FX Options and Structured Products, 2nd Edition

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Imagine you purchase Apple stock. By definition, you and the seller are on opposites sides of a binary trade — if Apple zooms up, you will have made money and the seller will presumably regret selling, and vice versa.

Do structured notes present a similar binary outcome between buyer and seller? If the investing purchaser makes money, does the issuing bank lose money? The answer is a resounding no! Purchasers of structured notes sometimes believe the issuer automatically wins when they lose, which would place a bank in conflict with their clients. The short structured products trading options interest rates and currency is that this is not the case. The outcome is not a zero-sum game, and ultimately both the investor and bank can win.

In this post, we will discuss the makeup of a structured note and how the trader at the issuing bank treats the product very differently than the client, resulting in a potential win-win situation. This becomes important when considering the more interest Treasury pays the structured note, the more the trading desk has to spend resulting in better characteristics e. Prior to the note being sold, the trading desk plays a critical role in creating interesting payoffs that will a sell in the market and b make money for the bank.

As mentioned previously, the trading desk utilizes the interest rate from Treasury to design the payoff — the higher the rate, the more generous the trading desk can be to the investor in terms of payoff characteristics. Once the note is sold, the desk is primarily tasked with taking the opposite position of the customer e.

The theoretical value is derived by the trader based on market inputs such as volatility of the underlying security, interest rates, and dividend rates. As we mentioned, the trader adds a spread to this theoretical fair value — e. The spread will be based on how easy or hard it is to hedge the risks of taking on the position and how competitive the market is on that specific trade e.

Client results gain or loss would have no positive or detrimental impact, making it certainly possible that both bank and client come out ahead. As mentioned above, given the customized nature of many structured notes, simply matching inverse exposures between customers is often not possible.

A derivative position results in a number of risks and alternative methods of hedging said risks. Portfolio management gets even more complicated. And this is what makes derivative trading so complex, dynamic, and interesting — there are many choices options! Each option consists of shares. If an investor believes XYZ will increase they may buy this option. In conclusion, most investors view the purchase or sale of an option or a structured note as a way to take a position on the direction of the security.

Typically, rather than focusing on whether XYZ will move up or down, the professional trader will treat this position by focusing on the way the security will move — the volatility interest rate, dividends and other inputs also matter but volatility is the name of the game. Structured products trading options interest rates and currency does he accomplish this hedge? The call option only makes money if XYZ increases, and as structured products trading options interest rates and currency mentioned earlier the trader wants to neutralize this outcome and become market neutral.

Now remember, an option consists of shares. The trader makes money in either direction and the amount of gain is equal! The trader does not care which way the market goes, as long as it goes somewhere. Now this is not a static one time hedge. Therefore hedging is constantly necessitated in order to remain neutral from a directional standpoint. Well that would necessitate an adjustment to the hedge.

Instead of being short 50 shares, the trader would adjust by purchasing 10 shares to become net short 40 shares. In other words, the trader is always adjusting the position resulting in multiple incremental gains. As long as the stock moves around enough — i.

A more advanced exercise can be to envision how to treat a short option position — perhaps a post for another time. Investors and traders have different ultimate exposures to a derivatives trade. Structured notes, for example, allow the investor to construct a specified view of the market for the investor, who will buy and hold the strategy.

The trading desk will hedge the derivative positions by offsetting with other derivatives or by delta hedging. In addition to any potential profit on the derivatives component, the bank is obtaining access to inexpensive cash when they issue a structured note, giving them yet other benefits to issuing a structured note and creating scenarios in which both the customer and bank can win. In conclusion, structured notes are not zero-sum games due to the participants bank and client structured products trading options interest rates and currency their exposures very differently — the structured products trading options interest rates and currency does not necessarily win when structured products trading options interest rates and currency investor loses and vice versa.

As you explain, they are their own profit center. The consumer advocate in this scenario is structured products trading options interest rates and currency other desk that structures the note. They must have a note that is marketable and competitive. Deconstructed Notes Imagine you purchase Apple stock.

