The use of structured products:

applications, benefits and limitations

for the institutional investor

Submitted by Anna Georgieva

Supervisors: Marcel Koebeli,

Marc Chesney, Pascal Botteron

December 2005

1
0. Introduction

1. What are structured products?

1.1. A definition
1.2. The generic exposure types

2. Applications

2.1 Payoff diversity

2.2 Isolating risks and exposure

2.2.1 Volatility
2.2.2 Correlation
2.2.3 Inflation
2.2.4 Credit
2.2.5 Hedge Funds

3. The institutional investor

3.1 Business needs and risk preferences
3.2 Institutional investors: readily invested in a structured product on the economy
3.3 Structured products, Indexation and the Core-satellite framework

4. Limitations of structured products as investment vehicles

2
0. Introduction

The institutional investor is in the business of understanding, pricing and managing risks to earn a
return for the benefit of all stakeholders. In this paper I discuss how structured products can be used by
institutional investors.

In a perfect world (Arrow-Debreu state-claim framework) there exist enough securities to recreate any
payoff. Some assumptions of this idealized world are: there exist basic securities, Arrow securities,
that they have a risk-free payoff in any state, no transaction cost, no information asymmetry, all
investors have the same expectations. Then derivatives are redundant instruments, as they can be
replicated. The price of the replicating strategy should be equal to the price of the derivative; otherwise
there is an arbitrage opportunity.

Several research papers discuss the optimal existence of derivatives. [Merton 1971], [Carr Madan
2001], [Carr Madan 1998], [Liu Pan 2003], [Ross 1976]) The research results are usually dependant
on assumptions about the process of the underlying. The case of including derivatives in an investor’s
portfolio is usually solved making the assumption that investor preferences follow a certain
mathematical function. The optimal investment in derivatives is then determined as the solution which
maximizes the investor’s utility function. A closed form solution may or may not be available
depending on the assumptions about the underlying process and the utility function.

I treat the problem in a practical, applied way. Needless to say, financial markets have readily justified
the existence of derivatives and derivatives related products. The focus is on how structured products
can be handy to an institutional investor, as opposed to how do we price, replicate and hedge them.
While in the back of every properly priced derivative there is a lot of mathematics, in this paper I
focus on the investment interpretation and application.

I present structured products as a natural investment choice of an institutional investor who faces the
business constraints of a liability stream and of stakeholder and client expectations. Their main
applications are in creating risk-return flexibility, isolating risks and providing exposure opportunities.
I point at possible specific applications, but there is no almighty product that will magically solve all
investment problems and unless a specific investor is consider it is impossible to make a strong
statement about the best choice.

For a retail institutional investor, structured products present new ways to reach the investment needs
of clients by adding new products to the product basket, preserving the level of distribution fees and
increasing the ability to raise new money.

For the pension or trust fund investor, in particular in a core-satellite framework, structured products
provide payoff flexibility, bundled or unbundled exposure to new and old asset classes, and can be
optimally added as satellites to the investment portfolio.

For the asset manager in an insurance company, structured products stand out with their ability to
implement sophisticated investment views, and to isolate and hedge risks.

Research on the pricing and replication of some of these structures are widely available; others do not
have a closed-form solution. The most flexible approach is using Monte Carlo (MC) pricing tool
Based on the martingale approach of derivatives pricing, this approach can price any possibly payoff
and has gained widespread acceptance among practitioners.

3
1. What are structured products?
1.1 A definition

Structured products are investment instruments that combine at least one derivative with traditional
assets such as equity and fixed-income securities. The value of the derivative may depend on one or
several underlying assets. Furthermore, unlike a portfolio with the same constituents the structured
product is usually wrapped in a legally compliant, ready-to-invest format and in this sense it is a
packaged portfolio.

The usual components of a structured product are a zero-coupon bond component and an option
component. The payout from the option can be in the form of a fixed or variable coupon, or can be
paid out during the lifetime of the product or at maturity. The zero-coupon bond component serves as
buffer for yield-enhancement strategies which profit from actively accepting risk. Therefore the
investor cannot suffer a loss higher than the note, but may lose significant part of it. The zero-coupon
bond component is a floor for the capital protected products. Other products, in particular various
dynamic investment strategies, adjust the proportion of the zero-coupon bond over time depending on
a predetermined rule.

From an economic point of view, the structured product can be broken down in two main components:

Investment view + Payoff structure = Structured product

The investment view is driven by factors such as:

• Investor expectations towards the underlying: bearish, flat, bullish, range bound, ladder etc
• Choice of underlying. The underlying may be available in a readily investable format or has to
be synthetically extracted:
o Single stock
o Basket of stocks
o Index or multiple indices
o Mutual fund, hedge fund, Fund of Hedge Funds, discretionary manager
o Systematically rebalanced strategy
o Volatility, correlation, dispersion
o Hybrid
o Credit
o Inflation
o Commodities etc

The investment view may be based on fundamental or technical research. The choice of the underlying
may depend on the market, on the investor’s expertise, and on fundamental factors.

Payoff structure
The payoff structure is a mathematical formula applied on the underlying. The features of the payoff
structure will include:

4
 • Cash flows timing: periodic coupons from an underlying that pays none; total lump payment
when underlying pays coupon; variable coupon or fixed coupon; fixed coupons during certain
periods of the life of the product etc.
• Risk profile: leverage, conditional capital protection, partial capital protection, full capital
protection
• Maturity: Short-term, medium-term or long-term

The importance of both components is evident when we look at the fundamental exposure types in the
next section. The focus here is that despite the fact that the option types have been known for a long
time, the investment view gives them a different interpretation.

1.2 The fundamental exposure types

The fundamental exposure types are the generic option payoffs. Combining these with a long zero
coupon bond gives the primal structured products, some of which have not failed to go out of fashion.
Figure 1 shows clearly the interaction between investment view and payoff structure. Some authors
seem to refer to prefer bullish payoffs, and consider only the payoffs in upper row of the table,
corresponding to the bullish investment view as structured products.

Fundamental exposure types

Delta one Yield enhancement Capital protected

(Certificate) products products -

+ + +

Bullish
investment view Premium

- - - Premium

1) 2)

+ + +

Premium
Bearish
investment view

- - -
Premium
3) 4)

Figure 1

5
 The Delta one (certificate) provides full exposure to the underlying. Investor gains wealth as
underlying appreciates and loses wealth as the underlying depreciates. The payoff is the same
independent of the investment view. The other 4 payoffs are:

1) Bullish investment view, yield-enhanced or return-enhanced exposure – capped upside,

unlimited downside. Investor prefers to sell the upside potential and receive a higher return.
Investor is actually bullish on the underlying, but prefers to cash in the expected return, rather
than wait for the uncertain appreciation to realize. Investor practically accepts the downside
risk of the underlying and receives a premium for that, which results in a higher yield
compared to the underlying.

2) Bullish investment view, capital protected exposure – floored downside, unlimited upside. The
investor pays a premium to ensure downside protection, but keep the upside exposure.

3) Bearish investment view, yield-enhanced exposure – capped upside, unlimited downside.

However the structure pays of when the underlying decreases in value.

4) Bearish investment view, capital protected exposure – floored downside, unlimited upside.
Again the structure pays as expected if the underlying decreases in value.

Typically, only payoff type 2), the long call, payoff is considered a capital protected payoff. Yet for an
outright bearish investor, this payoff is detrimental as it leaves him exposed to an appreciation of the
underlying.

The investment view is intrinsically connected to the split between yield-enhancement products, where
the investor chooses the higher risk-return combination, and capital protection, where the investor
prefers a lower risk-return combination.

