2. A REPUTATION?
It is not surprising that perhaps the word
‘Derivatives’ comes with a bit of a reputation due to
its role in causing the Great Financial Crisis’
(remember Ryan Gosling and Steve Carrell in The Big
Short?? :-))
Well, it was actually the subprime mortgage-backed
bonds back then.. But still, because of its perceived
complexity, only accredited or sophisticated investors
can get access to these most of the time.. It is
however, a very important building block of modern
finance and we shall delve into it...!
WELCOME MESSAGE
LETS GET STARTED
3. LIST OF CONTENT
PRESENTATION
In ‘lay-man’ terms..
OVERVIEW OF DERIVATIVES
01
How to price derivatives!
PRICING OF DERIVATIVES
02
Understand what it means..
STRUCTURED PRODUCTS
03
Learning the more common structures
TYPES OF STRUCTURED PRODUCTS
04
05 Final discussion and next steps..
CONCLUSION
4. OVERVIEW..
You will almost always hear structured products mentioned in the same breath as derivatives..
But are they the same?
Well technically, you may say that Structured Products are composed of derivatives but you
would not say that derivatives are composed of Structured Products.. So derivatives are more of
like building blocks... Contracts whose value is derived from its underlying...
The 4 main types of derivatives are: Options, Forwards, Futures and Swaps.
Options give buyers the right, but not the obligation, to buy or sell an underlying asset at an
agreed-upon price and date, Forwards is an agreement to buy or sell an asset at a specific price
on a specified date in the future.. Futures is somewhat similar to Forwards but it is a standardized
contract and Swaps allow two parties to exchange cash flows or liabilities from two different
financial instruments..
ARE DERIVATIVES AND STRUCTURED PRODUCTS THE SAME THING?
SOME SMALL TECHNICAL DIFFERENCES..
5. PRICING OF DERIVATIVES..
Given that the value of derivatives come from its underlying assets or pool of assets it should
come as no surprise that the pricing of derivative or structured products is also based on the
underlying assets..
In particular, the pricing of options deserve a mention because options is the building blocks of so
many different types of structured products.
Value of an Option = Intrinsic Value + Extrinsic Value (Time Value / Implied volatility)
There are also 4 main sensitivities of an option called Greeks used for risk management:
DELTA: Measures how much an option's price can be expected to move for every $1 change in the
price of the underlying security or index
GAMMA: Measures rate of change in an option’s delta when the stock price changes by $1.
THETA: Measures rate at which option’s price decline with each passing day.
VEGA: Measures rate of change in an option’s price based on a 1% change in implied volatility.
They are extremely important to traders who need to understand the risk exposure of their book of
options; they can use them to either make hedges against or bets on it!
BASED ON ITS UNDERLYING ASSET OR POOL OF ASSETS
6. Now, the above charts should not look unfamiliar to most of you.. A simple search would display all these graphs.. Left is what
payoff would be to you if you bought a call option. You do not immediately earn a profit once underlying stock moves past your
strike price because remember, you had to pay for the option!! So your break-even is higher. Same logic for long put.
THE FUNDAMENTALS IN ALL DERIVATIVES CLASSES
X AXIS AS STOCK PRICE AND Y AXIS AS PROFIT / LOSS
OPTION PAYOFF GRAPHS
Break-even point
X strike price
Profit / Loss
LONG CALL LONG PUT
Break-even point
X strike price
Profit / Loss
PROFIT ZONE! PROFIT ZONE!
7. Well, just somewhat of an opposite compared to Long call and Long Put, but one big difference is that unlike a Long Call and Put
where the maximum loss to an investor is just the option price paid (he or she can just not exercise the option..) there is somewhat
of an unlimited potential loss for SHORT CALL (because the stock can keep on rising..) and a potential huge loss for SHORT PUT
investor (his or her maximum loss is when the underlying stock reaches 0).. Why would anyone do this then? Well answer is that
these options can be combined with other options to limit losses or to change its payoff structure. See next page!!!!
