this name, will recover by expiration in March 2010 – 1 year from now

♦ Barrier is only active at expiration; but high volatility provides high enough premium for the yield pick up in the product


How to spend a option premium

♦ The use of the option premium

– BLOC: the option premium is used to lower the price of the investment

– GOAL: the option premium is used to boost the coupon

– Many other ways how to use the premium

♦ We can use the premium to "boost" small returns

♦ Example

– Today is July 30, 2004

– Gold spot is trading at 391

– You think that Gold spot will increase slightly over the next 6 months

– You do not think that gold will trade above 414 in 6 months

– How can you accurately express your view?

Optimisation


Speeder on Gold

♦ July 21, 2004: Gold is trading at USD 391

♦ Speeder is issued for same price as underlying: USD 391

♦ On Feb 11, 2005 the Speeder pays a USD cash redemption equal to

– Gold spot if Gold closes lower than 391

– 391 + 2 x (Gold spot – 391) if Gold closes between 391 and 414

– 437 if Gold closes above 414

If the underlying is a share you receive the physical share if spot trades below the lower strike

Speeder is also called sprint-certificate

Goldman Sachs calls such structures IMPACT:"Increased Market Performance At Capped Target“

Optimisation


Speeder LEGO – the debt focus

♦ The option strategy cannot be detached from the Speeder

– Without the debt part the option strategy might oblige the investor to make payments to the Issuer

BuyZCB

Face 437

SellPut

Strike 414

SellPut SpreadBuy 391 PutSell 414 Put

-30

-20

-10

0

10

20

30

40

50

370 381 391 402 412 423 433

Gold Price at Expiration

Prof

it &

Los

s

Put spread Option Strategy

Optimisation


Speeder LEGO – the Gold focus

BuyGold

Spot 391

SellCall

Strike 414

BuyCall SpreadBuy 391 CallSell 414 Call

-15

-10

-5

0

5

10

15

370 381 391 402 412 423 433

Gold Price at Expiration

Prof

it &

Los

s

Lend Gold

-15

-10

-5

0

5

10

15

20

25

380 390 400 410 421 431 441

Gold Price at ExpirationPr

ofit

& L

oss

Call spread Option Strategy

Optimisation

SECTION 4

Classic Structured Products – Capital Protection


Capital guaranteed products

♦ Today’s price of a Zero-Coupon Bond (ZCB) is the market price for receiving money in the future

– a fixed redemption amount

– At a fixed point in time

♦ Products protecting investments at a future point in time are (directly or indirectly) based on Zero-Coupon Bonds

Today

2 Years

910

1000

4.83%

Zero Coupon Bond


Principal Protected Note on FTSE100

♦ You have GBP1,000 to invest

♦ You need a guaranteed GBP1,000 cash redemption in 2 years

♦ You invest GBP 910 in ZCB

♦ You can invest the remaining GBP 90 in risky instruments

– You believe that the broad UK Equity market will outperform Bonds

– You might invest the GBP 90 in UK Certificates

– FTSE100 trades at 4790 today

– You will participate 9% in the FTSE performance

♦ Alternatively, you could invest in the FTSE100 PPN

– Guarantees a redemption of GBP 1,000 in 2 years

– Additionally, you get 100% of the positive FTSE performance

– You do not participate in the negative FTSE performance at maturity

Protection


A Zero Coupon Bond plus Call Warrant

♦ The PPN uses a call on FTSE to link the ZCB with the FTSE upside– Strike determines the point where the investor starts to participate

in the increase of the underlying

– Investor wants to participate now (strike is ATM spot)

♦ Unlimited PPNs

– 100% capital protection only at maturity

– Unlimited upside potential

– The call warrant might be detachable

♦ UBS calls this product

– PIP (Protected Index Participation)

– GROI (Guaranteed Return On Investment note)

Index Level in 2 years4790

1000

Bond with GBP 1,000 Face to protect the

capital

Call adds upside of risky market

5269

1100

Re

de

mp

tio

n

in 2

ye

ars

Protection


Participation rate

♦ Current yield environment is unfavourable for Capital Protection

– A lot of money goes into ZCB

♦ Can increase participation rate by

– A Floor instead of full protection

– Guarantee 950 minimum redemption instead of 1,000

– The longer the term, the higher the participation rate

– Cap the maximum return

– Use a ‘cheaper’ option (Averaging, Quanto, Barrier)

– Use a different underling (Less volatile, Lower dividend yield)

DEBTZero

CouponBond

EQUITY

High Protection Low ProtectionLow participation High Participation

PPN

Protection


Unlimited

PPN

Protection versus optimisation

♦ Equity Investor

♦ Fixed Income Investor

♦ This analogy is called Put-Call Parity

Buy Share

Sell Call+ = DC-

Dividend

Buy ZCB Sell Put+ = DC

Buy Share Buy Put+ =- Dividend

Unlimited

PPN

Buy ZCB Buy Call+ =


Lower Strike

Limited Principal Protected Note

♦ PPNs with limited earning potential

– Participates in the uptrend between two strikes.

