How is a Structured Productput together?

Mar 2009

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Content

IntroductionExample 1 – Zero Coupon Bond + CallExample 2 – Zero Coupon Bond + Geared CallWhat determines Structured Product pricing?Option pricing summary

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Introduction

Using examples, this presentation aims to illustrate how seeminglycomplicated structured products can be decomposed into simplercomponent parts.

Having determined the component parts of these sample products,the pricing parameters that determine the value of theseComponent parts are then discussed.

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Example 1 – Zero coupon bond + call

In Pictures

GBP1.00Investor’s

Cash

Share Price at Issue 100.00p

Zero-Coupon Bond 75.00p

Aggregate Costs 1.50p

Option Premium 23.50p

GBP1.00Zero-coupon

Bond

OptionProvidingEconomic

Return

One of the simplest types of structured product is one whereby the investor invests 100p onthe trade date in return for a guaranteed 100p back at a fixed time in the future (theMaturity Date) in addition to some kind of upside in an underlying asset of his choice (eg,FTSE).

Step 1 – It is first necessary to calculate how much must be invested on day 1 in order toGUARANTEE 100p is returned at maturity. If we assume the investor is investing in GBP,then this amount will depend on the prevailing GBP interest rate for the term over which heis investing. As a crude example, let us say that if the prevailing interest rate isapproximately 5% and the term is 5 years, the investor will have to invest 75p on the tradedate to guarantee 100p after 5 years. Another way of putting this is to say that a 5 year GBPzero-coupon bond costs 75p.

This means that the investor has used up 75p of his 100p to guarantee, and therefore has25p left to buy something else.

Step 2 - Let us assume that it costs 1.5% to put a structured product together. In this case,therefore, 1.5p of the remaining 25p would be used up, leaving 23.5p to buy some upside inan asset.

Step 3 – The final step is to decide what will be bought with the remaining 23.5p. If one 5year at-the-money call option on the FTSE were to cost 23.5p, then one of these optionscould be bought with the remaining 23.5p.

The Final Product – Putting the zero coupon bond together with the FTSE call option abovecreates a structured product that guarantees the customer all of his capital back atmaturity and also 1:1 in any increase in the FTSE. If the FTSE falls over the term of thetrade then the investor does not suffer any loss.

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Example 1 – Zero coupon bond + call

In Numbers

• Amount to spend = 100p• Zero coupon bond cost = 75p• Costs = 1.5p• Therefore cash remaining to spend = 100 – 75 – 1.5 = 23.5p• Cost of one FTSE atm call option = 23.5p• Therefore number of FTSE options bought = 23.5/23.5 = 1

• Therefore structured product is 1 x ZCB + 1 x FTSE call

This slide is a simple numerical example of the diagram explained in theprevious slide.

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Example 2 – Zero coupon bond + gearedcall

In Numbers

• Amount to spend = 100p• Zero coupon bond cost = 75p• Costs = 1.5p• Therefore cash remaining to spend = 100 – 75 – 1.5 = 23.5p• Cost of one SPX atm call option = 11.75p• Therefore number of FTSE options bought = 23.5/11.75 = 2

• Therefore structured product is 1 x ZCB + 2 x SPX call

This example is similar to the previous slide, but shows what could bebought if the cost for one option that the investor wants to buy is lower thanthe cash remaining to spend.

If we assume 23.5p is left to spend and one atm option on the SPX costs11.75p, then 2 atm options could be bought with the remaining cash.

The resulting structured product would guarantee the investor all his capitalback at maturity plus twice any positive return of the SPX. This would meanthat if the SPX was up 50% at maturity, the investor would receive 200p backfor every 100p invested. (100p from zcb, 50p from each option bought =100p + 2 x 50p).

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What determines Structured Productpricing?

• Two Price Components

• Zero Coupon Bond Price• Interest rates• Credit

• Option Price• Volatility• Time to expiry• Spot price• Strike price• Dividends• Interest rates

We have used some simple numerical examples in the previous slides thathave made assumptions about option and zero coupon bond prices, but howin practice are these two different components priced?

Let’s first deal with the zero coupon bond.

Like with any bond, its price is dependent on prevailing interest rates andthe credit of the issuer selling the bond. Two years ago most structuredproduct issuers were banks whose credits were trading at approximatelylibor flat. Post credit crunch, this is not the case. It is therefore importantto evaluate the creditworthiness of the issuer when deciding from whom tobuy a structured product. Issuers trading at high credit spreads should pricezero coupon bonds at a lower level, than those trading at low credit spreads,which means they will have more cash left over with which to buy options.This in turn means that the potential return of a structured product issuedby an issuer with a high credit spread should be better than that offered byan issuer with a lower credit spread.

Having understood how we work out the price of a zero coupon bond, wenow need to look at how we price the option component.

Option pricing is based on numerical models that DO NOT HAVE AN OPINIONON WHICH WAY THE MARKET WILL MOVE. They use probability theoryamong other numerical methods to try and model what options are worth.One fundamental point is that the models generally assume an equallikelihood of the asset moving.

