A goal
editThis page will be a prototype for the most comprehensive Finance Portal in the history of humanity. This Finance Internet Portal should provide historical returns for the rich variety of financial products.
A "Financial Google", if you like.
"It is literally true millions come easier to a trader after he knows how to trade, than hundreds did in the days of his ignorance".
"Those who cannot remember the past are condemned to repeat it".
Means to get financing to develop this portal.
Structured products are securities designed to provide alternative exposure to traditional or direct investments. Their returns are linked to the performance of underlying investments such as equities, fixed income, foreign exchange or commodities-whether individual securities, customized baskets or broad market indexes.
portfolio objectives
editStructured products are designed to help investors of all risk-return profiles pursue a range of portfolio objectives, including:
- Diversifying their portfolios
- Limiting downside risk
- Generating income
- Enhancing returns
- Addressing various market conditions (e.g., "flat", "sideways", "bull" or "bear" markets)
- Accessing investments and strategies not typically available to individual investors
More and more, we hear alternative investment managers say AWe are doing a structured product with XYZ Bank. Upon taking a closer look at the ins and outs of the structured business, we discover very little centralized information available. Herein, we offer an outline as to what structured products are, who is making them available, and what investors should be aware of when putting a deal together.
Fundamentally, structured products most often include a fixed income element which serves to protect investors= capital, combined with an equity or absolute return generator which can enhance the upside of the investment. The most basic advantage of this combination is that investors who hold their positions to maturity can participate in more volatile asset classes without risk to their principal. This presents an attractive alternative to a risk-averse investor.
return for a structured product
editWhile the return generator for a structured product can be as simple as the S&P 500 index, it is the alternative investment community which currently carries much of the performance enhancement responsibility for these investments. There are a variety of reasons for this. First, the heart of the alternative investment industry is built on expertise in derivatives, which often play a big role in creating structured products. Second, as alternatives seek to gain entrance to an investor=s portfolio, placing these strategies within an accepted traditional structure provides a bridge to broaching the mainstream. Finally, as a performance generator, the absolute return construct of many alternative strategies provides diversification opportunities and return potential that few traditional strategies can match.
Two Major Types of Structures
editTo the alternative investment community, structured products define a number of investment mediums that fall into one of two types. First is a simple zero coupon strategy that guarantees the principal of the investment at maturity, and offers a return based on an alpha provider. In figure 1, we have diagramed a simple flow of funds.
The most basic principal-protected products look like this. While this configuration is fairly standard, each of the components can be changed to fit the investor=s criterion. For example, an investor puts $1 million into a special purpose company (SPC) that is divided into two parts. First is a zero coupon bond that sells at a discount. For our example, we bought AAA US Treasury Zero Coupon bonds with a 5-year maturity at 5.92%. The discount or unused portion is used to fund the alternative investment generator. This portion may or may not be levered depending on the risk profile the client is seeking. The SPC is set up to isolate the bonds from the trading vehicle, on the premise that if the trader loses more that the discounted value, the bonds cannot be used to pay debts incurred by the trading losses. Quite often, the value of the zero coupon bond will be provided for through a bank letter of credit (LC), where the bonds are not actually purchased until the proposed net present value (or stop-loss) line is broached. If the trading portion is lost, trading will terminate and the investor will have to wait until maturity to get back his original investment.
Any variations to this theme traditionally manifest themselves in four different ways:
1) the type of bonds used for the guarantee;
2) currency base for the collateral portion of the alpha generator;
3) the investment strategy used as the alpha generator; and
4) substitution of a zero bond purchase or LC with a synthetic bond (option strategy).
The other type of structured product can be referred to as a leverage facility. In this scenario, a bank may assess the risk characteristics of the alpha generator and then lend or offer the client leverage against it. Typically, a bank will assess the risk of the portfolio and then allow the pool operators or fund of funds to lever up the pool, increasing both the risk and reward characteristics. Because the bank assumes lending risk, they may place a risk control measure on the portfolio to prevent a portfolio meltdown. While this transaction can be covered by a simple option or swap, financial engineering and transparency become a major issue for the lender to cover their risk at a competitive price.
Like the zero coupon-based strategy, the swap or leverage facility can take on many different twists. Since there is normally no public pricing of these vehicles, the price charged by the structurer can vary greatly. Typically, the more complex or unique the strategy, the costlier it will be.
Demand Drivers for Structured Products
editSo why buy, or for that matter, why sell a structured product? The motivation varies for each investor. Institutional investors such as insurance companies and pension funds desire structured products as a way to include alternative investment strategies into their portfolios under the structure of a fixed income investment. Benefits for the institution might include tax deferrals, portfolio diversification, or a desire to take advantage of the latest in financial engineering.
