This paper traces the survival of FX structured products in the private banking business when all other classes of structured products have suffered setbacks during the credit crisis. Different categories of FX products were showcase to illustrate the applications and risks of these derivative structures.
This paper explains the reasons for the resilience of this strain of structured products in the face of adversity. The FX accumulator was chosen to demonstrate the principles and considerations behind designing, pricing and hedging structures from an issuer's perspective. This paper concluded with lessons learned from structuring, pricing and risk managing of structured products.
Introduction Since the collapse and bankruptcy of Lehman Brothers in September , most investors have steered clear of structured products. Gone were the glorious days when bankers could easily package and peddle them by the truckloads and investors are attracted to them like ants to honey. Equity and commodity-linked structured products were particularly popular during the boom years of to when interest rates were low while the global stock markets rallied and commodity prices were breaching historical highs consistently.
When the markets tanked with the credit crisis, these structured products, with payoffs and principals pegged to bullish market performance, brought excruciating financial pain to millions of investors who bought them without fully appreciating the risks. However, in the less publicised world of private banking, a class of evergreen products continue to thrive in this post-crisis era.
These were the foreign exchange FX structured products. FX is a unique asset class, which is less influenced by movements in the global stock markets. The reasons why private banking clients continue to favour FX structured products are as follows. First, FX structures continue to serve a real hedging need in the daily conduct of their affairs and businesses, which span the globe.
Second, interest rate differentials between the developed and emerging markets continue to offer investment opportunities when the stock and commodity markets have come to a standstill. Third, FX derivatives and structured products allow these cash rich customers to speculate on directional view of currency movements influenced by macroeconomic and political events.
By industrial norms, a client is usually worth servicing only if he or she deposits assets above USD 5 million with the bank. As such, you can imagine the cash and holding power this group of investors have over the average retail investors. Private banking customers have a whole arsenal of investment tools and advisors at their disposal. The more mundane ones would include brokerage facilities, trust administration, custodian services, tax planning, offshore banking, portfolio management, investment advisory, succession planning, private equity and hedge funds investments, while the more exotic ones would include art and wine collection, jet financing and real estate procurement.
Some clients emphasize wealth preservation while others look for ways to enjoy the fruits of their labour. Whatever their needs, the shrewd private bankers would always have a personalized solution for them. As such, structured products that were initially targeted at large corporations soon found their way into the private banking world. These products, which started off as highly customised solutions, soon became commoditized due to the high margin they generated for the banks and their rising popularity among private banking clients.
Some strains of these structured products eventually flowed to the retail market. That is where the trouble began. Distribution and Marketing of Structured Products A private bank typically provides structured products or solutions to its clients through the following channels.
For global banks that combine investment banking, private banking, retail banking and asset management under one roof, the products will usually be conceived and customized by the private bank, structured and hedged by the investment bank, distributed internally to private banking customers first followed by retail customers for the vanilla ones, the asset management arm may also take on the custodian of the structured products.
For the boutique private banks that do not have the capability to structure and hedge these products in the capital markets, they will usually source these products from the investment banks that market them or act as co-lead managers to create the product and underwrite the issue. Most of the time, private banks do not have the capability to hedge complex structures. As such, they usually act as distributors for the issuers. In cases where they need to customize derivative solutions for their clients, they will execute back-to-back cover deals with their investment banks against their client deals.
They will usually only earn the spreads and not take any proprietary positions. Structured products in the private banking world can be broadly classified into 3 main categories, namely Participation products, Yield products and Hedging products.
Participation products are for investors who have a directional view bullish, bearish or ranging on the market or underlying and they would like to speculate on this trend. Yield products are for investors seeking guaranteed coupon or yield enhancement. These products usually offer a coupon that can be fixed, conditional or both. Twin Win is a structure that allows the investor to participate in the upside and the downside of the underlying from a strike level. This product is suitable for an investor who believes the underlying is set to rise bullish view or fall bearish view until a certain level but is not sure of the direction the movement will take.
The product adopts a strategy similar to a Straddle with barrier on both sides of the strike. If the underlying has not breached the lower barrier and has never breached the upper barrier during the product life, the investor recovers his capital plus a cash gain equal to the absolute performance of the underlying. If the underlying has traded at a level equal to or less than the lower barrier or has traded at a level equal to or higher than the upper barrier during the product life, the investor receives only its capital back.
The barriers have not been breached during the life of the product. The Upper barrier has been breached during the life of the product. The CUP is a participation product for investors willing to take a directional view on the underlying. If the barrier has not been breached, then a minimum return will be guaranteed at maturity.
If the underlying has never traded at a level less than its barrier level during the product life, the investor receives the best return between a bonus level and the positive performance of the underlying. Some common yield enhancement products include range accrual notes, binary notes, notes based on a basket of currencies and reverse convertible notes.