– Get maximum return if spot exceeds upper strike

– Call spread is a ‘cheaper’ option

– Higher participation rate between the strikes

Price of Underlying Spot

Advantage of Limited PPNs

Limited

Unlimited

Higher Strike

Guaranteed Capital

Protection


The usual lists

♦ Remember that “an investment is a distribution”

♦ Taking risk leads to higher EXPECTED return

♦ Remember that options are not priced based on expected return

– The expected return in excess of risk free return belongs to the investor (the risk taker)

– The bank’s role is to manage the uncertainty of settlement (exercise of options, i.e. volatility) and the cost is covered by the option premium

– Options are used to alter the distribution to cater for the risk capacity of the investor

♦ The degree of leverage often determines the options to be used


Early 2009 Product 3: Kick Out GROI


Redemption terms


Fit the time…

♦ Principle preservation is important

♦ Low rate regime means less money for risk participation: need to make the option cheaper by using the kick out feature

♦ Rebate makes the potential give up of the parity due to the barrier event easier to take


Range GROI: Wedding Cake structure

♦ Investors forego the interest on their investment and use it to purchase double lock outs


An Equity Example – Range Barrier Notes

♦ Tenor: 3 years

♦ Underlying: DJIA index

♦ Coupons

– 8% if DJIA traded at or beyond 35% on either side of the beginning level of the interest period within the interest period

– 4% if condition 1 is not fulfilled and DJIA traded at or beyond 25% on either side of the beginning level of the interest period within the interest period

– 1% if both conditions 1 and 2 are not fulfilled

1%

8%

4%

35%-35% 25%-25% 0%

Coupon Rate

Index return

SECTION 5

Protection via Portfolio InsuranceTechniques


Another form of protection

♦ You have GBP 1000 to invest for 3 years

♦ You need a minimum redemption of GBP1000

♦ A zero coupon bond with GBP 1000 face costs 868

♦ The FTSE100 index trades at 4790 today

♦ You believe that equity market outperforms bond market

♦ You decide to invest GBP500 in FTSE100 and GBP 500 in ZCB

♦ This is somehow risky given your needs

♦ You will have to rethink your portfolio split if markets move– What will you do if FTSE trades at 5750 in 1 month

– What will you do if FTSE trades at 3750 in 1 month


Portfolio Insurance

♦ Zero Coupon Bond (ZCB) provides capital protection

♦ Call option links structure to the upside of ‘risky asset’

♦ Structure does not need to be rebalanced

♦ Dynamically managed portfolio

♦ A combination of ZCB and ‘risky assets’

♦ participation is adjusted in accordance to predefined rules

Product value

Equity Return

ZCB Call Option

Risky Assets

Deleverage, if market moves down

Releverageif market goes up

Bond

PPN Portfolio Insurance

Protection


Portfolio Insurance – the strategy

♦ The bond floor is GBP 868 today– A portfolio with this value can be switched into a ZCB guaranteeing your minimum

return

♦ You have to prevent the portfolio value from falling below the bond floor at any time before maturity

♦ You expect a maximum fall in FTSE of 20% between rebalancing points– This is called the ‘Crash Size’

– The Size of the ‘Crash Size’ is an investment view

– Is your portfolio correctly balanced

♦ The technique to protect the portfolio value is called ‘Constant Proportion Portfolio Insurance’– UBS calls it ‘Constant Proportion Portfolio Technique’ (Compliance)

♦ The technique only works if you got your assumptions right

Protection


Optimal equity exposure

♦ Maximum ‘supportable’ loss in risky assets (‘Cushion’) is Portfolio Value - Bond Floor

♦ Maximum ‘supportable’ %-fall in share price is called the ‘Gap’

♦ The Portfolio is perfectly balanced with the Gap exactly equal to the Crash Size

60%

80%

100%

120%

140%

160%

180%

200%

Bond Floor

Portfolio Value

‘Cushion’ValueEquity

FloorBondValuePortfolioGap

−=

Protection


Portfolio Insurance – a simulation

♦ You have 100 to invest for 2 years

♦ A 2-year Zero coupon Bond with face 100 costs 95.12 (2.50%)

♦ You rebalance your portfolio quarterly

– Protection: 100%

– Crash Size = Leverage Trigger = Deleverage Trigger = 20%

– Minimum exposure (Equity): 0%

– Maximum exposure (Equity): 150%

♦ We investigate the following scenarios

– Stock tanks

– Stock soars

– Stock wobbles


CPPT – stock tanks

Time Equity Equity Equity Bond ZCB ZCB Portfolio(years) Price Value Weight Floor Value Weight Gap Value0 100 24.39 24% 95.12 75.61 76% 20.0% 100

1/4 92 22.43 23% 95.72 76.09 77% 12% 98.521/4 92 14.02 14% 95.72 84.50 86% 20% 98.521/2 84 12.80 13% 96.32 85.03 87% 12% 97.831/2 84 7.57 8% 96.32 90.26 92% 20% 97.833/4 76 6.85 7% 96.92 90.83 93% 11% 97.683/4 76 3.78 4% 96.92 93.90 96% 20% 97.68

1 68 3.38 3% 97.53 94.49 97% 10% 97.871 68 1.69 2% 97.53 96.18 98% 20% 97.871 1/4 60 1.49 2% 98.14 96.78 98% 9% 98.271 1/4 60 0.66 1% 98.14 97.62 99% 20% 98.271 1/2 52 0.57 1% 98.76 98.23 99% 7% 98.801 1/2 52 0.20 0% 98.76 98.60 100% 20% 98.801 3/4 44 0.17 0% 99.38 99.21 100% 5% 99.391 3/4 44 0.04 0% 99.38 99.34 100% 20% 99.39

2 36 0.03 0% 100.00 99.97 100% 2% 100.00

Market Price of 1 Share

Value of Equity in Portfolio

Equity Value as % of Portfolio Value

Market Value of Portfolio

Value of ZCB with Face 100

Value of Bonds in Portfolio

Bond Value as % of Portfolio Value

Supportable %-fall in Share

Rebalanced

Rebalanced

Rebalanced

Rebalanced

Rebalanced

Rebalanced

Rebalanced


CPPT – stock soars

♦ Before maturity, the value of the portfolio can fall below the protected amount

♦ The better the index performs the more participation in stock

Time Equity Equity Equity Bond ZCB ZCB Portfolio(years) Price Value Weight Floor Value Weight Gap Value0 100 24.39 24% 95.12 75.61 76% 20% 100

1/4 110 26.82 26% 95.72 76.09 74% 27% 102.911/4 110 35.97 35% 95.72 66.95 65% 20% 102.911/2 120 39.24 37% 96.32 67.37 63% 26% 106.601/2 120 51.41 48% 96.32 55.19 52% 20% 106.603/4 130 55.70 50% 96.92 55.54 50% 26% 111.233/4 130 71.55 64% 96.92 39.69 36% 20% 111.23

1 140 77.05 66% 97.53 39.94 34% 25% 116.981 140 97.27 83% 97.53 19.72 17% 20% 116.981 1/4 150 104.22 84% 98.14 19.84 16% 25% 124.061 1/4 150 129.57 104% 98.14 -5.51 -4% 20% 124.061 1/2 160 138.21 104% 98.76 -5.55 -4% 25% 132.661 1/2 160 169.51 128% 98.76 -36.85 -28% 20% 132.661 3/4 170 180.10 126% 99.38 -37.08 -26% 24% 143.021 3/4 170 214.53 150% 99.38 -71.51 -50% 20% 143.02

2 180 227.15 146% 100.00 -71.96 -46% 24% 155.19


CPPT simulation – some volatility

♦ You buy high and sell low

– How much does a zero coupon bond return?

– Volatility is not good for this strategy

– The trader calls this effect ‘short gamma’


1/4 95 23.17 23% 95.72 76.09 77% 15% 99.251/4 95 17.68 18% 95.72 81.58 82% 20% 99.251/2 100 18.61 18% 96.32 82.09 82% 24% 100.701/2 100 21.89 22% 96.32 78.81 78% 20% 100.703/4 95 20.79 21% 96.92 79.30 79% 15% 100.103/4 95 15.87 16% 96.92 84.23 84% 20% 100.10

1 100 16.70 16% 97.53 84.76 84% 24% 101.461 100 19.64 19% 97.53 81.82 81% 20% 101.461 1/4 95 18.66 18% 98.14 82.33 82% 15% 100.991 1/4 95 14.24 14% 98.14 86.75 86% 20% 100.991 1/2 100 14.99 15% 98.76 87.29 85% 24% 102.281 1/2 100 17.63 17% 98.76 84.65 83% 20% 102.281 3/4 95 16.75 16% 99.38 85.18 84% 15% 101.931 3/4 95 12.78 13% 99.38 89.15 87% 20% 101.93

2 100 13.45 13% 100.00 89.71 87% 24% 103.16



1/4 84 20.48 21% 95.72 76.09 79% 4% 96.571/4 84 4.27 4% 95.72 92.31 96% 20% 96.571/2 100 5.08 5% 96.32 92.89 95% 32% 97.961/2 100 8.22 8% 96.32 89.74 92% 20% 97.963/4 84 6.91 7% 96.92 90.31 93% 4% 97.213/4 84 1.44 1% 96.92 95.77 99% 20% 97.21

1 100 1.71 2% 97.53 96.37 98% 32% 98.091 100 2.77 3% 97.53 95.31 97% 20% 98.091 1/4 84 2.33 2% 98.14 95.91 98% 4% 98.241 1/4 84 0.48 0% 98.14 97.75 100% 20% 98.241 1/2 100 0.58 1% 98.76 98.37 99% 32% 98.941 1/2 100 0.93 1% 98.76 98.01 99% 20% 98.941 3/4 84 0.78 1% 99.38 98.62 99% 4% 99.411 3/4 84 0.16 0% 99.38 99.25 100% 20% 99.41

