Structured Products and the Mischief of Self-Indexing
Published in The Journal of Index Investing, Spring 2017, Vol. 7, No. 4, pp. 16-29.
In recent years, investment banks have issued structured products linked to indexes they create rather than just linking to standardized indexes from Standard & Poor's. In doing so, the issuers create additional difficulties for retail investors to understand these, sometimes complex, investments. We illustrate the potential conflicts of interest created with structured products linked to proprietary volatility indexes although the conflicts are present in other proprietary index based investments as well.
In the 1990s, investment banks switched from underwriting reverse convertibles and tracking securities issued by operating companies like Citicorp and Reynolds Metals linked to their own stock to issuing and underwriting structured products linked to unrelated publicly traded companies like Cisco Systems. This change in investment banks' role led to a dramatic proliferation of new issuances and ever more complicated payoff structures since the underwriters were no long limited to underwriting securities other companies wanted to issue. Investment banks could now issue notes in relatively small denominations linked to publicly traded companies that the brokerage firms could then sell through their retail sales force. The complexity of these notes made regulatory oversight more difficult and allowed issuers to sell structured products with very low issue date values.
Craig McCann's NASAA 2015 Presentation, Investments Through Time
Investments Through Time: The Evolution of Investment Products and How They are Sold.
Ex-post Structured Product Returns: Index Methodology and Analysis
Published in The Journal of Investing, Summer 2015, Vol. 24, No. 2: pp. 45-58.
The academic and practitioner literature now includes numerous studies of the substantial issue date mispricing of structured products but there is no large scale study of the ex-post
returns earned by structured product investors. This paper augments the current literature by analyzing the ex-post returns of nearly 18,000 individual structured products issued by
13 brokerage firms since 2007. We construct our structured product index and sub-indices for reverse convertibles, single-observation reverse convertibles, tracking securities, and auto-callable securities by valuing each structured product in our database each day.
The ex-post returns of US structured products are highly correlated with the returns
of large capitalization equity markets in the aggregate and individual structured products
generally underperform simple alternative allocations to stocks and bonds. The observed
underperformance of structured products is consistent with the significant issue date under-pricing documented in the literature.
Valuation of Structured Products
Published in The Journal of Alternative Investments, Spring 2014, Vol. 16, No. 4: pp. 71-87.
The market for structured products has grown dramatically in the past decade. Their
diversity and complexity has led to the development of many different valuation approaches,
and which approach to use to value a given product is not always clear. In this paper
we demonstrate and discuss four approaches to valuing structured products: simulation of
the linked financial instrument's future values, numerical integration, decomposition, and
partial differential equation approaches. As an example, we use all four approaches to value
a common type of structured product and discuss the virtues and pitfalls of each. These
approaches have been practically applied to value 20,000 structured products in our database.
Valuation of Reverse Convertibles in the VG Economy
Published in the Journal of Derivatives & Hedge Funds 19, 244-258 (November 2013).
Prior research on structured products has demonstrated that equity-linked notes sold to retail investors in initial public offerings are typically issued at above their
fair market value. A particular type of equity-linked note reverse convertibles embed down-and-in put options and other investors relatively high coupon payments
in exchange for bearing some of the downside risk of the equity underlying the note.
We analytically study the magnitude of the overpricing of reverse convertibles - one
of the most popular structured products on the market today - within a stochastic
We extend the current literature to include analytical valuation formulas within
a model of stochastic volatility - the Variance Gamma (VG) model. We show
that these complex notes are even more overpriced than previously estimated when
stochastic volatility is taken into account. As a result of their complex payouts and
the lack of a secondary market to correct the mispricing, reverse convertible notes
continue to be sold at prices substantially in excess of their fair market value.
Structured Product Based Variable Annuities
Published in the Journal of Retirement, Winter 2014, Vol. 1, No. 3: pp. 97-111.
Recently, a new type of variable annuity has been marketed to investors which is based on structured product-like investments instead of the mutual fund-like investments found in traditional variable annuities. Embedding a structured product into a variable annuity introduces substantial complexity into an investment typically considered conservative. In this paper, we describe structured product based variable annuity (spVA) crediting formulas and how they differ from traditional VAs, value the embedded derivative position for a range of example parameters, and calculate the fair cap levels required to fairly compensate investors for the derivative position. We also provide extensive backtests of spVA crediting formulas using our calculated cap levels and compare the results to their underlying indexes. Our findings suggest that the complexity of spVAs can be used to hide fees and reduce the comparability of variable annuities to other investments in the market.
The Rise and Fall of Apple-linked Structured Products
The rise in Apple's market capitalization in 2012 coincided with a dramatic increase in single-observation reverse convertibles, reverse convertibles and autocallable notes linked to Apple's stock price. These notes all transfer the downside risk of owning Apple to investors but cap the upside at somewhat more than corporate bond yields. Issuers use individual stocks like Apple as the reference obligations for reverse convertible structured products because investors underestimate the risk of suffering losses when the individual stock's price falls.
The decline in Apple's stock price from over $700 in September 2012 to $450 in January 2013 has resulted in over one hundred million dollars of losses in Apple-linked structured products. In this paper, we summarize our published reports on over 650 Apple-linked structured products and identify the impact of Apple's recent stock price decline on investors in these structured products.
Dual Directional Structured Products
Published in the Journal of Derivatives & Hedge Funds, (5 June 2014).
We analyze and value dual directional structured products - or simply dual directionals
(DDs) - which have been issued in large amounts since the beginning of 2012. DD's evolved
out of another type of structured product called absolute return barrier notes (ARBNs);
however, DD's lack principal protection and have different embedded options positions, which
have yet to be described in the literature. We find that DDs can be broadly organized into
two categories: single observation dual directionals (SODDs) and knock-out dual directionals
(KODDs). We determine the appropriate option decomposition for these categories and
provide analytical formulas for their valuation. We confirm our analytic results using Monte
Carlo simulation and use both techniques to value a large sample of DDs registered with the
Securities and Exchange Commission up to December 2012. Our results indicate that like
many types of structured products, DDs tend to be priced at a significant premium to present
value across issuers and underlying securities and that the present value of the decomposition
is smaller than the face value net of commissions. We find that DDs with embedded leverage
or a single observation feature tend to be worth less than products either without leverage
or with a knock-out option.
Modeling Autocallable Structured Products
Published in the Journal of Derivatives & Hedge Funds 17, 326-340 (November 2011).
Since first introduced in 2003, the number of autocallable structured products in the U.S. has increased exponentially. The autocall feature immediately converts the product if the reference asset's value rises above a pre-specified call price. Because an autocallable structured product matures immediately if it is called, the autocall feature reduces the product's duration and expected maturity.
In this paper, we present a flexible Partial Differential Equation (PDE) framework to model autocallable structured products. Our framework allows for products with either discrete or continuous autocall dates. We value the autocallable structured products with discrete autocall dates using the finite difference method, and the products with continuous autocall dates using a closed-form solution. In addition, we estimate the probabilities of an autocallable structured-product being called on each call date. We demonstrate our models by valuing a popular autocallable product and quantify the cost to the investor of adding this feature to a structured product.
The Anatomy of Principal Protected Absolute Return Notes
Published in the Journal of Derivatives, Vol. 19, No. 2, pp. 61-70, 2011.
Principal Protected Absolute Return Barrier Notes (ARBNs) are structured products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.
The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.
The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies.