p. 2 p. 4 p. 6 p. 8 p.2 p.4 p.6 p.8 p.10 p.12 Autocallable Lookback Outperformance Individual Cap p. 10 p. 12 p. 14 p. 16
Autocallable Lookback Outperformance Individual Cap Total Return vs. Price Return p.14 Rainbow Quanto-style Options p.16 Custom Indexes Rainbow p.18 Tailored Protection Custom Indexes p.20 Secondary Market Tailored Protection Secondary Market Accrual p.22 Range Range Accrual
The
Autocallable
>
100% capital + 5 x coupon X% 100% capital + 4 x coupon X% 100% capital + 3 x coupon X% 100% capital + 2 x coupon X% 100% capital + 1x coupon X%
100% capital + (n) x coupon
Maturity Auto-call level 100% When underlying < auto-call level at each autocall date (t), No early redemption, No coupon payment: the investment proceeds and the potential coupon are accrued for the next auto -call date
-
The definition
An auto-callable (or auto-call) product is essentially a market-linked investment, which can automatically mature prior to the scheduled maturity date if certain predetermined market conditions are achieved. The criterion for deciding whether the product is automatically matured (auto-called) is whether the underlying reference index is above a predetermined trigger level (the auto-call barrier). This auto-call test is usually carried out on a set of predetermined dates (for example, annually, quarterly, etc.) specic to that particular investment product, so that the product can only mature on one of these auto-call dates. The underlying reference index will typically be an equity index, but it can also be linked to stocks, basket of stocks, funds, etc. If a product is auto-called, the investor normally receives a predetermined coupon along with the capital redemption on that auto-call date. That coupon is typically proportional to the length of time from the start date to the auto-call date. Most auto-call products incorporate a protection feature so that, if the auto-call trigger has not occurred before the scheduled maturity date, capital is fully protected provided the underlying has not fallen below a certain level (the protection level) during the term of the investment. Only if the underlying has fallen below that protection level, and the product has not been auto-called prior to maturity, will investors be exposed fully to the downside of the underlying market at maturity.
Protection level P%
In this example of a ve-year auto-call investment, the auto-call barrier is 100%. Therefore the product will auto-call if the underlying index is above its original start level on any of the ve annual auto-call dates. The coupon payable is X% if the product is auto-called on the rst autocall date, two times X% if the product is auto-called on the second date and so on up to and including the maturity date. Its important to note that the auto-call barrier condition is also tested on the maturity date. At maturity, if conditions for an auto-call have not already been met, then the investor is long the underlying index but with the benet of full capital protection, provided the underlying index has not fallen below the protection level during the term of the investment. If the underlying index ever traded below the protection level during the term of the investment, then the capital protection no longer applies and the redemption will be equal to the index performance over the life of the investment.
attractive returns for small movements in the underlying index. If a coupon is not paid, because the auto-call barrier has not been achieved by the underlying index on an auto-call date, then the investor gets the opportunity to recoup the missed coupon on the next auto-call date. In addition, the protection level ensures that the investment is conditionally protected. If the underlying does not fall below the protection level, investors will receive at least the full principal amount back at maturity.
In all scenarios, the most likely outcome is that it is auto-called in year one with a coupon of 9% (the dark-blue segment). If it is not auto-called in year one, then gure 2 demonstrates the likelihood of it being called in subsequent years (the remaining lighter-blue segments). The likelihood of the product lasting until maturity is equivalent to the size of the red and pink sectors combined in each scenario, with the size of the red sector showing the probability of losing some portion of capital and the size of the pink sector representing the probability of the product redeeming 100% capital.
Scenario simulations
With each structure we examine in this monthly column, we will also provide some simulations designed to show how the product can behave in certain assumed market conditions. The following simulations are based on a Monte Carlo approach. The Monte Carlo simulation involves generating thousands of possible price paths for the underlying index, based on preset volatility and trend assumptions. The simulation calculates how the product would have performed using each of those simulated price paths and then summarises the results. We assume that returns on the underlying single index follow a process with constant growth rate and volatility. The example we use here is for a ve-year auto-call investment linked to the Dow Jones EURO STOXX 50 with an auto-call barrier at 100%, a potential coupon of 9% per annum and a protection level of 60%.
100 90 80 70 60 % 50 40 30 20 10 Auto-called year 2 with 18% coupon Auto-called year 1 with 9% coupon Not auto-called with capital loss at maturity Not auto-called with capital protection at maturity Auto-called year 5 with 45% coupon Auto-called year 4 with 36% coupon Auto-called year 3 with 27% coupon
Variations
As with any popular structure, a number of variations on the original idea exist. Some of the more commonly seen variations are: Performance auto-call: The auto-call coupon is not xed at a specic level but pays the greater of X% and the actual underlying performance in case of an auto-call event. Crescendo auto-call: The auto-call event depends on two underlyings being above the auto-call barrier. The additional condition on the second underlying provides additional nancing for higher auto-call coupons. Escalator auto-call: The auto-call barrier decreases each year increasing the likelihood of an auto-call event and reducing the probability of capital at risk. Bonus plus auto-call: Besides the auto-call coupon, investors receive a bonus coupon if auto-called early in the life of the product. The effective per annum coupon is high in early years compared with a standard autocall note and reduces towards maturity. Premium express: The auto-call barrier is below 100% of the initial strike level aiming to provide a high auto-call probability with full capital protection.
