Foreign exchange linked structured products

ZB05

Structured Foreign Exchange Products

for Wealth Management Services

in Greater China

3 IFPHK CE credits

3 SFC CPT hours

3 MPFA non-core CPD hours

Speaker: Dr. LAM Yat Fai (林日辉博士)

Doctor of Business Administration (Finance)

CFA CAIA FRM PRM MCSE MCNE

6:30pm to 9:30pm Wednesday 27th August 2014

2

� Why structured FX products?

� Major structured FX products

� RMB linked structured products

� International standards

� Sales and marketing

� Customer services

Outline

3

What is structured product?

� Very complex cash flows

� Prospectus difficult to understand

� No risk disclosure

� Small print in contract

� High expected return at high risk

� Mass destructive weapons

4

5

Structured products

under the SFO

� A financial instrument with its payoff determined

by reference to one or more of

� the value, rate, level (or a range of value, rate, level)

of any type or combination of types of currency,

interest, equity, commodity, credit event or index

� the value, rate, level (or a range of value, rate, level)

of any basket of more than one type or combination of

types of currency, interest, equity, commodity, credit

event or index

� Excluding bonds, mutual funds and exchanged traded

products

6

Defacto definition

� Simple financial instruments

� Without using derivatives

� Financial instruments with derivatives for hedging

� Using derivatives solely for hedging purpose

� Derivatives for profit making

� Single small or no initial cash outflow

� Single payoff

� Structured products

� A combination of derivatives that results

sophisticated payoff structure

7

Structured treasury products vs

structured credit products

� Treasury structured products

� Linked to currency rate, interest rate, equity price or commodity price

� Majority made for and sold to corporate and private banking customers

� Banks earn service fees

� Credit structured products

� Linked to credit events

� Bank’s own investments

� Banks earn interest income

8

Structured FX products

� Exempted from the SFO if sold by a bank

under the supervision of the HKMA

� The largest category of structured treasury

products in terms of transaction volume

� To capture earning potential under the

current environment of

� extremely low interest rate

� higher FX volatility

9

Why structured products?

� Customized to match the demand from

individual investors in terms of

� return-risk characteristics

� cash flow patterns

� Higher return vs lower risk

� Early cash inflows vs late cash outflows

10

Evolution of financial products

� Spot

� Linear derivatives

� Forwards and futures

� Vanilla options

� European and American, call and put

� Trading strategies

� Bull spread, bear spread, butterfly, straddle

11

Evolution of

financial products

� First generation exotic options

� Binary, one-touch, no-touch, barrier options

� Second generation exotic options

� Corridors, faders, step-up, step-down options

� Fixed income with embedded options

� Currency linked deposits

� Principal protected notes

� Multiple fixings

� Accumulator, decumulator, TARF

12







Outline

13

Major structured FX products

� Retail banking

� Currency linked deposits

� Principal protected notes

� Corporate and private banking

� Accumulators

� Structured forwards

� Pivots

14

Currency linked deposits

� At origination

� Customer makes a term deposit in HKD

� At maturity

� If HKD per GBP rate > target rate� Customer receives HKD principal + high interest

� If HKD per GBP rate < target rate� Customer receives GBP principal + high interest

bought at strike rate

� Worse performer of a simple HKD deposit and a simple GBP deposit

15

Currency linked deposits

� Objective

� To seek high return under a low interest environment

� Psychologically acceptable to receive the foreign

currency

� Risk

� To acquire foreign currency at the target rate above

the market rate at maturity

� Similar to investing in foreign currency

� Trade off

� Give up the potentially higher return of currency rate

16

Principal protected notes

� At origination

� Customer makes a term deposit

� At maturity

� Customer receives the principal

� Interim regular interest

� Linked to the performance of underlying

currency rate

17

Principal protected notes

� Objective

� To reserve the investment principal

� With a potential to earn higher coupon rate

� Risk

� To loss the interest

� Hidden vulnerability

� Chance of getting high coupon return is very

very small

18

Accumulators

� At origination

� Customer makes a longer term deposit in USD

� Every month

� If USD per GBP rate > strike rate

� Customer receives USD principal + high interest

� If USD per GBP rate < strike rate

� Customer receives GBP principal + high interest

bought at strike rate

19

Accumulators

� Objective� To seek high return under a low interest environment

� Psychologically acceptable to receive the foreign currency

� One deposit amount for multiple fixings

� Risk� To acquire foreign currency at the strike rate above

the market rate on fixing dates

� Similar to investing in foreign currency

� Trade off� Give up the potentially higher return of currency rate

20

Structured forwards

� At origination

� The customer makes no deposits

� Every month

� If USD per GBP rate > strike rate� Customer receives

Notional principal x (Spot rate – strike rate) x P

� If USD per GBP rate < strike rate� Customer pays

Notional principal x (Strike rate - spot rate) x Q

21

Structured forwards

� Objective

� To bet on the direction of currency rate

� One contract with multiple bets

� Risk

� Payment to bank when currency rate < strike

rate on fixing dates

� Similar to investing in several long/short

currency option contracts

22

Pivots

� At origination

� The customer receives upfront cash

� Every month

� If USD per GBP rate > upper strike rate

� Customer pays

Notional principal x (Spot rate – upper strike rate)

