AbstractThis paper is study of effect of hedging of structured productson exchange tradedequity products. We lookat various aspectsof the structured product marketsincluding the motivation to buy, the risks of the products, the hedging behavior andthe effect of hedging on exchange traded products. We conclude thehedging would be volatility supportive in a selloff and wouldbe volatility suppressing in significant rally. We also suggestintroduction of somenew exchange productsthat would makethe hedging process easyand also wouldhelp some retailinvestors express theirview in a better fashion without the transaction costs involved in structured products.Table of Contents Abstract 1 Introduction 4 Composition of the Structured Product Market 5 Evolution of Structured Notes in India 12 Framework for Analysis 13 Pricing and Modeling 17 Risks of Each Product 19 Aggregation of Risks 22 Effect on Exchange Traded Products 25 New Products 26 IntroductionDerivative trading is essential tool for the health of markets as theyenhance price discovery and supplement liquidity. Although derivatives have been introduced very late in Indian equitymarkets they picked up prominence veryquickly. In June 2000, indexfutures were introduced as the firstexchange traded equity derivative product in the Indian markets.
In a span of a year and a half after that indexoptions, stock optionsand lastly stockfutures were introduced. Since then, derivatives volumes have grown to multiples of cash market volumes and have been a mode of speculation and hedging for market participants, not possibleotherwise through cash markets. In 2007, Statistics from the NSE show that retail investorshave been the largest participants in the derivatives marketsin the past four-five years,accounting, on average,for around 60 per cent of all derivatives based activity.
Although derivatives aregood instruments to expresses complexnon linear viewson markets, lackof sophistication and understanding has given riseto investments into structured products, which havederivative like payoffsbut are bespoke and not exchange traded. With the adventof structured products, many retail and HNI investors have been ableto invest formore exotic payoffs compared to linear payoff they used to realizefrom their cash investments. In 2007, there were numerous institutions offeringstructured products to their clientsand that has lead to growth of theinstitutional presence in derivatives segment. While the investorinvests for a certain period,the issuer of theproduct constantly usesderivatives segment to hedge hispositions to createthe desired payoff for its clients. Before the arrivalof structured products the main avenuesof investment for individual investors have been eitherinvesting directly in stocks or equity basedmutual funds or in certaincases investing in fixedincome securities like corporate and government bonds.Structured products have been createdas an alternative to directly investing in underlying assetto give additional benefits to the investor.
The benefitsof structured products include: • principal protection• diversification benefits(if the productis linked to an index or a basket of securities)• tax-efficientaccess to fullytaxable investments• enhanced returns within an investment• reduced volatility (or risk) withinan investment• express specificview of the investor Unlike other exchange traded securities and derivatives, structuredproducts are by nature not homogeneous – as the varietyof underlying, payoffstructure and maturities can vary significantly. The underlying instruments in structured products can however be broadly classified under the following categories • Equity-linked Notes & Deposits• Interest rate-linked Notes & Deposits• FX and Commodity-linked Notes & Deposits• Hybrid-linked Notes &Deposits• Credit LinkedNotes & Deposits• Market Linked Notes& Deposits Although structured products and OTC derivatives can be traded on a variety of asset classesthe scope of this paper is to study the structured products linked to Equities. Now on when we say “StructuredProducts” it is to be assumed that we refer to the products linkedto equity only. Composition of the Structured ProductMarketPrudential ICICI introduced India’sfirst capital-protected constantproportion portfolio insurance(CPPI) product for Indianinvestors, dubbed the Principal Protected Portfolio (PPP). Developed with Deutsche Bank in London, theproduct was one of thebiggest innovations to hit theIndian marketPrudential ICICI’s CPPI has sincebeen copied by a hostof other issuerskeen to tapthe demand for principal protection. Typically, theseproducts are issuedwithin the portfoliomanagement services (PMS) line offered by banks to their high-net-worth clients, although the growing appeal of capital protection has also seen the CPPI structure filtering into retail market.
Subsequent to that anothermajor development has been the issuance of structured products in note format,created using ‘synthetic’ options.The first of these was issued by Standard Chartered and structured by Merrill Lynch, offering investorsan option-based payoff.The synthetic optionsare hedged by dealers withinternational branches and issued in debenture format1. As demand for these products developed themarket saw several issuers comingup with a range of products to suit the needs of the investors. Currently the suite of products available for investors is very richin variety and innovation.
The existing structured products in the equity space can be broadly classifiedinto the following categories: • Equity linked notes(debentures) with capitalprotection• CPPI and related structures• Range accruals on Equity index/basket of stocks• Autocallable notes and other exoticstructures• Structured on basketsof stocks In this sectionwe give a brief description of each of the products to enable the reader graspthe payoff of thesestructures. We also discuss the motivation behindinvesting in eachof the products. Equity Linked DebenturesAn Equity-Linked Note (ELN) is an instrument that provides investorsfixed income like principal protection together with equity marketupside exposure. Capitalprotected equity linkednotes are about the most prevalent of the structured products and constitute about 90% of the marketin Indian equity linkedstructured products.
