Time Your Purchase for Structured Investments - dummies

By David Stevenson

Investors in the UK can choose from structured investment products for their portfolio. The options and bonds built into a structured investment can come across as a tad complicated on first inspection, but one central insight is hugely valuable if you want to think like a hedge fund: any investment issued in times of high market volatility tends to pay out a bigger potential return for investors.

In essence, structured investments provide the smart investor with a simple way of making money from volatile markets.

Here’s how you, as an ordinary investor, can make money in these difficult circumstances. Imagine a structured product issuer coming to market during a period of intense market volatility. This volatility is going to affect various components of the investment hugely, such as:

  • The value of the options used within the structure: The premiums from issuing puts on the barrier increase as volatility spikes upwards. As volatility increases, you may reasonably expect large insurance companies and pension funds to seek even greater protection from big losses by buying your barrier-based puts.

    Increased options-based premium income should hopefully feed through into an increased upside; that is, increased annual returns on an autocall.

  • Counterparty risk: Increases in volatility may also feed through into increased uncertainty about the viability of a bank and its accompanying bonds.

    This means that the bank has to pay bigger interest coupons in order to borrow on the zero coupon markets, which translates through into even more generous funding for the structure. In other words, higher bond yields reduce the upfront cost of issuing a zero coupon bond, giving the issuer even more money to pump into the upside via the call option.

But volatility also reminds us that the markets change over time; over days, months and years markets move up and down. The key theme here is time, or what bond investors call duration risk. In simple terms, the longer the duration of an underlying option, the greater the cost – this notion of time value is hugely important in understanding structured products.

Autocalls are potentially very popular with some issuers because more than a decent chance exists that the structured products are going to call after the one-year anniversary; that is, equity markets will be the same or have advanced over that year, triggering a call and thus the payout of the product.

As a result, the issuer of an upside call (the option that funds the annual defined return) calculates that it stands a good chance of only having to issue an option for one year, which in turn implies lower costs for issuing the call.

A promise to pay out over five years, by contrast, involves longer duration risk and thus a smaller coupon – which helps explain why the annual returns on most five-year synthetic zeros are substantially lower than a five-year autocall.

Combine this understanding of how time and volatility interact, and then apply it to an autocall and you can begin to understand what may constitute the ‘perfect storm’ for a structured product – volatile markets, where investors are worrying about the solvency of a bank, which is in turn issuing a one- to five-year autocall structure.

To see how these factors work to your benefit, consider all the components available, including the call and put options and how they can change in different market conditions. Imagine that the stock markets start to bottom out after a bad fall – in this circumstance many call option issuers will reckon that markets are going to recover fast and be happy to charge a much smaller fee for writing the upside option.

Equally, worries about the credit rating of the bank result in a higher annual bank bond cost, which pushes down the upfront cost of issuing a zero coupon bond, increasing in turn the amount of money left over to pay for a call.

Last but by no means least, increased volatility pushes up the price of the put options sold to big pension funds and insurance companies looking to make money from falling markets.

The risks from such a perfect storm are all too clear! The most obvious is that the bank issuing the bonds that protect the initial investment does go bust. This counterparty risk potentially increases almost exponentially as volatility increases.

Equally, pension funds are willing to pay more money for downside puts for a very good reason; notably, that the risk of a nasty market collapse of 50 per cent or more is likely to increase. If that’s the case, your barrier is broken, and you may end up losing your initial investment and any hope of a positive return.