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Evaluating

Structured Investment
Products
IFPAC 2008 Conference
Presented by:
Foo Keah Keat
Director/Head, Derivatives & Structured Products
OSK Investment Bank Berhad
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Contents
Introduction
Choice of Product Strategies
Examining Some Popular Structured Products
Determining the Right Product
Understanding the Limitations and Risks
Avoiding Catastrophe
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What Are Derivatives
What is a Derivative?
1. Financial instrument whose value is derived from the value of an underlying asset.
2. Derivatives include Futures, Forwards, Options, Swaps, Warrants, etc.
3. Useful financial tools for both risk management and investment purposes.
4. Traded on various Exchanges as well as Over-the-counter.
5. Issued over different asset classes: Equity, FX, Commodities, Funds, Interest rates, etc.
Basically, any underlying asset that is tradable and sufficiently liquid.
Call and (Put) Options
Buyer has the right, but not the obligation, to buy (sell) the underlying asset from (to)
Seller at a fixed price (i.e. Exercise Price or Strike) within specified period.
Growth of Exotic Options
1. Options offering interesting and complex payoffs/features, e.g. Barrier options.
2. Reasons:
Advance in IT and financial modeling
Banks increasing appetite for risk-taking
Demand from increasing sophisticated investors
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What are Structured Products
Different Name, Same Product
Structured Product = Structured Investment = Structured Deposit = Structured Note
1. Different ways of wrapping the same product
2. Different regulatory and legal regime
3. Structured suggests that products have undergone some form of financial engineering
What are they
1. Hybrid products whose performance is linked to a selected underlying asset, e.g. index.
2. Usually a debt instrument (bond/deposit/debenture) with derivative(s) embedded.
3. Offer interesting variations of Risk-Return profiles that are different from conventional
instruments (asset classes) like bonds, equities, currencies, etc.
4. Relatively complex multi-asset financial products.
5. Payoff formula is usually well-defined.
6. Linked underlying asset can be equity, FX, funds, etc. or combination of several assets.
7. Sometimes viewed as a separate Asset Class.
8. Asset-backed securities (ABS), REITs, ETFs are excluded.
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LEGAL WRAPPER
(of selected currency)
Debt instrument, i.e. Note, Bond
Deposit
Certificates
Unit trusts or Funds
Vanilla options and forwards
Exotic options and multi-assets
Combination of options
DERIVATIVE
(of selected underlying asset or assets)

STRUCTURED PRODUCT
Path-dependent features
e.g. Lock-in, Knock-in,
Auto callable
Basic Building Blocks
Structured Products
Local / foreign underlying
Various asset classes
UNDERLYING
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Motivation and Benefits
1. Efficient execution of market view
Residual risk can be laid off (sold) in return for extra return.
Or giving up some return in exchange for protection against certain risk.
Remember the Bottom line: No Free Lunch !
2. Ability to modify and customise the investors Risk-Return profile.
Enhancing return/payoff profile, gaining capital protection or leverage
3. Offer other dimensions for trading: 1) Volatility 2) Correlation 3) Path-dependent
4. Provide more flexibility and more choices to investors.
5. Investor has direct input in product design decision. Feeling of in more control.
Once transacted, investment is in auto-pilot mode.
6. Resolve regulatory and market access restrictions.
Credit constraint in dealing with OTC derivatives
Allow market access to restricted markets, e.g. Participation Notes/Certificates
Structured Products
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Investors Choice of Option Strategies
1. Investor BUYS option(s)
Usually in principal-protected structures
Limited downside, unlimited upside
Lower risk
2. Investor SELLS option(s)
Usually in yield enhancement structures
Unlimited downside, limited upside
Higher risk
3. Combination of BUY and SELL Options strategies
Multiple options on multiple asset classes or underlyings
Structured Products
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Investors Choice of Risk Factors (Parameters)
1. Asset Class
Equities, Currency (FX), Commodities, Interest rates, Credit, Funds, etc.
Any asset class that is tradable and sufficiently liquid
2. Directional factor
Bullish, Bearish or Market Neutral
Straight-forward and most popular risk parameter
A path-dependent strategy can be seen as a combination of Directional strategies
Investors can maximise value using Path-dependent Options such as Barrier Options
if they have strong views on the future path movement of the underlying
3. Volatility factor
An important parameter that determines the value of an option
Value can be created and priced from market view/expectation on Volatility
4. Correlation factor
Most newer, complex derivatives feature this risk parameter
Implied correlation has become more widely traded and priced
Structured Products
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Basic Product Types
1. Capital Guaranteed or Principal Protected Products
Redemption of full or a large portion of the initial capital is assured.
