Since the last financial crisis much has been said, both by the specialized and public press, on the nature of derivatives and their role in the latest global financial meltdown. Actually, their diffusion and broad usage is much older than commonly thought. The oldest known transaction, in terms of actual features similar to an option or a futures contract, is reported by the Greek philosopher Aristotele around 2,400 years ago, and we know of organized markets for the trading of such contracts starting already from the XVII century. Starting from the second half of the XX century, triggered by an increased volatility in the market place (in the 70s we experienced major macroeconomic shocks within a more than ever interconnected market), derivatives theory and world derivatives usage exploded, reaching a size estimated in more than 7 times global GDP -in terms of notional amount- as of December 2016. As derivatives market expanded in such an impressive fashion, financial innovation made possible to develop a new generation of financial products that, starting from the 90s, appeared under the name of structured products.
A structured product is essentially a pre-packaged portfolio of derivatives and fixed-income securities that allows to set up a completely personalized payoff structure, based on the preferences of the final investor. The most common structured product comprises two components:
- A fixed-income security (usually a Zero Coupon Bond), which guarantees part or all of the invested capital.
- An option-like instrument, which provides a payoff in addition to the fixed-income payments. The payoff being linked to the performance of an underlying asset.
Among structured products there is one financial instrument that is broadly available to the retail investor and that can be easily found on regulated markets, that is Investment Certificates. These will be the focus of what follows.
Investment Certificates made their first appearance in Germany in 1989, when Dresdner Bank issued a Benchmark Certificate tracking the Dax index. Since then they have experienced a remarkable diffusion across Europe, particularly in Germany and Switzerland, with more than € 256 billion outstanding and with 1.4 million different products across the top 8 countries as of September 2016 (data from eusipa.org). They are currently listed in more than 14 European exchanges, with Stuggart, Frankfurt, Zurich, Milan and NYSE Euronext representing the largest share. Before adventuring into the specifics let’s provide an overview of the product.
Investment Certificates (ICs) are securitized derivatives, that is portfolios of derivatives replicating a specific investment strategy packaged into a bearer security. Being a structured product they are essentially a combination of Zero Coupon Bonds and Plain Vanilla/Exotic options that deliver exposure to a given underlying asset in both a linear and non-linear way. Their main advantage is to provide a tailor-made exposure to a specific underlying (sometimes difficult to trade directly) and to deliver superior risk-adjusted returns, which may be suitable especially for retail investors. Among the possible underlying assets there can be:
- Other Derivatives
ICs are characterized by a given maturity, a small notional amount and by different levels of capital protection and riskiness (being a securitized derivative they are anyway exposed to issuing counterparty risk, although certain issuers provide collateral guarantees). Investment Certificates are typically issued by a financial institution (because of capital requirements usually a bank) to retail investors either directly or through third parties (Primary Market) and subsequently listed on authorized trading venues (Secondary Market). These can be:
- Regulated Markets, such as the SeDeX market operated by Borsa Italiana, where professional operators (“specialists”) are required to continuously quote a Bid and Ask prices, giving the investor the opportunity to monitor, increase and liquidate her position at any given point in time.
- Multilateral Trading Facilities (ex. EuroTLX) – Trading venues operated by a group of financial institutions according to transparent rules.
- Systematic Internalisers (ex. Fineco Bank) – Institutions negotiating directly as a counterparty to the investor in a systematic and transparent way.
In Fig.1 and Fig. 2 we can see an overview of the Italian Primary and Secondary Markets over time. Especially by looking at the underwritten amount it is clear how the interest for such products has increased by almost 500% over the last 9 years, to an average underwritten amount of € 2.6 billion/quarter in 2015 vs € 0.45 billion/quarter in 2006. On the Secondary market if the trading activity has somewhat reduced during 2016 compared to the 2015 turnover peak of € 9 billion/quarter, the figure remains still 150% higher than the average 2012 amount. As of September 2016 there were 6,763 different products listing in the SeDeX market. It has to be mentioned how the data are not inclusive of all the products issued or traded in the Italian market, as some issuers do not adhere to reporting associations and some products may not be listed in regulated markets.
Since Investment Certificates are by their nature quite complex instruments, especially given their non-linear features, we will try to address them through specific examples.
Although they don’t have an official classification Investment Certificates can be defined based on the “Derivatives Map” provided by the European Structured Investment Products Association (EUSIPA), an association representing most of the structured products issuers operating in Europe’s leading markets. According to EUSIPA’s categorisation ICs can be divided into two main groups, based on their risk/return profile:
Investment Products: they represent those products delivering sophisticated payoff structures within a moderate risk profile. Proportionally to their riskiness they can be further broken down into:
- Capital Protection Products: at maturity, or at the relevant dates, they guarantee the repayment of the capital invested, providing in addition total or partial participation to the performance of the underlying. Examples are Equity Protection, Butterfly and Double Win certificates.
