INVEST – Instruments: Structured Products

Structured products are financially engineered investments which offer investors alternatives to conventional stocks and bonds. They are typically issued by financial institutions to suit specific client requirements, and offer formula-based returns which, in theory, could cover any imaginable investment scenario. Structured products are usually formed (and replicated) by combining a funding leg (such as a bond) with a performance leg (typically a derivative). These can be produced with varying terms, payouts and risk profiles that track the performance of an underlying asset or market. Given the derivatives element, it may be beneficial to read these study notes in conjunction with the Derivatives chapter.

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Structured products can be very complex and take time to put together. For this reason, they are marketed with detailed term sheets and fact sheets together with other literature to aid client understanding. Structured products can be listed on an exchange as exchange-traded notes, however many structured products are not listed.

Structured products are popular with clients who are looking for solutions to problems in their existing portfolio. They are bespoke in nature; therefore this area can be a complex one to understand. These study notes will begin by defining what structuring is, and why it can help in solving problems faced by clients. They will then cover the key benefits and risks (the latter is something clients need to critically understand prior to making investment decisions). What then follows is an overview of the types of products available, how they are constructed and what drives their price in the secondary market.

Learning outcomes

By the end of this chapter you should be able to:

Define structured products
Summarize the benefits and risks of structured products
Describe the components of structured products
Explain the categorization of structured products
Differentiate and categorize the impact of influencing factors and secondary markets upon the value of structured products
Describe the UBS shelf of structured products and how they complement the UBS Client Promise

15.1 Introduction to structured products

15.1.1 Benefits of structured products

The key benefits of structured products are:

Structured products allow investors to generate returns which are linked to an asset or market which moves up, down or even sideways

Products can be tailored precisely to the client’s requirements and expectations

Clients can access and/or diversify into a huge range of markets and asset classes

- Structured products are typically offerings that investors could not construct themselves due to the limitations of time and skill, and/or high barriers to market entry and high market transaction costs
- Additionally, products can deliver returns comparable to an actively managed strategy, for example, a volatility strategy that the client could otherwise not easily achieve themselves.
- Products can also be structured to the investor’s tax situation, for example, emphasizing capital gains over income or vice versa.

15.1.2 Risks of structured products

The key client risks include:

This is the overall term for the client’s exposure to the underlying asset or market. Examples of market risk factors which may affect financial performance of structured products include: Equity prices, commodity prices, real estate prices, FX rates, interest rates, inflation, credit spreads, volatility, dividends, correlation and basis risk.

A structured note is an unsecured bond, normally issued by a bank or financial institution. If the structured product performs adequately, but the issuer fails, there is a chance of large capital loss for the investor. This may be without any recourse to the local regulator or government for investor protection. This contrasts with bank deposits, where depending upon the jurisdiction concerned, retail or high net worth clients might have recourse to a government deposit insurance scheme in the event of bank failure.

Though structured products can often be sold back to the issuer at any time, under normal market conditions, clients should be prepared to hold most products until maturity to avoid suffering additional costs of liquidation. This is for two reasons:
- Issuers are not obliged to make secondary markets in structured products (although they will generally try to, as the existence of a secondary market will generally improve the attractiveness of the structured product to the client in the first place).
- Depending upon the structured product, the bid-ask spread could be quite wide. This is generally because the issuer has the expense of unwinding their risk hedge embedded in the structured product if the customer wants to redeem early.

Some products have the possibility of being bought back early or ‘called’ by the issuer. The capacity for the issuer to do this would be clearly stated in the associated term sheets and fact sheets. Such products generally reward the client for this potential risk via improved product terms.

As with all investments which provide foreign currency returns, clients face exposure to currency movements. To assist clients, some structured products offer returns linked to foreign assets or markets, which are then paid in the client’s domestic currency. These are known as ‘quanto’ products.

15.1.3 Components of structured products

Without knowledge of the components of structured products, it is impossible to follow and understand the effect of changes in influencing factors on prices.

Zero bond or direct investment

Zero coupon bonds may be embedded in capital-protected structured products or reverse convertibles structured products. These bonds do not pay coupons, but are issued at a discount to their nominal value and redeemed at 100% of this nominal value at maturity. The guarantee of a 100% redemption at maturity enables the construction of capital-protected products. (Note that although the term 100% guarantee is used here, this would still be subject to counterparty risk.)

The discount on the zero bonds therefore allows for the financing of options, for example call options for a capital-protected product that allow the client to participate in rising market conditions. Alternatively, it can allow the payment of guaranteed coupons including reverse convertibles and barrier reverse convertibles.

The payoff diagram of a zero-coupon bond is illustrated below:

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Instead of using zero coupon bonds, an alternative way to build a structured product is to directly buy the underlying asset or assets, for example individual stocks or a basket of stocks. Using this alternative approach, the client of such a structured product does not give up coupon payments, but instead forgoes the receipt of dividend payments. These dividend payments are then used to acquire derivatives. So instead of receiving dividend payments, the client accesses other features as financed by the derivative. This may be greater upside potential through an investment in call options, for example.