These generic payoffs have been embraced by the market. I show 3 widely known products that can be
directly matched to 3 of the generic payoffs and also present an investment case for their use. These
are:

1) The Delta One (Certificate) (Figure 2 & Figure 3)

2) The Reverse Convertible – as an example of bullish yield-enhancement payoffs (Figure 5
&Figure 4)
3) The Capital Protected Note – as an example of bullish capital protected payoffs (Figure 6)

Other payoff structures cannot be easily classified as only yield-enhancement or capital protected type.
I discuss some of them Section 2.1

6
Delta One (Certificate)
Certificates have the same payoff as the underlying

‹ Investor wants full exposure to the underlying.

Investment idea

‹ Investor goes long a zero strike call.

Structure
‹ Short-, mid- to long-term investment horizon.
‹ The investor receives the full upside and downside of the underlying.
Payout
‹ Certificates are a flexible way to invest in customized baskets and
implement fundamental long-only investment ideas.
Price Performance

Time
100
100 Underlying price
Initial price

Figure 3
Certificate on a Pharmaceutical Basket
We are bullish on European pharmaceutical companies

‹ Our investment view is based on an expected increase in peak sales of new products,
industry cost savings as the sales mix shifts towards secondary care, and positive volume
outlook in the US as new prescription drug benefits for seniors start in the end of 2005.
‹ Structure
– We go long a zero strike call on a basket of the following stocks: AstraZeneca, Novartis,
GlaxoSmithKline, Essilor International, Merck, Pfizer, Cardinal Health Inc.
– The basket can be equally-weighted, performance-weighted or custom-weighted.
– 3 year maturity.

‹ The certificate pays the performance of the basket.

‹ Very low structuring fees.

Figure 2

7
Reverse Convertibles
Reverse Convertibles are yield-enhancement strategies with short maturity

Investment idea ‹ Moderately bullish or range bound view

‹ Investor go long a zero-coupon bond and short a put, or a short DIP put
Structure
‹ Short-term investment horizon

Payout ‹ A coupon is always paid.

‹ Depending on the product features the investor is exposed to a different
degree to the downside of the underlying.
Price Performance

Time
100

100
Initial price

13
Figure 5

Reverse Convertibles on Porsche

3 examples with different barrier levels

‹ Given the barrier for the DIN put or the strike for the short put we solve for the coupon.
‹ The lower the barrier level the lower is the coupon.
‹ This is a very popular yield-enhancement structure for a bullish investor.

Performance Priced examples

Underlying Porsche Porsche Porsche

Barrier
Barrier 70% 80% No barrier

Maturity 1 year 1 year 1 year

100 Underlying price
Initial price
Coupon 5.9% 8.47% 9.8%

14 4
Figure

8
 Capital Protected Notes (CPN)
Capital protected notes are downside protected investments

Investment idea ‹ Bullish on the underlying, but we want downside protection.

‹ We go long a zero-coupon bond and long an option with upside

Structure exposure.
‹ Short-, mid- or long-term investment horizon.

Payout ‹ 100% of invested capital plus a coupon (or upside participation).

Price Performance

Lower capital protection with

higher participation rate

Time
100
Underlying price
100
Initial price

23 6
Figure

The zero-coupon bond plus option component of the structure has direct implication on the taxation of
structured products. I review these in Appendix 2.

2. Applications of structured products in the portfolio of an institutional investor

In a general framework, the two applications of structured products are payoff flexibility and isolating
or bundling risks.

1. Payoff diversity and flexibility, payoff timing flexibility, leverage

It is almost impossible to define payoff diversity and flexibility that structured products can provide. I
present six structures that exemplify the payoff flexibility and diversity that structure products can
offer. These are:
1) The Autocallable (Figure 7, Figure 8 &Figure 9)
2) The Reverse Convertible Autocallable (Figure 10 & Figure 11)
3) The Springboard (Figure 12)
4) The CertiPlus (Figure 13)
5) The Plain Turbo Certificate (Figure 14)
6) The Leveraged Airbag (Figure 14)
9
The Autocallable and the Reverse Convertible Autocallable can be easily classified as yield-
enhancement products. The Springboard is a capital protected product. However the Certiplus, the
Plain Turbo Certificate and the Leveraged Airbag cannot be easily classified into one of the
fundamental exposure types, because they are vehicles to express sophisticated investment views.

All examples are applied to a single stock underlying. Considering how central correlation is in the
pricing of baskets, I present examples in section 2.2.

The autocallable acts as a rational investor who has a range bound view on the underlying. If the
underlying appreciates enough, it is autocalled and the structure ceases to exist, that is, the payoff is as
if the investor has taken profit on the underlying. On the other hand of the underlying stays underwater,
the investor receives a coupon. The worst-case scenario occurs when the underlying goes down by
more than the investor expected. Then the investor will receive the bad performing underlying, but this
loss is nevertheless partially offset by the coupons that the investor receives until maturity.

Autocallables
Autocallables are yield-enhancement strategies

Investment idea ‹ Range bound view on the underlying.

‹ We go long a zero-coupon bond, short a down-and-in put (DIP), long a

Structure series of binary calls
‹ High likelihood of coupon payment and partial protection.
‹ Short- to mid-term investment horizon.
‹ The structure autocalls if the underlying is above the trigger level in the
Payout years before maturity. The investor receives a coupon equal to the number
of years multiplied by the initial coupon level.
‹ If underlying matures above the initial level and has not been autocalled,
investor receives a coupon equal to the number of years multiplied by the
initial coupon level.
‹ If underlying matures between barrier and initial price, investor receives
100% back.
‹ If the underlying matures below the barrier, investor receives only the
performance of the underlying. This is the worst-case scenario.

Figure 7

10
 Autocallables
Barrier Autocallable payoff Performance
Price
Barrier
level
1) 2) 1)
Coupon
Time 100 Underlying price
100
Initial price
1 2 3
3)
2) Barrier
Barrier
level
4) Coupon

1) Autocalled at the end of period 1; Investor 100 Underlying price

receives 100% of invested capital + coupon. Initial price
2) Product continues until maturity and pays
Barrier
100% of capital + coupon equal to =
level
(number of years * coupon). 3)
3) Product continues until maturity; Investor
receives 100% of invested capital only.
4)
4) Product continues until maturity; investor Underlying price
100
receives the performance of the underlying.
Initial price

Autocallable of Porsche

‹ The 4 scenarios show the representative payoffs of the autocallable structure.

‹ In case 1 the structure ceases to exist after period 1, in all other cases it matures after 3
years.

Summary terms
Price
Underlying Porsche
Barrier 70%
1) 2) Maturity 3 years
Invested 100 CHF
amount
Time Coupon 11.5%
100
Payoff
3)
Case 1 111.5% (autocalled after 1 year)
70 Case 2 100 + 3*11.5% = 134.5%
Case 3 100%
65 4)
Case 4 65%

Figure 8 &Figure 9

11
 Autocallable Reverse Convertible
Autocallable on the Spread Performance
Price Underlying
Barrier
level
1) 2) 1)
Coupon
Time 100 Underlying price
100
Initial price
1 2 3
3)
2) Barrier
Barrier
level
4) Coupon

1) Autocalled at the end of period 1; Investor

100 Underlying price
receives 100% of invested capital + coupon. Initial price
2) Product continues until maturity and pays a
coupon every year. 100% of capital is
repaid at maturity.
3)
3) Every year a coupon is paid. At maturity the Coupon
investor receives 100% back..
4) Every year a coupon is paid. Since the 4)
Underlying price
barrier is triggered the investor receives the 100
performance of the stock at maturity. Initial price

Autocallable Reverse Convertible

‹ An autocall occurs in year i if the following occurs

UNDERLYING t
f1
UNDERLYING 0

‹ Example for Swiss underlyings, 3 years, 60% Barrier, CHF

Underlying Coupon
UBS 4.00%
Novartis 3.50%
Roche 5.20%
Swiss Re 5.00%
Ciba 3.95%
Credit Suisse 4.90%