� If USD per GBP rate < lower strike rate

� Customer pays

Notional principal x (Lower strike rate - spot rate)

23

Pivots

� Objective

� To receive upfront cash

� To bet on the stability of currency rate

� One contract with multiple bets

� Risk

� Payment to bank when currency rate move

beyond the strike boundaries on fixing dates

� Similar to enter several short positions in call

and put options

24







Outline

25

RMB as underlying currency

� China trade emerges

� RMB becomes popular in Taiwan and Hong Kong

� Companies using RMB as transaction currency

� Outlook of appreciation of RMB

� Controlled free trade on RMB

� Offshore RMB – CNH

26

Customer base

� Companies with businesses in mainland China

� Individuals with investments in mainland China

� Wealthy Chinese as an emerging sector of private banking

� Downside risk: forced to acquire RMB at a unknown price

27

CNY/CHN TARF

� Linked to performance of CNY or CNH

� When customer’s profit has accumulated to an

upper limit, the contract terminates immediately

� A variation of upper knock-out barrier

� Customer

� Profit target is met

� Principal is collected early than maturity

� Bank

� Reduce the hedging cost (period)

� Pursue the customer enter another deal

28

Target accrual redemption forward

� Bull and bear TARF

� Dual-strike TARF

� Gap TARF

� TARF Pivot

29

Bull and bear TARF

30

Dual-strike TARF

31

Gap TARF

32

TARF pivot

33







Outline

34

SSPA classification

of structured products

35

36

Yield enhancement

� With capped upside potential

� Without capital guarantee

� Aim to generate a high return relative to

treasury yield

� Risk comparable to their underlying assets

in case of adverse market conditions

� The largest category of structured products

37

38

Capital protection

� Guarantee the redemption of the invested

principal at maturity

� Participate to a certain degree in the

performance of underlying risky assets

39

40

Participation

� Closely linked to the performance of their

underlying currency rates, volatility and/or

correlation

� Sometimes feature a conditional downside

protection or a leveraged upside

41







Outline

42

Sales and marketing

� Sales

� Retail banking

� Corporate banking

� Private banking

� Bank branches and subsidiaries in China and Taiwan

� Marketing

� Nice features of a structured product

� Strong sales channels – the dominating factor

43

Customers’ preferred

characteristics of SP

� Looked like a deposit

� Low initial cash outflow

� Initial cash inflow

� Shorter term, usually with maturity less than one year

� High nominal yield

� Early termination when subject to sufficient earnings

� Never loss

� Large safety zone

� Large potential loss only at extremity

� Psychological comfort when suffering from loss� Rebate, air bag, early termination

44

Payoff diagram

45

Risk-return alternation

� Treasuries

� Cash outflow: principal

� Interim cash inflows: fixed 0.5% semi annual

interests

� Principal protected

� Cash outflow: principal

� Semi annual interests invested in options

� Interim cash inflows: 0% to 10% semi annual

interests

46

Zero cost product

� Bankers’ Trust vs P&G

� Long a call option at an upper strike

� Short many put option at a very small lower

strike

� Total cost = Call price - many put price = 0

� Eventually, the underlying asset price moves

below the lower strike

� P&G incurred a huge loss

� P&G sued Bankers’ Trust for hiding the risk

47

Major sales channels

� Commercial bank

� Corporate banking

� “Nominal” hedging

� Private banking

� Professional Investor under the SFO

� Corporate private banking

� Private banking customer in legal form of a

company dedicated for investments

� Wealth management services

� Wealthy retail banking customers

48

Risk assessment of investing

in structured products

� Market risk� Sensitivity to underlying currency

� Credit risk� Default of structured product issuer

� Operational risk� Very tedious settlement procedure

� Liquidity risk� No secondary market due to high degree of

customization

� Legal risk� Lengthy contract with difficulty to understand legal

terms

49

50

Risk assessment

of treasury products

Hedging instruments which are only allowed to be acquired by Professional Investors

under the regulatory guidelines from the HKMA and/or SFC.5

Any hedging instruments with currency and/or interest rate as underlying and with

payoff more complex than that exhibited by currency options and interest rate

derivatives with first generation exotic payoffs. These hedging instruments may be

resulted by combining a few hedging instruments in Levels, 1, 2, and/or 3, and with

other additional and/or customized features embedded. These hedging instruments are

not prohibited from being sold to customers not classified as Professional Investors,

under the regulatory guidelines from the HKMA and/or SFC.