The payoff of a direct investment is illustrated below:

Instead of buying the underlying asset, the issuer could buy a so-called low-exercise-price-option (LEPO). A LEPO is essentially a deep in-the-money call option. In other words, the strike price is close to zero and delta close to one. This means that it tracks the price changes of the underlying asset with almost perfect correlation on a 1:1 basis. Therefore, a LEPO can be considered a substitute for direct investment into the underlying asset. The difference is that a LEPO does not pay dividends and does not contain voting rights. Instead, the client pays a discounted price, with the discount being equal to the present value of the expected dividends (see section on put-call parity below for more on LEPO pricing). In a similar way to zero coupon bonds, the difference between the price of the LEPO and the price of the underlying can be used to finance the preferred characteristics of the structured product. This could be, for example, using a long call strategy to achieve more upside potential.

Example: Assume an asset is trading at USD100, with a discrete dividend of USD5 due in one year’s time. A client could:

Buy the asset now at USD100 (breakeven) and spend USD5 in realized dividends on options in one year’s time; or
Buy a one-year LEPO now at USD95.24 (breakeven) and spend USD5 divided by 1.05 = USD4.76 discounted expected dividends on options now. (Note that dividing by 1.05 uses a discounted yield of 5% to calculate the present value of the USD5 that would otherwise be received in one year's time). This amount is then deducted from the USD100 to calculate the amount that can be spent now on the LEPO.

Since the product needs to be structured today, the LEPO is more beneficial to cash flow since cash is available to be spent on options immediately.

Options

As most structured products contain options, the pricing determinants of options play an important role in understanding how structured products’ prices are influenced.

The following chart exhibits the payoff diagrams of plain-vanilla options (standard options) at expiry.

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Standard options are very important building blocks of structured products because they allow the designing of a desired payoff diagram.

The most important types of plain vanilla options give a client the right (but not the obligation) to buy (call option), or sell (put option), a certain underlying at expiry (European option), or during the lifetime (American option), for a predefined strike price. The client can either take a long position (buy the option) or a short position (write/sell the option). In the latter case, the client will end up receiving the option premium upfront within the construction, but have an embedded obligation to the party who holds the long position.

The price of an option consists of an intrinsic value (which may be either zero or positive) and a time value. While the intrinsic value depends on the relationship between the underlying asset price and the strike price of the option, the time value is determined by the implied volatility, remaining time to maturity, expected dividends and interest rates. The higher the volatility and the longer the time to maturity, the more expensive the price of the options.

A lot of structured products are based on exotic options that differ from plain vanilla options in terms of calculating how or when the investor receives a certain payoff. Furthermore, they are more complex than plain vanilla options and are generally traded over-the-counter (OTC). Most exotic options are path-dependent, which means that the price development of the underlying asset, during the lifetime of the option has a significant impact on the payoff diagram of the option. As barrier options are often used as examples of exotic options, it is useful to take a closer look at them now.

The payoff of barrier options is similar to plain vanilla calls or puts, with the exception that they either cease to exist if the underlying hits a predefined price, or only start to exist if a certain price is hit. This predefined price is called the barrier. Options which suddenly vanish with all their incorporated rights are called ‘knock-out options’ or ‘kick-out options’, whereas options which only exist if a barrier is hit, are called ‘knock-in options’ or ‘kick-in options’. Furthermore, it is crucial to verify whether the barrier is valid continuously, daily or only at expiry. The features can be summarized in the following way:

In or out: Knock-in options become alive only if a barrier is hit; conversely knock-out options cease when a barrier is hit
Up or down: The barrier is set in relation to initial spot price and will be set above or below this price
Call or put
Long strategies can be utilized with call barrier options and short strategies can be utilized with put options

Note that UBS use some specific terminology here: UBS distinguishes some barrier options in a special way, naming them more specifically ‘kick-in’ or ‘kick-out’ options. The term ‘kick’ is used to indicate that the spot moved in-the-money direction when the barrier was hit. This is the case for four varieties (Calls: Up-and-in, up-and-out; Puts: Down-and-in, down-and-out). The other four varieties UBS calls ‘knock-in’ or ‘knock-out’ options.

Special features

In addition to the above-mentioned components, structured products sometimes include special features.

Products with an early redemption feature will automatically be redeemed early (in other words, before the usual expiration date), if an early redemption event occurs. An early redemption event occurs if, on any predefined observation date, all underlyings close at or above their respective early redemption levels. Note that, for bearish products, an early redemption event occurs if, on any predefined observation date, all underlyings close at or below their respective early redemption levels. The early redemption levels and the relevant observation dates for a specific instrument are always predefined and can be found in the term sheet of the instrument. Structured products that contain such an early redemption feature are also referred to as ‘auto-callable’, or ‘hard call’ products. If a product includes a callable feature, also known as ‘soft call’, the issuer has the right, but not the obligation, to redeem the product early at a certain, predefined point in time during the lifetime of the product. Since investors of callable or auto-callable structured products are exposed to a reinvestment risk, they are compensated accordingly, for example in the form of higher coupon payments.