Moderate market
2.5% growth rate pa
Bullish market
7.5% growth rate pa
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The
Lookback
>
investment period, registers a positive peak at year three and then enters a bearish trend. At the end of the investment, the option offers participation in the performance calculated on the maximum value of the underlying. A standard European call option would have offered a lower performance, considering only the level registered by the underlying at year ve. Figure 2 shows the mechanism of a lookback call with oating strike. The index has the same behaviour presented in the previous example. At the end of the investment, the structure offers participation to the performance calculated on a strike price equal to the lowest level of the underlying. A standard European call option would have offered a lower performance, considering a strike price equal to the initial level of the underlying.
Product rationale
The powerful concept behind a lookback option is that the investor has the privilege of benetting from a favourable market timing for his synthetic operations of buying or selling the underlying. In the case of a lookback call option, for example, the investor knows from the beginning the price at which he is synthetically buying the underlying (strike price) but he will choose at the end of the options life the price at
160 150 140 Index value (%) 130 120 110 100 90 80 70 0 1 2 Year 3 4 5 Fixed strike Performance Level of the index considered
160 150 140 Index value (%) 130 120 110 100 90 80 70 0 1 2 Year 3 4 Performance Floating strike Level of the index considered
4
4
which he will synthetically sell the underlying. This selling price will be the highest registered at the observation periods, in order to realise the maximum prot. The best market timing is automatic selected ex-post, by observing the underlying behaviour. The path-dependent aspect of the lookback structures provides the investor with protection from the markets uncertainties.
Scenario simulations
The scenario analysis conducted here present the results of simulations based on a Monte Carlo approach. The process is based on thousands of simulations, each one generating a specic path for the underlying index, on the basis of volatility and growth rate assumptions. For each simulation, the relative payoff is calculated and then results are summarised in order to obtain the expected behaviour of the structure. The product considered in this example is a ve-year lookback option with xed strike, linked to the Dow Jones EURO STOXX 50 and with a participation rate equal to 70%. Investors benet from full capital protection and have an exposure to 70% of the maximum performance of the index based on 10 semi-annual observations over the ve year investment period.
Volatility
5.0%
7.5%
Different hypothetical scenarios are analysed, each one with a specic combination of volatility and annual growth rate. In terms of growth trend, three main scenarios are analysed: Flat market: zero growth rate, no clear trend in the market Moderate growth market: the underlying has a positive drift of 5% per annum Bullish market: a growth rate of 7.5% per annum is assumed On the volatility side, three scenarios are considered: Low vol market: the volatility level is equal to 15% Moderate vol market: the volatility is equal to 20%, in line with the current implied volatility of the underlying High vol market: a volatility level of 25% is assumed The following table summarises the assumptions for the simulation and shows the average time to market peak for each combination of volatility and growth rate.
In a at growth scenario, the impact of the volatility is less relevant and the timing of the maximum peak of the underlying performance is around 2.7 years. Considering higher growth rate equal to 5% per annum, the impact of the volatility is more evident. In a low volatility scenario, the peak is registered on average after 3.6 years, while in the highest volatility scenario the maximum level is achieved a few months before. In a bullish market scenario, with a growth rate of 7.5% per annum, the average period that investors need to wait in order to record the maximum performance of the underlying oscillates between the 3.4 years of the high volatility environment and the 3.9 years of the lowest volatility scenario.
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The
Outperformance
At the end of the third year, the target asset doesnt achieve its objective, registering a performance lower than that realised by the second asset and a similar situation is observed at maturity. The coupon is not paid on these two coupon payment dates.
Scenario simulations
Using a Monte Carlo simulation approach, we can estimate the probability of the target asset beating the reference asset and thus generating positive cash ows for investors. We consider a ve-year product that pays at the end of each year, a coupon of x% if the over-performance is realised.
Product rationale
Lets consider a product that pays a xed coupon equal to x% if the return of the target asset is higher than that registered by the reference asset. The behaviour of the two assets is observed every year in order to calculate if the over-performance is realised; the observation is repeated until maturity. Thanks to the neutralisation of the markets directional trend, the structure can generate positive returns even in bearish scenarios. For example, in year one, both assets register a negative performance but the target has a higher value than the reference asset and the investor receives the target coupon in that year. At the end of the second and fourth year, the target asset generates over-performance and the structure pays the xed coupons for these years also.