2 100 0.19 0% 100.00 99.87 100% 32% 100.06

CPPT simulation – more volatility

♦ Unlike a bond-plus-call strategy, your final redemption is path dependent

– Hard to keep track

– Product not so transparent



1/4 110 26.82 26% 95.72 76.09 74% 27% 102.911/4 110 35.97 35% 95.72 66.95 65% 20% 102.911/2 105 34.33 34% 96.32 67.37 66% 16% 101.701/2 105 26.89 26% 96.32 74.81 74% 20% 101.703/4 80 20.49 21% 96.92 75.28 79% -6% 95.763/4 80 0.00 0% 96.92 95.76 100% NA 95.76

1 90 0.00 0% 97.53 96.36 100% NA 96.361 90 0.00 0% 97.53 96.36 100% NA 96.361 1/4 100 0.00 0% 98.14 96.97 100% NA 96.971 1/4 100 0.00 0% 98.14 96.97 100% NA 96.971 1/2 105 0.00 0% 98.76 97.58 100% NA 97.581 1/2 105 0.00 0% 98.76 97.58 100% NA 97.581 3/4 110 0.00 0% 99.38 98.19 100% NA 98.191 3/4 110 0.00 0% 99.38 98.19 100% NA 98.19

2 120 0.00 0% 100.00 98.80 100% NA 98.80

CPPT simulation – disaster strikes

♦ UBS guarantees repayment of notional at maturity

– Additional protection for the Investor

– UBS is taking the loss if assumptions (Crash Size) were wrong

Protection


Baring Hong Kong China Fund USD


CPPT on Baring Hong Kong China

Issuer UBS AG, Jersey Branch

Issue Date 27 October 2003

Maturity Date 27 October 2009

Issue Size USD 25,000,000

Currency USD

Denomination USD 1‘000

Issue Price 100% of nominal

Underlying FundBaring Hong Kong China $

Initial Basket 75% Fund, 25% ZCB

Rebalancing Daily

Capital Protection 100% nominal at expiry + Captured Profit

Annual Captured Profit 30% of Value above notional (after fees)

Management Fee 1.50% p.a. (0.90% if cash-locked)

Leverage Fee 0.9% p.a. of leveraged exposure

Minimum Fund Exposure 0%

Maximal Fund exposure 120%

Crash Size 29%

Deleverage Trigger 24%

Releverage Trigger 34%

Simplified Product Characteristics

Protection


CPPT GBP Note Linked to Hedge Funds

Issuer UBS AG, Jersey Branch

Issue Date 1 October 2004

Maturity Date 30 September 2009

Issue Size GBP 15,000,000

Currency GBP

Denomination GBP 10‘000

Issue Price 100% of Nominal

Underlying50% GAM Diversity (GBP)50% UBS O’Connor – Global Alpha Strategy

Fund (GBP) - institutional

Initial Basket 100% Fund, 0% ZCB

Rebalancing Monthly

Protected Amount 100% nominal

Coupon at MaturityMax(0, RBfin – Protected Amount)

RBfin = Value of Basket at Maturity

Contingent Fee 2.45% p.a on basket value if fund exposure is positive

Non-Contingent Fee 0.95% p.a. on basket value if no fund exposure

Minimum Fund Exposure 0%

Maximal Fund exposure 150%

Deleverage Trigger 15%

Releverage Trigger 25%


Protection

SECTION 6

Bonus Certificates - A Softer Protection


A historic example (or déjà vu?)

♦ Today is July 18, 2003

♦ Over the last 3 years the S&P500 has fallen by 34%

♦ You think that the worst is over

♦ You think that the future will be brighter

♦ But you might be wrong and the index falls another 20%

♦ You need some protection

♦ But you do not want it to hamper all your upside

SPX Daily Closing Prices

750

850

950

1050

1150

1250

1350

1450

1550

Jan-00 Sep-00 May-01 Jan-02 Sep-02 May-03


A historic example – Bonus Certificate

♦ PPN = Stock + long ATM Put – Dividends

♦ The put is expensive– You buy full protection against any fall in the underlying price

– Do you need all that protection?

– Do you really think that the index might fall another 40%?

– Might a softer protection be enough protection for you?

♦ The S&P500 (SPX) is trading for 993

♦ You can buy a 5 year Bonus certificate (Certificate Plus) for the same price: USD 993.23

♦ On July 18, 2008 the certificate pays a USD redemption equal to– Level of SPX if the index ever traded at or below 551.3

– The greater of SPX Spot and USD 993 if SPX never traded at or below 551.3

Performance


How the S&P500 performed

SPX Daily Closing Prices

950

1000

1050

1100

1150

1200

1250

Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05


♦ Bonus Certificates are also called PERLES Plus or Certificates Plus

– Direct, un-leveraged exposure to underlying

– Bonus feature that you get a minimum payout if the underlying never trades at or beyond a predefined level

♦ Fully exposed to the downside risk once the barrier has been touched

Buy Kick-Out-Put

BonusCertificate

PPN versus Bonus Certificate

Buy Share Buy Put+ =- Dividend

Unlimited

PPN

Buy Share

+ =- Dividend

Kick-Out-Put

993.32

Spot

551.29Kick Out


A product from 2006

Underlying Royal Dutch Shell

Ratio 1:1

Pricing Date 18 August 2006

Expiration Date 31 July 2009

Underlying Price: EUR 27.56

Issue Price EUR 27.56

Bonus Level: EUR 33.35 (121%)

