Chapter 2 Introduction to the Structured Products Market
2.1 The Structured Products
It all started back in the early 90's. Investment banks were looking for ways to attract investors into the Equity markets.
What better ways than providing innovative solutions with advanced payoffs on various assets?
This is what structured products offer. They allow investors to have access to innovative payoffs through different issuing wrappers. By doing so, they provide an excellent solution to invest in a product with a tailor-made risk-return profile in a cost-effective manner.
As structured products are sold over-the-counter (OTC), there must exists a sound legal contract between the two parties. This contractual agreement explaining the features of the structured product is referred to as a Term Sheet (TS).
For the OTC business of structured products to expand, the development of a secondary market was necessary to provide liquidity. The banking system has always been based on confidence. Investors will be more inclined to invest in structured products if they know they can partially/fully unwind their positions easily in the future.
To offer such liquidity, traders estimate the market value of structured products based on the current market data and make bid-ask quotes available to investors. Usually, notes trade in the secondary market with a 1% bid-ask spread. If the traders are struggling in risk-managing a specific product, they might increase their bid-offer spreads (except if legally defined otherwise in the term sheet).
Banks usually have valuation teams that help the salespeople to provide their clients with quotes.
This is more important than it looks! Clients may want to decrease/increase their exposure by selling/buying at the bank's bid/offer price. The fair price of the structured product lies somewhere between the bid price and the offer price but it does not have to be right in the middle. Depending on the estimated probability of the clients to increase/decrease their exposure, the valuation team will shift the bid-ask spread. Therefore the fair price may be closer to the bid price if the valuation team expects the client to increase his exposure. In this manner, the bank would make more money when the client buys at the offer price. In the same way, the fair price may be closer to the offer price if the valuation team expects the client to decrease his exposure. In this manner, the bank would make more money when the clients sell at the bid price.
The valuation job is not a cakewalk. Some illiquid parameters can hardly be implied and will need to be monitored closely. These parameters can considerably impact the whole trading book. Some market consensus data providers such as Totem can be used to mark some illiquid parameters at some market consensus between institutions active in the market.
2.1.2 Issuing Wrappers
As stated, structured products can be launched in different wrappers that have their particular legal status.
I am not an expert on the regulations and laws around the different wrappers and will only speak about their financial side. In the same way, I will only cover the wrappers I have been used to deal with.
126.96.36.199 Warrants and OTC Options
The warrant/option's holder is granted the right to buy a specific amount of shares in a company at an agreed price.
188.8.131.52 Notes and bonds
They are debt instruments issued by the banks usually as senior unsecured debt that can be listed or not.
Investing in such notes is not risk-free since the investor still faces the risk that the issuer of the note defaults. Furthermore, the investor could be selling an option inside a note, putting his capital at risk.
Example of a typical structured note
The structured note is composed of:
- a non-risky asset providing a percentage of protected capital
- a risky asset that adjusts the risk-return profile.
The "non-risky" part is typically a zero-coupon bond (ZCB). When saying "non-risky" here, I mean that the capital is guaranteed as long as the issuer does not default. As a ZCB is bought as a discount, you can consider its value to increase 'relatively' linearly through the life of the product to amount to 100% of the notional at maturity.
The initial price of the non-risky part is linked to the level of interest rates. Higher interest rates decrease the initial value of the ZCB and increase the amount available to the structurer to create an attractive payoff enabling the investor to increase his upside in the equity.
The risky part is typically composed of options on single or multiple assets. These options will enable the investor to make additional profit using leverage. This possibility of additional return comes with additional risk as their value can fluctuate considerably.
As we will see, options' price is convex and subject to many market parameter.
2.2 The Stakeholders
As in every market, the stakeholders can be classified into two categories: the sellers and the buyers.
2.2.1 The Sell Side
The salespeople are in charge of selling structured products to existing or new clients. Useless to say that they get commission for the transactions they settle so that their remuneration depends on:
- The number of deals
- The size of the deals
- The nature of the deals
The size of transactions is important for every sell-side stakeholders.
For the salespeople, their commission on a transaction is a percentage on the deal's notional. They might therefore be tempted to decrease their commission margin to increase their chances to settle the transaction and get a large dollar amount of P&L. Furthermore, there is less costs involved in terms of hours spent on the deal.
For traders and structurers, the size of transactions is important in the valuation of the structured products. The larger a deal with unhedgeable risks, the larger the risks for the traders to manage, the more dispersion in the prices offered to the investor.
Selling structured products is not like selling shoes. Before issuing them, salespeople will spend quite some time with potential buyers reviewing the payoff mechanism and potential return. They will use a large panel of marketing methods to explain the product's risk-return profile: back-testing, stress-testing, etc..
Their role is often underestimated as they usually have a slightly less technical background than the other stakeholders on a trading floor. I personally have a lot of esteem for them. They must understand a large panel of complex products, demonstrate strong adaptability and be able to build relationships of trust with their clients.
