Evaluating Structured Investment

Products

IFPAC 2008 Conference

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Contents

� Introduction

� Choice of Product Strategies

� Examining Some Popular Structured Products

� Determining the Right Product

� Understanding the Limitations and Risks

� Avoiding Catastrophe

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What Are Derivatives

� What is a Derivative?1. Financial instrument whose value is derived from the value of an underlying asset.2. Derivatives include Futures, Forwards, Options, Swaps, Warrants, etc.3. Useful financial tools for both risk management and investment purposes.4. Traded on various Exchanges as well as Over-the-counter.5. Issued over different asset classes: Equity, FX, Commodities, Funds, Interest rates, etc.

…… Basically, any underlying asset that is tradable and sufficiently liquid.

� Call and (Put) Options

Buyer has the right, but not the obligation, to buy (sell) the underlying asset from (to) Seller at a fixed price (i.e. Exercise Price or Strike) within specified period.

� Growth of Exotic Options1. Options offering interesting and complex payoffs/features, e.g. Barrier options.2. Reasons:

� Advance in IT and financial modeling� Banks’ increasing appetite for risk-taking� Demand from increasing sophisticated investors

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What are Structured Products

� Different Name, Same Product

Structured Product = Structured Investment = Structured Deposit = Structured Note

1. Different ways of wrapping the same product2. Different regulatory and legal regime3. “Structured” suggests that products have undergone some form of financial engineering

� What are they

1. Hybrid products whose performance is linked to a selected underlying asset, e.g. index. 2. Usually a debt instrument (bond/deposit/debenture) with derivative(s) embedded.3. Offer interesting variations of Risk-Return profiles that are different from conventional

instruments (asset classes) like bonds, equities, currencies, etc.4. Relatively complex multi-asset financial products.5. Payoff formula is usually well-defined.6. Linked underlying asset can be equity, FX, funds, etc. or combination of several assets.7. Sometimes viewed as a separate Asset Class.8. Asset-backed securities (ABS), REITs, ETFs are excluded.

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LEGAL WRAPPER(of selected currency)

����Debt instrument, i.e. Note, Bond����Deposit����Certificates����Unit trusts or Funds

����Vanilla options and forwards

����Exotic options and multi-assets

����Combination of options

DERIVATIVE(of selected underlying asset or assets)

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STRUCTURED PRODUCT

Path-dependent featurese.g. Lock-in, Knock-in,

Auto callable

� Basic Building Blocks

Structured Products

����Local / foreign underlying

����Various asset classes

UNDERLYING

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� Motivation and Benefits

1. Efficient execution of market view� Residual risk can be laid off (“sold”) in return for extra return.� Or giving up some return in exchange for protection against certain risk.� Remember the Bottom line: No Free Lunch !

2. Ability to modify and customise the investor’s Risk-Return profile. � Enhancing return/payoff profile, gaining capital protection or leverage

3. Offer other dimensions for trading: 1) Volatility 2) Correlation 3) Path-dependent

4. Provide more flexibility and more choices to investors.

5. Investor has direct input in product design decision. Feeling of “in more control”.� Once transacted, investment is in “auto-pilot” mode.

6. Resolve regulatory and market access restrictions.� Credit constraint in dealing with OTC derivatives� Allow market access to restricted markets, e.g. Participation Notes/Certificates

Structured Products

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� Investor’s Choice of Option Strategies

1. Investor BUYS option(s)� Usually in principal-protected structures� Limited downside, unlimited upside� Lower risk

2. Investor SELLS option(s)� Usually in yield enhancement structures� Unlimited downside, limited upside� Higher risk

3. Combination of BUY and SELL Options strategies� Multiple options on multiple asset classes or underlyings

Structured Products

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� Investor’s Choice of Risk Factors (Parameters)

1. Asset Class� Equities, Currency (FX), Commodities, Interest rates, Credit, Funds, etc.� Any asset class that is tradable and sufficiently liquid

2. “Directional” factor� Bullish, Bearish or Market Neutral� Straight-forward and most popular risk parameter� A “path-dependent” strategy can be seen as a combination of “Directional” strategies� Investors can “maximise” value using Path-dependent Options such as Barrier Options

if they have strong views on the future path movement of the underlying

3. “Volatility” factor� An important parameter that determines the value of an option� “Value” can be created and priced from market view/expectation on “Volatility”

4. “Correlation” factor� Most newer, complex derivatives feature this risk parameter� “Implied correlation” has become more widely “traded” and priced

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� Basic Product Types

1. Capital Guaranteed or Principal Protected Products� Redemption of full or a large portion of the initial capital is assured.� Investors typically buy options.� Risk-adverse, conservative investors who cannot afford to lose capital.

