Asian Structured Products

Structured products are financial instruments designed and created to afford investors exposure (to something) through a derivative contract. The underlying asset can be an equity price, an interest rate, an exchange rate, an index, a credit spread, a commodity price—anything, in fact, for which there is an existing financial market.

The structured products industry is so big and so diverse that it is helpful to break it down into three parts.

• Privately placed and individually negotiated transactions involving one investor or a very small number of investors. Such transactions are typically executed through medium-term notes.

• Products sold through syndication by such retail networks as banks, brokerages, financial advisers, and insurance companies.

• Products that are actively traded on exchanges or with market makers, constituting the fastest-growing segment.

The choice of instrument is predicated on such considerations as tax efficiency and convenience. Some popular structured products are:

• Target redemption forward—an example is provided for the USD/CNY instrument.

• Accumulator/decumulator—an example is provided of the popularity in Hong Kong and Singapore, for both onshore and offshore investors in other Asian markets.

• Autocallable notes—an example is provided for the Nikkei 225

The structured products industry is large enough and complicated enough that it should be examined by anyone involved or interested in finance and capital markets. The sums involved are comparable to those invested in hedge funds, yet these businesses are largely ignored by the press, the public, and even practitioners.

Structured products constitutes a large industry and an important part of investment and capital market activity. Despite the substantial size of the business, little is known or said about structured products by industry professionals not directly involved, except in the context of a noteworthy event, such as the Lehman Brothers Minibond scandal. In this paper, we seek to explain what structured products are, how they work, and why investors use them, with particular reference to East Asia.

Structured products are financial instruments designed and created to afford investors exposure (to something) through a derivative contract. The underlying asset can be an equity price, an interest rate, an exchange rate, an index, a credit spread, a commodity price—anything, in fact, for which there is an existing financial market. Derivatives are packaged in a way that is most suitable for the investor. Typically, they are embedded in a medium-term note or other type of security. In some cases, the instrument is a bank deposit, an insurance policy, or a simple contract. The choice is predicated on such considerations as tax efficiency and convenience.

Investors usually want to go long the market. In a typical transaction, a client buys a bond consisting of a zero-coupon bond (“zero”) and a call option on an equity index. If the index rises above the option’s strike price by the maturity date, the bondholders receive the proceeds of the bond and the option. Otherwise, the option expires worthless and the client forfeits any interest he might have expected to earn on his capital. That is the basic structure of a “capital-guaranteed” product. It works especially well when interest rates are high (cheap zeros) and option prices are low (low volatility).

When rates are low, as they have been recently, the “reverse convertible” is a popular structure: The client effectively invests in a zero-coupon bond and sells short a put option. The value of the put option and any interest due are combined and passed to the investor as a coupon. If the market falls below the option’s strike price at maturity, the loss is deducted from the proceeds of the zero and the net amount is the redemption value of the structured product. If the market rises above the strike price, the investor gets her money back along with a high coupon.

The structured products industry is so big and so diverse that it is helpful to break it down into three parts and consider each in turn.

• The first type of structured product is privately placed and individually negotiated transactions involving one investor or a very small number of investors. Such transactions are typically executed through medium-term notes.

  This mechanism is commonplace for high-net-worth investors, corporate treasuries, and other quasi-professional investors—but not hedge funds.

  These transactions are almost never disclosed to third parties; thus, this multi-billion-dollar industry is largely hidden from a potentially wide audience.

• The second type consists of products sold through syndication by such retail networks as banks, brokerages, financial advisers, and insurance companies.

  This segment is the most conspicuous part of the structured products industry—these products are widely advertised to attract customers. The investors are usually private clients and not necessarily rich ones.

  One of the most material manifestations of this kind of activity in Asia and North America is the variable annuity, an insurance policy with returns linked to stock market indexes.

• The third generic type of structured product includes those that are actively traded on exchanges or with market makers. These products constitute the fastest-growing segment. In Hong Kong, warrants and callable bull/bear certificates (CBBCs) are very popular; in Japan, Australia, and Singapore, contracts for difference (CFDs) are becoming popular.

  Some exchange-traded funds (ETFs) should be considered structured products, particularly those that are leveraged or that short the asset to which they are linked.

  Although the products themselves are quite visible, it is impossible to know exactly how much total capital is invested in them. The snippets of information we do have suggest that very large amounts of money are involved.

A. Clients and Their Motivations

It is important to consider who invests in structured products and what motivates them to do so. Such a large and diverse industry has many participants, whose circumstances and priorities vary. Later in the paper, we discuss specific examples. Now let us consider the generic advantages that structured products offer—as well as some of their shortcomings.