Kick-out Level EUR 20.67 (75%)

Redemption Amount

A) No Kick-out EventMax (EUR 33.35, Expiry Price RDS)

B) Kick-out EventExpiry Price RDS


75%

121%

121%

75%

“A Kick-out Event shall be deemed to have occurred if at any time during the period from the Start of Term of the Certificate until and including the Expiration Date the Level of the Underlying as continuously calculated and published, trades at or below the Kick-out level”

Performance


Kick-out Event


Revival Bonus Certificate on Daimler Chrysler

Underlying Daimler Chrysler

Ratio 1:1

Pricing Date 21 June 2006

Expiration Date 19 June 2009

Underlying Price: EUR 37.91

Issue Price EUR 37.91

Bonus Level: EUR 45.49 (120%)

Kick-out Level EUR 28.43 (75%)

Recovery Leverage 2

Redemption Amount

A) No Kick-out Event:Max (EUR 45.49, Expiry Price DCX)

B) Kick-out Event:

Expiration Price lower than Kick-out Level: Expiration Price DCX

Expiration Price higher than Kick-out Level: 28.43 + 2 x (Expiration Price – 28.43)


75%

100%

100%

75%

87.5%

Performance


Hmm…


2009 - Back to 2003

♦ In the credit crunch and the global downturn of 2009

♦ Market in long and many times sharp decline

♦ But you don’t want to miss the boat when the recovery happens

– As some people say it will be fast and furious

♦ Many experts tried to call the bottom and got burnt

♦ Timing the market is very difficult

♦ Don’t you want to have the best timing: buy at the lowest price


Timing PERLES


Fitting the current market


Is it behaving as expected?

SECTION 7

Interest Rate Structured Products

SECTION 7.A


Motivation


Have I made money

♦ Stock price is 100

♦ 1-year Interest rate is 5%

♦ Dividend is 1

♦ Stock price in a year is 103

♦ Should I have a celebration?

♦ What is the break even price?


yield curve

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

1 2 3 4 5 6 7 8 9 10

year

rate

Prices in the interest rates world

♦ A common shape of the yield curve

♦ Care to explain why it is more often upward sloping?


What trades should I do?

♦ If you think that the curve will be the same in a year time

– What trades would you do?

– What is the risk and are you paid for taking that risk?

– Try this

– A 4-year par bond at 4.75%

– A 1-year deposit at 3%

– Which one do you prefer?

♦ Another way to look at this…

♦ What should the yield curve be in a year time for trades to break even?

– An upward sloping curve prices in a rise in rates


yield curve

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

7.00%

1 2 3 4 5 6 7 8 9 10

year

rate

Looking forward

♦ Thinking about the forward means incorporating the basis

♦ Basis is cost minus benefit

♦ The 1-year forward yield curve (in other words you are looking at the back end of the curve)


It happens in FX too

♦ Dollar yen is 116 today

♦ USD 20-year rate is 5.5% (annual compounding)

♦ JPY 20-year rate is 3% (annual compounding)

♦ What is the 20-year forward in dollar yen?

♦ Do you believe that the forward is a good predictor of the spot in 20 years?

♦ If not what trade would you do and what is the risk?


Typical plays

♦ Receive fixed for long term

♦ Fund dollar assets by yen

– Heard of the yen carry trade?

♦ Sell options on the potential gains of the above

– Monetize upside into option premium

– Trade terminates if the chance of realizing the upside becomes higher

– Trade terminates if rates go lower or the curve becomes steeper

– Trade terminates if dollar becomes more expensive

♦ Buy options to protect against making a payout

– Protect against interest rates going too high

– Protect against dollar becoming too cheap

SECTION 7.B


Reverse Floaters


Reverse floater

♦ The reverse floater: investor pays 100 and receives coupon of “fixed rate – n times LIBOR”. For example 13.5% - 2 x LIBOR

♦ Minimum coupon is zero

♦ At pricing

– Investor receives fixed interest for his investment less the premium for the cap to protect against negative coupons

– Investor leverages up his exposure n times by entering into a swap receiving fixed

♦ Reward: large coupons if rates are realized at low levels

♦ Risk: poor return if rates are realized at high levels. Suffers mark-to-market losses if yield curve moves higher than the forward yield curve


Selling options

♦ If the reverse floater note is callable by the issuer at par

♦ Investor has monetized the potential upside at pricing into a high guaranteed initial coupon

♦ Reward: if the yield curve moves lower than the forward yield curve causing the note to be valued beyond par, the note will be called and investor gets back the principal. If this happens sooner, investor realizes a better return

♦ Risk: yield curve moves higher than the forward yield curve and rates are realized at high levels. Investor is stuck with the note and receives low coupons