2. Yield Enhancement Products� Partial or full amount of initial capital is at risk.� Investors typically sell options.� Investors with high risk appetite and who desire higher income yield.

3. Leveraged Products� Participation on the underlying asset is leveraged up.� Investors typically buy options in leveraged amount.� Investors with very high risk appetite.

4. Wrapper Products� Designed to gain market access or participation.� Participation Notes (or Certificates)

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� Example 1: Capital-Protected Structure

PRODUCT NAME: Index-linked Capital-Protected

UNDERLYING INDEX: KLCI Index

MATURITY: 3 years

PRINCIPAL AMOUNT: RM 1,000,000

ISSUE PRICE: 100%

COUPON: 0%

INDEX PARTICIPATION RATE (G): 60% ����

CAPITAL GUARANTEE RATIO: 100% ����

SETTLEMENT METHOD: Cash settled

REDEMPTION AMOUNT (R):

R = 100% + ( IPR x G ) ×××× 100% � 100%

IPR: Percentage Rise of Index over Maturity.

Assume Index Level on Start Date = 1400

Capital protection is only assured at maturity!

Redemption Amount

70%

80%

90%

100%

110%

120%

130%

140%

1000

1200

1400

1600

1800

2000

2200

Index Level at Maturity

Participation Rate (G) = 0.60

Strike=1400

Structured Products

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� Pros

1. Initial capital is assured at maturity, i.e. 100% capital protection. 2. Upside participation in the selected stock index (market).3. Out-performs bond/fixed deposit of similar tenure if stock market had performed well.4. Similar to investing in a Balanced-type unit trust.

� Cons

1. Limited exposure to stock market. 60% Participation Rate in this example.2. Underperforms stocks (e.g. index fund) if stock market had risen sharply.3. In low interest rates environment, Participation Rates will be lower and tenure longer.4. Investment capital is locked in over a long period.5. “Passive” investment management.

Example 1: Capital-Protected Structure

Structured Products

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� Enhancing the Structure

� Increasing the Participation Rate 1. Capping the index upside; e.g. call spread 2. Setting a higher strike level (for call option)3. Use of Asian-style (Averaging) options4. Extending the tenure5. Sell option(s) on other underlying assets and taking some risks6. Use of Path-dependent Options, e.g. knock-out and knock-in options

� Capturing and maximising the index upside1. Use of Path-dependent Options, e.g. Barrier Options

� “Lock-in” feature to lock in when the index had reached a certain level� “Look-back” feature to lock in the highest level reached

2. Such features come with additional cost; resulting in a lower Participation Rate

Example 1: Capital-Protected Structure

Structured Products

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� Example 2: Bull Equity-Linked Structure

PRODUCT NAME: Bull ELS or Reverse Convertible

UNDERLYING STOCK: Sime Darby

MATURITY: 35 days

ENTITLEMENT: 1 Bull ELS entitles 1 Share

REFERENCE PRICE: RM 11.80

ISSUE PRICE: RM 11.107 ����

EXERCISE PRICE: RM 11.210 ����

YIELD-TO-MATURITY*: 9.67% p.a., if redeemed at RM11.21

REDEMPTION AMOUNT:

(A) At Maturity, if Share � RM 11.210 Redemption= RM 11.210 ( i.e. YTM=9.67% )

(B) Otherwise, 1 Bull ELS redeems for 1 Sime Share Effective Share Purchase Price= RM 11.107

* YTM = { (11.210 − 11.107) / 11.107 } × ( 365 / 35 ) = 9.68%e.g. 3-month Bank Deposit: 3.0%

Structured Products

YTM

-20%

-15%

-10%

-5%

0%

5%

10%

15%

10.60 11.00 11.40 11.80

STOCK PRICE

YTM = 9.67%

Break-Even 11.107

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� Maturity Payoff

SCENARIO 1Final Price � Exercise Price

SCENARIO 2Final Price < Exercise Price

Investor pays on Issue Date. RM 11.107

Share price of Sime Darby at Maturity (i.e. Final Price). RM 12.00 RM 10.80

Redemption Amount received by Investor at Maturity. RM 11.21 1 share of Sime Darby

Market value of shares held by Investor at Maturity. No shares held RM 10.80

Profit(+)/loss(-) on investment 11.21 – 11.107 = + RM0.103 10.80 – 11.107 = – RM0.307

Return (in annualized simple yield) on investment. 9.67% − 28.82%

Structured ProductsExample 2: Bull ELS

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� Pros

1. Superior yield over bank’s Fixed Deposit if market view had been correct.2. “Target Buying” at below RM 11.21

� Effective purchase of shares at RM 11.107 if view had been wrong.� Must be “happy” to buy or be “long” the shares at RM 11.107.