1. Tax Efficiency

Tax efficiency is sometimes achieved through how the derivative is packaged—for example, insurance policies. Tax advantages can also be achieved by merging the interest or coupon of a bond with the more risky capital exposure from writing an option, leading to an after-tax improvement when capital gains are taxed more favorably (i.e., at a lower rate than interest income).

2. Currency Protection

Investors in overseas assets often suffer when the currency of the international asset depreciates. This risk can be neatly avoided by using derivatives.

3. Leverage

Some investors use structured products for short-term trading rather than long-term investment. Such products as CFDs and CBBCs are designed for this kind of activity.

4. Payoff Transformation

Derivatives allow investors to express their views and risk appetite in a more precise and nuanced way. Some will invest only if their capital risk is mitigated; capital-guaranteed products are well suited to such investors.

In this paper, we do not seek to promote structured products per se. There are reasons why some investors do not use structured products as well as considerations for those who do.

5. Transparent Pricing

The value of derivatives and structured products is a nebulous area, causing substantial problems for professional participants and their auditors. It is harder still for investors to properly understand the value of such products and thus the margins they are paying.

6. Complexity

Investors are rightly wary of things they do not understand. Some investors consider derivatives complicated. Although valuing structured products can be difficult, expressing the payoff is often quite straightforward.

Since the 2007–08 financial crisis, the most common structured products theme has been a “search for yield.” After the financial crisis, the US Federal Reserve lowered its target for the federal funds rate 10 times. Starting in December 2008, the target range was kept between 0.00% and 0.25%. In December 2015, the near-zero target range ended when the Fed increased the federal funds rate by 25 bps, to 0.25%–0.50%. US easy-money policies were echoed in Asia, which was not immune to the global financial shock and subsequent meltdown in commodity prices.

Among Asian countries, the spotlight has been on China, the second-largest economy in the world in 2016. The use of the renminbi has been extended from cross-border trade settlements to offshore investment activities linked to shares (the Shanghai–Hong Kong Stock Connect enables non-mainland investors to invest in eligible shares on the Shanghai Stock Exchange and mainland investors to invest in eligible shares on the Hong Kong Stock Exchange). According to SWIFT, in September 2015, the renminbi ranked 5th among world currencies as an international payment currency, with a 2.45% share, versus its ranking of 35th in October 2010.⁵ Offshore renminbi deposits have also jumped significantly. Renminbi deposits in Hong Kong, the largest offshore renminbi center, reached RMB864 billion in November 2015, compared with RMB576 billion in January 2012, according to the Hong Kong Monetary Authority.

Demand for renminbi-linked structured products was particularly strong among corporations that initially aimed at hedging their currency risk but ended up taking a directional bet on the renminbi in order to generate “yield.” Given the slowdown in the global economy (including China), some corporations used their credit facilities to finance investments in renminbi-linked structured products with a view toward generating returns to compensate for the weakness in organic business growth.

This product is set up as a zero-cost option strategy that enables the buyer to exchange one currency for another at a predetermined exchange rate (“strike rate”) according to a regular schedule, subject to a target redemption provision (“knockout event”). The buyer effectively enters into strips of forward contracts under which he benefits from a better exchange rate if the strike rate is higher than the prevailing market spot rate on the fixing date (“fixing rate”). The product is terminated early when the total accumulated positive value reaches the maximum target or cap (“exact knockout”) or when the target number of in-the-money fixings is reached (“discrete knockout”). The buyer is obligated to settle any profits or losses accumulated before the occurrence of a knockout event. For a leveraged trade, the notional of the sold leg is higher than that of the bought leg. With a leverage ratio of 2, which is common in most trades, the buyer is obligated to settle twice the underlying currency when the fixing rate is higher than the strike rate, thus incurring a higher mark-to-market loss. Exhibit 1 shows an example of a target redemption forward.

On a fixing date,

1. if the fixing rate is below the strike rate (e.g., fixing rate = 6.1000), the monthly positive value is USD10,000—that is, USD100,000 × (6.2000 – 6.1000); or

2. if the fixing rate is equal to the strike rate (e.g., fixing rate = 6.2000), the monthly positive value is 0—that is, USD100,000 × (6.2000 – 6.2000); or

3. if the fixing rate is higher than the strike rate (e.g., fixing rate = 6.3000), the monthly positive value is 0 and the client loses USD20,000—that is, USD100,000 × 2 (the ratio) × (6.2000 – 6.3000).

On the fourth fixing date, the accumulated positive value is greater than or equal to the maximum target, the knockout event has occurred, and the contract is terminated. The cumulative profit or loss for the buyer is USD20,000.

