FINA 6910M

Structured Product
Lecture 1 – Introduction

Spring 2024
 Introduction

About me:

➢ Partner at Lotus Asset Management Limited in charge of quantitative

investment strategies for hedge fund management

➢ Adjunct Associate Professor at HKUST

➢ Previously worked at Citigroup, Barclays Bank, and Singapore Management

University, etc.

➢ Ph.D. in Finance at Wharton School, B.S. in Mathematics from Fudan

University

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 Introduction

About this course:

➢ Go over syllabus

➢ Little math except simple algebra will be involved and tested in this course.

➢ Derivative pricing will not be discussed. This specialized skill is required for
quants, traders, and risk managers but not for most financial practitioners.

➢ Focus on the basic and practical knowledge of structured products, which

are necessary for all the practitioners in financial industry.

➢ You need to form a team of two to four members by the beginning of the
second lecture to work on assignments and final project.

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 Introduction

What do we need to know about structured products?

➢ From the perspective of investors

➢Payoff of various products

➢Legal forms: Note, TRS, OTC, Exchange-traded

➢Risk of various products

➢ From the perspective of issuers

➢Hedging, trading, and profit making

➢Marketing and sales

➢Risk management and regulation

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 Introduction

What are structured products?

➢ The payoff is what investors care most about for any financial product, so
it makes sense to define any financial product by its payoff function.

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 Introduction

What are structured products?

➢ U.S. Securities and Exchange Commission (SEC) Rule 434 defines

structured securities as

“securities whose cashflow 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 cashflows."

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 Introduction

➢ In short, structured products are defined as financial instruments whose

payoffs depend upon other securities or indices or interest rates (i.e., the
underlying assets).

➢ The underlying assets of structured products can be stocks, bonds,

currencies, commodities, interest rates, indices, mutual funds, hedge funds, or
any combination of these.

➢ In other words, structured products are financial products which are structured
to offer customized payoffs linked to various underlying assets to meet the
target risk/return profiles of clients. For example, a financial product whose
payoff is linked to the performance of HSI index and also offers principal
guarantee.
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 Introduction

One way to convey new and complex concepts is by linking them to

something we are familiar with.

➢ To better understand the concepts of structured products, let’s first look

at the payoff function of a direct investment into the underlying asset,
such as stocks and bonds.

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 Principal Protection

Assume the price of the underlying asset is denoted by S0 at time 0 and S 𝑇

at time T. These are the market price of the underlying and you can freely
buy or sell the underlying at its market price.

➢ At time 0, S0 is known but S 𝑇 is unknown.

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 Introduction

➢ If the price of an asset is 𝑆0 at time 0 and S 𝑇 at time T, then the return

realized at time T is given by r 𝑇 = SS𝑇 − 1. We have r 𝑇 ≥ −1.

0

➢ If you invest a dollar amount of N (principal) into this asset (e.g., HSI index)
S𝑇
at time 0, your payoff at time T will be Payoff 𝑇 = N × = N × (1 + r 𝑇 ).
S0

➢ At time 0, S 𝑇 and r 𝑇 is unknown and is viewed as a random number.

➢ For example, if the price of stock X was $150 at time 0 and you invested
$10K in this stock. The stock price declined to $120 after two years. Then
N = $10K, rT = 120
150
− 1=−0.2 and Payoff 𝑇 = $10K × 1 − 0.2 = $8K

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 Introduction
The payoff of investing one dollar directly into the underlying asset is
S𝑇
Payoff 𝑇 = = 1 + r 𝑇 . The relationship is plotted in the below. Note that
S0

r 𝑇 ≥ −100%.
Payoff 𝑇

-1 0 r𝑇
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 Introduction

➢ Depending on the value of r 𝑇 , the payoff could be as low as zero. In other

words, if the underlying asset performs poorly, you may lose all your
principal N at time T.

➢ Is there any product that can guarantee the principal N at time T?

➢We will need to design and structure a financial product which can offer
a customized payoff function. This is where structured products come
into play.

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 Introduction

Principal Protected products are designed and structured for investors who
are relatively more risk conservative.

➢ The bank can design a structured product with the payoff in the below. N is
the initial investment amount into the structured product. r 𝑇 is the return of
the underlying asset. This would be a 100% principal protected product with
a participation rate of 90%.
Payoff 𝑇 = N × [100% + 90% × max r 𝑇 , 0 ]

➢ Define max A, B = largest of A and B, min A, B = smallest of A and B.

For example, max 5,6 = 6, min 0, −8 = −8.