If a structured product has a worst-of feature, the redemption or barrier is not only linked to the performance of a single underlying, but to the worst performing among several underlyings. This is typically the worst performing asset out of a basket of two or three underlying assets.

Some structured products have a so-called quanto feature (quantity adjusted option) to eliminate currency risk. This is made possible by a mechanism integrated into the product structure by the issuer. However, this currency hedge might involve additional costs, depending on the exchange rate volatility and correlation between the exchange rate and the underlying. In consequence, the client is protected against the currency risk from currency depreciation, but also gives up the upside potential from a possible currency appreciation.

Furthermore, it is possible to build structured products using an additional zero coupon bond of a reference entity with an additional credit risk. If that counterparty exhibits a lower credit rating or creditworthiness, it will provide a higher discount on its zero coupon bonds. This higher discount could be used to finance the purchase of additional call options, resulting in an increased participation rate in the upward price movement of the underlying asset. Clients of structured products with an embedded reference entity should bear in mind that they should not only monitor the rating of the issuer, but also the rating of the reference entity and therefore concern themselves with two counterparty risks.

15.2 Categorization of structured products

The following section contains the market expectations, payoff diagrams and characteristics of four structured product categories based on the categorization of the Swiss Structured Products Association (SSPA).

15.2.1 Capital (or principal protection)

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Capital protection with coupon

These offer the investor the chance to earn a high coupon, which is conditional upon certain events. In most cases, they are 100% capital protected, meaning the minimum the investor receives at maturity is their initial capital. However, investors should not consider capital-protected products as risk-free, as they still bear a counterparty risk linked to the rating of the issuer. These products are suitable for risk-averse investors seeking high income.

Capital protection with participation

These products give the investor the chance to participate in the returns of an underlying market or asset, with the safety net of a pre-specified minimum return of most or all of the initial investment, should the market not perform as expected. The product is said to offer ‘linked’ returns to the underlying, and how much performance the investor receives is determined by the underlying performance and the initial participation rate. For example, an equity-linked product which, at maturity, provides capital growth of 12% when its underlying market has moved by 10%, has a participation rate of 120%, or 1.2x. The redemption amount in any event is expressed as a percentage, so a full capital protection product would redeem at least at 100% (the initial investment itself), but perhaps at 120% if the market performs. Capital protection levels normally range between 90% and 100%, where 100% is sometimes called hard protection and 100% is called soft protection. It is important to keep in mind that the protection against negative performance of an underlying is referenced to the issue price and is only valid at maturity. Prior to the maturity date of the structured product, the secondary market price could therefore fall below the protection level. These products are sometimes capped, meaning the investor receives a maximum return in exchange for enhanced participation. These products are suitable for risk-averse investors seeking capital growth.

According to the put-call-parity (as explained in the Derivatives chapter), capital-protected products could be replicated using the combinations of ‘stocks and put options’ or ‘zero coupon bonds and call options’:

Put-call-parity:

S + P = PV(X) + C

Where S = Underlying price; P = Put option; PV(X) = Zero coupon bond or time deposit; C = Call option

According to this equation, combinations of both the underlying assets with put options, as well as zero bonds with call options, provide the same payoff as capital-protected products. The zero bonds ensure the capital protection, whilst the call options allow for participation in increasing underlying prices.

Example of a capital protection with participation product:

An investor buys a three-year bull equity-linked note for a price of 100% of their initial capital, which delivers 80% (the participation rate) of the positive performance of the S&P 500 index, and offers 100% capital protection.
Upfront product fees are 1%, and the issuer uses the remaining 99% of the initial capital to replicate the product via two elements as follows:

Purchasing a three-year zero-coupon bond for 90%, for example, of the ultimate redemption value. In reality, this cash is often lent to the issuer’s treasury department.
Purchasing the appropriate amount of an at-the-money (ATM) three-year S&P 500 call option, with the remaining 9% available.

At maturity:

If the S&P delivers positive returns, then the client’s returns are made up of the zero-coupon maturity value (100% of the initial amount they have invested), plus the performance of the call options. More specifically, 80% of the positive performance of the S&P 500. So, hopefully greater than the 100% in total.
If the S&P delivers negative returns, the client’s returns are made up of the zero-coupon maturity value (100% of the initial amount they invested) only. The call options expire worthless in this case.

This type of note can be created in a similar way using other asset classes. This opens up a variety of opportunities for clients including equity-linked notes, commodity-linked notes, FX-linked notes etc. Performance can be generated from options on single assets (e.g. Apple, oil, EUR/USD), baskets of assets, or indices such as Eurostoxx 50 or UBS CMCI. For clients who have a bear or inverse sentiment, structured products which benefit from negative performance can easily be offered instead of the positive performance or bull products referred to above. This can be achieved by utilizing put options rather than call options.