Figure 10 & Figure 11

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Springboard
The Springboard profits from a sophisticated upside exposure view

‹ Bullish range bound view

Investment idea

‹ Long leveraged zero-strike call, short deleveraged call

Structure
‹ Short- to mid-term investment horizon.
‹ The springboard provides leveraged exposure up to the level of the
Payout
short deleveraged call

Performance
Price

Time
100
Underlying price
100
Initial price

Figure 12

CertiPlus
The CertiPlus products combine downside protection up to a certain level and upside
potential
‹ Range bound bullish/bearish on underlying
Investment idea

‹ We go long a zero strike call and long a down-and-out put (DOP)

Structure
‹ Short- to mid-term investment horizon
‹ We cash in a high coupon as long as the underlying stays between the
Payout barrier level and the strike level, but we are exposed to the downside
below the barrier
Price Performance

Barrier Strike
Time
100
100 Underlying price
Initial price

Figure 13

13
Variations
Turbos generate an Outperformance compared to the Underlying
Performance
‹ Plain Turbo Certificate
– Outperformance between the 2 strikes. Cap Level

– Full downside exposure.

– Long ATM call, long zero strike call,
100 Underlying price
short 2 OTM calls. Initial price
– Short-term investment horizon.

Performance

‹ Leveraged Airbag
Strike
– Outperformance on the upside and partial Level
downside protection.
– Long zero strike call, long ATM put,
100 Underlying price
short a leveraged OTM put, long a fraction
Initial price
of an ATM call.
– Mid-term investment horizon.

Figure 14

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 2. Isolating risk and gaining exposure: volatility, correlation, inflation, credit, hedge funds

Structured products provide the capacity to isolate and trade asset classes that are mixed-in in
traditional assets or may not be directly investable due to constraints on the asset side or the investor
side. I look at 5 specific investment classes: volatility, correlation, inflation, credit and hedge funds.
Not all of them are recognized as asset classes; however the existence of structured products shows
investor interest.

An asset class is a set of investments that exhibit similar and distinctive investment characteristics
(return, volatility and relationship to the returns of other investment assets). The asset class represents
a distinctive type of risk. For accepting this risk any rational investor expects to earn an appropriate
return. The rational investor judiciously accepts risk and expects an appropriate return.

2.1 Volatility

Derivatives are both directional and volatility instruments (Neftci provides an excellent exposition).
That is, the investor makes a bet both on the direction which the underlying will take and on implied
vs. actual volatility. If the actual volatility exceeds implied volatility the long side of the transaction
will realize a profit, assuming all other factors the same. Vice versa, if the actual volatility is lower that
implied volatility the short side of the transaction will realize a profit at the maturity of the option.
Volatility is an exogenous input in the Black-Scholes (or another pricing formula or Monte carlo
simulation) and it shows the volatility view of the investor.

The specific dynamics of volatility can be summarized in the following 4 points

• It jumps when the market crashes
• It reverts back towards its long-term mean
• It experience high and low regimes
• It is usually negatively correlated with the underlying asset return

[GM 1998], [Qu 2000] discuss volatility as an asset class. [Carr and Madan 1998] provide the
replication and pricing formula for volatility and variance swaps.

Volatility structured products can be used to make sophisticated bets on volatility. An excellent
exposition on the pricing of volatility products are the classic [Derman ??], [Hosker ??] and [Mougeot
2005]. The following table summarizes some of the applications.

Straddle Delta- Variance Gamma Conditional Corridor Correlat

hedged swap swap variance variance ion
option swap swap swap
Volatility bet + + ++ ++ ++ ++ –
Volatility – – ++ + + ++ –
hedging
Dispersion + – ++ ++ – – –
trading
Correlation – – + ++ – – ++
trading
Asymmetric – – - + ++ ++ –
vol bets
Smile – – ++ ++ + + –
trading

15
While volatility swaps on currencies exist, the main application seems to be in equity index and swap
rate volatility. For an indexed investor, the volatility swap is of direct interest as it can help be used to
manage the tracking error. Apart from the swaps presented above, other volatility products are:

• Volatility options – An example is a call option on volatility. The option gains rapidly in value
when volatility increases sharply.
• Volatility swaps combined with equity futures – volatility swaps entail an implicit directional
view on market price movements. There is evidence of negative correlation between the equity
market performance and the level of volatility. Volatility tends to be high during market
crashes. Thus, the seller of volatility swaps has an implicit expectation that the equity market
will increase in values and the buyer has an implicit expectation that the equity market will
decrease in value. To hedge the directional effect of the volatility swap the investor can trade
equity futures.
• Volatility bonds – the coupon is proportional to the difference in the swap rates of a certain
maturity, for example the 20 year swap rate, between the start and the end date of each year.
The investor is buying a series of 20 year swaption straddles.

Here I show an example where variance swaps can be directly used to hedge secondary guarantees
offered by insurance companies. Secondary guarantees exist in two forms: death benefits and living
benefits. Among living benefits the most popular product are the guaranteed minimum withdrawal
benefits (GMWBs), which guarantee the principal, may allow step-ups and allows set percentages of
withdrawal each year, even if account values is zero. The key attraction to customer of this product is
the protection against another bear market and they give life insurers a competitive advantage over
mutual fund providers.

The main risk for the insurer offering such a guarantee is a prolonged equity downturn which poses a
“catastrophe” type risk. The GMWBs will go deep in the money potentially creating large losses for
the insurance company if they are not properly hedged.

Because secondary guarantees are long-term illiquid benefits with liabilities that are expected to
extend over a 20-30 year time period and contain the uncertainty of policyholder utilisation rates, there
are essentially no financial derivatives that can be found to form a perfect hedge. Even if derivatives
were available for 20-30 year periods, the counterparty risk over such long durations would be
unacceptably high.

The long-term illiquid nature of the benefits means that they are suited to dynamic hedging strategies.
The insurer will establish a portfolio of fairly short-dated futures and put and call options which can be
rolled over providing a rolling hedge to offset the guarantee risks based on assumptions about future
market behaviour and policyholder utilisation. The dynamic element of the strategy lies in using
futures and options that are typically fairly short dated at around 3-9 months as these are normally the
most liquid. By rolling the positions over and adjusting those to reflect changes in the book, often on a
daily basis, a fairly effective continuous hedge against most market risks can be achieved.
The three Greeks of concern are:

Hedging Greek Risk Typically used instruments

Delta Change in the market value of the Equity Futures
fund
Vega Change in the market volatility Put and call options (straddles)
Rho Change in interest rates US Treasury futures

16
The straddles are the easiest way to partially hedge volatility, however they do not provide pure
exposure to volatility. The problem with the straddle is that once the stock price has moved away from
the initial level, the straddle delta is not zero anymore. Also, since both options are initially in the
money, straddles are usually expensive.

For the insurance company, the variance swap is the best hedging solution. The variance swap is a
forward contract that pays at maturity the difference between the realized variance of an underlying
and the initially defined variance strike price K.

The Variance Swap

Buyer and seller exchange payments based on the level of variance

σ *N
2

Variance buyer Variance seller

KVariance * N

‹ Carr and Madan show that the variance swap can be replicated by a continuum of puts and
calls inversely wghted by the sware of their strike price. The solution is model-free.
‹ The perfect hedge involve buying a continuum of put with strike from 0 to Fo, the current
level, and buys a continuum of call options with strikes from Fo to infinity:
2e rT ⎡ F0 1 ∞ 1 ⎤
V f [σ 2 0,T ] = ⎢
T ⎣0 K ∫ 2
P0 ( K )dK + ∫
F0 K 2
C0 ( K )dK ⎥
⎦

Figure 15

2.2 Correlation

Correlation is a key input into the pricing formula of baskets of securities. Therefore, in a manner
similar to betting on volatility, the investor can bet on correlation. If realized correlation is lower or
higher than the implied correlation the investor may realize a gain or loss depending on whether the
investor is long or short correlation.