3. Enforces market/investing discipline, instead of trying to time the market. No leverage.

� Cons

1. Relatively more risky. � Suffers loss if share falls below RM 11.107 (break-even price). � Potential loss is unlimited.

2. Potential upside is limited. Maximum yield 9.67% p.a. (or 0.93% in absolute terms).3. Unattractive Risk-Return profile. Investor takes substantial risk for a small 0.93% pick-up.4. Investment is locked in for 35 days.5. Requires full capital upfront. Cannot leverage.

Example 2: Bull ELS

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� Enhancing the Structure

� Achieving a higher yield 1. Setting a higher exercise price (or strike).2. Select stocks that are more volatile.3. Extending the tenure.4. Use “Worse-of” Put option

� Addition of another risk factor (correlation) into the pricing.� Select stocks with higher negative correlation(s); higher option value.� Negative: Investor will have risk exposure to more than one stock.

Structured ProductsExample 2: Bull ELS

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� Example 3: Auto-callable with Digital Coupon

PRODUCT NAME: Auto-Callable USD Quanto Nikkei-linked Notes with Digital Coupon and Knock-in feature

REFERENCE INDEX: Nikkei-225

MATURITY: 5 years

PRINCIPAL AMOUNT: USD 100,000

INITIAL INDEX LEVEL: 15,700

COUPON: Payable in USD on a quarterly basis, determined as follows:

(A) 11.00% p.a. if Index �13,600 on each Observation Date

(B) 0% if otherwise.

OBSERVATION DATES: 5 Market Days before each coupon payment date

REDEMPTION (R): Payable in USD if Early Redemption has not occurred, and is determined as follows:

(A) R = 100% if Knock-In Event has not occurred before maturity;

(B) R = 100% × [Final Index Level / 15,700 ] if otherwise.

FINAL INDEX LEVEL: Index level at maturity.

KNOCK-IN EVENT: Considered to have occurred if Index trades at/below 10,000 at any time before maturity.

EARLY REDEMPTION: Automatically early redeemed if Index � Trigger Level on any Observation Date.

TRIGGER LEVEL: 16,000

Structured Products

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Structured ProductsNikkei-225 Index price performance

Issued 8/3/06Nikkei=15,700

Early redemption triggered after only 6 months.1/9/06 COB: Nikkei=16,134

Put Knock-in = 10,000

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� Pros1. Good possibility of receiving high interest coupons over 5 years

� Earns 11% p.a. coupon if Index � 13,600 i.e. 13% decline from initial level 15,700

2. Good possibility of early redemption � Index only have to rise 2% (15,700 � 16,000) after 3 months or thereafter� Outperforms similar maturity time deposit if it had early redeemed after 3 months

3. “Low” possibility of capital being at risk (i.e. Knock-in Event triggered)� Index has to decline 36% (15,700 �10,000)

4. No currency risk if you are a USD based investor (i.e. “Quanto-ed”)

� Consa. Potential income and capital loss if Nikkei had crashed below 10,000b. Long investment holding (5 years) and equity risk exposure if not early redeemedc. Upside is capped (total income = 55% p.a.) d. Coupons have a “digital” payoff, i.e. either 11% or 0%

e. Re-investment risk, in the event of early redemption

Structured Products

Example 3: Auto-callable with Digital Coupon

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� Enhancing the Structure

� Achieving a higher yield 1. Setting a higher threshold Index level for coupon determination2. Setting a higher Knock-in Level3. Setting Observation frequency to “intra-day (continuous)” for Knock-in Event 4. Leveraging on the “short” Put option

� Reducing the risk 1. Replacing the “short” put with a put spread (e.g. 20% spread)

� Limit the potential capital loss to the spread (i.e. 20%)� Trade in for a lower coupon