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For example, given a growth rate of 7.5% per annum for the target asset and a growth rate of 5% for the reference asset, the investment offers, on average, more than three coupons during the ve years of investment. By reducing the correlation between assets returns from 80% to 50%, it is possible to observe how the average number of paid coupons is affected. If the same growth rate is assumed for the target asset and the reference asset, the change in correlation doesnt have any effect. The analysis shows that lower correlation between the two assets increases the likelihood of coupons occurring by chance in scenarios that are typically negative for the structure, but decrease the likelihood of coupons occurring in scenarios that are typically positive for the structure.
Variations
The basic outperformance payout can be developed in order to create more sophisticated structures that are able to offer a linear participation to the over-performance registered by the target index. There are also variations that are based on the behaviour of three or more underlying assets. Here are some of the most common variations. Variation 1 The digital coupons amount paid when the over-performance occurs is not xed, but linearly reects the realised over-performance. Variation 2 The investor receives, at relevant payment date, the highest amount between a conditional xed coupon and a participation in the over-performance realised during the observed period. Variation 3 The coupons amount is linked to the number of underlying assets that perform better than the reference asset.
5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 0.00% 5.00% Growth rate of target asse t 7.50% 0% growth rate of reference asset 5% growth rate of reference asse t 7.5% growth rate of reference asset
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The
Individual Cap
cap level and are therefore considered at the xed value of 175% in the baskets performance calculation; the remaining three assets are observed at their respective nal value. The individual cap basket registers a lower value than the uncapped basket in any scenario where at least one of the assets reaches a nal value higher then the xed cap level. However, the individual cap call option is cheaper to purchase than uncapped call on the same basket and therefore provides for structured investments with higher participation. This can allow for better returns overall, even in cases where some of the components perform better than the cap level.
Scenario simulations
Using a Monte Carlo simulation approach, we can observe the average payout of an individual cap call and compare it to the performance of an uncapped call under various sets of volatility and correlation assumptions. For the purposes of this simulation, we consider fully capital protected structured products, linked to a basket of ve equity stocks with a maturity of ve years. The leveraged exposure to the growth is equal to 155% for the individual cap version and 110% for the uncapped version.
Product rationale
Lets observe a structure that offers an exposure to the growth of the basket over a ve year investment period; the structured product offers full capital protection for the amount initially invested. The underlying basket is composed of ve assets and each is capped at 175% of its initial value. In this example, Asset 1 and Asset 2 register a nal value higher than the
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product offers an average overperformance of more than 6%, thanks to the higher participation rate to the growth of the basket. Clearly, a market environment characterised by low volatility will represent a favourable condition for individual cap structured products to perform better than uncapped call structures. Both structures are positively affected by an increase of correlation. However, the individual cap structure benets more from the higher correlation assumptions of simulations here presented.
Variations
The individual cap call payout can be structured in different variations; here are presented some of the most common. Variation 1 The premium amount received by imposing cap on the performance of the asset is used to nance oors on the single performance of the basket, in order to mitigate the effect of adverse market scenarios. Variation 2 The cap level is xed on the average baskets performance; the premium received is generally lower than the one obtained by selling a call on each single underlying asset. Variation 3 The premium linked to individual cap is not invested to nance a higher participation to the individual cap basket but to generate xed coupons paid to the investor during the products life.
2. Payout at maturity
Individual cap 145% Average payout at maturity 143% 141% 139% 137% 135% Vol 15% Correl 20% Vol 15% Correl 50%
Uncapped
For example, given a volatility of 15% for each stock and an average correlation between pairs of stocks equal to 20%, the individual cap structured
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The
The Total Return vs. Guide to Structured Product Terminology Price Return
The performance of structured products can be affected by the way dividends are treated in the underlying equity index calculation. The investor can choose to assume a direct exposure to the dividend ow effectively paid by the stocks composing an index by opting for structured products linked to the growth of a total return equity index
The definition
The two common approaches in terms of the dividend treatment of equity indexes are (i) the reinvestment of dividends as they are paid by the relevant companies; or (ii) the disregard of this cash ow for index return calculation purposes. The former describes a total return index; the latter a price return index. The dividend yield is one of the main components in determining the price of a structured product, and the choice between a total return index or a price return index can have an impact on the price of the structure. In the case of a structured product offering exposure to the growth of a price return index, the investor will benet from a higher participation rate. The same structure linked to a total return index will have a lower participation rate, due to the higher cost of purchasing the option offering the exposure in the appreciation of the index (call option). Dividends paid will be reinvested in the index and, therefore assuming that all or some of the underlying stocks pay a dividend the performance of a total return index will be higher than the price return version of the same index. return index. However, the outperformance generated by dividend reinvestment tends to compensate for the effect of a reduced participation in the growth in scenarios where the realised growth rate is low or moderate.