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 Introduction

For example, Mr. Zhang invested $10K into a principal protected product
linked to stock X. The product matures in 5 years and provides with 100%
principal protection with 80% participate rate with the payoff function
Payoff 𝑇 = N × [100% + 80% × max r 𝑇 , 0 ]

➢ In 5 years, if the price of stock X rises by 50%, he will get a payoff

Payoff 𝑇 = $10K × 100% + 80% × max 50% , 0 = $14K

➢ In 5 years, if the price of stock X declines by 50%, he will get a payoff

Payoff 𝑇 = $10K × 100% + 80% × max −50% , 0 = $10K

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 Introduction

➢ It is important to point out that the principal is guaranteed only at

maturity, but not if the investor redeem the structured product prior to
maturity. Normally the liquidity of secondary market of structure products
is low.

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 Introduction
The payoff of investing one dollar into the above principal protected product is
Payoff 𝑇 = 100% + 80% × max r 𝑇 , 0 and the relationship is plotted in the below.
Note that the dotted line refers to the payoff 1 + r 𝑇 for a direct investment into the
underlying asset.
Payoff 𝑇

-1 0 r𝑇
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 Introduction

Why do we see an increasing demand of structured products from institutional

and individual investors? It is because structured products can have highly
customized payoffs to meet different investment needs of investors.

➢Investors can have different risk appetites – some love to take risk while
some are more conservative.

➢Investors can have different market views – some are bullish while some
are bearish.

➢Investors can face different investment restrictions – some clients lives in

countries with no access to international investments.

➢So, structured products business is a client-driven business.

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 Introduction

Investors with different risk appetite:

➢For risk conservative investors, a principal protected product with the

payoff in the below would be attractive. The downside risk is limited
because the payoff at maturity is floored at 100% of the principal N
regardless of the performance of the underlying asset r 𝑇 .

Payoff 𝑇 = N × 100% + 85% × max r 𝑇 , 0 .

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 Introduction

➢ For risk aggressive investors, a leveraged product with the payoff

function Payoff 𝑇 = N × (1 + Lev × r 𝑇 − fee) would be attractive. Lev is

the leverage ratio of the product. fee is determined by the pricing of the
issuer and depends on the financing rate.

➢ For example, an aggressive investor, who is bullish on the stock

market, can invest $10K in a 1-year leveraged product linked to HSI
index with Payoff 𝑇 = N × (1 + 2 × r 𝑇 − 5%). If HSI index rises by
7.5% in one year, the product payoff will be $11K, which is a return of
10%. However, if HSI declines by 7.5% in one year, the product
payoff will be $8K, which is a return of -20%.

➢ Both the upside potential and the downside risk are increased in a
leveraged product. 19
 Introduction

Investors with different market views:

➢For example, if the investor believe that the price of the underlying asset
is unlikely going to rise or fall dramatically between time 0 and time T, a
structured product with the payoff function in the below would be
attractive.

N × 115% if −10% < rT < 10%

Payoff 𝑇 = ቊ
N Otherwise

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 Introduction

Investors facing different investment restrictions:

➢For onshore investors in mainland China who have no access to the

stock market in U.S., a structured product denominated in CNY with its
payoff linked to S&P500 index would be highly attractive.

➢ For example, a 2-year CNY denominated principal protected product

issued in China with its payoff in the below

Payoff 𝑇 = N × 100% + 85% × max r 𝑇 , 0

where r 𝑇 refers to the return of S&P500 index in the 2-year period.

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 Introduction

Term Sheet is the most important legal document for a structured product.

➢ Term Sheet includes all the key terms of the product and should be carefully
read by all the investors.

➢ If a salesperson or an investment advisor is speaking to a retail client, he has

the duty to ensure the Term Sheet is fully understood by the client.

➢ In addition to Term Sheet, Prospectus is another legal document, usually 40

to 60 pages long, and includes conventions (i.e., business days, yield
calculation conventions, etc.), full description of issuers, regulators, etc.

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 Introduction

The key elements of a structured product are all included in the Term Sheet:

➢ Underlying asset

➢ Payoff function at Maturity

➢ Intermediate coupon payments if any

➢ Currency (USD, EUR, CNH?)

➢ Tenor

➢ Issuer

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 Introduction

Structured products are mostly over-the-counter (OTC) products and are

usually designed and issued in the form of

➢ Structured Note

➢ TRS (Total Return Swap)

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 Introduction

➢ A structured note is legally a debt security issued by banks

On the trade day, the client makes one-off

payment to buy the structured note from the bank
Client Investment Bank

The client receives the payoff of the structured

note from the Bank in terms of intermediate
coupons (if any) and payment on maturity

➢ The payoff of a structured note is a payment promised by the bank and hence
bears the credit risk of the bank.

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 Introduction

➢ TRS is a swap agreement in which one party, the receiver, pays the other
party, the payer, a fixed or floating financing rate in exchange for the total
return of an asset. It allows the receiver to benefit from the price movements
of an asset without actually owning it. The payers are typically banks while the
receivers can be any type of investors such as wealthy individuals or pension
funds.

