Cost of embedded options in structured products

Discussion in 'Options' started by trade2live, Aug 13, 2009.

  1. I am doing some research on structured products, these products offered by private banks are not popular in the US but represent a sizeable market for asset managers and advisors in Europe. By structured products I mean reverse convertibles,
    principal protected notes (option + zero) and certificates on baskets of stocks but also warrants issued by banks over stocks trading on the exchanges.
    Personally I would not invest in any of those products, what I am trying to understand is why this market is so big in Europe but virtually non existent in the US except at private banks catering to a privileged few (and where those products I believe are usually customized). I am also trying to understand how banks are able to make big profits on these products while still delivering something that is beneficial or at least looks beneficial to customers (the market accounts for a large share of revenues at Swiss private banks for ex. and some small firms focus exclusively on structuring and selling such products as well as more run of the mill option strategies).

    I assume the money comes from overpriced embedded options and management fees but I am no expert in option strategies and pricing and am looking for the opinions of those that are familiar with those products and their inner works.
  2. With respect to Capital guarantee products; one possible reason could be that Interest rates were/are traditioanlly higher in Europe and UK allowing for Higher Equity forwards creating advantageous derivative pricing of these products (long equity put or Long equity put + short Equit call) in conjunction with the higher interest earned on the cash deposit portion. It was just a thought, but i may be wrong. Maybe there is another fundamental reason.
  3. The number one reason for their popularity or lack off IMO is regulation.

    I cannot speak for Europe but here in Canada, the only way a small investor is allowed to buy a product that has a hedge fund type of mentality is to invest in those. Otherwise to invest in a hedge fund you need to come up with 150K.

    Also, the 6 major banks in Canada do offer these products and typically will tell their clients to put 10% of their investments in those. They are very profitable because:

    1) they take a 5% fee off the bat, aka if you invest 100$ as a client, from day one your investment is worth 95$.

    2) Although it is not said anywhere, I suspect they do not pass the options "at cost" to the consumer, they take a profit.

    3) When they actually buy stocks, you can kiss your dividend goodbye, the bank pockets it.

    4) There are penalties if you want to get out (typically for 2 years).

    There are mainly 2 types of capital protected note: the dynamic protection and the zero-coupon protection.

    The main advantage of the dynamic is that the bank will track the value in time of what it owes you and the value of the investments they make with the money. So in theory you get leverage.

    The main downside (and that happened alot in 2008) is that if the two value lines cross (if the investment tanks), then the note is "knocked-out", which means they will buy a zero coupon at that point to protect what they owe you. That means that whatever the market does after that point, you will only get the amount that was garanteed to you.

    The second type buys a zero coupon from the get-go and they will leverage the remaining money like crazy. Trouble is: interest rates for zero coupon are in the toilet so they have very little money to actually invest so don't expect a bonanza...

    They have now come up with a new hybrid after the meltdown of 2008. Basically it has a trigger level under which your capital is not protected anymore. Ex: if the s&p is at 1000, they will say, your capital is 100% protected unless the s&p goes below 800 at any point in time. If that happens, at the end you get market value (could be lower or higher than what you invested depending on the comeback afterward)

    One last thing you want to check out, here in Canada, if you hold on to the investment until maturity then it is considered interest income that is taxable like a b*tch. May be different in Europe though...
  4. It's a combination of factors, actually...

    IMHO, these structured products gained in popularity in Europe for a whole variety of reasons. Some of the reasons are cultural (French people tend to think they're very sophisticated), while others relate more to accounting/tax treatment of structured products (Italy/Greece). As a result, the business grew into a semi-legitimate scam that enriched both the banks and the officials (in a predictable, brown envelope sort of manner).

    The profits on these products for the banks come from two sources, mainly. Firstly, it's the simple fact that bid/offer on these products is relatively large, so if a desk can generate significant volume, it's going to make a killing (there's all sorts of anecdotes about exotics desks being able to record $100m pnl on a single Italian deal). Secondly, most of these notes involve selling volatility to increase yield pickup. This was all fine and dandy during the good years and the exotics desks were able to consistently make good money. However, they were caught with their pants down in a most spectacular fashion last year (in at least two episodes) and lost a huge chunk of all they have made over the years.

    Moreover, now it looks like the banks might even have to give back more money as they're getting sued by their erstwhile clients for mis-selling these notes.

    That's my view on the matter. I might add that you might find people willing to give you more educated answers if you ask on places like Wilmott and Nuclear Phynance, rather than ET.
  5. bidask


    don't shit in your oown backyard :)
  6. If you are doing genuine research you will in fact discover that billions of dollars of structured notes have in fact been issued and trade under utp rules here. Citi and Morgan offer them into the retail and institutional community. Many are listed NYSE and the old AMEX. Many were structured as imbedded buywrites where the yield was enhanced and the upside was capped. The retail market includes everything from single stock structures to sectors and a few index based products.
    If you have a friend at Citi or Morgan they can get you a copy of the offerings.