Product rationale
We can consider two structures that offer exposure to the growth of an equity index over a ve-year investment period; the product is designed to offer, at maturity, full protection of the amount initially invested. The participation rates in the growth of the total return index and price return index are calculated considering an annualised volatility of 20% and an expected dividend yield of 3.50%. A rst hypothetical structure linked to the total return index offers a participation rate of 77% in the growth of the index over the ve years. A second structure, linked to the price return version of the same index, offers higher participation in the growth of the index, equal to 115%. The total return index outperforms the price return index by an amount equal to the nal value of dividends reinvested in the index. In this scenario, the payout at maturity of the two structures is equal; the lower participation in the growth of the total return index is offset by a higher performance of the index compared with that of the price return index.
Year
10 10
100% of the initial invested 100% of the initial invested capital capital 77% of the growth of the index 115% of the growth of the index
the pricing, average payouts of the two structures present similar levels. Conversely, in a scenario where the dividend yield is higher (4.5%), the investment in the structure linked to the total return index would have been more protable for the investor. This structured product linked to the total return index would have offered, in this scenario, participation in the realised growth of the dividends reinvested in the total return index, greater than the dividend income of 3.5% estimated in the pricing. The nal payout of the structured product linked to the price return index is not affected by the amount of dividends effectively paid. Keeping the same volatility assumption and under the hypothesis of a realised dividend yield equal to the level of 3.5% assumed in the pricing of the two structures, it is possible to observe the effect of changes in terms of growth rate.
Growth rate of 3.72% Price return index-linked Total return index-linked 144.23% 144.96% Growth rate of 4.72% 150.06% 150.05% Growth rate of 5.72% 156.31% 155.44%
Scenario simulations
Using a Monte Carlo simulation approach, we can compare average payouts under different dividend yield and growth rate assumptions and observe how the choice between a total return and a price return index could affect the products payout at maturity. In the rst step of the analysis, a xed growth rate is considered and average payouts at maturity are simulated on the basis of different assumptions on the realised dividend yield. In a second step of the analysis, the dividend yield is considered xed and three different growth rates are assumed in order to simulate nal payouts. For simulation purposes, the annualised volatility is assumed to be 20% for both indexes and the growth rate is set at 4.72%, reecting the level used to calculate the participation rates for the two structures. In order to observe the effects on the nal average payouts, the realised dividend is set equal to 2.5%, 3.5% and 4.5%, respectively. Final average payouts corresponding to each dividend yield hypothesis are simulated and compared for the two structures. Figure 2 represents the average payouts at the end of the life of a ve-year hypothetical investment associated with each set of dividend assumptions. Given a hypothetical scenario in which the realised dividend yield is equal to 2.50%, the investment in the structured product linked to the price return index would have generated a higher return on average, offering the investor an outperformance in respect to the structure linked to the total return index. Given a dividend yield of 3.5%, equal to the level assumed in
The results of the simulation show that, for a small reduction in terms of the growth rate, a structured product linked to the price return index registers a larger decrease in terms of performance compared with the equivalent product linked to the total return index, which registers only a few basis points change in terms of average payout. An increase in the growth rate produces a better performance in both of the structured products, with a slight outpeformance for the structure linked to the price return index. The investment in a structured product linked to the growth of a price return index will tend to provide, on average, the same expected return as the one offered by the investment in a structured product linked to the growth of the total return version of index if the realised growth rate and the realised dividend yield reect the same levels considered in the pricing. In scenarios where the realised dividend yield is higher than the level assumed in the pricing model, and the realised growth rate is equal or lower than the level considered in pricing, the investor in a structured product linked to the growth of a total return index will tend to benet from higher returns. The effect will be the opposite when the dividend yield is lower than the level assumed in the pricing model and the realised growth rate is equal to or higher than the level considered in pricing. Considering a realised dividend yield equal to the level assumed in pricing, the increase of the realised growth rate will have a stronger positive effect on the payout of the structured product linked to the growth of a price return index, thanks to the leverage offered by the higher participation rate in the growth of the underlying index.
DivYield 4.50%
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The
Quanto-style Options
Product rationale
The main product rationale is for the investor not to take any FX risk. It also provides the advantage of avoiding currency changes (and conversion costs), paying off investors directly in the currency of their choice. For simplicity, we compare here the different payouts of the quanto and the vanilla option. Because EUR rates are higher than YEN rates, the discounting effect will tend to make the quanto option cheaper than the corresponding vanilla. However, the correlation priced between the Nikkei performance and the EUR/YEN FX rate will also drive the forward of the quanto and therefore impact the relative costs of the quanto versus the vanilla option.
Scenario simulations
Using a Monte Carlo simulation approach, we can compare average payouts under different growth rate assumptions for either the underlying (i.e., the Nikkei) and the EUR/YEN FX rate.