One variation of this product is different strike rates for different fixing dates. For instance, in Exhibit 1, the strike rate is set at 6.2000 for fixing dates 1–3, 6.1600 for fixing dates 4–6, and 6.1200 for fixing dates 7–12.

Target redemption forwards are commonly embedded with a European knock-in barrier. On a fixing date, if the fixing rate is at or below the relevant European knock-in barrier, the buyer is not obligated to settle, even when the fixing rate is higher than the strike rate.

As Exhibit 1 shows, an investor can enjoy a better-than-market exchange rate. Despite limited upside (owing to the cap) and unlimited loss potential, demand for USD/CNY target redemption forwards has been triggered by expectations of the renminbi’s continued appreciation. Investors began to suffer losses, however, after the unexpected trend reversal in early 2015.

B. Popular Product: Accumulator/Decumulator

An accumulator/decumulator is a combination of barrier call options and barrier put options. An accumulator allows an investor to accumulate the underlying asset (typically an individual equity or currency) at a strike price lower than the initial spot price, subject to a knockout event that terminates the contract immediately. A decumulator is the reverse of an accumulator—an investor sells, or “decumulates,” the underlying asset instead of buying or accumulating it. A leveraged accumulator/decumulator is usually offered at two or three times the underlying asset. An investor is obligated to accumulate or decumulate two or three times the underlying asset if the fixing price is lower than the strike price on any fixing date (accumulator) or if the fixing price is higher than the strike price on any fixing date (decumulator). A leveraged accumulator/decumulator enables investors to enjoy a more attractive strike price, but the downside risk is higher. Exhibit 2 shows an example of an accumulator.

Absent a knockout event, an investor can purchase 100 shares of stock at USD90 on an exchange business date. So long as the prevailing market price is higher than USD90, the investor makes a profit. But if the prevailing market price is lower than USD90, the investor is still obligated to purchase 200 shares of Stock A at USD90, thus suffering a loss. If a knockout event occurs, the contract is terminated and the investor bears no further obligation or liability. Exhibit 3 shows an example of a decumulator.

Absent a knockout event, an investor can dispose of 100 shares of Stock A at USD105 on an exchange business day. So long as the prevailing market price is lower than USD105, the investor makes a profit. But if the prevailing market price is higher than USD105, the investor is obligated to dispose of 200 shares of Stock A at USD105, thus suffering a loss. If a knockout event occurs, the contract is terminated and the investor bears no further obligation or liability.

The accumulator/decumulator is popular in Hong Kong and Singapore, for both onshore and offshore investors in other Asian markets. Investors are attracted by the opportunity to purchase or sell at a better price than the initial spot price, subject to a knockout event. Moreover, because most investors need to pay an initial margin of only 20%–40%, the leveraged return is lucrative. Although sales volume has dropped after peaking before the 2007–08 financial crisis, the accumulator/decumulator has become a core commoditized product that continues to play an important role in the Asian structured products market.

C. Popular Product: Autocallable Notes

The autocallable note is a variant of the reverse convertible. For example, the investor sells a put option on the market (typically an equity or equity index) to the bond issuer. The investor is remunerated for the sold option with a coupon stream that is paid until the bond expires or is knocked out. On the observation dates (every six months), 3% is paid to the investor until a coupon date arrives when the market is above 20,000 and the whole structure expires—the investor receives her principal and the last coupon payment. If no such knockout event occurs by the end of the bond’s life, the market is below the strike and the bond redeems below par. So, if the Nikkei falls by 10%, the investor gets 90% of the principal back. Exhibit 4 shows the terms of this autocallable note.

It is also possible to make the coupons dependent on the market level. The put option can be out of the money and can be leveraged up. A large number of varieties can be deemed autocallable, which refers to the automatic redemption that occurs when the market is above the knockout level on an observation date.

Autocallable notes are very popular in Japan and Europe, where longer-dated structures are more prevalent. They have been produced and distributed for over 20 years and thus seem likely to be around for a while yet. A version based on interest rates, known as the power reverse dual currency (PRDC) note, became wildly popular in Japan but caused so much damage to both investors and product producers that it is no longer commonplace. A more detailed explanation of the genesis of autocallables and of the PRDC debacle, along with the risk management problems these products have presented, can be found in Structured Products: Evolution and Analysis, edited by Clarke Pitts (London: Risk Books, 2013).

There are several sorts of risk that can be easily identified.

A. Investors’ Risks

For the investor, there is investment risk. When the underlying assets do not perform as expected, the structured product will also disappoint. Investment risk is the largest class of risk for any party but is neither the most interesting nor the most important risk in any other sense.