Structured Products

Example 3: Auto-callable with Digital Coupon

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Structured Products

� When and Why invests in SW

1. Desire for Gearing (leverage)

� Gain large market exposure with small investment outlay

� “High risk, high return” and more “speculative” in nature

2. “Limited downside, unlimited upside” and cash extraction strategy

� Defensive strategy in times of very volatile, “bullish but nervous” market

3. Arbitrage and volatility trading

4. More Trading-driven and shorter term investment horizon

� SW positions must be actively monitored

� Beware of time decay

� Usually not intended to be held until expiry

Example 4: Structured Warrants (“SW”)

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� Some of the features/mechanisms offered

1. Lock-in

2. Knock-in and Knock-out

3. Digital payoff

4. Cap on cumulative (total) return

5. Auto Callable (i.e. early redemption trigger)

6. Averaging out of risk (or return)

7. Daily accrual (i.e. payoff determined on a daily basis)

8. Currency immunisation

9. Correlation play

10. “Best of”, “Worst of” and relative performance

� Offering More Flexibility, More Opportunities, More Possibilities and More Choices

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� Today: If you have a View, there’s a Way

TRADING STRATEGY & ACTION

MARKET VIEW CONSERVATIVE AGGRESSIVE

Bullish Buy Stocks Buy Futures / Sell Puts

Very Bullish Buy Call Warrants Buy Futures / Buy Calls

Bearish Buy Puts Short Futures / Sell Calls

Very Bearish Buy Puts Short Futures

Bullish but nervous Buy Call Warrants or Buy Stocks + Buy Puts

Bearish but nervous Buy Puts

Neutral / Sideways / Range Sell/Buy Options Sell Options (e.g. straddle)

Lower Volatility anticipated Sell Options

Higher Volatility anticipated Buy Options

Path movement of underlying Buy/Sell Path-dependent Options

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� Determining the Right Product

1. Identifying the Underlying Asset Class

� Which asset class and market: Equities, FX rate, etc.

2. Market View and Market Timing?

� Bullish, Bearish or Market Neutral

3. Determine your Investment Objective and Risk-Return Profile

� Minimum, Average and Maximum potential return?

� Maximum (affordable) potential capital/income loss? Risk appetite?

� Asset allocation (more conservative) or return-driven (more aggressive)?

4. Do you have “holding power”?

� Are you able to ride through the market volatility or downside?

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� Understanding the Limitation and Risks

1. Making the distinction between and Trading and Investment

2. Structured Products are intended to be held until maturity. Not for trading

3. Secondary market liquidity risk � No secondary market. Very much a bilateral contract.

� Early redemption risk. Investor can only unwind trade with the issuer.

4. Pricing may not be straight-forward, especially for complex, multi-asset products� Multi-asset, more features means larger built-in margin and wider bid-offer spread.

� Pricing models not readily available to investors.

� Try to avoid Products linked to less liquid underlying

5. Credit risk exposure to the Issuer

� Major consideration if tenure is long (> 3 years).

6. No free lunch!

� If the risk is perceived to be higher, the option will be priced higher, and vice-versa.

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� Avoiding Catastrophe: Due Diligence and Suitability

1. Has the Investor the capability to understand?

� Investment experience and education background

2. Is the Product consistent with investment objectives and risk-return profile?

� Looking for an Apple, bought an Orange !!

3. Is the Product suitable for the Investor in relation to his financial standing, etc?

4. Read the Product Terms, Disclaimers and fine print, etc.

� “…. Return of up to X% ….”

� Be careful if the terms are too good to be true

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Disclaimer / Risk Warning

This material has been prepared and published solely for informational purposes only, and should not be construed as a solicitation or an offer to buy/sell any securities/products or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor intended to be a complete statement of summary of the securities, market, etc. referred to herein.

Structured Products, Warrants and Derivatives can be volatile instruments and investing in them involves significant risk. These products are subject to a number of risks and may result in a complete or partial loss of an investment in them. No person should deal in any type of Structured Products, Warrants or Derivatives unless he/she understands the nature of the relevant transaction and the extent of his/her exposure to potential loss. Each prospective investor should consider carefully whether such instruments are suitable for it in the light of its circumstances and financial position. Prospective investors of any Structured Products and Warrants should therefore consult their own legal, tax, accountancy and other professional advisers to assist them in determining the suitability of any Structured Product or Warrant for them as an investment and for their particular circumstances.

Structured Warrants/Products