THE FUNDAMENTALS IN ALL DERIVATIVES CLASSES
X AXIS AS STOCK PRICE AND Y AXIS AS PROFIT / LOSS
OPTION PAYOFF GRAPHS
Break-even point
X strike price
Profit / Loss
SHORT CALL SHORT PUT
Break-even point
X strike price
Profit / Loss
PROFIT ZONE!
PROFIT ZONE!
8. MORE MORE AND MORE
PAYOFFS! A WORD.
AND SO THE PAYOFF OF THE OPTION CHANGES...
For instance, although a long call option technically has the
possibility of UNLIMITED LOSSES, one can add on say a
LONG CALL overlay at another strike price to limit losses..
There are a lot of flexibility in terms of using options to
create a payoff chart that is aligned with your view of the
markets and underlying asset.. But it has to make economic
sense to structure such a structure... Specialists can also take
advantage of certain price movements to create attractive
structured products...
Well the truth is there are countless of option types and
countless of payoff graphs structure.. There are KICK IN, KICK
OUT, KNOCK IN, KNOCK OUT OPTIONS which in general are
also known as BARRIER OPTIONS (option whose payoff is
dependent on the underlying asset's price breaching a barrier
level during option lifetime)
9. STRUCTURED PRODUCTS
As mentioned at the beginning, derivatives and structured products have quite a
reputation due to what transpired during the Great Financial Crisis..
But structured products are also flexible instruments that allow individuals to express
their views on financial markets.. For instance an individual who believes that the
underlying stock or asset would move sideways in the next 1-3 months may invest in an
investment that may cap his or her upside, but allows him or her to receive a periodic
coupon during the time period.. Some individuals also appreciate the extra yield that such
products can provide..
You will hear all sorts of product names that banks give to their in-house structured
products; synonyms such as PERLES, KIKO, but DON’T FRET !!!!! Just remember that
structured products are simply made up of options.. Once you understand the individual
option’s payoff, you can learn how to combine them together to form the payoff of the
structured product. Remember also that structured products can have equities, bonds or
FX as underlying; all across asset classes!!!!
ACROSS ALL ASSET CLASSES
UNDERSTANDING THAT THEY ARE FORMED BY OPTIONS
10. A DUAL CURRENCY INVESTMENT (DCI)
Well, this is a popular FX structured products which is
relatively simple as well so let’s delve into it... Imagine that
a USD investor (base currency USD) has some needs in EUR
and does not mind being converted into EUR... In the
meantime he or she is happy earning some yield in USD in
the event that this conversion does not happen...
DCI always involve one selling call option on BASE
CURRECY.. So you must have a slightly bearish view on the
currency... However, if USD does appreciate over threshold
level, you are ok with being converted into EUR at the strike
price... In other words EURUSD continues to fall, such that
you would have to convert your USD at agreed strike price
as opposed to market FX rate...
FOR INSTANCE, EURUSD..
UNDERLYING AS 2 CURRENCIES..
The next thing you may be interested to understand
is is there then a maximum loss for a DCI
investment?
Well, the answer is technically, if your converted
EUR is not worth anything then you would have
suffered maximum losses in USD terms...
But your be your
own verdict of what the
‘maximum loss’ may
mean for you!!!!
IS THERE A MAXIMUM LOSS?
11. CONCLUSION
We are not exaggerating when we say the content
covered here is just the tip of the iceberg because it IS!!
Derivatives is a very interesting subject where one can
delve a lot further into the details... But what this course
deck covers is a broad overview of its function which
allows one to be able to speak more confidently on the
subject of derivatives and structured products... There
are tons and tons of structured products out there and in
some ways, the flexibility of it all may be what
continues to to draw knowlegeable people in deep
finance into the financial and derivatives field..
MUCH MORE TO LEARN..
JUST THE TIP OF THE ICEBERG