While in linear payoffs correlation and volatility are positively correlated, there are payoffs where the
investor can profit from high volatility and low correlation of the stocks in the basket. These are the
so-called dispersion payoffs. I give an example to show why such a product can be interesting for an
investor.

17
Correlation is usually measured as

Cov( A, B) 1 n SA 1 n
ρ A, B = and Cov( A, B ) = ∑1 ( Ai − A )( Bi − B ) and Ai = ln( iA ) , A = ∑1 Ai
σ A ,σ B n Si −1 n

This formula clearly makes the assumption that the log returns of the two assets are normally
distributed, and may underestimate or overestimate true correlation if this is not the case.

Correlation is a measure of the diversification and is closely linked to the volatility of the basket.

To show the link between correlation and volatility, let us consider a basket of two stocks, A and B,
and assume that both have a constant volatility of 25%. As the correlation increases from -100% to
100% the volatility of the basket will increase at a decreasing rate and will finally be equal to the
arithmetic average of the volatilities of the two stocks (Figure 16). The non-linear rate of decrease is
due to the fact that volatility is a power function in correlation.
Volatility of the basket in %

30%

25%

20%

15%

10%

5%

0%
-100% -50% 0% 50% 100%

Correlation in %

Figure 16

Correlation is not considered a separate asset class, possibly due to its direct linked to volatility.
Correlation in credit derivatives markets has become a key input commensurate to volatility in equity
derivatives markets. I discuss it briefly in section 2.4. Correlation between asset classes is also still a
research topic.

Correlation is also the measure of diversification. Correlation is low when the stocks in the basket
move apart, and is high when the stocks in the basket move concordantly. When the market is bullish
and correlation is high, the investor wants to be long correlation, so that he can profit from the
leverage effect. Yet, when market is bearish and correlation is high the investors wants to be short
correlation, so that he can benefit from the diversification effect.

Dispersion bets are bets that stocks in the basket will move in different directions. The best payoff is
achieved when we take the difference between the best performing stock and the worst performing
stock. This can be achieved through a combination of a long lookback call plus a long lookback put.

18
This is obviously the primal volatility trade, and due to the lookback feature it can be prohibitively
expensive.

With the proper payoff structure, the dispersion of the stocks in the basket can generate higher IRR or
consistent and uncorrelated performance.

First, I compare the price and the IRR of a structured product that pays off the average of call spreads
on a basket of stocks and a structured product that pays the call spread on the average of basket of
stocks. I introduce the floor and the cap in order to obtain financially sensible prices and results.

Basket of Call Spreads

The coupon is the average of the call spreads on the underlyings

‹ Moderately bullish on a basket of 3 indices (NKY, SPX, FTSE)

Investment idea
‹ But we want downside protection.

‹ We go long a zero-coupon bond and 3 long call spreads on the indecis.

Structure
‹ Mid- to long-term investment horizon.

‹ 100% of invested at maturity.

Payout
‹ The coupon depends on the return of the stocks in the basket and is
capped.
‹ The annual coupon is paid accordingly to the following formula:

1 3 ⎛ ⎛ Indexi, t ⎞⎞
∑
3 i =1
Max⎜ FloorLevel , Min ⎜⎜
⎜
, CapLevel ⎟⎟ ⎟
⎟
⎝ ⎝ Indexi,0 ⎠⎠

Figure 17

19
 Call Spread on a Basket
The coupon of the Call Spread on a Basket depends on the average performance of a
basket

‹ Moderately bullish on a basket of 3 indices (NKY, SPX, FTSE)

Investment idea
‹ But we want downside protection.
‹ We go long a zero-coupon bond and a long call spread on the indices in
Structure the basket.
‹ Mid- to long-term investment horizon.

Payout ‹ 100% of invested at maturity.

‹ The coupon depends on the average return of the stocks in the basket
and is capped.
‹ The annual coupon is paid accordingly to the following formula:

⎛ 3
1 ⎛ Index i, t ⎞⎞
Max⎜ FloorLevel , ∑ x Min ⎜⎜ , CapLevel ⎟⎟ ⎟
⎜ i =1 3
⎟
⎝ ⎝ Index i,0 ⎠⎠

Figure 18
I choose 2 indices that are correlated (the S&P 500 and the FTSE 100) and one (the Nikkei) that is not
correlated.

Historical Performance
Performance of the 3 indices during the backtest period 20-Dec-1990 until 20-Dec-2005

Index

500

450

400

350

300

250

200

150

100

50

0
Dec-90 Oct-91 Aug-92 Jun-93 Apr-94 Feb-95 Dec-95 Sep-96 Jul-97 May-98 Mar-99 Jan-00 Nov-00 Sep-01 Jul-02 Apr-03 Feb-04 Dec-04

NKY FTSE S&P 500

Figure 19

20
The correlation matrix fed into the MC prices is the same. (3 year period 20-Dec-2002 until 20-Dec-
2005, daily observations)

Correls (avg) 57.00%

20-Dec-02 UKX NKY SPX

UKX 100.00% 51.59% 67.84%
NKY 51.59% 100.00% 51.56%
SPX 67.84% 51.56% 100.00%

Figure 20

The call spread on the basket clearly dominates the average of the call spreads, because of the bubble
period. The call spread on the basket is a dispersion trade compared to the basket of call spreads as the
average of the basket out or underperforms the individual call spreads as the indices disperse up or
down, while the call spread on the individual indices does not allow them to disperse outside of the
cap and the floor. Despite the fact that there is no leverage applied, we observe a leverage effect that
will clearly be stronger if correlation would increases and vice versa.

Price and IRR Comparison

Call spread on basket Basket of call spreads

‹ Underlying Indices: SPX, NKY, FTSE 50%

‹ Maturity of 5 years with annual coupons 40%

‹ Floor 95%, cap 120% 30%

‹ Charts on the left show IRR distribution 20%

(top) and historical IRR
10%

0%

.7 % to 3 .5
%
to 7 .7
% .9% 1 6.1
%
to 2 0
%
to -0 to 1 1 % to
Call spread on Basket of call -4 .9 % -0 .7 % 3 .5 % 7 .7 % 11.9 1 6.1%
basket spreads
Basket of call spreads Call spread on basket
Average 9.93% 7.76% 25%
Min -5.00% -5.00%
Max 20.00% 18.82% 20%

Price 21.99% 22.18% 15%

Call spread on Basket of call 10%

Range basket spreads
5%
-4.9% to -0.7% 18% 18% 16-Apr1996
11-Jul-2001
-0.7% to 3.5% 6% 5% 0%
3.5% to 7.7% 10% 8%
-5%
7.7% to 11.9% 12% 44%
11.9% to 16.1% 23% 20% -10%
Dec-95

Dec-96

Dec-97

Dec-98

Dec-99

Dec-00

Dec-01

Dec-02

Dec-03

Dec-04

Dec-05

16.1% to 20% 30% 5%

Figure 21

21
 Two Examples from the Backtest

FTSE NKY S&P 500 Call spread Call spread on Call Spread on Basket of call Call spread on
FTSE NKY S&P 500 return return return Average on FTSE NKY S&P 500 spreads basket
16-Apr-91 2,519.50 26,813.30 387.62
16-Apr-92 2,638.60 17,959.76 416.04 5% -33% 7% -7% 4.7% 0.0% 7.3% 4.0% 0.0%
16-Apr-93 2,824.40 20,297.86 448.94 12% -24% 16% 1% 12.1% 0.0% 15.8% 9.3% 1.2%
18-Apr-94 3,138.20 20,277.36 442.46 25% -24% 14% 5% 20.0% 0.0% 14.1% 11.4% 4.8%
17-Apr-95 3,208.80 16,304.15 506.13 27% -39% 31% 6% 20.0% 0.0% 20.0% 13.3% 6.2%
16-Apr-96 3,825.30 21,868.17 645.00 52% -18% 66% 33% 20.0% 0.0% 20.0% 13.3% 20.0%
IRR 9.8% 5.9%