Variable Maturity Note

♦ Also called target redemption note

♦ Redemption occurs as soon as the Aggregate Coupons reach a predetermined Cap

♦ Aggregate coupon is often floored

– Minimum aggregate coupon floored

– Protection of the sum of all coupon payments

– Guaranteed Total Payout of the Note

♦ More transparent early redemption criteria


Variable Maturity Inverse Floater -VMIF

♦ Issue Date: 06 Feb 2004

♦ Min Maturity: 06 Aug 2006

♦ Max Maturity: 06 Feb 2014

♦ Coupons (semi-annual)– Year 1: 8%,

– Years 2-10: 10% - 2*Euribor

♦ View that the Euro short term rates will remain stable or only slightly increase

♦ Based on forwards the Note is expected to redeem in 2.5 years

♦ Aggregate Coupon Cap and Floor: 12.00%

♦ Note redeems at par if cumulative coupon is 12%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

Aug-04Aug-05

Aug-06Aug-07

Aug-08Aug-09

Aug-10Aug-11

Aug-12Aug-13

Expected Coupons

Aggregate Coupon

Coupon Cap/Floor

Maturity implied by forwards

12%


Value and risk

♦ Essentially the same as the callable reverse floater

♦ Investor sells option on the potential upside beyond the aggregate coupon level

– It depends more on the short end of the curve

♦ Investor expects to collect the aggregate amount of coupon within the expected life of the note

♦ If rates are realized at lower levels, investor collects the coupon within a shorter period of time than expected, realizing a better return

SECTION 7.C


CDRAN


CDRAN

♦ Callable Daily Range Accrual Note

♦ Use digital options

♦ Daily expiration

♦ Easy to risk manage as digital risk is small on a daily basis

♦ Looks like a coupon bond for fixed income investors

– Except that the coupon is variable (and may be zero)

♦ Investor sold options to boost guaranteed coupon

– Achieved better return against the guaranteed coupon if the note is called early


Early 2009 Product 4: CDRAN


CDRAN: good pricing (risk premium) with steep curve

SECTION 7.D


Flatteners and Steepeners


Why is the product valuable?

♦ Steepeners’ value comes from the Forwards: the backend of the yield curve tends to be flat

♦ Forward curves imply that the yield curves are going to invert in the future (e.g. EUR 10y-2y spread is predicted to become negative in January 2018). However

– This only happened once in the past, after the German reunification

– There is no strong economical reason for the curve not to remain upward sloping in the future (risk premium)


Historical and forward EUR 10y-2y CMS spread

Historical and Forward EUR 10y-2y Spread

(2)

0

2

4

6

8

10

Sep-88 Sep-93 Sep-98 Sep-03 Sep-08 Sep-13 Sep-18 Sep-23 Sep-28 Sep-33

%

EUR10yCMS EUR2yCMS Spread

Historics Market Implied


Historical USD 10y-2y CMS spread


Early 2009 Product 5: Steepener


Non callable CMS Spread Note


Risk and Reward

♦ Like the reverse floater, investor enters into a CMS swap leveraged at a certain number of times the note notional, receiving long end and pays short end

♦ If the structure is not callable, investor enjoys large coupon if the curve does not flatten as the forward predicts

♦ If the structure is callable, investor sells option on the potential upside and collects premium to enhance the guaranteed initial coupon

♦ Risk: if the yield curve flattens more than the forward and the realized barbell spread is low, then the investor will be stuck with a note paying low coupons. And of low mark to market value

SECTION 7.E


The PRDC


PRDC – Power Reverse Dual Currency

♦ Dual currency note: investment and coupons in low interest rate currency, redemption in high interest rate currency

♦ Reverse dual currency note: investment and redemption in low interest rate currency, coupons in high interest rate currency

♦ Power (hyper) reverse dual currency note: all cash flows in low interest rate currency, but the coupon is linked to FX with a high interest rate currency; e.g.

Coupon = Notional*(9%*FX1/FX2 – 4.5%)

where FX1 is FX at reset dates and FX2 is initial FX

♦ Callable PRDC: investors sells option on the potential upside at pricing, monetizing that upside into option premium embedding it in an enhanced guaranteed initial coupon


Dollar Yen PRDC

♦ During the days when the PRDC was popular in Japan, USDJPY rate differential was large (highly negative), so long dated forward was very low (i.e. the forward predicted that USD will weaken against JPY significantly)

♦ USDJPY was not perceived to follow the forward


A closer look

♦ Dual currency note: investor enters into a JPY funded long USD forward

♦ Reverse dual currency note: investor enters into a cross currency coupon swap receiving USD coupons instead of JPY coupons

♦ PRDC: similar to the reverse dual currency note on the one hand and similar to the reverse floater note on the other hand

– Investor enters into a cross currency coupon swap receiving USD coupons paying JPY coupons at a certain number of times of leverage

– Investor realizes the USD coupons in JPY at the FX at reset dates

– Investor buys protection against negative coupons

♦ Investor can further risk the principal amount by incorporating the risk from the dual currency note


The callable structure

♦ Reward: in general the underlying exposure is a long dollar short yen position. Investors sells option on the potential upside and so short ATM FX volatility and long FX volatility at lower strikes. The note can achieve higher valuation, and thus will be called if

