Equity-Linked Structured Products

Question 1

1. List the six primary types of structured product wrappers.

Answer 1

• Over-the-counter contracts (OTC), medium term notes/certificates/warrants, funds, life insurance policies, structured deposits, Islamic wrappers

Question 2

2. What can cause the after-tax rate of return of a product with tax deferral and tax deduction to be higher than the after-tax return of an otherwise identical product with tax deferral only?

Answer 2

• When the income tax rate at withdrawal (e.g., retirement) is lower than the income tax rate of the investor when the contribution was made.

Question 3

3. What does a participation rate indicate in a structured product?

Answer 3

• The participation rate indicates the ratio of the product’s payoff to the value of the underlying reference, asset or index.

Question 4

4. How does a long position in an up-and-in call differ from a short position in a down-and-out put?

Answer 4

• Both option positions are bullish, but the up-and-in call has a payoff that is positively correlated with the underlying asset only in the region above the strike price and barrier, while bullish payoff region of the short put position is below its strike price. The up-and-in call has unlimited profit potential while the profit potential of the short position in the down-and-out put is limited to the premium received.

Question 5

5.What is the name of an option that offers a payout in a currency based on the numerical value of an underlying asset with a price that is expressed in another currency?

Answer 5

• A quanto option is an option with a payoff based on one currency using the numerical value of the underlying asset expressed in a different currency.

Question 6

6. What simple option portfolio mimics the payout to an absolute returns structured product?

Answer 6

• A long position in an at-the-money straddle, which generate profits via large movements in either direction (of the price of the underlier).

Question 7

7. List the three major approaches to estimating the value of a highly complex structured product.

Answer 7

• Partial differential equation approach (PDE approach)
• Simulation, such as Monte Carlo simulation
• The building blocks approach (i.e., portfolio approach)

Question 8

8. Describe the difference between an analytical solution and a solution estimated with numerical methods.

Answer 8

• Analytical solutions such as the Black-Scholes model are exact, because the model can be solved using a finite set of common mathematical operations. A solution estimated with numerical methods is not exact. It utilizes a potentially complex set of procedures to form an estimate.

Question 9

9. In an informationally efficient market can a structured product be engineered to offer both any payoff diagram shape and any payoff diagram level?

Answer 9

• No. The level drives whether the opportunity has a positive, negative or zero net present value.

Question 10

10. Briefly summarize the evidence on whether the offering prices of structured products are over-priced
    or underpriced relative to the values of similar exposures composed of market-traded products.

Answer 10

• Based on evidence, the offering prices of some structured products are over-priced to the values of similar exposures composed of market-traded products.
• Deng and others (2011) find that the fair price of ARBNs “is approximately 4.5% below the actual issue price on average”.
• McCann and Luo estimate that “between 15% and 20% of the premium paid by investors is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces”.