Abstract volatility suppressing in significant rally. We also


This paper is study of effect of hedging of structured products
on exchange traded
equity products. We look
at various aspects
of the structured product markets
including the motivation to buy, the risks of the products, the hedging behavior and
the effect of hedging on exchange traded products. We conclude the
hedging would be volatility supportive in a sell
off and would
be volatility suppressing in significant rally. We also suggest
introduction of some
new exchange products
that would make
the hedging process easy
and also would
help some retail
investors express their
view in a better fashion without the transaction costs involved in structured products.

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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



Derivative trading is essential tool for the health of markets as they
enhance price discovery and supplement liquidity. Although derivatives have been introduced very late in Indian equity
markets they picked up prominence very
quickly. In June 2000, index
futures were introduced as the first
exchange traded equity derivative product in the Indian markets.
In a span of a year and a half after that index
options, stock options
and lastly stock
futures 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 possible
otherwise through cash markets.


In 2007, Statistics from the NSE show that retail investors
have been the largest participants in the derivatives markets
in the past four-five years,
accounting, on average,
for around 60 per cent of all derivatives based activity.


Although derivatives are
good instruments to expresses complex
non linear views
on markets, lack
of sophistication and understanding has given rise
to investments into structured products, which have
derivative like payoffs
but are bespoke and not exchange traded.


With the advent
of structured products, many retail and HNI investors have been able
to invest for
more exotic payoffs compared to linear payoff they used to realize
from their cash investments. In 2007, there were numerous institutions offering
structured products to their clients
and that has lead to growth of the
institutional presence in derivatives segment. While the investor
invests for a certain period,
the issuer of the
product constantly uses
derivatives segment to hedge his
positions to create
the desired payoff for its clients.


Before the arrival
of structured products the main avenues
of investment for individual investors have been either
investing directly in stocks or equity based
mutual funds or in certain
cases investing in fixed
income securities like corporate and government bonds.
Structured products have been created
as an alternative to directly investing in underlying asset
to give additional benefits to the investor.


The benefits
of structured products include:


principal protection

•     diversification benefits
(if the product
is linked to an index or a basket of securities)

access to fully
taxable investments

enhanced returns within an investment

•     reduced volatility (or risk) within
an investment

•     express specific
view of the investor


Unlike other exchange traded securities and derivatives, structured
products are by nature not homogeneous – as the variety
of underlying, payoff
structure 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 &

Credit Linked
Notes & Deposits

Market Linked Notes
& Deposits


Although structured products and OTC derivatives can be traded on a variety of asset classes
the scope of this paper is to study the structured products linked to Equities. Now on when we say “Structured
Products” it is to be assumed that we refer to the products linked
to equity only.



Composition of the Structured Product

Prudential ICICI introduced India’s
first capital-protected constant
proportion portfolio insurance
(CPPI) product for Indian
investors, dubbed the Principal Protected Portfolio (PPP). Developed with Deutsche Bank in London, the
product was one of the
biggest innovations to hit the
Indian market

Prudential ICICI’s CPPI has since
been copied by a host
of other issuers
keen to tap
the demand for principal protection. Typically, these
products are issued
within the portfolio
management 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 another
major 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 investors
an option-based payoff.
The synthetic options
are hedged by dealers with

international branches and issued in debenture format1. As demand for these products developed the
market saw several issuers coming
up with a range of products to suit the needs of the investors. Currently the suite of products available for investors is very rich
in variety and innovation.


The existing structured products in the equity space can be broadly classified
into the following categories:


Equity linked notes
(debentures) with capital

CPPI and related structures

Range accruals on Equity index/basket of stocks

Autocallable notes and other exotic

Structured on baskets
of stocks


In this section
we give a brief description of each of the products to enable the reader grasp
the payoff of these
structures. We also discuss the motivation behind
investing in each
of the products.


Equity Linked Debentures

An Equity-Linked Note (ELN) is an instrument that provides investors
fixed income like principal protection together with equity market
upside exposure. Capital
protected equity linked
notes are about the most prevalent of the structured products and constitute about 90% of the market
in Indian equity linked
structured products. Hence we devote significant part of this section and the
future sections discussing various
aspects of these notes.


