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This is to certify that the project titled A Detailed Study of Structured Products has been successfully completed by Mr. Mriganka Pattnaik, IIT Guwahati, in NATIONAL STOCK EXCHANGE OF INDIA LTD as a part of his one month internship programme in the month of December, under my guidance.
ACKNOWLEDGEMENT
I sincerely thank Mr. Hari K(Vice President-Listing) and Mr Johnson Joseph(Chief Manager-Listing) for giving me an opportunity to work on a project in this esteemed organisation. I would also like to thank, Mrs Pramila DSouza, without whose guidance, this project would not have been possible. I would like to take this opportunity to thank the various members of the listing department for their help and support during my internship programme in the month of December.
CONTENTS
1. Introduction-Structured Products 2. Interest Rate Linked Structured Products 3. Credit Derivative Products 4. Currency Linked Notes 5. Equity Linked Structures 6. Commodity Linked Structures 7. Indian Scenario
Rs. 1000 lakhs 5 years 17.25% less 6 months MIBOR Payable semi-annually 0% pa- at no time will there be negative interest for investor
simultaneously purchases a call option with an identical strike yield(effectively a forward purchase). The forward purchase is hedged with offsetting derivative transactions, effectively insulating the issuer from the risk of variations in the redemption amount. The economic logic underlying the transaction is based on the economics of the embedded derivative position. In the example, the investor would usually be writing a put that was substantially in-the-money and buying an out-of money call. The dealer would sell the put on the 30 year bond at a higher premium than the outlay needed to purchase the call, with the difference being used to subsidise the issuers cost. Example 2-Bond Linked Notes Quatrain Co., through Nomura International, undertook a 3 year 10.00% US$100 million issue of Treasury indexed bonds on 15 May 1986. Redemption value was linked to the 9.25% 2016 US Treasury Bonds via the following formula: R= US$100,000,000 x (MIP 26.491782) / 100 Where R=redemption value in US$ MIP=market index price of the 9.25% 2016 US Treasury bond at the maturity of the issue
To avoid any credit risk, the purchaser of the cap paid Shearson a lump sum that was reinvested inTreasury zero coupon securities which produced the quarterly income stream equivalent to 0.375% pa. The structure of the transaction is laid out below.
COLLARED FRNSS
The basic structure of the collared FRN entails a normal FRN structure with an interest coupon related to overnite inter-bank rates. The interest rate coupon is subject to a minimum and maximum interest rate level(say 5% and 10% respectively). The initial issues were undertaken for maturities of 10 years. Basically, the collared FRN combines a standard FRN transaction with an overnite inter-bank rate(Eg: US$ LIBOR) cap and floor. The investor purchases a package consisting of the following elements: 10 year US$ LIBOR based coupon FRN. Sells a cap on US$ LIBOR at the maximum interest rate level(10% pa) Purchases a US$ interest rate floor at the minimum interest rate level(5% pa) Diagram 2 sets out the various components of a collared FRN and Example 4 sets out the term of the JP Morgan issue
Diagram 2
Example 4 Issuer Amount Maturity Interest Rate Fixed re-offer price Minimum Interest Maximum Interest Call Option
JP Morgan & Co Inc. US $200 million 10 years 3 month LIBID 99.85 5% 10% None
Under the total return swap structure, the investor receives interest payments and any fees including commitment fees and pays MIBOR plus or minus an agreed margin. All payments are calculated on the notional principal adjusted for any amortisation or repayments on the underlying bond.
with short term default risk. The investor hedges the credit risk with the following credit default swap. Buyer of Protection Seller of Protection Maturity Reference Entity Reference Bond Credit Event Default payment Default Swap Premium Payment of Default Payment Investor Dealer 3 years ABC Company Reference Entitys 10 year 8.50% coupon bond Bankruptcy or insolvency event Notional Amount X[100%- Fair market value of Reference Bond after Credit Event] 1.25% pa payable by Buyer of Protection to Seller of Protection Payable by Seller of Protection to the Buyer of Protection upon occurrence of credit event
Yen 25,000 million 5 years 7.75% pa payable annually in Yen US$115.956 million(payable in US$)
This includes a wide range of note structures entailing structured currency risk. The notes feature a bond combined with a currency derivative(forward or option). The derivative is used to alter the coupon or principal payments of a conventional bond to create specific exposure to currency movements. Example 8 Heaven and Hell Notes The first issue of Heaven and Hell Notes was arranged by Nomura International for IBM Credit Corporation. The IBM issue raised US$50 million for 10 years with a maturity date of 4 December 1995. To entice investors aboard IBM paid a high coupon of 10.75% pa in US$. The redemption amount for the issue payable in US$ varied according to the following formula: R=US$50,000,000[1+((S-169)/S)] Where: R=Redemption value in US$ S=Yen/US$ spot exchange rate on 21 November 1995 If the Yen/US$ exchange rate at maturity was stronger than Yen 84.5/US$1, investors would get no principal return.