Investors typically buy options.
Risk-adverse, conservative investors who cannot afford to lose capital.
2. Yield Enhancement Products
Partial or full amount of initial capital is at risk.
Investors typically sell options.
Investors with high risk appetite and who desire higher income yield.
3. Leveraged Products
Participation on the underlying asset is leveraged up.
Investors typically buy options in leveraged amount.
Investors with very high risk appetite.
4. Wrapper Products
Designed to gain market access or participation.
Participation Notes (or Certificates)
Structured Products
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Example 1: Capital-Protected Structure
PRODUCT NAME: Index-linked Capital-Protected
UNDERLYING INDEX: KLCI Index
MATURITY: 3 years
PRINCIPAL AMOUNT: RM 1,000,000
ISSUE PRICE: 100%
COUPON: 0%
INDEX PARTICIPATION RATE (G): 60%
CAPITAL GUARANTEE RATIO: 100%
SETTLEMENT METHOD: Cash settled
REDEMPTION AMOUNT (R):
R = 100% + ( IPR x G ) 100% 100%
IPR: Percentage Rise of Index over Maturity.
Assume Index Level on Start Date = 1400
Capital protection is only assured at maturity!
Redemption Amount
70%
80%
90%
100%
110%
120%
130%
140%
1
0
0
0
1
2
0
0
1
4
0
0
1
6
0
0
1
8
0
0
2
0
0
0
2
2
0
0
Index Level at Maturity
Participation Rate (G) = 0.60
Strike=1400
Structured Products
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Pros
1. Initial capital is assured at maturity, i.e. 100% capital protection.
2. Upside participation in the selected stock index (market).
3. Out-performs bond/fixed deposit of similar tenure if stock market had performed well.
4. Similar to investing in a Balanced-type unit trust.
Cons
1. Limited exposure to stock market. 60% Participation Rate in this example.
2. Underperforms stocks (e.g. index fund) if stock market had risen sharply.
3. In low interest rates environment, Participation Rates will be lower and tenure longer.
4. Investment capital is locked in over a long period.
5. Passive investment management.
Example 1: Capital-Protected Structure
Structured Products
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Enhancing the Structure
Increasing the Participation Rate
1. Capping the index upside; e.g. call spread
2. Setting a higher strike level (for call option)
3. Use of Asian-style (Averaging) options
4. Extending the tenure
5. Sell option(s) on other underlying assets and taking some risks
6. Use of Path-dependent Options, e.g. knock-out and knock-in options
Capturing and maximising the index upside
1. Use of Path-dependent Options, e.g. Barrier Options
Lock-in feature to lock in when the index had reached a certain level
Look-back feature to lock in the highest level reached
2. Such features come with additional cost; resulting in a lower Participation Rate
Example 1: Capital-Protected Structure
Structured Products
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Example 2: Bull Equity-Linked Structure
PRODUCT NAME: Bull ELS or Reverse Convertible
UNDERLYING STOCK: Sime Darby
MATURITY: 35 days
ENTITLEMENT: 1 Bull ELS entitles 1 Share
REFERENCE PRICE: RM 11.80
ISSUE PRICE: RM 11.107
EXERCISE PRICE: RM 11.210
YIELD-TO-MATURITY*: 9.67% p.a., if redeemed at RM11.21
REDEMPTION AMOUNT:
(A) At Maturity, if Share RM 11.210
Redemption= RM 11.210 ( i.e. YTM=9.67% )
(B) Otherwise, 1 Bull ELS redeems for 1 Sime Share
Effective Share Purchase Price= RM 11.107
* YTM = { (11.210 11.107) / 11.107 } ( 365 / 35 ) = 9.68%
e.g. 3-month Bank Deposit: 3.0%
Structured Products
YTM
-20%
-15%
-10%
-5%
0%
5%
10%
15%
10.60 11.00 11.40 11.80
STOCK PRICE
YTM = 9.67%
Break-Even
11.107
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Maturity Payoff
SCENARIO 1
Final Price Exercise Price
SCENARIO 2
Final Price < Exercise Price
Investor pays on Issue Date. RM 11.107
Share price of Sime Darby at
Maturity (i.e. Final Price).
RM 12.00 RM 10.80
Redemption Amount received by
Investor at Maturity.