FTSE NKY S&P 500 Call spread Call spread on Call Spread on Basket of call Call spread on
FTSE NKY S&P 500 return return return Average on FTSE NKY S&P 500 spreads basket
11-Jul-96 3,749.00 21,892.58 645.67
11-Jul-97 4,799.50 19,875.49 916.68 28% -9% 42% 20% 20.0% 0.0% 20.0% 13.3% 20.0%
13-Jul-98 5,958.20 16,360.39 1,165.19 136% -25% 80% 64% 20.0% 0.0% 20.0% 13.3% 20.0%
12-Jul-99 6,545.50 18,274.18 1,399.10 160% -17% 117% 87% 20.0% 0.0% 20.0% 13.3% 20.0%
11-Jul-00 6,475.80 17,504.36 1,480.88 157% -20% 129% 89% 20.0% 0.0% 20.0% 13.3% 20.0%
11-Jul-01 5,391.90 12,005.11 1,180.18 114% -45% 83% 51% 20.0% 0.0% 20.0% 13.3% 20.0%
IRR 13.3% 20.0%

Figure 22
I show two particular examples in Figure 22. In the last two columns “Basket of call spreads” and
“Call spread on basket” I show the calculation of the IRR.

The second dispersion payoff structure shows how dispersion can be used to create decorrelated
returns.(Figure 23 & 24)

Dispersion
The coupon is the average of calls on the absolute value difference between the
performance of each index and the average of the basket

‹ Indices within the basket will disperse

Investment idea
‹ We want downside protection and decorrelated returns

‹ We go long a zero-coupon bond and 3 long call spreads on the indecis.

Structure
‹ Mid- to long-term investment horizon.

‹ 100% of invested at maturity.

Payout
‹ The coupon is calculated as follows:

1 3 Indexi , t 1 3 Indexi , t
Min(CapLevel, ∑ − ∑
3 i =1 Indexi , t − 1 3 i =1 Indexi , t − 1
)

Figure 23
22
 Dispersion – Price and IRR
‹ Underlying Indices: SPX, NKY, 60%

FTSE 50%

‹ Maturity of 5 years with annual 40%

coupons
30%

‹ Cap level 5.5%

20%

‹ Charts on the left show IRR

10%
distribution (top) and historical IRR
0%

to 3.2% to 3.6% to 4% 4 .4% to 4.8% to 6%

2.8% 3.2% 3.6% 4% to 4.4% 4.8%
Average 4.73%
Min 2.81% 7%

Max 5.50% 6%
Price 20.80%
5%

Range Frequency 4%

2.8% to 3.2% 0.4%

3%
3.2% to 3.6% 4.6%
3.6% to 4% 7.9% 2%

4% to 4.4% 15.8% 1%
4.4% to 4.8% 20.7%
0%
4.8% to 6% 50.6%
Dec-95

Jun-96

Dec-96

Jun-97

Dec-97

Jun-98

Dec-98

Jun-99

Dec-99

Jun-00

Dec-00

Jun-01

Dec-01

Jun-02

Dec-02

Jun-03

Dec-03

Jun-04

Dec-04

Jun-05

Dec-05
Figure 24

2.3 Inflation

Inflation presents a major risk to institutional investors concerned with capital preservation. The
purpose of inflation derivatives and inflation structured products is the transfer of inflation risk.
Although cash instruments already exist (inflation-linked bonds) inflation derivatives allow for tailor-
made solutions. I discuss some of these after a brief review of the market.

Inflation products are attractive to banks, pension funds, mutual funds and insurance companies.

Institutions that are natural inflation payers can benefit from issuing inflation-linked debt in the market
or from selling inflation. Inflation derivatives are attractive to debt investors who prefer real returns
rather than nominal returns or to investors who are looking to hedge their inflation exposure.
Furthermore, inflation linked securities will have a lower nominal cost to the issuer reflecting the
lower risk premium as the real rate is guaranteed.

Investment managers face implicit inflation risks. Inflation receivers are typically institutional
investors who need to pay inflation-linked cash flows. For example, the liabilities of pension and
superannuation funds, workers compensation insurers and disability insurers are linked directly to
inflation or indirectly linked to inflation through salary or other income levels. Furthermore, fixed-
income specialist mutual funds/unit trusts have been established to invest in inflation indexed
securities. If the current trend of a changeover from defined-benefit to defined contribution pension
schemes continues, retail investors and mutual funds can become key players in the market of private
23
pension schemes, long-term savings solutions and retirement income products and they will look to
provide inflation hedge for their clients.

The Market for Inflation Products

Overview of the participants in the gloabal inflation market

Inflation Payers
Inflation receivers
ƒSovereigns
ƒPension funds
ƒUtilities Global ƒInsurance companies
ƒAgencies Inflation ƒInflation mututal funds
ƒProject Finance Market ƒRetail banks
ƒReal Estate
ƒCorporates (ALM)
ƒRetailers
ƒOthers
ƒOther

Payers/receivers
Investment banks
Hedge funds
Relative value funds
Other

Figure 25
The case of inflation as a separate asset class is discussed in [Borutta 1997] and [Lamm 1998]. The
key arguments for considering inflation as an asset class considering its risk-return characteristics are:

• Inflation linked securities will underperform conventional investments in times of low inflation,
but will outperform at times of high inflation. This is a distinguishing return feature.
• Inflation linked securities have lower volatility than conventional securities
• The correlation of inflation linked securities with other asset classes is similar to conventional
fixed-income securities. At time of high inflation however, it will be negative as inflation
linked securities will not experience loss of value.

The whole variety of fixed-income payoffs such as forwards, various option on inflation, swaptions on
inflation etc, can be applied to inflation. Unlike inflation-linked bonds, inflation derivatives can be
applied as an overlay on the existing asset allocation, or included as partial hedges.

The inflation swap is a flexible solution to hedge inflation risk. It is a bet on the breakeven inflation
level and is similar to an unfunded interest rate swap, except for the fact that the underlying payments
depend on the level of an inflation index.

24
Breakeven Inflation
Breakeven inflation is the spread between nominal yield and real yield

– If we think of nominal yields as being (~ Fisher equation):

Nominal yield = Real yield + Inflation

– Rearranging the equation:

Breakeven inflation = Nominal yield − Real yield

(Ex-ante) (Ex- post) Investor Preference

Breakeven Actual/realized Investor is indifferent between an
inflation = inflation IL bond and a nominal bond
Breakeven Actual/realized Investors make money by holding nominal bonds as
inflation > inflation inflation component of payout is less than expected

Breakeven Actual/realized Investors make money by holding IL bonds as they

inflation < inflation receive protection from higher than expected inflation

Figure 26

The Inflation Swap

Applications
‹ For institution with an inflation exposure
– Hedge concentrations of inflation risk
– Hedge inflation exposures that are not traded in the cash market
– Easily match the maturity of the inflation exposed liability.
– The swap is off-balance sheet and there is no regulatory charge
‹ For investors and arbitrageurs
– Take a view on inflation, go long or short inflation which may not be possible with
inflation linked bonds
Net Index Increase

Fixed rate
Inflation
Inflation buyer
Or Seller

LIBOR - spread

Figure 27

25
2.4 Credit

Credit-sensitive bonds are one of the first yield-enhancement investments available. By investing in
corporate bonds and loans, or sovereign debt the investor receives an additional return spread over the
risk-free rate. The investor however is exposed to the default of the counterparty.