They must also be strategist and know their clients. For example, in competitive auctions, they must sometimes accept not to charge much to get the deal and be able to charge smartly on the secondary-market depending on their clients' habits to unwind or increase their positions.
An excellent salesperson is a rare thing and is a pleasure to work with for a structurer.
Their role involves pricing existing structures and creating new ones. When creating new products, the structurer must be innovative and creative.
This innovation is a collaborative innovation as the structures must have a close interaction with salespeople to understand what the investors are willing to buy.
The capability of innovating is a key asset for an investment bank to stand out in the competitive market of structured products.
When pricing structured products, the structurer analyses all the risks. He also works closely with traders to agree on the levels they will charge for taking those risks.
Structurers must discuss and negotiate with traders on the value of the market parameters used to price the products. This is because, after a deal has been closed, the product is booked in the trader's portfolio. The trader will therefore be in charged of hedging the products' risks.
An exotic trader in an investment bank is therefore more a hedger than a speculator. They usually have a more dynamic view of the products than the other stakeholders as they will have to manage the risks during the entire life of the products. Those risks are quite elaborated and it is not always possible to hedge them completely. The trader will manage them as best as possible within the specified limits set by the risk department.
184.108.40.206 The balance of power
It is important to understand the balance of power at play on a trading floor with different stakeholders having diverging interests.
Sales are focus on increasing their commissions as much as possible and therefore closing as many deals as possible. Traders also want business since they want to increase the size of their books but not at all cost. They will not want to take unhedgeable risks except if the risk is well rewarded, otherwise they might end up losing money on such positions.
Sales will tend to be agressive and traders defensive. Structurers stand in the middle trying to reconcile at best these diverging interests.
2.2.2 The Buy Side
Buy side clients can be classified into two categories: retail and institutional.
220.127.116.11 Retail Investors
Most of them are asset management firms that invest in structured products to redistribute them to individual end clients.
The payoffs are highly simplified and marketed accordingly.
The process usually works as follow. Retail investors request indicative prices from several banks before moving to a live auction. Based on the indicative prices received, retail investors will select the most competitive counterparties to participate at the live auction.
At the live auction, they will request the selected counterparties to update their indicative prices into tradeable prices. Those live prices might be similar or different than the indicative ones based on two things: - the evolution of the market parameters between the indicative request and the live auction. - the agressivity of the bank might have changed based on the client's feedback after the indicative prices.
Retail investors typically select the bank that offers the most competitive price but may also spread a large notional over several investment banks.
Spreading a large notional over several banks enables the investor not to be fully dependent on the bid-ask of a unique bank if he wants to partly/fully unwind his position. In the same way, it will also allow him to spread the credit risk of having a unique counterparty.
The categories of yield enhancement products are the most popular among retail investors.
18.104.22.168 Institutional Investors
They include financial institutions such as hedge funds or mutual funds.
Transactions with institutional investors tend to be larger in terms of notional sizes and more sophisticated in terms of payoffs than with retail investors.
Solutions offered to institutional investors are business-tailored. As a result, it is less competitive than the retail business but the development of the solution is a much larger part of the job.
As payoffs can be more sophisticated, the room for innovation is greater.
22.214.171.124 A word on credit risk
I said above that the investors will typically select the bank that offers the most competitive price for the structured product. It is not always the case as the buyer of a structured note will also pay carefull attention to the seller's credit rating. An investor might decide to trade a product with a better credit-rated issuer even if he finds a more attractive price with a lower credit-rated issuer.
The price difference between several issuers can be quite substantial. This is not surprising as the zero-coupon bonds of low credit-rated issuers are worth less. Indeed the rate used to price the zero-coupon bond part of the structured note can be seen as a reference rate plus some rate that the bank's treasury offers on deposits. This funding rate varies greatly based on the issuer's credit-rating. The lower the issuer's credit-rating, the higher this rate, the lower the value of the issuer's zero-coupon bond. If the non-risky part costs less, it means more money remaining to spend in the risky part of the note. So the riskier issuer can potentially offer a more attractive payoff for the same price or a more attractive price for the same payoff.
Investors should know about the impacts of credit ratings on the structured note investments.
When markets are falling and volatility getting higher, it is quite usual to observe a flight for quality, meaning that investors favour the creditworthiness of their counterparties rather than their price competitiveness.
The credit risk from the structured note's issuance can be hedged using credit default swaps (CDS).
A few words can also be said about collateralized line investments that do not involve counterparty risk. When considering swaps, you can structure the swap along with collateralized lines with a third party to avoid problems in case of default events. It might sound complicated at first but it is not. It is simply about computing the value of the swap and setting aside the equivalent amount as collateral with a third party. This comes at the investor's cost as it mitigates his counterparty risk. I might adress a small chapter of these notes on credit-related adjustments in derivatives valuations even though it is not my domain of expertise.