The investor also bears default risk. If the issuer of the structured product fails before the product matures, the investor may suffer. Sometimes, the products are guaranteed by a third party to improve the credit quality for the investor.

Underperformance risk is sufficiently commonplace to merit a mention. Investors often do not appreciate that while they may be making a profit in a rising market, their participation can be curtailed by caps on the payoff or by early redemption of the structured product.

Should investors want to sell a structured product owing to a change in their market view or other circumstances, they may find doing so difficult or expensive. Liquidity risk often arises when financial markets are turbulent (e.g., 1998 and 2008), just when liquidity may be needed most.

B. Intermediaries’ Risks

Investors often buy structured products through intermediaries, such as brokers, financial advisers, and private banks. Although intermediaries act as agents, they are also susceptible to significant risk.

Intermediaries can have reputational risk and even investment risk. When investors suffer losses from structured products, especially unforeseen losses, they sometimes accuse the selling party of misleading them or failing to properly explain the products. In some jurisdictions, courts have upheld such claims and have required intermediaries to pay compensation. These so-called mis-selling scandals have been rife in the United Kingdom and Hong Kong but have also occurred in many other countries.

Even if the investor’s litigation fails, the intermediary will probably have to endure negative publicity and significant loss of goodwill with existing clients. Therefore, many organizations have stopped offering structured products completely. Others charge high markups to mitigate the risk or to pay for very expensive indemnity insurance.

C. Product Manufacturers’ Risks

Although the banks that create these products also suffer from reputational risk and are sometimes sued by investors, their main problems stem from market risk and model risk.

Each structured product includes derivatives, which generate the payoff for holding the product. Banks hedge these derivatives. Their ability to do so relies on the markets’ behaving in ways that are consistent with the assumptions made in the model and on the suitability and resilience of the model itself.

Early generations of structured products incorporated derivatives for which there were established markets and models. For the most part, managing these products was straightforward. By the mid-1990s, early redemption, multiple assets, capped payoffs, forward-starting derivatives, and currency protection had all been introduced. These new payoffs were beyond the scope of conventional models, and so new, more sophisticated tools were introduced. The industry has not been uniformly successful in finding its way to safety, and a number of spectacular losses have been caused by model failure.

Another serious problem—sometimes called the “crowded trade” problem—arises when the hedging activity around these derivatives starts to significantly influence the asset price. Some structured products are so popular that the positions in them constitute many days’ volume of the underlying asset. Thus, when banks start hedging, the asset price is materially affected by the size of the orders. The magnitude of this effect can cause markets to become extremely volatile—or occasionally becalmed. This phenomenon is usually very detrimental to banks.

Popular products often cause problems when they lead to two distinct assets becoming highly correlated. In such cases, the movement of one asset requires banks to adjust their position in the other. For example, JPY-denominated long-dated swaps tracked the USD/JPY exchange rate for a long time, owing to the huge popularity of PRDC bonds in Japan.

The risks associated with structured products constitute a large and complex topic. Those interested in learning more should read Chapter 10 in Structured Products: Evolution and Analysis. A few other books on this topic are also very useful.⁶

The structured products industry is large and complicated enough that it should be examined by anyone involved or interested in finance and capital markets. The sums involved are comparable to those invested in hedge funds, yet these businesses are largely ignored by the press, the public, and even practitioners.

Structured products are financial instruments designed and created to afford investors exposure (to something) through a derivative contract. The underlying asset can be an equity price, an interest rate, an exchange rate, an index, a credit spread, a commodity price—anything, in fact, for which there is an existing financial market.

The structured products industry is so big and so diverse that it is helpful to break it down into three parts.

• Privately placed and individually negotiated transactions involving one investor or a very small number of investors. Such transactions are typically executed through medium-term notes.

• Products sold through syndication by such retail networks as banks, brokerages, financial advisers, and insurance companies.

• Products that are actively traded on exchanges or with market makers, constituting the fastest-growing segment.

The choice of instrument is predicated on such considerations as tax efficiency and convenience. Some popular structured products are:

• Target redemption forward—an example is provided for the USD/CNY instrument.

• Accumulator/decumulator—an example is provided of the popularity in Hong Kong and Singapore, for both onshore and offshore investors in other Asian markets.

• Autocallable notes—an example is provided for the Nikkei 225

The structured products industry is large enough and complicated enough that it should be examined by anyone involved or interested in finance and capital markets. The sums involved are comparable to those invested in hedge funds, yet these businesses are largely ignored by the press, the public, and even practitioners.