15.2.2 Yield enhancement

Some structured products offer lower, or no, participation, in favor of more income. Yield enhancement products are suitable for sideways moving markets or, in case of barrier versions, slightly decreasing performance. These products are appropriate for neither decreasing markets (as they are affected by downside movements), nor increasing markets (as clients will only participate from upward movements to a certain level – the so-called cap level, or maximum return).

The most popular yield enhancement products are discount certificates and reverse convertibles. Whilst discount certificates are priced in absolute units of currency, reverse convertibles are priced in percentage figures. The reason for this involves the replication techniques embedded in these structured products.

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If we take the put-call-parity formula (see above) and rearrange it, we get the following equation:

Put-call-parity (rearranged):

S – C = PV(X) – P

Where S = Underlying price; P = Put option; PV(X) = Zero coupon bond or time deposit; C = Call option

The left side of the equation shows the components of discount certificates, whereas the right side represents the replication of reverse convertibles. Therefore, discount certificates include an investment in the underlying asset (or a LEPO) combined with a short call option strategy, which is indicated by the negative sign. Hence, the discount of these structured products is composed of the present value of expected dividends (LEPO) and the premium from writing call options. In contrast, reverse convertibles are composed of zero coupon bonds combined with a short put option strategy, which is again reflected by the negative sign in the equation above. Instead of a discount, reverse convertibles offer a fixed and guaranteed coupon payment over the lifetime of the structured product. The coupon payment is made up of the sum of forfeited coupons on the zero coupon bonds and the premium from writing put options. An insight into these components is crucial to understanding the optimal market situation. This understanding is also needed to construct such yield enhancement products, as well as to appreciate the impact of changes in influencing factors on them. Even if their way of replication is completely different, reverse convertibles and discount certificates provide the same payoff profile.

For both types of structured products, there are versions including barrier options. Barrier reverse convertibles, for example, include a short strategy with down-and-in put options instead of plain vanilla put options. This leads to a lower coupon payment in exchange for a certain downside protection, as down-and-in put options only become live if the barrier is hit. This is the reason why these products are also suitable for slightly downward-moving underlying asset prices, but with the restriction that the barrier remains untouched. Sometimes, barrier reverse convertibles are based on more than one underlying asset (often three) and are therefore called multi-asset barrier reverse convertibles.

Multi-asset barrier reverse convertibles generally contain a worst-of feature, which means that the client will get the worst performing underlying asset in case of a barrier touch. Such products allow the offer of higher coupon payments, but at the cost of higher risk. Clients should also keep in mind that they do not benefit from diversification. Instead, such products are effectively ‘anti-diversification’ as low correlation between the underlying assets leads to a higher risk that the barrier will be hit.

Barrier discount certificates exhibit the same payoff profile as barrier reverse convertibles, but are priced in absolute units of currency. Clients must decide whether they prefer a discount on the underlying(s), as with (barrier) discount certificates, or a fixed and guaranteed coupon payment, as with (barrier) reverse convertibles. For structured products with barrier options, clients should make sure in advance whether the implied barrier is only valid at maturity (European barrier), on a daily basis, or continuously during the lifetime of the product (American barrier). Hitting the barrier during the life of a barrier discount certificate therefore does not necessarily lead to a loss for the investor. For example, a client holding a European barrier discount certificate will only suffer a loss if the underlying asset exceeds the predefined strike level at maturity.

15.2.3 Participation

Participation products allow investors to benefit from increasing (bull) or decreasing (bear) movements in underlying asset prices. The charts below only exhibit the bull versions of the participation products. It is important to keep in mind that these products generally bear higher risk than capital-protected and yield enhancement products, but also offer higher return potential.

Tracker certificates are the simplest form of participation product, as they offer linear participation in an underlying asset or a basket of assets.

There are several other participation products with different characteristics and payoff profiles which enable clients to invest their money in line with a certain market view. Participation products are either constructed using a direct investment or a synthetic direct investment (LEPO). The market environment of high dividend yields provides favorable market conditions to construct participation products based on a LEPO. This is due to the higher discount available relating to the dividends that are forgone. Furthermore, to construct, for example, outperformance certificates, low volatility is preferred as these products incorporate a long strategy in call options. The more volatile the value of the underlying asset then the more expensive the options premium.

15.2.4 Leverage

Leveraged products bear the highest risk of all structured product categories, but at the same time offer the highest return potential. Warrants are often used within these products given their similarity to traded (standardized) options. Clients can benefit from upward-moving markets by utilizing call warrants, or downward-moving markets by utilizing put warrants. A main distinction between non-standardized warrants and traded options is that, with warrants, investors can only take on long positions as the issuer is always the writer.

A special kind of warrant is the so-called knock-out warrant. Such exotic options contain a knock-out barrier, which means that the client will lose the total amount of invested capital as soon as the barrier is hit. There are some other types of leveraged products which are not available in all countries and are therefore not explained in detail here. Leveraged products can be constructed using options, futures or forwards.