The credit-sensitive bond is (similar to) a short put on the value of the company. While credit risk has
historically been regarded as illiquid, credit derivatives have successfully isolated it from the
underlying credit asset (bond, loan etc). The CDS is the basic credit derivative, and economically it is
a short put. Packaged with a bond component, the CDS is similar to a reverse convertible. Unlike the
reverse convertible however, the premium is paid over the life of the product. FtD baskets are the
credit equivalent of the worst-of-put baskets from the universe of equity products.

Historically, credit has been regarded as illiquid. This has been due to sensitivity bank-client
relationship and the high administration costs and market frictions.

Structured credit products have the capacity to provide pure exposure to credit risk. Furthermore, they
provide the investor with the ability to trade credit in a liquid format with relatively low transaction
costs.

The use of credit derivatives allows the separation of credit and liquidity premiums on the credit-
sensitive securities. For the traditional credit investor, this means that instead of investing in relatively
illiquid corporate bonds, he can invest in highly liquid securities and overlay with credit derivatives,
economically achieving the desired yield-enhancement effect but maintaining high liquidity. This is a
major benefit for the liquidity-conscious ALM investor.

Credit risk has low correlation with property and casualty risk. Therefore it makes a valuable addition
to the investment portfolio of an insurance company.

The [BAA 2004] outlines the market for credit structured products is comprised of the following
products as follows:

• CDS
• Synthetic CDOs
• Index linked structures
• Credit linked notes
• Credit spread products
• Asset swaps
• Total return swaps
• Basket products
• Equity-linked products

CDS take up to 51% of the market and are the building block of the credit market. Synthetic CDOs,
index linked structures, some credit linked notes, basket products and credit spread products use single
name CDS.

CDS are short puts on credit, and thus can be straightforward described as yield-enhancement products.
Index linked structures can be in delta one form or may be used as underlying and combined with a
payoff structure. Asset swaps ant total return swaps are economically similar to the delta one payoff.
Credit linked notes and credit spread products are similar to the equity structured products presented in
Section 2.1. Basket products are similar to baskets of options, typically the options being single name
CDS.
26
As products unique to the credit world, I look at CDOs. CDOs are attractive to investors as they
provide the ability to invest in a diversified portfolio of credit risks, they provide payoff structures that
are otherwise not available in the cash market (the tranches are options), and leverage and credit
management expertise.

CDOs bundle the following 2 risks: credit and correlation. The tranches of the CDO can be viewed as
standalone options and they can be used to take investment views or hedge the 3 underlying risks.

CDO Tranches as Options

CDO tranches are options on the underlying pool of credits
‹ The equity tranche loss is a short the tranche loss (losses are negative) up to the exhaustion point K1;
the investor is effectively long gamma as he benefits from uncertainty regarding the loss amount
‹ The mezzanine tranche loss is short a put option written to the equtiy investor and long a put option
written by the senior investor. The strikes are the the attachment point K1 and the detachment point
K2
‹ The senior tranche loss is a long call option on the underlying loss with strike K2, the senior investor
is short gamma
‹ As such investor can monetize second order risks

Equity Tranche Loss Mezzanine Trance Loss Senior Trance Loss

K1 K2 Loss K1 K2 Loss K1 K2 Loss

Figure 28

[Thompson, Trinh, Greenberg 2004] is an excellent source of insight about investing in CDOs from an
investor’s standpoint. Figures 29, 30 and 31 present their results.

27
CDO Tranches as Options
‹ The distribution of the senior tranche is negatively skewed with large excess kurtosis
‹ The distribution of the mezzanine tranche is less negatively skewed, has smaller excess kurtosis and fatter left tail
‹ The equity tranche has a distribution with small negative skewness, due to the limited upside

Source: [Thompson, Minh, Greenberg 2004]

Figure 29

Sensitivities of the CDO Equity Tranche

‹ The equity tranche profits from increasing correlation and low volatility
‹ The larger the equity tranche the higher the return
‹ Spread widening increases volatility and decreases return

Source: [Thompson, Minh, Greenberg 2004]

Figure 30

28
 Sensitivities of the CDO Equity Tranche
‹ [Thompson, Minh, Greenberg 2004] show that CDOs provide diversification to the credit inverstors in
two ways:
– Exposure to credit risk with less interest rate risk than corporate bonds
– Leveraged exposure to credit since CDO tranches are options on the loss of the credit pool
‹ Realistic asset allocation and statistical studies are not feasible due to insuffiecient historical data
‹ Optimizing a portfolio of credit with a CVaR they show that including CDO tranches can expand the
efficient frontier of a credit investor

Figure 31

2.5 Hedge Funds

The case of investing in hedge funds has been increasingly drawing the attention of institutional
investors. While hedge funds have not been definitely classified as a separate asset class, structured
products are available to meet the institutional investor’s interest and overcome the difficulties of
investing directly.

Two potential features make hedge funds attractive for an institutional investor: superior investment
management and niche investment strategies that can profit from market inefficiencies.

As an investment vehicle, hedge funds exhibit specific constraints:

Limited liquidity
No secondary market
Long valuation and settlement cycle
Low transparency

Yet, these and several big blow-ups during the last decade have failed to cool the investors interest.

As an investment vehicle, hedge funds exhibit higher return and higher volatility, potentially leverage
and are exposed to gap risk

29
Popular structured products on hedge funds provide:

• Full exposure – plain certificate, total return swap

• Capital protection – typically zero-coupon bond plus call option, CPPI, option on CPPI
• Leverage – option on CPPI, leveraged total return swap
• Portable Alpha – investor wants exposure only to the positive alpha of the hedge fund manager.
Therefore the investor goes long the hedge fund and shorts the hedge fund index or another
benchmark.
• Packaged solution - Collateralized Fund Obligations

Hedge Fund Structured Products

Most popular structured products on hedge funds
Lower risk-return Higher risk-return

Dynamic principal protection Bank provided leverage

Static principal protection CFO Equity

Direct
investment
Exotic options
CFO Senior Tranche CFO Mezzanine
Call options
Source: Man Investements

Benefits of structured HF products for investors Managed accounts: the newcomer in the product pallette
Other
Regulatory/A 2%
ccounting Leverage ‹ Managed account platforms are vehicles for
6% 41% perfomance duplication of pools of hedge funds
Risk ‹ They take over administrative tasks that make
management
investing in hedge funds difficult
7%
Customised – Heavy due dilligence and control
basket
– Reporting and riks management
8%
Principal – Provide liquidity
Better tax protection
treatment
– Administration of the segregated pool
23%
13%
Source: Man Investements Source: Lehman Brothers, Credit Agricole

Figure 32

30
Traditionally, options and traditional structures were not suitable for hedge funds, due to the fact that
the underlying was not traded, there was no options market making gamma and vega hedging
impossible and the trading periods were infrequent so that even delta hedging could not be carried out
accurately.

The CPPI (Constant Proportion Portfolio Insurance) was introduced to overcome these problems. I
present it briefly and I compare it with options on CPPI and bond plus call payoff.

The aim of the CPPI structure is to maximize the exposure to a risky premium asset while
simultaneously guaranteeing a capital protection at maturity. To achieve this we reshuffle the portfolio
on a regular basis between the two components: a riskless component and risky premium asset.

We define target exposure as the maximum sustainable proportion of the balance account which can
be invested into the premium asset without jeopardizing the capital protection at maturity. The
difference between the portfolio value and the bond floor is called distance, and it is the amount of
capital that can be put at risk without jeopardizing the capital protection at maturity

The multiplier is reciprocal to the crash size and denotes the maximum expected loss of the underlying
premium asset between two potential rebalancing dates. The rebalancing depends on the liquidity of
the underlying (daily to up to 3 months).

The main ides is to simulate a stop-loss strategy. Initially all funds are invested in the risky asset. If the
risky asset drops, its share is gradually reduced. If the risky asset increases in value, leverage may be
introduced.

The amounts invested in the risky asset and in the bonds are function of

• The volatility of the risky asset and the riskless asset

• The liquidity of the risky asset
• The returns of the risky asset
• The interest rate term structure

Because the rebalancing occurs non-continuously, the CPPI is actually exposed to gap risk. If the risky
asset drops between two rebalancing dates as low as the bond floor level, the so-called knock-out
occurs. There are no more funds available to invest in the risky asset and the CPPI turns into a zero-
coupon bond equivalent. This means that the CPPI is actually not suitable for highly volatile asset that
exhibits downward jumps. The best underlying for this structure is a low volatility, stable return risky
asset that out-performs the risk-free interest rate. Potential leverage benefits can actually recover the
cost of the CPPI. On the other hand, the CPPI is not appropriate for range bound risky asset as the
rebalancing will generate transaction costs and slippage.

31
 3. The institutional investor

3.1 Business environment and risk preferences

Institutional investors are large investors who accumulate wealth capital, manage it and disburse it to
match an uncertain liability stream. As long as the asset stream is greater than the liability stream there
is a surplus, or vice versa, there is a deficit. As deficits accumulate, the company will experience
deterioration of its financial position and may reach insolvency.

The academic framework to modelling the behaviour of the investor uses utility functions. The CARA
and the CRRA utility function families seem to be particularly popular as they have tractable
optimization solutions. However, as [Clarkson] points out, the limitations of mathematical modelling
of the risk perception of an individual may be outweighing the benefits.

The utility functions approach is mathematically elegant and provides the basis for determining ht
optimal investment weight in a portfolio of a risky and a risk-less asset. In the case of derivatives and
structured products investments, the risk-averse investor then should naturally prefer capital protected
products, due to their downside protection. The risk-loving investor should prefer yield-enhancing
structured products, which active take on risk and receive a higher return. However, the institutional
investor cannot be classified as risk-averse, risk-neutral or risk-loving.

The institutional investor faces the problem of matching a certain liability stream. The stream may be
of stochastic or non-stochastic nature. Furthermore, the institutional investor may face the
requirements of various stakeholders. The investor is risk averse up to a certain threshold, yet beyond
that maximizes expected profit. Risk aversion however in this case is not related to the preference of
more wealth to less wealth. The institutional investor is first and foremost concerned with the
avoidance of bankruptcy or regulatory action. I will call the amount of wealth below which the
institutional investor may start experiencing increasing cost of capital due to bankruptcy concerns the
minimum sustainability threshold. For a defined-benefit pension fund that has to provide a minimum
guaranteed return on the beneficiaries’ assets, the minimum sustainability threshold is this minimum
return. For a life insurance company it is the minimum guaranteed rate of return embedded in the life
insurance products.

Now, let’s assume that the institutional investor can meet this requirement at a satisfactory level, for
example with a probability of 99% over a horizon of 3 years. Then for any budget above this level we
cannot assume that the investor will be acting a risk-averse manner. Any budget above the minimum
threshold has to be spent in a way that maximizes the firm’s value or the beneficiaries’ profit. That is,
the institutional investor is expected to judiciously take risks and exercise professional expertise, and
we can describe this behaviour more as risk-neutral rather than risk-averse. That is, the investor will
expect constant additional return for each risk he accepts. Investing in a risk-averse manner in this case
is detrimental to stakeholders, as it is equivalent to paying for double protection that is actually not
necessary. This is further supported by the fact that any investor, be it risk-averse, risk-neutral or risk-
loving benefits from diversification, assuming that assets that are not perfectly positively or negatively
correlated exist.

We might be able to justify even risk-loving behaviour, if the manager remuneration is positively
dependent on the return of the. Indeed, it is more realistic to assume that the degree to which the

32
portfolio stakeholders can exercise control over the institutional investor and business and regulatory
environment will be one of the determinants of qualitative “utility” function of the institutional
investor.

To summarize, the institutional investor:

In this framework, the institutional investor benefits from the use of structured products as they help
me better:
• Hedge a liability stream and a minimum threshold level when hedge instruments are not
available on the market
• Accept risks judiciously in order to earn return
• Diversify in order to manage risks

The implications of this line of thought are that the institutional investor will invest in structured
products, because they provide a flexibility that is not available in traditional assets and they isolate
risks, so that the investor can take diversified or non-diversified views.

3.2 Institutional investors: readily invested in a structured product on the economy

Structured products are not a new invention, but the development of financial theory has helped us
understand better the ways we transact financially.

In his groundbreaking work, [Merton] shows that the value of the equity and the bonds of a company
can be represented as a long call and a short put option on the value of the firm. On the other hand,
[Markowitz] first showed that an investor should invest in some combination of a risk-free asset and
the market portfolio, with the optimal weights determined by the investor’s utility function.

If we view the value of a stock index as a call option on the whole economy, and ignore cash for a
while, the investor is actually holding a long call + risk-free bond. Any investor that has been invested
in the traditional equity/risk-free bond/cash portfolio has actually been holding a structured-product-
like portfolio.

Let S represent the value of the whole equity market, p and c are a put and a call on the equity market
(as represented by the stock index), and Ke − rT is the value of risk-free discount instrument, that pays K
in time T, the implicit assumption being that the investor is interested in investing in a finite period of
time T.

Then the put-call parity holds

p + S = c + Ke − rT

We see that the typical long-only equity plus government bond portfolio is actually the right-hand side
of this equation. For an investor who also invests in corporate bonds, it is easily shown that he is
actually holding delta-one like payoff on the whole investable company universe.

Because the investor cannot directly access the true firm value of all investable companies, by holding
a portfolio of zero-coupon bond, equities and corporate bonds, he has gained exposure to the aggregate

33
investable firm value by creating a portfolio of 2 options and one zero-coupon bond - a structured
portfolio payoff. (Figure 33)

Equity + Zero-coupon bond Corporate bonds Delta-one exposure to the value of all
investable companies

+ + +

- - -

Figure 33

3.3 Structured products, indexation and the core-satellite framework

The institutional investor manages its liability exposure by investing the available assets passively by
indexing the assets or can try outperforming the market by either managing them actively or
employing an outside active manager.

Indexation is the construction of a portfolio that is designed to provide returns that match as close as
possible a certain benchmark. Indexation is an improper name for a investing in a customized
benchmark. An index aims to represent a market or a particular risk such as a style, sector etc. A
benchmark tries to be representative of a management strategy, and there is no requirement to stick to
a particular index. The index is expected the represent the pure systematic risk factor. Thus it supports
the construction of a benchmark and is not a substitute for allocation. The benchmark may or, more
often, may not be a readily available market index, and this creates the need for a synthetic index that
will reflect the liability needs of the institutional investor.

The three practical implementations of indexation:

• Pure indexation – indexing the whole portfolio

• Enhanced indexation strategy – this approach seeks to modestly outperform the index while
essentially retaining the characteristics of the index
• Core-satellite strategy - indexing significant portion of the total capital and investing the non-
index part in active alpha portfolios.

Indexation is superior to active asset allocation in:

• Its ability to match a liability stream

• It avoids the problems of potential market impact of large changes in asset allocation
• It is more cost efficient in the meaning that fees are paid only for pure alpha and not for beta
performance
• The satellites are generally of smaller size and are invested in a larger variety of investment
strategies; this also provides a greater diversification benefit

34
Major indexed investors are pension and trust funds. The benefits of indexation stand out in
international equity investment, where significant additional costs and inefficiencies may significantly
dent the performance.