movements in the relevant index. This is because the two tranches are designed to be perfectly offsetting and to provide the issuer with a known fixed stream of cash flow payments into the future. The issuer effectively assumes no risk to movements in the relevant index, as changes in the redemption value of one tranche(for example the bull tranche) are offset by asymmetric changes in the redemption value generates by the other tranche(the bear tranche) Example 9 illustrates the type of stock index bull-bear issue involving the Nikkei Index on the Tokyo Stock Exchange. Example 9 AB Svensk Exportkredit on 25 July, 1986, issued a series of Yen bull and bear bonds. The SEK issue involved two tranches each for five years. The bull tranche involved an issue of Yen 10,000 million and paid a high coupon of 8.00% pa to compensate investors for the additional risks they had undertaken. The redemption value of the bonds was indexed to the Nikkei index in the following manner: For bull bonds: R=Yen 10,000,000,000(I + ((I-26,067)/22720) For bear bonds: R=Yen 10,000,000,000(I + ((I-19,373)/22720) Where R=Redemption value in Yen I=Nikkei stock average at maturity of the bonds R is also subject to the following constraint: If I is greater than 28,461 at maturity, R=Yen 6,000,000,000 If I is less than 16,769 at maturity, R= Yen 11,054,000,000
At present, structured products listed on NSE and BSE are all principal protected as a result of the latest SEBI order to all rating agencies according to which non principal protected products shall not be given a rating.
INDIAN SCENARIO
Globally, structured product is a $700 billion industry, while the Indian market is estimated to be $1 billion. Inspite of their complexity, the advantage of structured products lies in the fact that they can be customised to hedge specific risks as well as provide unlimited high returns. Hence, High net worth investors (HNI) in India have been showing an increase interest in structured products. Banks such as ICICI Bank, Citibank, SG Private Banking, BNP Paribas, Standard Chartered, ASK Wealth Advisors etc offer structured products. Primarily Equity Linked Structured Products are listed in Indias National Stock Exchange. Earlier both principal protected and non principal protected structured products were listed in the NSE. The following extract shows SEBIs earlier policy regarding structured products: A CRA may undertake rating of structured finance products, namely, instruments / pay-outs resulting from securitization transactions (under SARFAESI Act, 2002 read with SEBI (POLSDI) Regulations, 2008). In such cases, apart from following all the applicable requirements in case of non-structured ratings, few other additional requirements shall also be complied with. The rating symbols shall clearly indicate that the ratings are for structured finance products. A CRA shall also disclose at least once in every six months, the performance of the rated pool, i.e., collection efficiency, delinquencies of the Structured Finance Products. Source: SEBI CIR/MIRSD/CRA/6/2010 dated 3rd May 2010 However, recently SEBI has asked credit rating agencies not to rate non-capital protected structured products, putting an end to issuance of these instruments. This is because a non-capital protected structured product carries both credit and market risk. When a CRA rates these products, we comment only on the credit risk. Because of this, there is a possibility of misunderstanding among investors
About 80% of the structured products issued in the country are pegged to the Nifty index. The top issuers of these products in India among foreign companies are Citigroup Inc. and Merrill Lynch and Co. Inc. The top local issuers include Kotak Securities Ltd and Edelweiss Capital Ltd
BIBLIOGRAPHY
Das, Satyajit(2006), Structured Products Volume 1; Wiley Finance Das, Satyajit(2006), Structured Products Volume 2; Wiley Finance http://www.hsbcnet.com/treasury/structured-products http://en.wikipedia.org/wiki/Structured_product http://www.oenb.at/en/img/phb_internet_tcm16-11173.pdf www.economist.com