Similar categorizations are utilized by the European Structured Investment Products Association (EUSIPA) and by local professional associations.

15.3 Influencing factors and secondary market

15.3.1 Secondary market effects: Influencing the trading price of the product

A client buys a three-year (bull) equity-linked note for a price of 100%, which delivers 80% of the positive performance of the S&P 500 index, and offers 100% capital protection
The product is structured by buying both a three-year zero coupon bond and an ATM three-year S&P 500 call options
The structured product price or value = Replicating portfolio price + fees
So, with the equity-linked note: 100% of the structured product price = 90% (bond) + 9% (call options) + 1% (fees)

From this equation, we can see that anything which affects the price of the replicating portfolio, directly affects the price of the structured product.

Favorable secondary market influences refer to events which increase the structured product’s price once the client holds it.

Before we explore this further let us firstly remind ourselves how the value of an option may be referred to as being ‘in the money’ (ITM), ‘at the money’ (ATM) or ‘out of the money’ (OTM). An option is:

ITM when the price of the underlying asset > strike in the case of calls, or the price of the underlying asset < strike in the case of puts
ATM when the price of the underlying asset = strike
OTM when the price of the underlying asset < strike in the case of calls, or the price of the underlying asset > strike in the case of puts

The ‘Greeks’ also relate to the sensitivity of option values and therefore the value of a structured product which incorporates that option

Delta refers to the sensitivity of the value of an option or structured product to a change in the price of the underlying asset
Vega refers to the sensitivity of the value of an option or structured product to a change in the implied volatility of the underlying asset
Theta refers to the sensitivity of the value of an option or structured product to a change in time to expiry of the option
Rho refers to the sensitivity of the value of an option or structured product to a change in interest rates
Phi refers to the sensitivity of the value of an option or structured product to a change in expected dividends

Remember also that anything which increases either the bond price or call option premium also increases the price or value of the structured product. The factors referred to above can therefore be summarized as follows:

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^* Technical note on time to maturity:

If we assume there is no change in any other factors which may affect the value of the underlying asset, such as its credit rating, then in the early years as the product slowly moves towards maturity (maturity shortens), the value of a zero coupon bond rises faster than the ATM calls fall. This in turn means that the structured product price rises. However, towards maturity, the ATM calls fall faster than the bond rises, which means the structured product price actually falls, and tends to 100%. This is because the bond price rise is ‘steady’, but the call price fall accelerates towards maturity, due to its Theta. This means that a structured product with less than a year to maturity could actually be negatively affected by the passage of time, not positively.

**Technical note on interest rates and underlying asset yields:

In the Black-Scholes options pricing model, it is assumed that the underlying asset value follows the initial forward curve as time evolves. This is called the ‘risk-neutral’ assumption. It means that anything which results in higher forward prices makes calls more ITM (and puts more OTM – see below). This would include the effects of higher interest rates and lower expected dividends.

***Technical note on price of underlying:

With a participation rate of 80%, if the S&P 500 rises by 10%, the product price will increase by 8% at maturity only. This is because the option’s delta will be 1 (the maximum it can be). A delta of 1 indicates that the option experiences a 1:1 movement with the underlying itself. Prior to maturity, the price of the structure will increase (and decrease) by less than 80% x market performance. This is because the delta is <1, meaning that the product is less sensitive to changes in the value of the underlying asset.

15.3.2 Primary market effects: Setting the initial participation rate

Favorable primary market influences refer to events which decrease the structured product’s price before the investor purchases it, or enable the investor to buy a more attractive product at issue, since it is common to offer the product at close to 100% (par) in any event.

Example: Using the (bull) capital protected note from earlier, constructed with call options:

Consider this environment (the opposite of the changes in market risk factors outlined above):

Lower issuer ratings/higher credit spreads
Higher interest rates
Higher expected dividends
Lower implied volatility
Lower price of underlying

These would have the effect of reducing the price of the structured product. This is good news for the prospective investor. Effectively pricing at a fixed level of 100% in this favorable environment means that there is more available cash to spend on call options, since the bond and/or call options will be cheaper at the time of issue. This can be expressed as follows:

More remaining cash to spend → Higher participation rate → More attractive product to investors

The participation rate can also be increased, independently of favorable moves in market risk factors, by adapting the initial structure itself. For example, by offering:

Longer-term products: These will usually incorporate bonds with higher yields which are cheaper.
Lower capital protection
Capped upside: This can be achieved by selling higher strike OTM calls or buying knock-out or knock-in barrier calls instead of vanillas

Pricing at a fixed level of 100%, with the above changes to the terms, means that there is more available cash to be spent on call options, hence further increasing the participation rate. However, any structuring changes need to be useful to clients.

15.3.3 Secondary market effects on other components

Equity-linked notes could also be structured by adding put options rather than call options, so it’s important to compare the two choices. In summary, market risk factors have an opposing effect concerning interest rates, dividends and underlying price. This is because these relate to whether an option is ITM or ATM. However, for implied volatility and time to maturity, the effect on the value of both calls and puts is directionally the same. This can be summarized as shown below:

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We’ll see later that some products are structured using a LEPO, e.g. zero strike call (ZSC) option, which is akin to an investment in the underlying asset, but the ZSC trades at a discount to the underlying asset where expected dividends are greater than zero.