Why Are We Interested? Conceptually, a structured note is no different than a bond — a typically inexpensive way for the bank to access capital for a defined period of time. The treasury department of the bank is responsible for setting internal rates for borrowing and lending.

How competitive a bank is on the credit component of a note is purely a function of whether the bank needs or wants funding — e. Derivative Component — the remainder of the investment is priced by the derivatives trading desk in creating the derivatives strategy placed in the note FYI — my former role.

The Takeaway Investors and traders have different ultimate exposures to a derivatives trade.

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In structured finance , a structured product , also known as a market-linked investment , is a pre-packaged investment strategy based on a single security , a basket of securities, options , indices , commodities , debt issuance or foreign currencies , and to a lesser extent, derivatives.

The variety of products just described is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of some structured products is a "principal guarantee" function, which offers protection of principal if held to maturity. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy calls for. Theoretically an investor can just do this themselves, but the cost and transaction volume requirements of many options and swaps are beyond many individual investors.

As such, structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets.

Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio , or to utilize the current market trend. So structured products are not derivatives. Securities and Exchange Commission SEC Rule regarding certain prospectus deliveries defines structured securities as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows".

Structured product business, as a key part of customer-driven derivatives business, has changed dramatically in recent years. Its modern setup [3] requires comprehensive understanding of:. The risks associated with many structured products, especially those that present risks of loss of principal due to market movements, are similar to risks involved with options.

Financial Industry Regulatory Authority FINRA suggests that firms "consider" whether purchasers of some or all structured products should be required to go through a similar approval process, so that only accounts approved for options trading would also be approved for some or all structured products.

Some firms attempted to create a new market for structured products that are no longer trading; some have traded in secondary markets for as low as pennies on the dollar. The regulatory framework for structured products is hazy and they may fall in legal grey areas. In India , equity-related structured products may violate the Securities Contract Regulation Act , which prohibits issuing and trading equity derivatives that do not trade on a nationally recognized exchange.

Structured investments arose from the needs of companies that wanted to issue debt more cheaply. This could have been done by issuing a convertible bond —i. In exchange for the potential for a higher return if the equity value would increase and the bond could be converted at a profit , investors would accept lower interest rates in the meantime.

However, the worth of this tradeoff is debatable, as the movement of the company's equity value could be unpredictable. Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection.

These extra features were all strategies investors could perform themselves using options and other derivatives, except that they were prepackaged as one product.

The goal was again to give investors more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand, the goal for investment banks was to increase profit margins since the newer products with added features were harder to value, and thus harder to gauge bank profits.

Interest in these investments has been growing in recent years, and high-net-worth investors now use structured products as way of portfolio diversification. Nowadays the product range is very wide, and reverse convertible securities represent the other end of the product spectrum yield enhancement products.

Structured products are also available at the mass retail level—particularly in Europe, where national post offices, and even supermarkets, sell investments on these to their customers. Structured products aspire to provide investors with highly targeted investments tied to their specific risk profiles, return requirements and market expectations.

Historically, this aspiration is met with an ad hoc approach: Within this approach it can be difficult to articulate the precise problem the product is designed to solve, let alone to claim the product as optimal for the client. Nevertheless, this approach is still widely used in practice.

A more advanced mathematical approach to product design has been proposed. This approach demands higher proficiency from both the structurer who designs the product and the client who needs to understand the proposal. Once the product is designed, it is manufactured through the process of financial engineering. This involves replicating the product through a trading strategy involving underlyings like bonds , shares , indices , commodities as well as simple derivatives like vanilla options , swaps and forwards.

The market for derivatives has grown quickly in recent years because they perform an economic function by enabling the risk averse to transfer risk to those who are willing to bear it for a fee. Disadvantages of structured products may include: Structured products are not homogeneous—there are numerous varieties of derivatives and underlying assets—but they can be classified under the following categories:.

From Wikipedia, the free encyclopedia. Its modern setup [3] requires comprehensive understanding of: Manufacturing and Managing Customer-Driven Derivatives. Arcane Names Hiding Big Risk". Retrieved April 19, Retrieved from " https: All articles with unsourced statements Articles with unsourced statements from August Articles with unsourced statements from June Views Read Edit View history.

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