150.0 145.0
Average payout
FX rate mvt
12
100% of the initial invested 100% of the initial invested capital capital 120% of the growth of the index 120% of the growth of the index
For simplicity of analysis, we assume a constant participation rate for both the quanto and vanilla options. The annualised volatilities are assumed to be 20% for the equity index and 7.5% for the EUR/YEN FX rate with an annualised correlation of approximately -25% between the two. The assumed yearly growth rates for both the Nikkei index and the EUR/YEN FX rate are -5%, 0% and 5%, respectively, hence we consider nine cases in total. Final average payouts corresponding to each case are simulated and compared for the two structures. Figure 1 represents the average payouts at the end of the life of a ve-year hypothetical investment associated with our assumptions. Given this hypothetical scenario in which the Nikkei growth rate is equal to 0%, the investment in the vanilla option payout would have generated a higher return on average, offering the investor an outperformance in respect to the quanto, if the FX rate had depreciated, i.e., if the underlying currency (YEN) had appreciated versus the derivative currency (EUR). A similar though much less pronounced effect would be obtained for no growth in the FX rate. However, in a scenario where the FX rate would appreciate by 5% annually, the investment in the quanto would be more protable for the investor (as the depreciation of the YEN versus the EUR would hurt signicantly the conversion of YEN received from the vanilla option back into EUR). It is worth noting that, in all cases, a higher average payout will yield a higher standard deviation of returns. Also, an increase in the Nikkei growth rate produces a better performance in both the quanto and vanilla payouts (as one would expect, given a stronger appreciation of the Nikkei will yield higher payouts in both cases). However, the relative outperformance of quanto versus vanilla increases with an increasing Nikkei growth rate in the case of a 5% FX movement.
250.0
Average payout
FX rate mvt
On average, an investment in a quanto-style structured product will tend to provide an expected return comparable to the vanilla structured product when there are no signicant FX changes.
Variations
Other structures can also be considered, such as American Depositary Receipt (ADR)-style options. The payout of an ADR-style option will be based on the product of the underlying and the FX rate in the nal performance calculation. It is different from either a quanto or a vanilla option. For instance, suppose the underlying appreciates by 10% but the FX depreciates by 20%, our at-the-money vanilla call would pay 10% Nikkei appreciation on a YEN notional and the quanto on a EUR notional. But the ADR-style option will pay nothing as the product of the FX times the Nikkei level at maturity (80% * 110% = 88%) will be less than 100% and, hence, the ADR-style option will expire worthless.
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The
Rainbow
Product rationale
We can consider a structure linked to the growth of a basket composed of three indexes, each representative of a different equity market. The structure has a ve-year investment term, offers full capital protection and is denominated in euros. At maturity, the investor receives 80% of the growth of the basket, calculated by attributing a weight of 50% to the bestperforming index, a weight of 30% to the second-best index and a weight of 20% to the worst-performing index. The performance is calculated by comparing the nal value of each index at the end of the investment term with the initial value observed on the strike date.
1. Rainbow mechanism
Underlying indexes performance Example of rainbow automatic allocation
70% 60%
Realised per formance
Best performer
Second performer
In the example presented in gure 1, the best-performing asset registers a performance of +60% during the ve-year investment period, the second performer increases by 25% and the worst performer decreases by 10%. The automatic allocation mechanism of the rainbow option allows the investor to benet from higher participation in the best-performing index, reduced exposure to the worst-performing index and moderate participation in the second-best-performing index. The indexes are ranked on the basis of realised performance, allowing a retrospective allocation that is more favourable for the investor than an equally weighted allocation.
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Scenario simulations
Using a Monte Carlo simulation approach, we can observe how the performance of a rainbow call option is affected by changes in volatility and correlation parameters and compare its behaviour with that of a simple call option on an equally weighted basket. For the purposes of this simulation, we consider a fully capital-protected structured product, linked to a basket composed of three equity indexes and with a maturity of ve years. The investor receives, at the end of the fth year, 100% of the initial invested capital plus 80% of the growth of the rainbow basket.
in pricing, the average payout of the two structures is similar. In scenarios characterised by lower correlation between indexes, the rainbow option tends to outperform the vanilla call on the equally weighted basket. Conversely, the effect of an increase in terms of average correlation is positive for the vanilla call and negative for the rainbow call options payout. Assuming levels of correlation equal to values used in the calculation of participation rates, it is possible to observe the effect of a change in volatility levels. Figure 3 represents the distribution of average simulated payouts associated to changes in volatility assumptions. Both structures are positively affected by an increase of volatility and negatively affected in a similar way when the volatility is reduced.
100% of the initial invested capital 80% of the Rainbow baskets growth
120.0%
-3.00%
Unchanged
+3.00%
Variations
In the wide range of derivatives dened as rainbow options, we have selected a few variations that represent some of the most common structures.
Dynamic exposure the weights attributed to each underlying asset
129.5%
are not predened but depend on the amplitude of the index variation; the more an index increases, the higher its respective weight. Asian rainbow the rainbow allocation process is applied at each predened observation date and the investor receives, at maturity, participation in an average of the basket performance observations. Prole rainbow the performances of different asset allocation schemes, each representing a different risk/return prole, are observed at maturity and then ranked on the basis of realised performance. The investor receives higher participation in the best-performing allocation.