Below is a comparison of a LEPO premium or ZSC premium with a bond or deposit:

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****Technical note on pricing ZSC options

If there are no dividends, the price of a ZSC equals the price of the stock (S or underlying).
If there are dividends, the price of a ZSC is simply the stock price, discounted at the dividend yield.

This can be seen via put call parity (including dividends): Se^-dt + P = Xe^-rt + C
With a strike of zero, P = 0 (since OTM) and Xe^-rt = 0 (since X = 0). This leaves C = Se^-dt
Therefore, the only market risk factors which can affect the price of the ZSC are: Changes in the value of the underlying asset (Delta), dividends (Phi), and time to maturity (Theta).

Clearly the stock earns realized dividends, so for a fair comparison of holding a ZSC or S, this should be taken into account.
Example: A client buys a stock trading at USD15, and a 1 year ZSC. The expected and continuously compounded dividend yield is 3% per annum

The price of the ZSC today = USD15 divided by e^3%; = USD14.55667
In one year’s time, if dividends are realized as expected and the underlying asset value is unchanged:

ZSC earns LN (15 divided by 14.55667) = 3% (continuously compounded return)
S earns LN ((15 x e^3%) divided by 15) = 3% (continuously compounded return)

In summary:

S earns more than the ZSC if realized dividends > expected dividends.
S earns less than the ZSC if realized dividends < expected dividends.
S earns the same as ZSC if realized dividends = expected dividends.

15.4 The UBS structured product shelf

Clients need to understand how their structured products might perform in various market scenarios. This section looks at the UBS product categories; illustrating how the various products work, and how certain underlying market movements affect the product returns and their redemption values. Note, although a large selection of products is covered, this is by no means exhaustive. The UBS intranet has more information on this area.

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UBS has grouped structured products with similar risk and return potential into four categories: Capital protection, yield enhancement, participation, and leverage. Taking note of the chart shown opposite, and the colors associated with the ascending risks being blue, green, yellow and red, may make it easier to locate the appropriate product. As with other financial investments, the relationship between risk and return potential applies for structured products. Therefore, the higher the return potential, the higher the risk one must take.

UBS then takes these categories and applies them to the following sub-categories as shown below:

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As can be seen above, structured products offer UBS clients a wide range of investment opportunities with different risk and reward profiles. The structured products under each of the four main UBS categories are explored below.

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15.4.1 UBS capital protection products

Capital protection products are the most defensive form of structured product, and are therefore suitable for clients with a low to moderate risk tolerance. The capital protection at maturity ranges between 90% and 100% of the nominal amount, depending on the product features. The principal is always subject to the credit risk of the issuer and is only protected if the structured product is held until maturity. During the term, however, the price of a structured product may be quoted below the capital protection level.

We can further divide protection products as follows:

Income (protection with coupon): Full principal protection at maturity of 100%, generating pre-defined cash flows during the lifetime and/or at maturity to potentially outperform traditional bonds
IncomePlus (protection with participation): Partial or full protection between 90% and 100% at maturity, participate in growth potential of underlying asset

15.4.2 UBS capital protection products: Income (protection with coupon)

Products in this category generate predefined cash flows during their lifetime and/or at maturity to, potentially, outperform a traditional bond investment. These products are capital-protected (but subject to issuer risk), which means that, in addition to the cash flows, the notional principal amount is redeemed at 100% at maturity, provided the issuer does not default. It is important to be aware that the capital protection only applies at the redemption date. During the lifetime of the structured product, the price might fall below 100%.

Fixed rate notes (FixRN)

FixRNs redeem at 100%, but pay regular cash flows during the lifetime of the product. These cash flows are defined and fixed in advance, and are therefore independent of market changes.

Because of this, they offer the following simple and predictable payoff (blue bars):

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Floating rate notes (FRN)

FRNs pay regular coupons during the lifetime of the product, but as the term ‘floating’ suggests, the coupons are variable and adjust regularly to movements of relevant interest rates. This enables a client to participate in rising interest rates. Often, the coupon is directly linked to an interest reference rate like LIBOR.

FRNs may offer a payoff as shown by the blue bars in the chart below:

Boston Consulting Group Global Wealth 2017

Fixed to floating rate notes (Fix2FRNs)

Fix2FRNs are a mixture of a fixed rate note and a floating rate note. The coupon payments are fixed for a predetermined period only; thereafter, the fixed rate note turns into a floating rate note, paying floating coupons based on an underlying interest rate. A client may be interested in investing in such a product if they believe that future interest rates will be initially lower than those currently predicted by the market, but also wants to be able to profit if interest rates rise at a later date.