RM 11.21 1 share of Sime Darby
Market value of shares held by
Investor at Maturity.
No shares held RM 10.80
Profit(+)/loss(-) on investment 11.21 11.107 = + RM0.103 10.80 11.107 = RM0.307
Return (in annualized simple
yield) on investment.
9.67% 28.82%
Structured Products
Example 2: Bull ELS
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Pros
1. Superior yield over banks Fixed Deposit if market view had been correct.
2. Target Buying at below RM 11.21
Effective purchase of shares at RM 11.107 if view had been wrong.
Must be happy to buy or be long the shares at RM 11.107.
3. Enforces market/investing discipline, instead of trying to time the market. No leverage.
Cons
1. Relatively more risky.
Suffers loss if share falls below RM 11.107 (break-even price).
Potential loss is unlimited.
2. Potential upside is limited. Maximum yield 9.67% p.a. (or 0.93% in absolute terms).
3. Unattractive Risk-Return profile. Investor takes substantial risk for a small 0.93% pick-up.
4. Investment is locked in for 35 days.
5. Requires full capital upfront. Cannot leverage.
Example 2: Bull ELS
Structured Products
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Enhancing the Structure
Achieving a higher yield
1. Setting a higher exercise price (or strike).
2. Select stocks that are more volatile.
3. Extending the tenure.
4. Use Worse-of Put option
Addition of another risk factor (correlation) into the pricing.
Select stocks with higher negative correlation(s); higher option value.
Negative: Investor will have risk exposure to more than one stock.
Structured Products
Example 2: Bull ELS
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Example 3: Auto-callable with Digital Coupon
PRODUCT NAME: Auto-Callable USD Quanto Nikkei-linked Notes with Digital Coupon and Knock-in feature
REFERENCE INDEX: Nikkei-225
MATURITY: 5 years
PRINCIPAL AMOUNT: USD 100,000
INITIAL INDEX LEVEL: 15,700
COUPON: Payable in USD on a quarterly basis, determined as follows:
(A) 11.00% p.a. if Index 13,600 on each Observation Date
(B) 0% if otherwise.
OBSERVATION DATES: 5 Market Days before each coupon payment date
REDEMPTION (R): Payable in USD if Early Redemption has not occurred, and is determined as follows:
(A) R = 100% if Knock-In Event has not occurred before maturity;
(B) R = 100% [Final Index Level / 15,700 ] if otherwise.
FINAL INDEX LEVEL: Index level at maturity.
KNOCK-IN EVENT: Considered to have occurred if Index trades at/below 10,000 at any time before maturity.
EARLY REDEMPTION: Automatically early redeemed if Index Trigger Level on any Observation Date.
TRIGGER LEVEL: 16,000
Structured Products
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Structured Products
Nikkei-225 Index price performance
Issued 8/3/06
Nikkei=15,700
Early redemption triggered
after only 6 months.
1/9/06 COB: Nikkei=16,134
Put Knock-in = 10,000
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Pros
1. Good possibility of receiving high interest coupons over 5 years
Earns 11% p.a. coupon if Index 13,600 i.e. 13% decline from initial level 15,700
2. Good possibility of early redemption
Index only have to rise 2% (15,700 16,000) after 3 months or thereafter
Outperforms similar maturity time deposit if it had early redeemed after 3 months
3. Low possibility of capital being at risk (i.e. Knock-in Event triggered)
Index has to decline 36% (15,700 10,000)
4. No currency risk if you are a USD based investor (i.e. Quanto-ed)
Cons
a. Potential income and capital loss if Nikkei had crashed below 10,000
b. Long investment holding (5 years) and equity risk exposure if not early redeemed
c. Upside is capped (total income = 55% p.a.)