Some retail investors, who are often shielded from directly investing in hedge funds and CTAs, like the idea of owning a speculative investment where their principal is guaranteed for a specific term. In Canada, for instance, The Bank of Montreal issued CDs that swapped the relatively low and stable bank CD rate for the potential of a higher variable rate, based on an underlying portfolio of CTAs. This product was simple, appealing, and quite successful in terms of marketing alternative investments on a retail level.
In the States, regulatory hurdles remain as roadblocks for institutions and retail investors alike. On the retail side, only qualified investors are allowed to participate in CTAs and hedge funds, and institutions seeking to import alternative investments through a structured product have run into clear regulatory roadblocks.
The Impact of SFAS No. 133
In an effort to define fair value of all financial assets and liabilities, the Financial Accounting Standards Board (AFASB) has recently issued a Statement of Financial Accounting Standard No.133, Accounting for Derivative Instruments and for Hedging Activities (ASFAS 133). According to Christopher Bianucci, Senior Manager at Arthur Andersen LLP, Financial Services, ASFAS 133 changes the previous accounting definition of a derivative instrument, such as options and futures contracts and swaps, expanding it to include embedded derivatives.
This has two major consequences for structured products. First, listed derivatives have traditionally been held Aoff balance sheet, where their value was not normally accounted for as a change in net assets. Now these positions must be accounted for and will thus effect the balance sheet of the investor. Secondly, in the past, a structured product may have effectively masked the use of derivative trading found in the alpha generator, thus allowing an investor to import an alternative strategy under the guise of a fixed income investment. SFAS goes on to define how and where embedded derivatives and hedges must account for, thus a mark to market hedge or investment may be shown as a loss. Given these developments, it is likely that regulatory issues will stunt the growth of alternative investment-based structured products in the United States, at least for now.
Regulations on the use of alternative investments vary widely from country to country, and this can contribute to the degree of popularity that structured products enjoy in different regions. Stephane Liot of Bank Nationale de Paris explains, AThere is a lot of demand for alternative investments in Europe, but many institutional investors don=t have the right to buy offshore funds. Structured products are a way to buy these products without violating any regulations. In Europe and in Japan as well, structured products are very popular for that reason.
Strategies and Providers
editAs alternative investments rise in popularity among institutional and high net worth investors, many financial institutions are getting into the game as structure/leverage providers. We contacted many of these players and outlined below those groups that have emerged as industry leaders. While no two players are alike, we attempted to list the products and services associated with each (where available) in:
Please note that this is not an exhaustive list of products or service providers. It should also be made clear that in some institutions, the product line is rapidly evolving and their services may not be centralized.*
Though each particular structure and deal has its own character, many share similar benefits and drawbacks. While straight zero coupon strategies may not be able to provide the same amount of working capital as option strategies, a benefit is their flexibility to guarantee capital with different grades of investment paper, depending on the needs of an individual investor. In addition, creative structures will develop a means of freeing up more working capital.
Instead of a plain zero coupon strategy, we will use a zero coupon swap with a letter of credit, says Aleks Kins of Credit Agricole Indosuez, Carr Global Advisors, (CAI, CGA). Then we can put 100% into trading from day one. From there, we can lever up based on the riskiness of the alpha generator.
Like CAI, CGA, the distributor of the structured notes will generally decide on the appropriate levels of leverage for the alpha generator, as to properly fit the needs of their target market.
One popular options strategy will use a note to guarantee the principal and imbed a long call that will guarantee a percentage of the upside of the return generator=s performance. This tactic combats the effects of de-leveraging during drawdowns, which prevents many structured products from guaranteed returns. If there is an early and long portfolio drawdown followed by a sharp rally, for example, the product will be de-levered and will only realize a small part of that rally because most of the assets will be in the guaranteed reserve.
Options strategies can have the advantage of providing more working capital than a straight format zero-coupon strategy. The options trader is taking on a risk to defend the targeted drawdown levels and has the ability to de-lever the fund, if necessary. In this case, it is important for the investor to be vigilant as to how the structure is being compensated for taking on the risk.
The different absolute return generators have their own set of benefits and drawbacks. Managed futures products offer easier access to managed accounts. This ultimate transparency allows the risk manager/investor to see the actual positions, marked to market daily. Though a hedge fund of funds may provide more diversification, many hedge funds are reluctant to provide the degree of transparency available to an investor looking for a managed account. Because structurers often measure the risk of the portfolio both on an individual manager level and on a portfolio level, they often demand to have a separate managed account with a manager for accurate risk control. Flexibility is also an issue. We found that some structurers restrict the pool operator from changing managers because it changes the risk characteristics of the portfolio; if they do allow it, there is often an additional fee charged which ultimately gets passed along to the investor.