The client pays the financing rate SOFR + Spread

Client Investment Bank

(receiver) (payer)
The client receives the return of the underlying
asset, whether positive or negative

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 Introduction

For illustration purpose of this course, we will focus on the discussion of

structured notes instead of TRS since their underlying mechanisms are
similar.

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 Introduction
Term Sheet Example:
EUR PROTECTED BULL NOTES ON S&P500
ISSUER A+ rated Issuer
CURRENCY EUR
NOTIONAL 10 Million

ISSUE DATE January 5, 2024

MATURITY DATE January 5, 2030

ISSUE PRICE 100%

UNDERLYING S&P500 Index
COUPON Zero coupon
PARTICIPATION 80%
REDEMPTION AMOUNT SP500𝐹𝑖𝑛𝑎𝑙
100% + Participation × Max( − 1,0)
SP500𝐼𝑛𝑖𝑡𝑖𝑎𝑙
Where SP500𝐹𝑖𝑛𝑎𝑙 is the closing price of the Underlying 3
business days before the Maturity Date and SP500𝐼𝑛𝑖𝑡𝑖𝑎𝑙 is
the closing price of the Underlying on the Issue Date.
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 Introduction

➢The note is priced at Notional x Issue Price = EUR10M, which is the

amount the investor needs to pay on the Issue Date.

➢The note will be redeemed with the payoff

SP500𝐹𝑖𝑛𝑎𝑙
Payoff = EUR10M × [100% + 80% × Max − 1,0 ]
SP500𝐼𝑛𝑖𝑡𝑖𝑎𝑙

➢If the index rises by 50%, the investor will receive

Payoff = EUR10M × 100% + 80% × Max 50%, 0 = EUR14M

➢If the index falls by 20%, the investor will receive

Payoff = EUR10M × 100% + 80% × Max −20%, 0 = EUR10M

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 Introduction

Risk of structured products faced by investors

➢ Credit risk of the issuer – The payoff of a structured product is the issuer’s
liability to the investors.

➢ Low liquidity – A structured product usually has a maturity date. Early

redemption is usually possible only via the issuer.

➢ Low transparency in pricing – The issuers usually charge fees in implicit

ways in the pricing of the structured products.

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 Introduction

The classification of structured products in terms of underlying assets:

➢ Equity linked products with equity as the underlying asset

➢ Interest rate linked products with interest rate as the underlying asset

➢ Commodity linked products with commodity as the underlying asset

➢ Currency linked products with FX rate as the underlying asset

➢ Fund linked products with mutual fund or hedge fund as the underlying asset

➢ Hybrid products with a mix of asset classes as the underlying asset

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 Introduction

The classification of structured products in terms of risk-return profiles:

➢ Principal protected products

➢ Yield enhancement products

➢ Participation products

➢ Leveraged products

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 Introduction

Risk Risk-Return Profile

Leveraged

Participation

Yield Enhancement

Principal Guaranteed

Return

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 Introduction

Who designs, prices, trades, and issues structured products?

➢ Investment banks (usually the global market division) take the role of
designing, pricing, trading, and issuing structured products. They also act as
the Calculation Agent to calculate the final payoff of the products for clients.

➢ International investment banks (e.g., Goldman Sachs) are capable of

manufacturing from scratch, i.e., dynamic hedging and pricing with
underlying assets.

➢ Local investment banks (e.g., Haitong International) have the capability of

doing back-to-back structuring with international ones.

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 Introduction

The term structuring or financial engineering refers to the process of creating a

wide variety of structured products whose payoffs are linked to one or more
underlying assets.

➢ Product structuring to determine the payoff structure

➢ Product pricing to determine the key parameters in the payoff structure such
as principal protection level or participation rate

➢ A process usually involving multiple functions in the global market division of

investment banks

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 Introduction

What are the front-office roles/functions supporting structured product

business in the global market division of investment banks?

➢ Traders: risk hedging, run a P/L book

➢ Structurers: product development and structuring

➢ Quants: modelling and pricing, support traders and structurers, mostly Ph.D.
in science

➢ Sales: clients pitching, deal closing, generate sale credit

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 Introduction

What are the middle/back-office roles/functions supporting structured

product business at investment banks?

➢ Risk management: assess pricing models, set up risk parameters for

traders, monitor trading P/L, etc.

➢ Settlement: deal with the back office of the counterparty for trade
settlement and reconciliation

➢ Legal and compliance: legal documentation and compliance assurance

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 Introduction

Who are the typical investors of structured products?

➢ Retails, HNWIs, family offices, insurance companies, endowments, pension

funds, hedge funds, and banks, etc.

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 Introduction

How are the structured products distributed?

➢ Direct sale: sell the products to institutional investors directly by the sales
team of investment banks.

➢ Channels sale: sell the products to retails and HNWIs via commercial
banks.

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