The following slides deal with these points in turn. 7

What determines Structured Productpricing?

Volatility – It’s all about the bell curve!

The first thing to consider is volatility. When an asset is expected to have a highvolatility over the term of a trade, one could say that the chance of that assetmoving up a lot or moving down a lot over that term is higher than if that asset isexpected to have a low volatility.

The diagram on this slide shows different normal distribution curves – or bellcurves. Normal distribution curves illustrate how scattered about their mean aseries of figures are. When applying this to options, we could say that the mean isthe “average” value of an asset at a point in time, and that the figures that go intocreating this mean are all the possible values of that asset at maturity.

To use an example, let’s assume that an asset has a price of 100p today. Given thatwe assume there is an equal likelihood that that asset will move up or down, wecould argue that the chance of that asset being equal to 150p after 5 years is thesame as the chance that it will be worth 50p. The same could be said about theasset finishing at 90p or 110p.

Pictorially the red curve could represent the expected returns of an asset in a lowvolatility environment – ie, high probability the asset will finish close to where itstarts. The blue curve could represent the expected returns of an asset in a highvolatility environment.

What does this mean for the return of a call option as described previously? Forboth the red and blue curves, the left hand side of the graph can be ignoredbecause if the asset finishes below where it starts the option will be worthless,regardless of how far below its start level it is.

So we need to consider the right hand sides of the two curves. It can be seen thatin the high volatility environment (blue curve) there is a higher probability that theasset will finish at a higher level than in the low volatility environment (red curve).The next step is to realise that this means that the average or expected payoff(from a probability perspective) is higher in a high volatility environment comparedwith a low volatility environment.

This quite convoluted explanation aims to explain why “options are more expensivewhen implied volatility is higher”.

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What determines Structured Productpricing?

Time to expiry – it’s all about the bell curve – again!

We can again use the bell curve to explain why longer dated option aregenerally more expensive than shorter dated ones.

This time, instead of the red curve representing a low volatility environmentand the blue curve representing a high volatility environment, the red curvecan represent the possible returns of an asset over a short period and theblue curve can represent the returns of that same asset over a longer timeperiod.

This makes sense intuitively because the longer the time an asset has tomove, the greater the chance it has to move away from its start level, bothup and down.

Given that any returns on the left hand side of both curves can be ignoredagain, we can use the same arguments as those on the previous slide tounderstand why a longer date option is generally worth more than a shorterdated one on the same asset.

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What determines Structured Productpricing?

The remaining parameters are:

• Spot price• Strike price• Dividends• Interest rates

• These are all used to generate the forward price

Dividends also play a role as typically a structured product promises to giveinvestors participation in the price index. As a result when pricing an optionthe dealer gets to keep the dividends. The higher the dividend forgone thecheaper the option. However, It’s important for dealers to price theseexpected dividends correctly as the dealer is now carrying the dividend risk.Though this can be hedged out to other market participants via the dividendswap market, these risks may end up being warehoused. Under normalmarket conditions this may not cause any sleepless nights, though dealersare now more conscious of this dividend risk, especially with thosefinancials!!

To tie in with the dividend we now turn to something known as the“forward” i.e. the spot price + rates – dividends. This is the cost today ofbuying the index (or stock) in x years time. An option on an index with ahigher forward would be deemed to have a higher probability of maturing inthe money, therefore be more expensive than an option on an index with alower forward.

The final consideration for considering what would effect the price of anoption, on a non UK structured product, would be the currency, or morespecifically interest rates. Most non UK structured products are priced in as“Quanto GBP”. This means GBP investors have exposure to the underlyingasset class without any currency risk. To quanto an option, means to hedgeout the currency. Clearly this can work to the advantage of investors or thedetriment, though many investors just like to have this risk hedged out. IfUK rates are high relative to those rates in Europe then the positive carrycheapens the option, as was the case until fairly recently. However, now UKrates are lower than those in Europe there’s negative carry as you’reswapping a low yielding currency for a high yielding currency.

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Option pricing summary

In summary, the input parameters for optionpricing break down into the three categoriesbelow:

• Volatility – Most important parameter• Higher vol = more expensive option

• Time to expiry• Longer dated = more expensive option

• Forward price• Found using spot, rates and expected dividends

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Disclaimer

The information in this document is derived from sources believed to be reliable but which have not been independently verified. Catley LakemanSecurities makes no guarantee of its accuracy and completeness and is not responsible for errors of transmission of factual or analytical data, nor is itliable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data.The opinions in this document constitute the present judgment of Catley Lakeman Securities, which is subject to change without notice.

This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. This document is intended for theuse of institutional and professional customers and is not intended for the use of private customers. This document is not intended for distribution in theUnited States of America or to US persons. This document is intended to be distributed in its entirety. No consideration has been given to the particularinvestment objectives, financial situation or particular needs of any recipient.

Catley Lakeman Securities is a LLP registered in England and Wales, Registered Office : One Eleven Edmund Street, Birmingham, B3 2HJ. RegistrationNumber: OC336585, Vat Number: 936371705, FSA Reference: 484826

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