129.0% Structured 80% rainbow call 128.5% Structured 100% vanilla call 128.0%
127.5%
127.0%
-20.00%
Unchanged
+20.00%
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The
Custom Indexes
Product rationale
Figure 1 provides an example of a simple structured product over the Citi Climate Change Index (CECCP Index). The CECCP Index reects the performance of a basket of stocks selected from a universe of companies that have the potential to benet from climate change. The stocks constituting the universe are selected by Citi Investment Research (CIR). The universe may comprise, for example, stocks in companies developing alternative fuels, electric vehicles or renewable energy technologies. The rationale for developing this index is that companies that are well-positioned with respect to climate-changefriendly activities have signicant opportunities for economic growth as
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climate change becomes an increasing (political, public and corporate) concern throughout the developed world and many emerging markets and creates new niche opportunities. The CECCP Index benets from a bottom-up selection process based on predetermined rules. Figure 1 provides a summary of the simplied construction methodology of the CECCP Index:
1. Simpli ed construction methodology of the CECCP Index 1. UNIVERSE Citi Climate Change Universe (approximately 100 stocks, reset every six months)
2. RESEARCH FILTERING
minimum guaranteed redemption of 75% of the initially invested capital. In the hypothetical performance scenario illustrated in gure 2, the CECCP Index underperforms the reference equity index at the end of the rst year and then outperforms in the next two years. In this scenario, the investor would receive the maximum coupon of 20% at the end of the second year and a coupon of 5% at the end of the third year, in addition to the full redemption of initial capital invested.
4. RANKING
5. GEOGRAPHIC DIVERSIFICATION
Index value
6. SELECTION
Of up to 30 stocks
The CECCP Index is rebalanced semi-annually. This construction and rebalancing methodology enables the CECCP Index to capture growth from new niches and business opportunities created by climate change.
Year
Hypothetical performance
An outperformance structure enables an investor to implement the view that stocks beneting from the consequences of climate change, as represented by the CECCP Index, may perform better than other stocks over the next three years. By way of example, an outperformance structure linked to the CECCP Index offers a potential coupon of up to 20% per annum over an investment period of three years. The payout would be as follows: on each annual observation date, if the CECCP Index outperforms a predened reference equity index, the investor receives a coupon equal to the excess performance generated by the CECCP Index over the reference equity index, with an upper limit of 20% per annum. Otherwise, the investor receives no coupon for that specic year. At maturity, if the CECCP Index is the best performer of the two indexes, the nal payout is equal to 100% of initial capital invested, plus the value of the third annual coupon. Otherwise, the investor receives the difference between 100% and the underperformance of the CECCP Index, with a Custom indexes offer investors the opportunity to implement a specic investment rationale (geographic or business sectors and/or investment strategies) within the framework of a transparent and consistent underlying portfolio construction and reallocation methodology. Structured products provide a further element of customisation, allowing investors to gain exposure to and potentially benet from tailored products on custom indexes that can optimise their risk reward prole.
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The
Tailored Protection
The definition
One of the advantages of structured products is the capability to protect the capital invested. The protection can apply to the entire capital or to a proportion thereof. It can also be applied to any potential cash ows offered by a product, in the form of xed coupons or minimum level of performance. The protection offered safeguards the investor against adverse movements in the underlying markets; however, in the case of most structured notes, the investor is exposed to the credit risk of the issuer. The cost of full capital protection depends on a wide range of factors and the main impact can be attributed to the relevant interest rates with regard to the product currency and maturity, as well to the nancial strength of the issuer. The latter factor will determine the spread applied to relevant interest rates. When only a proportion of the capital is protected, the money available to be invested in the derivatives component is higher and this, in turns, tends to increase the performance potential.
Payout at maturity
SP 100% capital guarantee payout SP 80% capital guarantee payout Underlying basket (dividends excluded)
0%
20%
40%
60%
80%
100%
120%
140%
In this example (above) the payout is linked to the basket level at maturity and not to the basket growth. This allows the product to present positive returns even in negative scenarios.
Product rationale
As an example, we can consider a simple structured product linked to the growth of a basket composed of three equity indexes. Each index represents a specic European market and is equally weighted within the basket. The investor receives at maturity 105% of the nal value of
Conditional protection
As a further example, we consider a structured product with conditional protection, which allows the investor to benet from higher exposure to
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lower than 100% Expected average positive payout (scenarios where payout is higher than 100%)
0.00%
33.36%
40.18%
126.01%
140.34%
144.50%
162.60%
the market and full protection to their investment, provided that the trigger index doesnt fall by more than 25%. The investor protects their capital from adverse moves in the underlying three indexes of the basket but is accepting exposure to the event of a negative performance of the trigger index, representing the world equity market. As an example, let us look at a structure that offers leveraged exposure of 110% to the nal underlying basket value and a full capital protection of initial invested capital if the trigger index does not register a loss of more than 25% of its initial value at any time during the life of the product. If this adverse scenario is realised, the investor maintains their leveraged exposure to the underlying basket but no longer benets from a protected minimum redemption. The underlying basket is the same one considered for previous structures and the trigger index represents in this example the global equity market. The leverage offered by the conditional protected structure (110%) is higher than would be possible for a full capitalprotected structure (105%). However, the investor is assuming a global equity market risk. Figure 2 represents the payout prole at maturity of the conditional protected structured product. The blue line in gure 2 represents payouts associated with each nal level of the underlying basket in a scenario where the trigger index has not fallen by more than 25% of its initial value at any time during the investment term. If the trigger index representing
the world equity market registers a loss higher than 25%, the payoff prole at maturity is the one represented by the orange dotted line. If the frequency of observations of the world index performance is switched to a semi-annual basis, the level of participation changes from 110% to 108%. In this case, the world index could register values lower than the 75% during the six-month period between observation dates and recover before being observed, without affecting the principal protection; this advantage for the investor is reected in a lower level of participation.
Simulations
Using Monte Carlo simulations, we can examine the probability of the different structures analysed to deliver a payout lower than the initial invested capital. For simulation purposes, levels of volatility, correlation and growth are the same as those used in the indicative pricing model. Table A presents the probability of receiving a payout lower than the initial invested capital and the associated potential of performance, expressed as an average expected payout in scenarios where the nal return is higher than 100%. Dening the appropriate degree of protection is a critical element of customisation offered by structured products. Full capital protection safeguards the investment from adverse market scenarios but tends to present high costs for the investor. A lower level of unconditional protection allows a wider proportion of available capital to be invested in the derivatives component, enhancing the performance potential versus increased risk exposure to the performance of the underlying. A conditional protection allows the investor to safeguard their capital from the risk connected to the underlying performance, while transferring part of their risk exposure to a different asset, that acts as a trigger for the protection.
ity
100% 90% 80% SP conditional trigger index >75% SP conditional trigger index <75%
Pa
70% 60% 50% 40% 40%
50%
60%
70%
80%
90%
100%
110%
120%
19 19
The
Secondary Market
The definition
Each structured product may have a specic sensitivity to various market factors, such as volatility, correlation and interest rates. These market factors are used to determine the price of the structured product on the strike date. After the strike date, the product becomes live and all of the market factors relevant to pricing are subject to constant change; in addition, the time factor begins to play a role, having a major impact on the present value of expected future cashows. Furthermore, the sensitivity of the price to the various factors shifts over time, altering the way the product reacts to these dynamic parameters.
Product rationale
We can observe the behaviour of two different structures by simulating their value in hypothetical secondary market scenarios. The rst product we consider in this analysis is a fully capital protected structure that offers at maturity 85% participation in the positive performance of a European equity index (table A).
The second structure is an auto-callable product with a maximum maturity of ve years and conditional capital protection (table B). At the end of each year, the underlying value is observed and, if it is higher than its original level on strike date, the product redeems at 100% plus a coupon of 14% multiplied by the number of years since the issue date. For example, if the product is called at the end of year two, investors receive 128%; if it is called at the end of year three, the payout is 142%.
20
If the product is not called before the nal observation date, investors have the benet of soft protection at maturity. This means that, provided the level of underlying has not fallen lower than 50% of its initial value, the entire invested capital is protected and redeemed at maturity. However, if the soft protection barrier has been breached at anytime during the investment term, investors will receive the nal value of the underlying at maturity, expressed as percentage of its initial value.
Simulations
Figures 1 and 2 show the simulated secondary market values of the two structures at different points in time following inception. The analysis shows an indicative fair value for the structures, disregarding any potential bid/offer spread, assuming that volatility and interest rates remain static
1 month into the lif e 11 months into the lif e 23 months into the lif e 35 months into the lif e 47 months into the lif e 59 months into the lif e 60.0% 80.0% 100.0% Underlying value 120.0% 140.0% 160.0%
40.0%
over time. For the purposes of these simulations, the soft protection barrier of 50% on the auto-callable structure is deemed to have never been breached. The simulations of the fully capital protected structure in the secondary market illustrate the smoother reaction of the product to changes in the underlying value. For example, if after 35 months from the strike date the underlying has risen by 10%, the value of the fully capital protected product is around 107.4%, compared to a value of 141.3% for the autocallable structure. On the downside, the auto-callable product tends to drop in value quickly in negative market scenarios. By contrast, the value of the fully capital protected does not drop below the present value of protected amount at maturity, even when the derivative component tends to be worthless. For example, where the underlying has dropped by 40% after 47 months, the simulated value of the auto-callable structure is 69.9%, while the simulated value of the protected structure is 95.1%. The auto-callable structure is clearly more sensitive to variations in the underlying and has a concave distribution of values, due to the fact that the maximum potential payout is capped at specic levels (14% multiplied by the number of years elapsed since inception). The results of these simulations, based on the hypothetical behaviour of the underlying index and on simplied assumptions on volatility and interest rates, show how widely the valuations of these structures can vary during their investment terms, even though both are linked to the same underlying index. The volatility of secondary market pricing can have a signicant impact on an investment strategy and should be considered as a major factor in the investment process. During the life of a structured product investment, market conditions could offer the opportunity to realise prots early through liquidating the position. Trading out of the product in the secondary market may also enable an investor to close out of a position in order to avoid excessive risk. Citi offers a daily secondary market on most of its structured product issues with a typical bid/offer spread of approximately 1%. The level of liquidity and transparency available in the secondary market plays a crucial role and should be highly regarded in the selection process of the product.