The investment structure
generally provides 100% principal protection, which means the capital of the
investor is returned back at maturity. The coupon at maturity on the
other hand is variable and is determined by the appreciation of the underlying equity. The payoff
of a simple structured product
with capital protection is juxtaposed with the payoff
of investing in the underlying in the chart below.2 By giving up part of upside (participation in upside is typically less than 100%) the investor
gets 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, assume
an investor buys
a hypothetical five-year 100% principal protected Equity-Linked Note with
80% participation in the upside
of the S&P Nifty Index
for Rs. 1,000.
The starting index level
is 4000. At maturity, if the S&P
Nifty Index level
is above 4000,
then the payoff
of the note will be Rs. 1,000 in principal plus
an equity-linked coupon
equivalent to any increase in the index.
For example, if the index level
in five years
is 5000 (an appreciation of 25%), then
the coupon would
be Rs. 200 (80%*25%*1,000) and the total
payoff would be Rs. 1,200
(1,000 + 200).


If the index level is below 4000
at maturity, i.e.,
the underlying equity
performance is negative, the final payoff to the investor
will be Rs. 1,000 in principal.

An ELN is structured by combining the
economics of a long call option on equity with
a long discount bond position.


Bond + Call Option => Equity Linked Note => Principal
Protection + Equity Participation



Participations of more
than 100% can
be achieved by capping the
upside beyond a certain level.
In this case the payoff of the client
linearly increases if at maturity
the underlying is more than at the start of the
product but after
certain level the profits become
flat. The chart
below illustrates the
payoff of such a


In this case the ELN is equivalent to a zero
coupon bond plus
a long ATM call and short position
in high strike call.

Bond + Call Option

High strike call
option => Principal Protection + Equity
Participation with a cap

Opportunity Cost:
Although ELN’s repay
an investor their
principal at maturity, there is an opportunity
cost even where an investor receives a return
of principal in down markets; i.e., that investor
has lost the use of his/her
invested principal for the term of the ELN (in
an investment in a risk-free asset like bank
fixed deposit).

Call-trigger: The structures normally
also have a call feature
embedded within them which enables
the issuer to call
back the note if the underlying sells
of by more than a trigger amount
(typically 50%) from the
start value. In this case
the investor gets back only
his principal at the end of maturity
irrespective of how the underlying behaves
once the trigger
level is breached.


affecting Price of an ELN


•     Increase in Equity Price (+)

Increase in Volatility (+)

Increase in Interest
rates (-)

Increase in Time to Expiration (+/-)

•     Increase in Dividend Yield (-)

•     Issuer’s
Credit Rating (+)



Equity linked debenture attains capital protection by replicating a call option
pay off. The
other way to achieve capital protection is by dynamically managing a portfolio so that the investor always
has the money to buy a zero coupon
bond, providing the money for
capital payback at maturity. For example,
say an investor has a portfolio of Rs. 100,
a floor of Rs. 90 (price of the bond
to guarantee his RS. 100 at
maturity) and a multiplier of 5 (ensuring protection against a drop of at most
20% before rebalancing the portfolio). Then on day 1, the writer
will allocate (5 * (100
– 90)) = Rs. 50 to the
risky asset and the
remaining Rs. 50 to the
riskless asset (the
bond). The exposure
will be revised
as the portfolio value

changes, i.e. when the risky asset
performs or sells
off. These rules
are predefined and agreed once
and for all during
the life of the product.3

A variant to CPPI is DPI (Dynamic
Portfolio Insurance) where
the multiplier is not specified upfront but varies according to certain parameters like the volatility of the underlying.

The exposure to risky asset
is completely unwound
if the portfolio value falls below
the bond floor.
The bond floor is the value below which the CPPI value should
never 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 because
to ensure payment
of principal at maturity one needs
more cash upfront if interest
rates are lower
than if they are higher.
Executing a CPPI would involve buying when the underlying rallies and selling
when the underlying sells off. This
process would further accentuate the market volatility as the hedging
goes in the same direction as the market


Range Accruals

Range accrual security is a kind
of structured product
where the interest
is accrued only
on days when the underlying equity/index is
within 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 maturity
of the product. Products with single observation at the maturity
have been the most popular
amongst range accrual
notes. In this
case the coupon is digital, as in if the underlying ends up within
the range the
investor gets a fixed coupon
or else he just gets his principal back.
The chart below
shows the payoff
of range accrual
note for various values of underlying.