Hence we devote significant part of this section and thefuture sections discussing variousaspects of these notes. The investment structuregenerally provides 100% principal protection, which means the capital of theinvestor is returned back at maturity. The coupon at maturity on theother hand is variable and is determined by the appreciation of the underlying equity. The payoffof a simple structured productwith capital protection is juxtaposed with the payoffof investing in the underlying in the chart below.2 By giving up part of upside (participation in upside is typically less than 100%) the investorgets a protection against downside.
The instrument is appropriate for conservative equity investors or fixed income investors who desire equity exposure with controlled risk. As an example of an ELN, assumean investor buysa hypothetical five-year 100% principal protected Equity-Linked Note with80% participation in the upsideof the S&P Nifty Indexfor Rs. 1,000.The starting index levelis 4000. At maturity, if the S&PNifty Index levelis above 4000,then the payoffof the note will be Rs.
1,000 in principal plusan equity-linked couponequivalent to any increase in the index.For example, if the index levelin five yearsis 5000 (an appreciation of 25%), thenthe coupon wouldbe Rs. 200 (80%*25%*1,000) and the totalpayoff would be Rs.
1,200(1,000 + 200). If the index level is below 4000at maturity, i.e.,the underlying equityperformance is negative, the final payoff to the investorwill be Rs.
1,000 in principal.An ELN is structured by combining theeconomics of a long call option on equity witha long discount bond position. Bond + Call Option => Equity Linked Note => PrincipalProtection + Equity Participation Participations of morethan 100% canbe achieved by capping theupside beyond a certain level.In this case the payoff of the clientlinearly increases if at maturitythe underlying is more than at the start of theproduct but aftercertain level the profits becomeflat.
The chartbelow illustrates thepayoff of such aproduct. In this case the ELN is equivalent to a zerocoupon bond plusa long ATM call and short positionin high strike call.Bond + Call Option–High strike calloption => Principal Protection + EquityParticipation with a capOpportunity Cost:Although ELN’s repayan investor theirprincipal at maturity, there is an opportunitycost even where an investor receives a returnof principal in down markets; i.e.
, that investorhas lost the use of his/herinvested principal for the term of the ELN (inan investment in a risk-free asset like bankfixed deposit).Call-trigger: The structures normallyalso have a call featureembedded within them which enablesthe issuer to callback the note if the underlying sellsof by more than a trigger amount(typically 50%) from thestart value. In this casethe investor gets back onlyhis principal at the end of maturityirrespective of how the underlying behavesonce the triggerlevel is breached. Factorsaffecting Price of an ELN • Increase in Equity Price (+)• Increase in Volatility (+)• Increase in Interestrates (-)• Increase in Time to Expiration (+/-)• Increase in Dividend Yield (-)• Issuer’sCredit Rating (+) CPPI/DPIEquity linked debenture attains capital protection by replicating a call optionpay off. Theother way to achieve capital protection is by dynamically managing a portfolio so that the investor alwayshas the money to buy a zero couponbond, providing the money forcapital payback at maturity. For example,say an investor has a portfolio of Rs. 100,a floor of Rs. 90 (price of the bondto guarantee his RS.
100 atmaturity) and a multiplier of 5 (ensuring protection against a drop of at most20% before rebalancing the portfolio). Then on day 1, the writerwill allocate (5 * (100- 90)) = Rs. 50 to therisky asset and theremaining Rs. 50 to theriskless asset (thebond).
The exposurewill be revisedas the portfolio valuechanges, i.e. when the risky assetperforms or sellsoff. These rulesare predefined and agreed onceand for all duringthe life of the product.3A variant to CPPI is DPI (DynamicPortfolio Insurance) wherethe multiplier is not specified upfront but varies according to certain parameters like the volatility of the underlying.The exposure to risky assetis completely unwoundif the portfolio value falls belowthe bond floor.The bond floor is the value below which the CPPI value shouldnever fall in order to be able to ensure national’s guarantee at maturity.Bond floor is a function of time to maturity and interest rates.
As interest rates fall, bond floor goes up becauseto ensure paymentof principal at maturity one needsmore cash upfront if interestrates are lowerthan if they are higher.Executing a CPPI would involve buying when the underlying rallies and sellingwhen the underlying sells off. Thisprocess would further accentuate the market volatility as the hedginggoes in the same direction as the marketmovement. Range AccrualsRange accrual security is a kindof structured productwhere the interestis accrued onlyon days when the underlying equity/index iswithin a range. The capital is protected in most structures only the interest/coupon is variable. The coupon of the range accrual is paid according to a pre-agreed formula: The fixed % and the range are agreed at the start of the investment.
The observation days could be daily,monthly, quarterly or even a single observation at the maturityof the product. Products with single observation at the maturityhave been the most popularamongst range accrualnotes. In thiscase the coupon is digital, as in if the underlying ends up withinthe range theinvestor gets a fixed couponor else he just gets his principal back.The chart belowshows the payoffof range accrualnote for various values of underlying.