An Introduction to Structured Investments March 2012
AGENDA Who are Catley Lakeman? Structured Investments Overview & Composition Overview Composition: How is a Structured Investment put together? Structured Investments Pricing & Risks Pricing: Volatility Pricing: Counterparty Credit Pricing: Overview Pricing: Structured Investment Pendulum Risks: What are the risks associated with Structured Investments?
CATLEY LAKEMAN SECURITIES
WHO ARE CATLEY LAKEMAN? Founded July 2008 Team of 7 Combined investment sales experience – 42 years Combined structured Investment trading experience – 19 years Combined structured Investment specific experience – 34 years FSA authorised securities and futures firm Outsourced origination and distribution business that sells and supports private placement securitised derivative investments to professional asset managers and institutions in the UK Represent eight banks on a contractual basis STUART CHANDLER RUSSELL CATLEY ANDREW LAKEMAN NINA GILLTOM MAYCHRIS DAGG JONATHAN DAGG Non-Executive Chairman Sales Sales & Research Trading & Structuring Trading & Research T M T M T M T M T M T M CITIGROUP CREDIT SUISSE HSBCJP MORGANNOMURARABOBANK ROYAL BANK OF CANADA UBS CDS 197 bpsCDS 145 bpsCDS 136 bpsCDS 98 bpsCDS 277 bpsCDS 117 bpsCDS 118 bps*CDS 167 bps Credit Default Swap (CDS) levels relate to basis points over LIBOR per annum, referencing the 5yr CDS level Funding is ordinarily related to a bank’s CDS, although it will differ between Investment and term *RBC’s CDS is an estimate, based on where their 5yr bonds are currently trading Source: Bloomberg, as at 23-Mar-12
STRUCTURED INVESTMENTS OVERVIEW & COMPOSITION
The truth about Structured Investments in general.. o Certainly need to be managed in a portfolio o The risks are easily definable, as are the costs o Majority of payoffs are actually very simple to understand o Are almost universally adaptable o Have proved to be pretty much the most liquid asset you can hold o Tend to do exactly “what it says on the tin” STRUCTURED INVESTMENT OVERVIEW
You, as the investor, set the parameters.. STRUCTURED INVESTMENT OVERVIEW Funds / Absolute Return Volatility / Correlation / Dividends Inflation / Commodities Interest Rates Currencies / Credit Equities / Indices Predictable paths Conditional/ Unconditional return Defined Risk & Return Reduced Volatility Capital Protection Liability Driven JP Morgan Nomura Rabobank Royal Bank of Canada UBS HSBC Credit Suisse Citigroup STRUCTURED Investment Income or Growth Underlying Asset Investment Objective Wrapper Taxation Investment Term Counterparty Risk Management
How is a Structured Investment put together? Share Price at Issue p ZCB / Swap 87.00p Aggregate Costs 1.00p Option Package 12.00p STRUCTURED INVESTMENT COMPOSITION Hard Protection GBP1.00 Investor’s Cash GBP1.00 Zero- coupon Bond/ Swap Option package Providing Economic Return
How is a Structured Investment put together? Share Price at Issue p ZCB / Swap 87.00p Aggregate Costs 1.00p Net Option Package 12.00p [Sell put risk premium p] [Buy options for return27.00p] Option package Providing Economic Return Sell European Put Option Risk At 50% Strike (‘Knock-In Put’) GBP1.00 Investor’s Cash GBP1.00 Zero- coupon Bond/ Swap Option package Providing Economic Return GBP1.00 Zero- coupon Bond/ Swap STRUCTURED INVESTMENT COMPOSITION Soft Protection
HSBC 6 year Fixed Rate Bond 46% Knock-In-Put (capital eroded if FTSE falls more than 54% of its initial level at maturity) Digital option paying 47.1% coupon if FTSE is above 46% of its initial level HSBC 367 6yr FTSE Digital 47.1% Step 1: Zero Coupon Bond Start with a fixed rate bond from the counterparty in question, and remove the fixed coupons Step 2: Downside: Sell a Knock-In Put Put capital at risk by incorporating an x% European Knock-In Put, where capital is eroded if the underlying Index has fallen by more than x% between the trade date and maturity Step 3: Upside: Buy an Option Package For example: add a final coupon, the payment of which is conditional on the Index is above x% of its initial value. This is called a ‘Digital Option’. Fixed Rate Bond – Fixed Coupons – Knock-In Put + Digital Option Example: Constructing a Digital Structured InvestmentSecondary Market Example STRUCTURED INVESTMENT COMPOSITION Step by Step Construction
