Structured Products

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The Force of Habit

Believe it or not: the financial crisis has barely gone into rigor mortis yet, and what is happening? Signs are rife in the structured products industry that “worst-of” barrier reverse convertibles are rising from the ashes. Of all things, the product type that wreaked so much havoc on so many investment portfolios. The falling share prices that accompanied the recent crisis managed to break all the barriers of these products, which in turn resulted in investors having their accounts credited with the lowest-yielding stocks in the underlying basket of securities. Performance was not the only thing that suffered; it also became patently clear just how difficult risk management can be when one doesn’t know which shares will ultimately land in one’s account. At the late-September Structured Products Fair in Zurich, the whispers between competing product specialists were almost audible: “Hey, are your worst-ofs running again, too?“ Mostly, the answer was a hushed “Yes” or a slight nod. Hardly any of the specialists were particularly pleased about that fact, however. Today they take skeptical view of these products, which caused not only investors but also the banks to lose massive amounts of money. Why then are these products so popular, especially in Switzerland? It certainly can’t be due to their tax efficiency, because a Swiss investor pays income tax on the fixed-interest portion of the coupon. Using worst-of barrier discount certificates would be preferable from a tax point of view. Thus, the attractiveness of the product is most likely attributable to its high coupon, which tends to be in line with investors’ desired target yield. But in the process, the chances for a barrier violation are drastically underestimated. Did you know that the probability of that happening lies at roughly 40 percent on average? So the fact is, barrier reverse convertibles rarely correspond to the risk profile of private banking clients because they produce left-skewed return distributions. In other words, the upside potential is limited to the coupon, while the downside risk is unlimited. There are of course specific market conditions in which it might be reasonable to employ a worst-of barrier reverse convertible on two stocks (or indices): for example, in anticipation of sideways-tending share prices, coupled with declining volatility and increasing correlation. Not exactly a high-probability scenario, is it? Especially today, with volatility readings already back at their pre-crisis levels. Moreover, experience shows that adding a third or even fourth stock to a worst-of product’s basket is in most cases senseless because it boosts the coupon only marginally even as the related risk increases sharply. So after all of the aggravation that came from investors being served up a dish of poorly yielding shares, wouldn’t it be reasonable to consider buying capital-protected products? For example like I wrote on my blog the other day, 90 percent capital protection on the Eurostoxx50, with an exercise price at 90 percent and a term of nine months, results in a participation rate of ca. 75 to 80 percent. You risk “only” 10 percent but are on board if the markets continue to rise. Investors should give serious thought as to whether they are actually prepared to relive the scenarios seen in 2008. Prior to the crisis, investors were accustomed to cashing-in on generous coupons. And despite the shocking experiences of last year, it appears that those get-rich-quick expectations are not to be eradicated. Once again, it would seem that force of habit is over-trumping any rational argument.