The blue bars in the following chart visualize the possible payoff of Fix2FRNs:

Boston Consulting Group Global Wealth 2017

Callable step-up notes (CSUNs)

With a CSUN, the client purchases a note with a maximum term and with coupon payments that increase periodically. In effect, the investor sells the issuer the right (but not the obligation) to redeem the note at 100% on any given call date (hence the term ‘callable’ in the name). In return, the client is compensated by an option premium in the form of an increased coupon. Therefore, the coupon earned by the client on the note from issuance to redemption usually outperforms the interest earned on a comparable straight bond with the same tenor and credit quality.

There are two main types of CSUN:

Single call date CSUNs, also known as European Call CSUNs: These are callable by the issuer on just one specific date.
Multiple call date CSUNs – These can have a variety of stated multiple call dates for example, annual, semi-annual or even quarterly.

The question of whether a callable step-up note will redeem early or not depends on the market expectations regarding the interest rate’s development when the product was priced (referred to as the ‘forwards’) and the interest rate’s actual development. Think of it as a race: At launch, the pricing of the note was based on the ‘then current’ forward rates, and as time passes by, the product is moving closer to these forward rates. If interest rates are moving far above the forwards, the price of the callable step-up note will suffer, thereby lowering the probability of being called. In contrast, if rates are not catching up with the forwards, then the price will appreciate, which will increase the probability of the note being called at the originally stated call price.

The blue bars in the following chart exhibit the possible payoff of CSUN:

Boston Consulting Group Global Wealth 2017

Daily range accrual notes (DRANs)

With a DRAN, the coupon payments are not fixed in advance, but instead are dependent on the movements of an underlying interest rate. An attractive coupon is accumulated for each day that this reference interest rate remains within a certain range. No interest accrues on other days.

The blue bars in the following chart show the possible payoff for a DRAN:

Boston Consulting Group Global Wealth 2017

Callable daily range accrual notes (CDRANs)

A variation on the DRAN is the Callable Daily Range Accrual Note (CDRAN). CDRANs have a callable feature in addition to the features of DRANs, and therefore can be redeemed early by the issuer.

Further income products, which offer both capital protection and a coupon include capital protected certificates with coupon. The capital protected products we have looked at so far utilize a fixed income underlying asset. For capital protected products with equity and FX underlyings, a capital protected certificate with coupon is used. With such products, the client can expect to receive periodic coupon payments which vary depending on the performance of the underlying asset.

15.4.3 UBS capital protection products: IncomePlus (protection with participation)

Products in this category offer redemption at or above 90% of the nominal value. A lower minimum redemption of 90%, for example, will enhance the upside participation rate in increasing underlying asset prices. The upside participation can be leveraged and/or capped.

Capital protected certificates with participation

A capital protected certificate with participation combines a fixed income investment (typically a zero coupon bond) with an option strategy (typically a long call). This combination allows the client to participate in the development of one or more underlying assets. It is possible for a client to participate either to an unlimited extent or to a specific (capped) level defined at the time of issuance. Capped capital protected certificates with participation include a short OTM call option strategy. This enables a higher participation rate at the cost of a maximum return at the cap level. Both products feature a predefined minimum repayment amount, payable by the issuer on the redemption date irrespective of the price movement of the underlying asset. The products are also affected by issuer risk. There are ‘bull’ (positive market view on underlying assets) and ‘bear’ (negative market view on underlying assets) versions available. The participation rate is driven by the cost of the embedded option(s) and the interest rate on the zero-coupon bond (including credit spreads).

Capital protected certificates with participation with unlimited upside potential have been labelled under different names for the different asset classes (e.g. protected index participation (PIP) on indices). While most capital protected certificates with participation on equities are available to all market players, those linked to an underlying foreign currency or precious metal are usually only available as customized solutions. The capital protected certificate with participation family is a wide range of products offering investment solutions based on almost all asset classes (equities, interest rates, foreign currency, precious metals, commodities, etc.) and with a variety of participation and payoff schemes. This is why it is important for the wealth management advisor to request the individual product descriptions for information on the specific features of a particular product.

The general payoff of a capital protected certificate with participation is shown by the bold blue line in the following diagram:

Capital protected note – working with the redemption formulae
A four-year bull capital protected certificate with participation is issued on an underlying asset trading at 225. The initial fixing level is 225, its participation rate is 0.80, and its capital protection level is 100%. What is the client's return if, at maturity, the underlying's final fixing level is 360?

The return is the highest of the asset return or 0, multiplied by the participation rate
So, Max [(360 / 225) -1.0] x 0.80 = 0.48 of the amount invested or 48% expressed as a percentage

What is the client’s return if, at maturity, the underlying's final fixing level is 200?

Max [(200 / 225) -1.0] x 0.80 = -0.088 or - 8.8%% but remember:

The return will always be 0% if final fixing <= initial fixing
So, the client's return is 0% and they receive back just their initial investment

Commonly, the payoff is written in terms of total redemption. Assume that the client’s initial investment is represented as 100%. What is the client's redemption amount if, at maturity, the final fixing level is 360?