STRUCTURED INVESTMENT PRICING & RISKS
Or in other words.. Volatility - It’s all about the bell curve! STRUCTURED INVESTMENT PRICING Volatility HIGH IMPLIED VOLATILITY LOW IMPLIED VOLATILITY
The graph below shows 5 Year Credit Default Swaps (CDS) Credit Default Swap (CDS) levels relate to basis points over LIBOR per annum, referencing the 5yr CDS level Funding is ordinarily related to a bank’s CDS, although it will differ between Investment and term Source: Bloomberg, as at 23-Mar-12 STRUCTURED INVESTMENT PRICING Counterparty Credit
The table below shows 5 Year Credit Default Swaps (CDS) Credit Default Swap (CDS) levels relate to basis points over LIBOR per annum, referencing the 5yr CDS level Funding is ordinarily related to a bank’s CDS, although it will differ between Investment and term Source: Bloomberg, as at 23-Mar-12 STRUCTURED INVESTMENT PRICING Counterparty Credit
Why counterparty credit always matters.. Credit Default Swap (CDS) levels relate to basis points over LIBOR per annum, referencing the 5yr CDS level Funding is ordinarily related to a bank’s CDS, although it will differ between Investment and term Source: Bloomberg, as at 16-Jan-12 HSBC 289 US Supertracker ISIN: GB00B3Z2023 Start date: 16-Feb-11 Performance to 28-Nov-11: % 5.5 year term 60% soft protection 179% upside participation Morgan Stanley 5.5 Years S&P 500 Enhanced Tracker Notes ISIN: XS Start date: 14-Feb-11 Performance to 28-Nov-11: % 5.5 year term 60% soft protection 190% upside participation STRUCTURED INVESTMENT PRICING Counterparty Credit
What affects secondary market pricing, once a structure has traded? The table below illustrates how changes in each parameter will affect the value of each component, from the investors’ point of view STRUCTURED INVESTMENT PRICING Overview
Ongoing focus on yield-based structured products – issuance can be a key driver for long-end Sources: UBS Equity Derivatives Strategy, Bloomberg, Jan 2012 Participation Demand high interest rates low option prices strong market trend Income Demand low interest rates high option prices weak market trend Participation Notes Twin-Win Autocallables / BRCs STRUCTURED INVESTMENT PRICING Pendulum
What are the risks associated with Structured Investments? 1. Market Risk Self evident and common across all risk investment vehicles 2. Credit Risk The investor is reliant on each individual bank being in a position to repay each structure at maturity. As a general rule, the lower-rated the issuer, the more funding they will pay you within the pricing of the structure. The 5yr Credit Default Swap (CDS) is often used as an indication of credit risk and is essentially the rate at which institutions insure credit risk against each other (see appendix) 3. Liquidity / Mark-to-Market Risk If structured correctly, there will be full intra-day liquidity, proven in extremis Intra-day “live” prices available on websites, Bloomberg, Reuters Very easy to trade through Crest/Euroclear by DFM trading teams Accurate modeling and scenario analysis is used to assess the mark-to-market risks before issuance STRUCTURED INVESTMENT RISKS
The information in this document is derived from sources believed to be reliable but which have not been independently verified. Catley Lakeman Securities makes no guarantee of its accuracy and completeness and is not responsible for errors of transmission of factual or analytical data, nor is it liable for damages arising out of any person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data. The opinions in this document constitute the present judgment of Catley Lakeman Securities, which is subject to change without notice. This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. This document is intended for the use of institutional and professional customers and is not intended for the use of private customers. This document is not intended for distribution in the United States of America or to US persons. This document is intended to be distributed in its entirety. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient. Catley Lakeman Securities is a LLP registered in England and Wales, Registered Office : One Eleven Edmund Street, Birmingham, B3 2HJ. Registration Number: OC336585, FSA Reference: DISCLAIMER