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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.

The rise of online trading platforms

A new structured product needs a certain volume in order for the issuing costs to be covered. The typical size is around one million. Groans across the audience… Who does have one million, be it USD, GBP, EUR or CHF, to invest in one single product? If you want to maintain a certain diversification in your portfolio by limiting the position size to 5%, you have to belong to the super-rich, the so-called Ultra-High-Net-Worth-Individuals with 20 millions of assets, to be able to ask your banker to structure a product that fits your needs. Well, not anymore. More and more banks have already or are in the process of developing online trading platforms that drastically lower the issuing costs of a product. Where previously USD 1’000.- were needed to pay for the trading, market-making, back-office operations and documentation for issuing a product, they now amount to a mere USD 50.- or even less. Hence, some issuers have lowered the economical size to issue products to less than USD 50’000.- or equivalent. That’s the power of automation at the service of the investor. If you still want to maintain the same degree of diversification, the total size of your portfolio need only amount to… 1 Million. Much more reasonable, don’t you think? Of course, not all product issuers have developed such tools. They are expensive and sometimes extremely difficult to program. Whole processes have to be reviewed, trading books reassigned or consolidated, internal resistances have to be overcome and a stable environment, based on the Internet, has to be developed. In some cases, the issuer has to make a strategic choice about which clients it wants to target. If institutional clients are the issuer’s main target, then online trading tools may not be worth its costs. Those clients’ needs go often beyond any standard product that can be programmed and easily issued by a trading machine. However, private banking clients may appreciate the fact that they can parameter their own standard products. Speaking of which, what products can be issued with these online trading tools, and how is it done? The available product range really depends on the platform of the issuer. Some have developed more products than others have. As of this moment, capital guaranteed products with or without cap, yield enhancement products like reverse convertibles, barrier reverse convertibles, worst-of barrier reverse convertibles and more variants of the same type, discount certificates and barrier discount certificates; participation products like (capped) bonus certificates or (capped) outperformance certificates can be issued. Beside the main stock indices, the underlying assets encompass a few hundred stocks. Some structures can be issued with a quanto option, and some issuers allow the products to be collaterized at the stock exchange. On the FX side, two dozen currencies can be combined. Commodities like gold or silver are also offered. Overall, the possibilities are large enough to fulfill the majority of the typical private banking needs. At least for those investors, the progress made has a real benefit: products can again be tailor-made and need not be taken from a shelf, which restores a primary advantage of structured products: they can again be parametrized to one’s needs. Off-the-shelf products did also have the additionally drawback that they had an initial trading date that was determined by the issuer. With an electronic trading platform, the investor can choose his own time and place. The method for issuing the products is simpler than filling out an online form to buy a book at Amazon. Once you know what you want, a few clicks are enough to parameter your product. Begin by selecting the desired product type, for example a capital guaranteed product. Then choose an underlying asset, the notional to invest, the maturity, the level of the capital guarantee, and then solve for the participation. After a few seconds, the price request is sent back from the issuer with the result. If the product is matching your requirements, press the ‘trade’ button and the deal is done. An electronic trading confirmation is sent from the issuer with the final details. Another advantage of these platforms is the possibility for private banking clients to compare prices. The client need only have several banking accounts (which is the regular case anyway, investors not wanting to place all their eggs in the same nest), ask each bank for a quote and trade with the bank offering the best price. The transparency is enhanced, a critic that was often attributed to structured products. The advent of the Internet did not only profit Google or Amazon. Some banks are innovating in areas that didn’t exist a few years ago. Speaking of Amazon, the future of these online trading tools is likely to be bright. I’m waiting to see the day where I can put a product “into my basket”, like I would with a book. Even better would be the thought of a GoogleBank, where one can put together the parts of an investment, and Google pulls them from the cheapest bank. The investor would have to accept Google issuer risk, though.

Libor-Linked Deep Barrier Reverse Convertibles

Libor Linked Deep Barrier Reverse Convertibles are financial products of the yield enhancement category similar to classic barrier reverse convertibles. In July 2010, investment banks suddenly started to issue these products with a coupon linked to the LIBOR rate (London Inter Bank Offer Rate, the short-term interest rate) and with barriers often set at or below 50% of the current spot price of the underlying index or stock. The maturity was often set at three or four years, far longer than the usual twelve months. Example (Product 1 in the table below):
  • Type: Libor Linked Deep Barrier Reverse Convertible
  • Underlying Asset: SMI Index
  • Initial SMI Index Level (spot and strike price): 100%
  • Coupon (p.a.): CHF Libor + 3.70%
  • Maturity: 3 years
  • Barrier: 50% of spot at issue
Let's suppose that in this example, the Libor rate is currently set at 0.50%. The investor receives a guaranteed yearly coupon of 3.70% + 0.50% = 4.20%. If on the following year, interest rates rise and the Libor rate quotes at 1.00%, the coupon in the second year will then amount to 4.70%, etc., until maturity. The invested capital is protected against losses by the barrier, unless the SMI Index drops by 50% or more from its initial level and breaks through it. Should the latter occur, the capital protection disappears and the investor will most likely incur a loss amounting to the negative performance of the index. A drop of fifty percent may seem like a long way to go for the SMI, and the product may induce the investor to believe that he is buying a bond replacement product. Not quite! A backtest over the last 10 years (August 2000 to August 2010) shows that this product would have put a dent in an investor's finances in 17% (!) of all occurrences (using weekly data) - on average quite a large dent, in fact. If the underlying asset drops by 50% and breaks through the barrier, it is likely that the loss will be accordingly high, unless the asset recovers an doubles in value until maturity. I backtested other structures, all of which are being issued by various investment banks as of August 2010: [caption id="attachment_78" align="alignleft" width="300" caption="Backtest Deep Barrier Reverse Convertibles"]Backtest Deep Barrier Reverse Convertibles[/caption] The results show that all but one structure would have produced negative returns at some point in time during the last ten years. Of yourse, there were two really big crashes during that time: the internet bubble in 2000-2003 and the big recession during 2007-2009. Hence the results are dependent on the weekly data over that time, but it still shows the products in a light that is seldom shed on them. Only the last structure (Product 10, one of my own devising, to be issued at the end of the month by a AAA issuer) would never have been hit over that period. That isn't to say that it won't be hit in the next two years, but it's as safe as can be with still a decent coupon. Note that the coupon isn't linked to the Libor rate. That's because I don't believe that the Swiss National Bank will raise rates anytime soon. Hence, I'd rather take a flat coupon, rather than lose 0.40% for the chance of a higher one I don't think will materialize. Somehow, I can't shake the feeling that these deep barrier reverse convertibles with their Libor-linked coupon are somehow designed by clever investment banks to fool the investor into thinking they buy a Floored Floater with a super-high floor. Well, some will say I like to paint the devil on the wall... Be it as it may, I also like to shorten the maturity from 3 or 4 years to 2, as it lessens the counterparty risk (bankruptcy of the issuer) for the investor. I'll conclude by saying that once more that it would be a mistake to take these products for bond-like investments. They are rather to be taken as extremely conservative equity-like structures, useful for the investor whose target return is rather low, but who can bear the risk of an extremely unlikely large loss. And one more thing: avoid worst-of structures on single stocks. With three or four years maturity, they have a high chance of producing high losses; not something you would want in your portfolio.

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