The investor is taking the view that the reference index will not change much, or will remain within specified levels. The capital is protected at maturity. Investor is short volatility while issuer is long volatility.
Range accrual notes typically have life spans of 6 to 24 months. The call option allows the issuer to early redeem the structure before maturity, at par, under some specific market conditions, on each observation date t , subject to a non-call period. A Binary note is a structure with a protection on capital at maturity that pays an attractive coupon, above the risk free rate, if a condition on the underlying is fulfilled. It gives the investor the flexibility to choose the condition s based on his view of the market.
European-style options structures are ideally suited to purely directional strategies and operate as follows:. The investor plays a purely upward or downward strategy on the underlying and fixes a strike, which reflects his expectations. He earns a coupon only if the spot rate on the maturity date is at the same level as or is above or below the pre-defined strike. American-style options structures suit all other strategies and operate in the following manner:.
The investor has no precise idea about the future trend of the underlying but thinks that it may reach a certain limit upward or downward during the course of its trend. The investor fixes a strike, at the level of this limit, which reflects his expectations. He earns a coupon only if the spot rate hits the pre-defined strike at least once during the whole life of the product. He earns a coupon only if the spot rate never hits the pre-defined strike during the whole life of the product.
The investor has no precise idea about the future trend of the underlying upward or downward but reckons on the underlying moving within a wide range.
He fixes a range a lower limit and an upper limit , which reflects his expectations. He earns a coupon only if the spot rate hits either of the limits at least once during the whole life of the product.
The investor has no clear idea of the future trend of the underlying upward or downward but reckons on the underlying remaining stable. He earns a coupon only if the spot rate never hits either of the limits during the whole life of the product.
Hedging Products Hedging products are for investors wishing to hedge their portfolio. Usually the investor would have an existing deposit or portfolio denominated in a specific currency with the intention to convert it into another currency, likely his home currency or safe G7 currency, in the foreseeable future.
Certificates replicate the performance of an underlying asset or theme. For both strategies, the investor benefits from the flexibility to choose any combination of strike prices according to his directional view of the market and risk appetite.
An FX Accumulator Forward is a structure that allows the investor to hedge his currency exposure through an accrual mechanism. The investor is able to secure a more favourable conversion rate than the outright forward rate for the same period.
There are many variations of this product in the market, but in general they abide by the same basic framework. The time frame of such products can range from 3 to 24 months. In this example, the investor has a EUR deposit of 1 million and wishes to convert the deposit to USD at a more favourable rate than the existing outright forward rate. In order to remove the risk of the capital being converted at a worse rate compared to the spot rate upon maturity and to enable the investor to benefit from any favourable movement in the underlying currency pair, the investor may choose to add a second knock-out level in the direction that he wishes to speculate.
During the product's life, as long as the spot rate remains within the range created by the two knock-out levels, the investor accumulates on a permanent basis, at each observation period, a portion of the nominal to be converted.
If, during the products life, the spot rate hits either of the knock-out barriers at least once, the accumulation ceases and the investor knows from then on what amount he will have to convert and what amount will remain in his deposit currency upon maturity.
In order to increase the probability of converting the nominal, the investor may opt for a temporary knock-out instead of a permanent knock-out. In this case, he sets a Fade Forward level instead of a knock-out. If the spot fulfils the condition relating to the structure, relative to the Fade Forward level, at each observation period the investor accumulates a portion of the nominal to be converted.
If for one observation period, the spot rate does not fulfil the required condition, the accumulation ceases temporarily. The accumulation resumes as soon as the spot rate fulfils the condition relating to the structure again at any subsequent observation periods. In the following sections, the different types of products under the 3 categories described above are illustrated. In the previous section, a brief description of an FX Accumulator Forward and its variations has been explained from an investor's perspective.
The following section will attempt to design, price and hedge the product from an issuer's perspective. An accumulator forward is a highly path dependant product that can be structured as a zero-cost forward enhancement without a guaranteed worst case.
As such it tends to be speculative in nature. At the beginning, it was a very popular product among many corporates in Europe, particularly France, Italy and the UK. Subsequently, the product was adapted to suit the private banking and retail customers. Equity Accumulators were very popular among Asian retail investors, particularly in Hong Kong and Singapore, during the pre-crisis days when the stock markets were bullish.
They were viewed as safe vehicles to tap the market rallies. These products enabled investors to purchase stocks at a discount when the market was bullish but exposed them to unlimited downside risk when the market turned south. Many high profile court cases highlighting the negative aspects of Equity Accumulators were reported in the media throughout Asia when the crisis started to unfold.
In spite of the bad press, for Accumulators in general, FX accumulators continue to enjoy success with private banking clients due to the following reasons. First, an FX Accumulator can be used as a hedge that offers a better rate than an outright forward. Second, an FX Accumulator can be structured as a zero-cost product, which makes it an attractive alternative to purchasing a costlier option.More...