In the perennial discussion of passive vs. active asset allocation, structured products can be used as
investment tools on both sides.

On the one hand, they can provide exposure to pure risks, which if considered separate asset classes
should be included in the portfolio of an institutional investor, due to their diversification benefits,
such as credit, volatility and inflation. Alternatively they can be used to hedge risks which the investor
is not willing to take.

On the other hand, structured products can be used to gain exposure to superior investment
management skills, to exploit niche strategies or to implement investment bets. Thus they can be
directly applicable in an active investment management framework.

The core-satellites framework which stands between the purely passive and the purely active
approaches has recently gained prominence. The French government introduced this approach to
manage part of the state pension fund. CALPERS, the largest pension fund employs it as well.

The Core-Satellite Asset Allocation Framework

The Core-Satellite approach Practical issues
I. Construct an ALM model of the ‹ ALM model
pension scheme ‹ Defined-benefit or defined contribution scheme

II. Divide portfolio into Core part ‹ Core portfolio tracks the liability stream
and Satellite part ‹ Split of alpha and beta
‹ Core portfolio is beta-only portfolio, Satellite portfolios
are alpha-only portfolios

III. Core portfolio ‹ Invested in highly efficient markets: mostly government

bonds, broad equity indecis
‹ Cost-efficient, purely passive investment approach
‹ May include a hedging strategy if there is a minimum
guaranteed return on the liability stream

IV. Satellite portfolios ‹ Yield-enhancement strategies, pure diversification

strategies, active alpha managers, concentrated
portfolios, market-opportunity strategies
‹ No particular or customized benchmarks

Figure 34

The core-satellite framework has developed to overcome the natural mismatch between of the
available investment classes, such as equities, bonds etc, and the liabilities of an institutional investor.

35
Broad market indices are not appropriate benchmarks because they are not a natural hedge to the
liability stream. This calls for a synthetic benchmark that replicates the liability stream.

Securities with the required maturity or risk-return profile may be unavailable. Embedded minimum
guarantee liabilities can be hedged either through investing in a zero-coupon risk-free bond with the
same maturity, if such is available, or through dynamic replication. This presents a case to apply
derivatives overlays or structured products that will provide timing and risk-return flexibility.

An investment manager should not be paid for accepting beta risk, but only for the positive alpha that
they generate. Alpha and beta risk and the remuneration paid for accepting them should be clearly split.

Constraining the active managers with tracking error limits is suboptimal as it constraints the alpha
around the benchmark. Then the risk budget is not fully spent on the alpha strategy. Active managers
should be given more freedom to implement their investment skill and should not be imposed tracking
error mandates that render them passive

Below I present the approach of Calpers and approach in the core-satellite framework, Liability-
Driven Investment. Structured products naturally fit in a core-satellite or enhanced indexation portfolio
as satellites.

Core-Satellite Framework – Calpers

Calpers, the largest pension fund in the US, employs a type of core-satellite asset
allocation
‹ Investment policy

– Goal #1: Implement strategic asset allocation in an effective and cost-efficient way
– Goal #2: Seek added value through tactical asset allocation
‹ Implementation:
– Beta drivers and alpha drivers are split and monitored separately
– There are no “restricted” securities; thus the funds may invest in high-yield bonds, hedge funds etc

Non-linear
Concentrated payoffs
Active Market portfolios
return Absolute segments
returns

Long only

Enhanced Index

Passive
Beta drivers Alpha drivers Active risk

Figure 355

36
 Liability-Driven Investing

‹ Core portfolio, called Minimum Risk Portfolio, is invested in very low-risk or risk-free securities and
closely matches the liability stream

‹ There is no consensus about structure of the core portfolio, yet generally discussed strategies are
– Government bond liability matching
• However longer-term maturities may not be available
• If investor chooses to roll-over shorter-term securities, he forgoes the long-term premium
– Cash + Swap liability matching
• Enter into long-term swap agreements
• Perfect replication at the cost of flexibility (liabilities may change over time)
– Customized benchmark: government bonds + swaps

‹ As satellites, the fund employs pure alpha strategies, targeting yield enhancement and diversification
– Portable alpha strategies, concentrated portfolios, credit risk etc

Figure 36

4. Limitations

Structured products are not an asset class. Structured products may allow access to one or several asset
classes, but they are investment vehicles that do not carry original risk factor.

For capital guaranteed products, capital guarantee typically applies only if the product is held until
maturity.

For some products there may be liquidity issues: There may not be a secondary market; secondary
market may be illiquid.

Fees, fees, fees – hidden and obvious, nothing comes for free

Mark-to-model risk, especially for longer maturity options

As investment vehicles, structured products may suffer from performance transparency as it may be
difficult to establish benchmarks.
37
Appendix 1
The Swiss Taxation System

Swiss Taxation System

The governing Swiss law is the Kreisschreiben Nr. 4, April 1999

‹ Total return is due to capital appreciation and dividend/coupon income (Kapitalgewinne

plus Vermögenserträge); Usuallly capital appreciation is tax-exempt, coupon income is
taxable
‹ Structured products usually consist of a bond part and an option part

Taxation of structured products

Transperant Products
Transparent products Non-transperant products
(Analytical Method)

‹ The value of the bond and
the option part can be
clearly separated
‹ Only bond component is
taxable, option
component is tax-
exempt
‹ Bond and option component ‹ The bond and option
can be split analytically cannot be split
‹ Issuer usually publishes the ‹ The total return is
bond value only (Telekurs) taxable
‹ Only bond component is
taxable, option component is
tax-exempt

Taxation of Certificates
‹ Main differentiation is between classical and dynamic index or basket certificates
‹ Critical difference is whether the basket is actively managed or not

Classical Underlying Dynamically Rebalanced Underlying

‹ The stocks in the underlying index or
basket in a classical certificate are not
systematically rebalanced
‹ Any dividends that the basket earns over
time are not paid directly to the investor
when received, but are transferred to the
investor by selling the product as deep
discount
‹ Yet the whole product is tax-exempt
‹ The basket is dynamically rebalanced over
time, and is similar to a managed
investment fund
‹ Therefore the products are fully taxable
‹ There are 3 exceptions:
– Basket if rebalanced according to an
objective, predetermined selection rule
(Example: High-dividend yield basket)
– The basket is rebalance according to
preset rule
– The rebalancing mechanism is patent
protected

38
Taxation of Yield-Enhancement Products
‹ Main differentiation depends on maturity
‹ Longer maturity products are considered non-transperant unless shown otherwise and are
partially or fully taxable
‹ Shorter maturity products are tax exempt

Product Criteria Taxation

‹Coupons are taxable only
Transperant partially
Maturity of more ‹Total return taxation
than 1 year ‹Taxable amount equal to
Yield (Reverse Final price less Purchase price
Not transperant
Enhancement Convertibles etc) and is taxable at maturity
Products ‹Coupons are taxable when
paid
Maturity of less
than 1 year ‹Fully tax-exempt
(Discount Certificates, etc)

Taxation of Capital Protected Products

‹ Main differentiation is between transparent and non-transparent products
‹ UIP (French: interet unit predominant, Deutsch: überwiegend einmalverzinslich) products
have an annual interest rate on the bond component that is higher that half of the IRR of the
whole product; These are usually deep-discount bonds
Product Criteria Taxation
Option Option part is always tax-free
component
UIP (Zero-coupon ‹Modified Taxation
or very low coupon ‹Allpayments from the bond
Transparent deep discount bonds) component are taxable at maturity
Products Non UIP (High ‹Coupon is taxable when paid
Capital coupon discount ‹Discount appreciation is payable
Protected Bond bond) at maturity
Products component

‹Total return taxation

‹Taxable amount equal to Final
Not transparent
price less Purchase price and is
products taxable at maturity
‹Coupons are taxable when paid

39
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