4

Currency options and interest rate derivatives with first generation exotic payoffs, and

packages combining

(a) a single currency option or a single interest rate derivatives, up to first generation

exotic payoff, and

(b) its underlying and/or cash positions to form a slightly adjusted first generation exotic

payoff.

3

Vanilla currency options and interest rate derivatives with optionality.2

Vanilla currency and interest rate derivatives without optionality.1

DescriptionLevel

51







Outline

52

Revenue model

� Financial engineering – investment bank� Construct with liquid underlying currency and vanilla

options at a lower cost

� Sell to a wholesaler at a higher price

� Pocket the price-cost differential

� Hedge through out the life of the structured product

� Subject to market risk and operational risk

� Intermediary – commercial bank� Buy from an investment bank at a lower cost

� Sell to a customer at a higher price

� Pocket the price-cost differential

� Subject to operational risk and credit risk

53

Cost model



� Hedging� Raw material

� Hedging

� Back-to-back

� Labour – traders

� Settlement

� Technology

54

Raw material cost

� Component approach

� Decomposition into component options and

deposits

� Structured product = Sum of components

� Monte Carlo simulation

� Exotic payoff which cannot be deposited into

components

55

Monte Carlo pricing

56

Pricing

� Price = Cost x (1 + profit margin)

� Too cheap

� Loss on each sale

� Too expensive

� No customer

� Completion among banks force the

convergence of price

57

Market risk management

� Static hedge� Back-to-back hedge the entire structured products

� Lower risk, lower profit and fixed hedging cost

� Dynamic hedge� Continuous Delta and Vega hedges with liquid underlying

currency and vanilla options

� Higher risk, higher potential profit at variable hedging cost

� Semi-static hedge� Periodically re-balance with quantitative models

� Component hedge� Decomposition into component options and deposits

� Static, dynamic or semi-static hedge selected components

� Hybrid hedge� A combination of dynamic, semi-static and component hedge

58

Credit risk management

� Customer deposits collaterals of high liquidity to the bank

� The bank grants a credit line to the customer, covering the� Upfront cash outflow

� Unrealized loss

� Potential future loss

� Credit limit determined by� value of vanilla collaterals

� loss from structured products

� discounted gain from structured products

59

Current exposure vs

potential exposure

Potential exposure

Current exposure

60

Notional method

( )

Nk

k=1

k

EAD

Notional principal of

component option=

in short position

× margin conversion factor

Credit expsoure

= EAD + Total unrealized loss

- Total unrealized gain × 1 - hair cut

∑

61

Portfolio netting

[ ]

N

k

k=1

N

k

k=1

Current expsoure with netting

= Max - Market value , 0

Current expsoure without netting

= Max - Market value , 0

Net-gross ratio

Current expsoure with netting=

Current expsoure without net

∑

∑

ting

62

Basel III

current exposure method

( )N

k

k=1 k

EAD

= Current expsoure with netting

+ 0.4 + 0.6 × Net-gross ratio

Notional principal×

× Credit conversion factor

Credit expsoure

= EAD + Total unrealized loss

- Total unrealized gain × 1 - hai

∑

( )r cut

63

Credit conversion factor

for OTC derivatives

15.012.010.0Other

commodities

8.07.07.0Precious

materials except

gold

10.08.06.0Equity

7.55.01.0Currency rate

and gold

1.50.50.0Interest rate

Longer than 5

year (%)

1 to 5 years

(%)

Up to 1 year

(%)

Residual

maturity

64

Operational risk

� Mis-selling

� Over promising return

� Hiding risk

� Variable payoff

� Different on every payment

� Terms and conditions

� Human language insufficient to describe

mathematical payoff

� Cross copying among banks

65

Other back office functions

� Settlement

� Decompose a structured product into many fixings

� To be settled on individual fixing basis

� Very tedious due to the variable payoff

� Subject to high operational risk

� General ledger

� Each fixing generate one set of GL transactions

� A challenging topic to accountants

66

Portfolio management

� Settled fixings

� Position

� Realized profit and loss

� Unsettled fixings

� Potential cash inflows/outflows

� Hedging

� Offsetting transactions

� Offsetting components

67

Documentation

� Deal contract

� Deal confirmation

� Fixing ticket

� Ad-hoc, day-end and month end

statements

� Online enquiry

68

Q & A

69

Thank You

70

Upcoming IFPHK Continuing Education Programs:

http://www.ifphk.org/CEP/ce-calendar

Institute of Financial Planners of Hong Kong

13/F, Causeway Bay Plaza 2,

463 - 483 Lockhart Road, Hong Kong

Tel: 2982 7888

Fax: 2982 7777

Email: [email protected]

Website: www.ifphk.org

Economy & Finance

Foreign exchange linked structured products