Thomas Graham of Zurich Capital Markets finds that Acurrently, the most popular products are principal-protected notes linked to hedge funds. These are popular among investors in low interest rate environments who receive enhanced returns on their fixed-income portfolios, as well as investors who are beginning to enter alternative investments.
Graham notes that choosing a single hedge fund as an alpha provider in lieu of a fund of funds requires extra vigilance, not only in terms of transparency, but in liquidity as well. In fact, many structures who also act as distributors are wary of marketing single manager, high volatility notes because the risk of stop-out is so high.
Like any investment that involves alternative strategies, structured products are all susceptible to drawdown risk from the absolute return generator. With structured products, however, this risk is particularly apparent during early stages of the investment. Because investment capital is guaranteed, structured products cannot sustain large drawdown levels without stopping out, in which case investors are left waiting for their principal to return with no hope of those once dreamed-of high variable returns.
Factors in Assessing Structured Products
editFees can vary dramatically from one product to another, depending largely on the degree of risk assumed by the structurer. These can range from a flat percentage rate to assuming a share of the upside. Regardless of the fee structure, experienced investors in structured products warn that transparency can be an issue in fee arrangements. The complexity of some deals can mean hidden costs.
Ways to analyze the markets
editCould you predict the market?
editQuantitative Finance
editOptions
editTypes of Options
editThe two types of options are puts and calls.
Option's volatility
editMajor Futures Markets
edit- Financial futures
- Energy
- Agriculturals
- Metals
Financial Futures
editRepo is short for repurchase agreement. Those who deal in government securities use repos as a form of overnight borrowing. A dealer or other holder of government securities (usually T-bills) sells the securities to a lender and agrees to repurchase them at an agreed future date at an agreed price. They are usually very short-term, from overnight to 30 days or more. This short-term maturity and government backing means repos provide lenders with extremely low risk.
Repos are popular because they can virtually eliminate credit problems. Unfortunately, a number of significant losses over the years from fraudulent dealers suggest that lenders in this market have not always checked their collateralization closely enough.
There are also variations on standard repos:
Reverse Repo - The reverse repo is the complete opposite of a repo. In this case, a dealer buys government securities from an investor and then sells them back at a later date for a higher price
Term Repo - exactly the same as a repo except the term of the loan is greater than 30 days.
While the historical data makes for a very persuasive argument for investing in stocks (small stocks in particular), it can also be used to show the volatility and risks inherent in short term investing. There have been many periods when returns have been inconsistent with long term figures. Here are some examples.
- Bonds outperformed stocks in the 1980s although the reverse is true for longer time frames.
- Venture Capital from 81 to 91 had negative returns despite being one of the best long term investments.
- Japanese stocks have done extremely well since world war II but since peaking in 1989 returns have been negative.
1926-1996 Average annual rates of return
Small Stocks 12.5%
Real Estate 11.1%
DJI 10.0%
Bonds 5.2%
T-Bills 3.7%
Inflation 3.1%
Bund and Bobl
editThe spread trades are very active in the Bund (10yr), Bobl (5yr), and Schatz (2yr), just as they are in the US in the FIT (pronounced Fite, 5 vs 10), and the NOB (Notes over Bond, 10 vs 30).
Eurex is bringing back the BUXL, the 30 year Euro contract, just as the US is re-issuing the 30 yr US Treasury product.
Some traders actually trade the Euro yield curve spreads against the US yield curve spreads.
Crude oil is the world's largest cash commodity in terms of dollars (the annual value exceeds $500 billion) and volume.
In fact, 20 per cent of the world entire trade is in oil (only money and its derivatives are bigger).
Agriculturals
editWheat CBT
editWheat KBT
editWheat MGE
editMeats
editSofts
edit27-Jan-06 Last Change
Alum Aly, $/mt (lme) 2,135.00 62.50 Chromium, AL 99% $/ton 5,625.00 0.00 Copper, Grd A, $/mt (lme) 4,857.50 10.00 Lead, Std, $/mt (lme) 1,414.75 5.50 Moly Roasted $/lb 23.50 0.00 Moly, Western 65% $/KG 53.50 0.00 Moly, Chinese 60% $/KG 46.00 0.00 Nickel, Cash $/MT (lme) 14,987.50 -45.00 Tin, $/mt (lme) 7,347.50 -135.00 Zinc, SHG, $/mt (lme) 2,272.50 2.75