How is a Structured Product put together? Mar 2009

Content Introduction Example 1 – Zero Coupon Bond + Call Example 2 – Zero Coupon Bond + Geared Call What determines Structured Product pricing? Option pricing summary

Introduction Using examples, this presentation aims to illustrate how seemingly complicated structured products can be decomposed into simpler component parts. Having determined the component parts of these sample products, the pricing parameters that determine the value of these Component parts are then discussed.

Example 1 – Zero coupon bond + call In Pictures GBP1.00 Investor’s Cash Share Price at Issue p Zero-Coupon Bond75.00p Aggregate Costs 1.50p Option Premium23.50p GBP1.00 Zero-coupon Bond Option Providing Economic Return

Example 1 – Zero coupon bond + call In Numbers Amount to spend = 100p Zero coupon bond cost = 75p Costs = 1.5p Therefore cash remaining to spend = 100 – 75 – 1.5 = 23.5p Cost of one FTSE atm call option = 23.5p Therefore number of FTSE options bought = 23.5/23.5 = 1 Therefore structured product is 1 x ZCB + 1 x FTSE call

Example 2 – Zero coupon bond + geared call In Numbers Amount to spend = 100p Zero coupon bond cost = 75p Costs = 1.5p Therefore cash remaining to spend = 100 – 75 – 1.5 = 23.5p Cost of one SPX atm call option = 11.75p Therefore number of FTSE options bought = 23.5/11.75 = 2 Therefore structured product is 1 x ZCB + 2 x SPX call

What determines Structured Product pricing? Two Price Components Zero Coupon Bond Price Interest rates Credit Option Price Volatility Time to expiry Spot price Strike price Dividends Interest rates

What determines Structured Product pricing? Volatility – It’s all about the bell curve!

What determines Structured Product pricing? Or in simple terms! High Implied Volatility Low Implied Volatility

What determines Structured Product pricing? Time to expiry – it’s all about the bell curve – again!

What determines Structured Product pricing? The remaining parameters are: Spot price Strike price Dividends Interest rates These are all used to generate the forward price

Option pricing summary In summary, the input parameters for option pricing break down into the three categories below: Volatility – Most important parameter Higher vol = more expensive option Time to expiry Longer dated = more expensive option Forward price Found using spot, rates and expected dividends

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