- Yield Enhancement Products: as their name suggests these products contribute to the amplification of portfolio performance. They are characterized by reduced downside risk compared to the underlying asset in the form of conditional capital protection. Moreover they offer exposure to the performance of the underlying. Examples include Bonus, Airbag, Express, Cash Collect and Twin Win certificates.
- Participation Products: They provide unlimited exposure to the underlying asset, being often used as a portfolio diversification vehicle. Typical examples are Benchmark and Outperformance certificate.
Leverage Products: as their name suggests these represent those products delivering leveraged exposure to a specific underlying, with no capital protection. As such, they entail the most risky payoff profile. They can be further broken down into:
- Leverage Products without Knock-out: They provide leveraged exposure to the underlying instrument, both with Long and Short features. Examples are Spread Warrants.
- Leverage Products with Knock-out: Like the previous category, but with a Stop Loss feature. Examples are Turbo, Short and Mini Futures.
- Constant Leverage Products: They provide exposure to the underlying with a constant degree of leverage.
Let’s now examine how the payoff of an investment certificate is structured starting from each individual derivative and fixed-income component. Specifically let assume we want to build a certificate that pays a fixed positive return at maturity as long as the price of the underlying (in our case a non dividend-paying stock) has not fallen below a given threshold (called Barrier level) during the certificate’s life, otherwise it pays the minimum between the fixed return and the performance of the underlying. That is a Bonus Certificate with a Cap feature. The payoff at maturity for such a certificate can be described by Fig. 3.
Assuming the reader is somewhat familiar with option theory, we provide some definitions in order to understand what is going on. Let S0 be the price of the underlying stock at the issuance date and let M be the quantity of the underlying stock “controlled” by the certificate, that is M=100/S0. The reason for which we put 100 at the numerator is because Investment Certificates are usually issued at a price of € 100, which is also equal to our invested amount. Let B be the fixed positive return (that is the bonus) recognized to the investor at maturity –conditionally to the performance of the underlying- and let b be the Barrier level, both expressed as a percentage of S0. Then we can define:
We can replicate (or “structure”) the certificate described above by setting up the following portfolio:
- The first term is a Zero Coupon Bond with notional amount equal to Bonus and maturity T yielding r at the issuance date, with T being the maturity of the certificate and r the observed risk free rate for maturity T.
- The second term is an exotic European Down&In Barrier Put Option over M units of the underlying with maturity T, having the barrier set at S(Barrier) (that is at the same Barrier level of the certificate) and strike price equal to S(Bonus). In order to replicate the certificate’s payoff we need to write (i.e. sell) such an option.
As their name suggests Down&In Barrier Options are option contracts that come into existences only at condition that the underlying asset touches a given threshold –which is lower than the underlying’s price at the issuance date- over the option’s life (American barrier). An European put option in particular gives the buyer the right (but no the obligation) to sell the underlying asset at a given price (the strike) at maturity. As expected the price of a Barrier Option is always lower or equal to the price of a plain vanilla option with same maturity and strike price.
Provided with the main components of this relatively simple payoff structure, we can summarize in the following table how each of them contributes to the final payoff, where S is the price of the underlying stock at maturity:
As it has been already mentioned, the usual price for an Investment Certificate is € 100, so that the relevant parameters of the payoff structure (B and b, that is the bonus and the Barrier level) have to be set accordingly to a trade-off perspective, given the other observed parameters. As an example givenwith σ defining the “expected” volatility of the underlying stock, provided that we want to deliver a bonus of 135.75% (B) the price for the Zero Coupon Bond will be of € 129.91, so that the market value of the Put Option should be of € 29.91 for the certificate to price € 100. This corresponds to a Barrier level of around 75% (remember that the option in this case is written over M=100/S0 = 2 shares). Note that as we diminish the Barrier level the price of the Put option decreases as well (it is less likely that the barrier will be touched) so that our Bonus Certificate results overpriced. The price for the Barrier Put option has been computed via Monte Carlo simulation using the simple Geometric Brownian motion hypothesis for the price of the underlying, more sophisticated (and realistic) methods exist such as the Reiner-Rubinstein model.
In Fig. 4 we can observe different price realizations for the Certificate and the underlying stock with the parameters described above.
Finally, much of the complexity of structured products, Investment certificates being no exception, is the non linearity of their payoff (at this point not surprisingly given the relevance that options have in their structures). This characteristic makes ICs particularly sensitive to changes in market quantities other than the price of the underlying, perhaps giving rise to misconception from certain retail investors, unable to fully appreciate their risk exposure. Because of the complexity of some structures, an analysis of this kind (called sensitivity analysis) can be conducted as a first approximation using a static method, that is by evaluating the effects that changes of relevant market parameters have on the price of the certificate, everything else being equal. With respect to our Bonus Certificate we can observe the following effects as evaluated at the issuance date (similar analysis can be conducted under different scenarios).