– Dollar strengthens against yen

– Yen rate rises

– Dollar rate falls

– ATM volatility comes in

♦ Risk: the main risk is if dollar weakens more than the forward, the investor will be stuck with the note and realize low coupons

SECTION 8

Basket Products


Relationships

♦ You may have a view about how two underlying co-move

♦ USDJPY and EURJPY

♦ USDJPY and AUDJPY

♦ USDJPY and N225

♦ You can trade a derivative on a basket


Correlation

♦ Correlation affects the pricing of derivatives on a basket

♦ Correlation affects the pricing of the forward

– If co-movement leads to losses in the hedge, then positive correlation is a cost

– If co-movement leads to profits in the hedge, then positive correlation is a benefit

♦ Correlation affects the pricing of volatility

– If correlation enhances the fluctuation of the return of the basket then the basket volatility is higher

– If correlation causes cancellation and dampen the fluctuation of the basket then the basket volatility is lower

♦ By using the pricing of correlation in the market relative to the view about correlation of the investor, one can increase the leverage in structures


Basket 1

♦ Half the amount in A and half the amount in B

♦ If the correlation is much less than 1, what is the chance of scoring 5 on the basket?

♦ If your view is that the marketis going to go upanyway, what isyour trade?

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0

(0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5

(1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0

(1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5

(2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5 3.0

(2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0 2.5

(3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5 2.0

(3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0 1.5

(4.0) (3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5 1.0

(4.5) (4.0) (3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0 0.5

(5.0) (4.5) (4.0) (3.5) (3.0) (2.5) (2.0) (1.5) (1.0) (0.5) 0.0


0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.0 1.0 1.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.0 1.0 1.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 1.0 1.0 1.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Basket 2

♦ Get paid 1 if both A and B are equal or more than 3, else nothing

♦ If the correlation is much less than 1, what is the chance of getting a payout?



Basket 3

♦ Worst of A and B

♦ If the correlation is less than 1, what is the chance that you have a positive score?


(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0 4.0 5.0

(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0 4.0 4.0

(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 3.0 3.0 3.0

(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 2.0 2.0 2.0 2.0

(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 1.0 1.0 1.0 1.0 1.0

(5.0) (4.0) (3.0) (2.0) (1.0) 0.0 0.0 0.0 0.0 0.0 0.0

(5.0) (4.0) (3.0) (2.0) (1.0) (1.0) (1.0) (1.0) (1.0) (1.0) (1.0)

(5.0) (4.0) (3.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0) (2.0)

(5.0) (4.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0) (3.0)

(5.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0) (4.0)

(5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0) (5.0)


FX TARN

♦ FX1 is USDJPY, FX2 is AUDJPY

– Indexed rate = (FX1 – 106.41) x 1.00%

– Minimum rate = 0

– Maximum rate = (FX2 – 87.77) x 1.00%

– Structure early terminates if aggregate coupon > 19.20%

– Final redemption USD or AUD whichever cheaper against yen

♦ A “worst of” basket of PRDC on USDJPY and AUDJPY

♦ Investor sells option on the potential upside via target redemption

♦ Final redemption uses a dual currency structure: the exposure is a forward on the “worst of” basket of USD and AUD

– However the forward is canceled if the note early redeems


Digital coupon trigger note

♦ Knock-out wedding cake structure (or knock-out range GROI) on the “and”basket of USDJPY and N225

Payout

“Price” levelKnock-out

level

SECTION 9

Summary


Many more…

♦ This class discussed the fundamental considerations in product structuring

♦ There are many more variations

♦ Also there are the credit products – if the market has not died out

– Credit Linked Notes

– First-to-default Notes

– Collateralized Debt Obligations

♦ Remember that a successful structure usually arises naturally from needs to meet investment objectives of the time

♦ More importantly, the success of the product hinges on the choice of the underlying and the structure that fits the time

– In the early part of the 2000’s there were many innovations in product structures

– But the later part is more about the selection and combination of the underlying risks, including commodities, rates, equities and FX

– What about in the global downturn?

APPENDIX A

Strategy Certificates & Cliquet PPN


Strategies

♦ A strategy is a plan that is intended to implement a view

♦ If you don’t have a view, you can’t have a strategy

♦ Structured products

– can implement a view

– can help to tailor risk and return profile

– at known cost

– with a more predictable results

♦ Structured products cannot

– make your view correct

– give you profits when you’re wrong


A real Sprint – the rolling speeder

♦ Your View is that the DAX will moderately outperform Fixed Income market

– Invest in DAX speeder over and over again

♦ Alternatively, invest in the Germany Rolling Sprint Index

– Open End Certificate on the Germany Rolling Sprint Index

– Management Fee: 75 Basis points per year

♦ Germany Rolling Sprint Index tracks performance of 1-months sprint certificate (speeder) on the DAX on a rolling basis

– Rolled over every months

– long at-the-money call and short 2 of the 3% out-of-the-money calls

– Option prices calculated at EUREX mid plus 1%

Optimisation


Cliquet Options

♦ You have a positive view on the Nasdaq

♦ You feel that you need a product that protects your initial capital

♦ You would also like to lock in the achieved gains, since you fear periodic downside corrections

♦ Invest in “Rolling PPN Strategy”– You pay the option premium on the roll-over dates

– The option premium will determine your participation

– Participation will the depend on future option market (future implied volatility)

♦ Why not buy all the options today, but set the strikes later at the then current index levels– Such an option is called “Cliquet or Rachet option”

– Cliquet options are baskets of forward-start options

Protection


Cliquet PPN on the Nasdaq 100 Index

Underlying Nasdaq

Nominal USD 5,000


Issue Date 6 February 2004

Maturity Date 6 February 2009

Guaranteed Minimum 5,000 at Exp

Coupon 2% p.a.

