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Balance Sheets Best Practice

Using Structured Products to Manage Liabilities

by Shane Edwards

Executive Summary

  • Structured products (SPs) are derivative contracts that are tailored for a specific purpose, such as hedging the value of an uncertain future liability.

  • The value of a SP is derived from one or many underlying reference asset values, which causes uncertainty in the value of the liability to be hedged.

  • SPs are typically transacted between a client and an investment bank, and can take various legal forms.

  • The fact that SPs are flexible and can be tailored to client needs distinguishes them from standard derivatives, which have generic fixed terms.

  • However, SPs tend to be regarded as more complex financial instruments, and they are more difficult to value than vanilla derivatives.

 

Introduction

Only a decade ago, the use of structured products (SPs) was largely confined to sophisticated institutions that used them for risk management purposes. Now SPs are embraced across the client spectrum and are owned by millions—from retail individuals investing in capital-protected equity products, to global corporations that tailor SPs to meet their often complex and highly specific liability management needs.

In the liability management arena, SPs have an important role to play due to their highly customizable nature. They are used by corporate treasurers as a way of actively managing borrowing costs and hedging foreign exchange liabilities. Many companies have also embraced SPs, outside of treasury, to manage expected future liabilities (for example, airlines hedging the price of jet fuel or importers/exporters hedging the foreign exchange rate). SPs are also used by many pension funds as a strategic initiative to manage the asset–liability mismatch and tailor the pension deficit risk profile.

The increased appetite for SPs is a result of improved client education and the rapid pace of innovation at investment banks, where SPs have become a major source of business. The growth in SP volumes is expected to continue its rapid pace in the years ahead.

Anatomy of a Structured Product

A derivative is a financial instrument that derives its value from one or more underlying reference asset values. Derivatives can range in complexity from very simple with standardized terms (vanilla derivatives), to very complex with highly customized features (exotic derivatives). Broadly, there are three levels of complexity in derivatives, listed here in order of complexity:

Linear derivatives (for example, futures, forwards, zero strike calls), which reflect the performance of an underlying asset on an almost one-to-one basis but without legal ownership of the underlying asset. These derivatives can be simply priced through arbitrage (cost of carry) arguments.

Nonlinear derivatives (for example, call options), where at expiry the price of the derivative will vary linearly with the underlying asset price if the underlying is above a predefined strike level. If this is not the case, the option price will be worth zero. Well-understood models are available that rely heavily on the volatility of the underlying asset to determine the derivative price.

Exotic derivatives, which have path-dependent payouts, restriking features, or hybrid (multiasset class) characteristics. They require sophisticated mathematical models to price and are highly sensitive to calibrations of the underlying probability distribution and correlation assumptions (in the case of multiasset underlyings).

Any of the three derivative types may be regarded as structured products due to the amount of customization that is contained in the contract terms. Common customizations include:

  • Underlying assets (underlyings): These may include anything that is transparent and tradable, such as equities, interest rates, foreign exchange rates, commodities, and inflation. Hybrid SPs can be created where multiple asset classes are used.

  • Tenor: Clients are able to tailor the maturity of a SP to any extent where the counterparty providing the hedge allows it, which in turn is dictated by the liquidity of the underlying asset. SPs can include features that allow early maturity, such as: puttability (where the client may choose to early-terminate the structure with preagreed payout), callability (where the hedge counterparty can terminate at its discretion), or automatic termination (where maturity will occur once a predefined event has occured).

  • Path dependency: The payouts of many SPs are determined with reference to how the underlyings have performed through the life of the product, and not simply as a function of the final underlying asset level. Examples are Asian options (where the average level of an underlying is calculated) and lookback or barrier options (where the highest or lowest observed levels of an underlying determine the payout).

  • Payouts: SPs can have interim payouts (coupons) and/or a final payout at maturity as specified.

  • Currency: SP payouts are often requested in currencies other than the currency of the underlying asset; such products are known as quanto or composite options.

 

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Further reading

Books:

  • Adam, Alexandre. Handbook of Asset and Liability Management: From Models to Optimal Return Strategies. Chichester, UK: Wiley, 2007.
  • Hull, John C. Options, Futures, and Other Derivatives. 7th ed. Upper Saddle River, NJ: Prentice Hall, 2008.
  • Rebonato, Riccardo. Volatility and Correlation: The Perfect Hedger and the Fox. 2nd ed. Chichester, UK: Wiley, 2004.
  • Wilmott, Paul. Paul Wilmott on Quantitative Finance. 2nd ed. Chichester, UK: Wiley, 2006.

Articles:

  • Black, Fischer, and Myron Scholes. “The pricing of options and corporate liabilities.” Journal of Political Economy 81:3 (1973): 637–654.
  • Dupire, B. “Pricing with a smile.” Risk 7:1 (1994): 18–20.
  • Heston, Steven. L. “A closed-form solution for options with stochastic volatility with applications to bond and currency options.” Review of Financial Studies 6:2 (1993): 327–343.

Magazines:

  • Risk, Structured Products, Euromoney, Derivatives Week.

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