160% 140% 120% 100% 80% 60% 40% 40.0% 60.0% 80.0% 100.0% 120.0%
1 month into the lif e 11 months into the lif e 23 months into the lif e 35 months into the lif e 47 months into the lif e 59 months into the lif e
140.0% 160.0%
Underlying value
21 21
The
Range Accrual
Product rationale
We can consider a full capital protected range-accrual product with a ve-year life and a target coupon of 7.5% annual equivalent, distributed at maturity. The underlying is an index representative of the European equity market and the structure is denominated in EUR. The coupon is accrued on a daily basis if the index daily closing price is above the lower barrier of 95% of initial strike price; this is equivalent to an accrual surface ranging from 95% to +innite. For each day the condition is met, the portion of the coupon is secured for payment. For example, if the condition is met for two-thirds of the total observed days of the rst annual period, the secured coupon for the rst year is equal to 5% (= 7.5% x 2/3).
The definition
A basic range-accrual structure offers a target level of return, multiplied by an accrual ratio. For each observation period when the underlying value xes in a specic range, the product accrues a portion of the coupon. Each observation period contributes independently to the whole target return. The accrual ratio is calculated by dividing the number of observations, where the underlying is within the range, by the number of total observations in the investment period. If the underlying always remains within the range, the ratio is equal to one, and the whole target return is received.
If we substitute the lower barrier with an upper barrier xed at 120%, the return is accrued when the underlying index xes below 120% of its initial price at daily observation dates. Maintaining the indicative cost of the structure above, the potential payout offered by this alternative structure is 6% per year; the probability implied in the pricing of observations occurring outside the range is lower and this is reected in a reduction of the potential return. We can observe the effect of restricting the range by combining the two previous barriers in a single range-accrual structure. The coupon is accrued when the underlying index xes between 95% and 120% at observation dates. The effect of narrowing the range, therefore increasing the probability of being out of the accrual zone, is reected in a higher target coupon of 13% (see gure 1).
22
1. Range-accrual structure
125% 120% 115% Index value 110% 105% 100% 95% 90% 0 1 2 3 4 5 6 7 8 9 10 11 12 First daily observation dates Upper barrier Index Lower barrier
Frequency
We can compare the Monte Carlo simulations of a hypothetical rangeaccrual structure with the simulated performance of a traditional knock-out barrier structure; both structures have full capital protection at maturity. The barriers of the range-accrual structure are xed at 95% (lower barrier) and 120% (upper barrier). The return of the knock-out barrier structure is generated with the same mechanism as the range-accrual structure (i.e. the index should x between the barriers at daily observation dates) with the difference being that, if one of the barriers is touched, the whole return is lost and the investor will receive at maturity only the initial investment capital equivalent. The knock-out risk affecting the entire payout at maturity is reected in a wider accrual range of a lower barrier of 55% and an upper barrier of 150%. Figure 2 shows the simulated payout distribution at maturity: the grey bars represent the frequency of range-accrual payouts for each return bracket and the red bars are associated with the traditional knock-out barrier structure. The mitigation of the digital risk of the range-accrual structures is evidenced in this graphical representation of payouts. While the knock-in effect results in a polarisation of two possible scenarios full target coupon
12 0.0 1 1 12 12 5.0 5.0 1% 1 13 13 0.0 0.0 1 1% 13 5.0 5 1% 1 14 0.0 1 1 14 145 5.0 .0 1 1% 15 150 0.0 .0 1 1% 15 155 5.0 .01 1 % 16 0.0 1%
13 .0 .0 40 1
up
Simulated payout
of 65% paid at maturity (= 13% x 5 years) if barriers are never touched or zero additional return the accrual mechanism over time presents a smoother distribution. Range-accrual structures could represent an alternative to traditional knock-out barrier structures, offering the opportunity of mitigating the digital risk of losing the entire payout if the barrier is touched at a single observation.
fro m
23
16 5.0 1%
Simulations
% % .0 .0 20 15 1 1 .0 .0 11 11
1
1% 5.0 16 1 0.0 16
23
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