Monthly CAP 102.375%

Monthly FLOOR 95%

Max Redemption 242% of Nominal

Redemption Formula:

NA: Nominal GM: Guaranteed Minimum Payout NDXi: Level of the Index close of

business at the resetting date of month i

95%

95%

102.373%

Capped & Floored monthly Performance

Floored monthly performance

Summing up capped & floored monthly performances

Protection


Standard Cliquet PPN

♦ The investor in a Standard Cliquet is confident that the underlying will move up

– A Cliquet PPN pays the maximum performance in an up-trending market

♦ Cliquet PPNs lock in moves in the underlying that happened during the lifetime of Product

– The standard Cliquet is an alternative to the ‘Rolling PPN’ strategy

♦ In a volatile market environment Cliquet PPNs ‘filter out’ the positive periodic performances

– Standard Cliquet offers insurance against the risk of market downside

– With a Standard Cliquet you are long vega

Protection


Not afraid of downside moves?

♦ You are somewhat bullish on the market

♦ You believe that the Euro STOXX either trends slowly but constantly up or stays at its current levels

♦ You do not have a particularly negative view on Euro STOXX

♦ Specially, you do not think that there will be large periodic down-side moves in the index

♦ One possible strategy is to sell the upside you do not believe in– Why not invest in ‘Rolling Discount certificates’ explained earlier?

♦ Another strategy would be to sell the periodic downside protection you are not afraid of– In a protected form

– This is a Reverse Cliquet PPN


Reverse Cliquet PPN

Underlying Euro STOXX 50

Nominal EUR 5,000


Issue Date 30 April 2002

Maturity Date 30 April 2007

Guaranteed Minimum EUR 5,975 at Expiration (119.5%)

Max Redemption 190% of Nominal

Redemption The greater of Formula or Guaranteed Minimum

Redemption:The greater of

the Guaranteed Minimum Or

Nominal x (Max return – sum of negative monthly performances)

Max return – sum of negative monthly performances

SX5Ei: Level of the index close at the resetting date of month i

Protection


The Euro STOXX 50 so far

Date Price Monthly Cum Neg30-Apr-02 3574.23 Return Return

1 30-May-02 3388.44 -5.2% 5.2%2 1-Jul-02 3131.39 -7.6% 12.8%3 30-Jul-02 2691.91 -14.0% 26.8%4 30-Aug-02 2709.29 0.6% 26.8%5 30-Sep-02 2204.39 -18.6% 45.5%6 30-Oct-02 2468.8 12.0% 45.5%7 2-Dec-02 2662.49 7.8% 45.5%8 30-Dec-02 2386.41 -10.4% 55.8%9 30-Jan-03 2238.19 -6.2% 62.0%

10 3-Mar-03 2142.39 -4.3% 66.3%11 31-Mar-03 2036.86 -4.9% 71.2%12 30-Apr-03 2324.23 14.1% 71.2%13 30-May-03 2330.06 0.3% 71.2%14 30-Jun-03 2419.51 3.8% 71.2%15 30-Jul-03 2483.9 2.7% 71.2%16 1-Sep-03 2600.9 4.7% 71.2%

Date Price Monthly Cum NegReturn Return

17 30-Sep-03 2395.87 -7.9% 79.1%18 30-Oct-03 2571.51 7.3% 79.1%19 1-Dec-03 2674.62 4.0% 79.1%20 30-Dec-03 2750.09 2.8% 79.1%21 30-Jan-04 2839.13 3.2% 79.1%22 1-Mar-04 2918.56 2.8% 79.1%23 30-Mar-04 2791.58 -4.4% 83.5%24 30-Apr-04 2787.48 -0.1% 83.6%25 1-Jun-04 2713.29 -2.7% 86.3%26 30-Jun-04 2811.08 3.6% 86.3%27 30-Jul-04 2720.05 -3.2% 89.5%28 30-Aug-04 2697.05 -0.8% 90.4%29 30-Sep-04 2726.3 1.1% 90.4%30 1-Nov-04 2834.03 4.0% 90.4%31 30-Nov-04 2876.39 1.5% 90.4%32 30-Dec-04 2951.24 2.6% 90.4%

Redemption in 2007 will be EUR 5,975The product is now a Zero Coupon Bond


Contact Information

For further information:

•UBS Internal: Type ‘FME’ into your browser

•UBS External: Email [email protected]

[email protected]


Disclaimer

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Disclaimer continued

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