d. Coupons have a digital payoff, i.e. either 11% or 0%
e. Re-investment risk, in the event of early redemption
Structured Products
Example 3: Auto-callable with Digital Coupon
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Enhancing the Structure
Achieving a higher yield
1. Setting a higher threshold Index level for coupon determination
2. Setting a higher Knock-in Level
3. Setting Observation frequency to intra-day (continuous) for Knock-in Event
4. Leveraging on the short Put option
Reducing the risk
1. Replacing the short put with a put spread (e.g. 20% spread)
Limit the potential capital loss to the spread (i.e. 20%)
Trade in for a lower coupon
Structured Products
Example 3: Auto-callable with Digital Coupon
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Structured Products
When and Why invests in SW
1. Desire for Gearing (leverage)
Gain large market exposure with small investment outlay
High risk, high return and more speculative in nature
2. Limited downside, unlimited upside and cash extraction strategy
Defensive strategy in times of very volatile, bullish but nervous market
3. Arbitrage and volatility trading
4. More Trading-driven and shorter term investment horizon
SW positions must be actively monitored
Beware of time decay
Usually not intended to be held until expiry
Example 4: Structured Warrants (SW)
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Some of the features/mechanisms offered
1. Lock-in
2. Knock-in and Knock-out
3. Digital payoff
4. Cap on cumulative (total) return
5. Auto Callable (i.e. early redemption trigger)
6. Averaging out of risk (or return)
7. Daily accrual (i.e. payoff determined on a daily basis)
8. Currency immunisation
9. Correlation play
10. Best of, Worst of and relative performance
Offering More Flexibility, More Opportunities, More Possibilities and More Choices
Structured Products
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Today: If you have a View, theres a Way
TRADING STRATEGY & ACTION
MARKET VIEW CONSERVATIVE AGGRESSIVE
Bullish Buy Stocks Buy Futures / Sell Puts
Very Bullish Buy Call Warrants Buy Futures / Buy Calls
Bearish Buy Puts Short Futures / Sell Calls
Very Bearish Buy Puts Short Futures
Bullish but nervous Buy Call Warrants or Buy Stocks + Buy Puts
Bearish but nervous Buy Puts
Neutral / Sideways / Range Sell/Buy Options Sell Options (e.g. straddle)
Lower Volatility anticipated Sell Options
Higher Volatility anticipated Buy Options
Path movement of underlying Buy/Sell Path-dependent Options
Structured Products
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Determining the Right Product
1. Identifying the Underlying Asset Class
Which asset class and market: Equities, FX rate, etc.
2. Market View and Market Timing?
Bullish, Bearish or Market Neutral
3. Determine your Investment Objective and Risk-Return Profile
Minimum, Average and Maximum potential return?
Maximum (affordable) potential capital/income loss? Risk appetite?
Asset allocation (more conservative) or return-driven (more aggressive)?
4. Do you have holding power?
Are you able to ride through the market volatility or downside?
Structured Products
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Understanding the Limitation and Risks
1. Making the distinction between and Trading and Investment
2. Structured Products are intended to be held until maturity. Not for trading
3. Secondary market liquidity risk
No secondary market. Very much a bilateral contract.
Early redemption risk. Investor can only unwind trade with the issuer.
4. Pricing may not be straight-forward, especially for complex, multi-asset products
Multi-asset, more features means larger built-in margin and wider bid-offer spread.
Pricing models not readily available to investors.
Try to avoid Products linked to less liquid underlying
5. Credit risk exposure to the Issuer
Major consideration if tenure is long (> 3 years).
6. No free lunch!
If the risk is perceived to be higher, the option will be priced higher, and vice-versa.
Structured Products
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Avoiding Catastrophe: Due Diligence and Suitability
1. Has the Investor the capability to understand?
Investment experience and education background
2. Is the Product consistent with investment objectives and risk-return profile?
Looking for an Apple, bought an Orange !!
3. Is the Product suitable for the Investor in relation to his financial standing, etc?
4. Read the Product Terms, Disclaimers and fine print, etc.
. Return of up to X% .
Be careful if the terms are too good to be true
Structured Products
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Disclaimer / Risk Warning
This material has been prepared and published solely for informational purposes only, and
should not be construed as a solicitation or an offer to buy/sell any securities/products or
related financial instruments. No representation or warranty, either expressed or implied, is
provided in relation to the accuracy, completeness or reliability of the information contained
herein, nor intended to be a complete statement of summary of the securities, market, etc.
referred to herein.
Structured Products, Warrants and Derivatives can be volatile instruments and investing in
them involves significant risk. These products are subject to a number of risks and may
result in a complete or partial loss of an investment in them. No person should deal in any
type of Structured Products, Warrants or Derivatives unless he/she understands the nature
of the relevant transaction and the extent of his/her exposure to potential loss. Each
prospective investor should consider carefully whether such instruments are suitable for it
in the light of its circumstances and financial position. Prospective investors of any
Structured Products and Warrants should therefore consult their own legal, tax,
accountancy and other professional advisers to assist them in determining the suitability of
any Structured Product or Warrant for them as an investment and for their particular
circumstances.
Structured Warrants/Products

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