The redemption is 100% + highest of the asset return or 0, multiplied by the participation rate
So, 100% + Max [(360 / 225) -1.0] x 0.80 = 148%

What is the client's redemption amount if, at maturity, the final fixing level is 200?

100% + Max [(200 / 225) -1.0] x 0.80 = 100%
The redemption will always be 100% if final fixing <= initial fixing

Many structured products contain these types of redemption formulae in their term sheets. Time should be spent on understanding term sheets, since the formulae can be very complex and there is no standard way of expressing the redemption. In fact, some products are so complex that they are too difficult to describe using formulae alone or at all.

Consider this capped capital protected certificate with participation on an equity index. At maturity, the client receives:

85% + [Return of 205 x [(Final index / Initial index) – 1] x 100] (Min return 0% Max return 50%) = Redemption %

Explanation of the redemption formula:
85%: This product offers soft capital protection of 85%. This is the minimum that the investor gets back in any circumstance (always assuming there is no failure of the issuer).
MAX: If the index rises, the investor receives 2.5 x the performance (the participation rate = 250%). If the index falls, the investor receives nothing for the performance element.
MIN: The investor receives the positive performance, or 50%, whichever is smaller – i.e. the performance is capped at 50%.
Overall: 2.5 or 250% is leveraged participation (anything over 100% participation is leverage) which needs to be paid for. Given no favorable change in market conditions, cash from a lower protection level and from the sale of OTM calls can be used to fund this aggressive participation, which is how the above product is typically structured.

A four-year capped capital protected certificate with participation is issued on an underlying trading at 225. The initial fixing level is 225 and the participation rate is 250%. There is a capital protection level of 85% and performance cap level of 50%. What is the investor's redemption amount if, at maturity, the final fixing level is 360?

The index has returned [(360 / 225) - 1] x100 = 60% and 2.5x this performance is 150%
But the performance will be capped at 50%
So the investor receives the capital protection of 85% + performance of 50% = 135%

What is the investor's redemption amount if, at maturity, the final fixing level is 200?

The redemption will always be 85% if final fixing <= initial fixing.
So, the investor receives the capital protection level of 85 + 0% performance = 85%

Barrier Capital Protected Certificates are another example of IncomePlus (protection with participation) products. These provide the possibility of a rebate payment once the barrier is breached plus limited profit potential.

15.4.4 UBS optimization products

Optimization (referred to as yield enhancement in SSPA) products are suitable for clients with a moderate risk tolerance who want to benefit from the sideways price movements of an underlying asset(s). The enhanced return potential compared to a direct investment in the underlying is provided by coupon payments or by a discount on the underlying. The client receives these enhanced returns in exchange for the capping of the upside return potential of the underlying asset. At the same time, the invested capital is at risk for some products with a partial protection. The potential loss is always lower than with a direct investment in the underlying, due to the fixed coupon payments or the discount. There are yield enhancement products that include more than one underlying asset (multi-asset) and/or barrier options. The building blocks of this category are either zero bonds or underlying assets in combination with a short option strategy (put or call).

Yield enhancement products can be further divided as follows:

YieldCoupon: Fixed coupon payment independent of development of underlying asset, capped upside, capital at risk
YieldDiscount: Invest at a discount, capped upside, capital at risk

15.4.5 UBS optimization products: YieldCoupon

Reverse convertibles
Reverse convertibles, e.g. on a stock or equity index (formerly known as GOAL) combine a zero coupon bond with a short put option strategy on the underlying asset. Because of the replication with zero coupon bonds, reverse convertibles are quoted in percentages of the nominal value.

This value normally reflects dirty pricing in the secondary market. The following chart exhibits the payoff of a reverse convertible:

The client receives fixed coupons at the expense of a limited participation in the underlying asset value.

If the underlying asset closes above the strike level of the product at expiration, the client will get back 100% of the nominal in cash. They also receive coupon payments during the lifetime of the product.
If the underlying closes at or below the strike level at expiration, the client will receive delivery of the underlying asset.

The coupon will be paid out in any scenario, except for the bankruptcy of the issuer. Compared to a direct investment in the underlying asset, the key disadvantage for a client is the receipt of a lower amount from the fixed coupon payments. The fixed coupons received by the client are composed of a zero coupon bond discount and the premium from the short put strategy.

The main benefits of reverse convertibles to the client are:

They receive a fixed coupon payment in any scenario.
They may outperform a direct investment in the underlying asset in a sideways market.
They can be traded on the UBS Investor tools platform. This is tailor-made for structured products and therefore offers the client a high degree of flexibility.

Main disadvantages and risks:

The client's return potential is limited to the fixed coupon, which is capped
Redemption is also linked to the negative performance of the underlying: If the underlying price closes at or below the strike level on the expiration date then the client will receive the lower value with no capital protection
The client receives no dividends or income on the underlying (although they do receive fixed coupons as described above)
The client is exposed to the default risk of the issuer.

The higher the strike price compared to the current spot price of the underlying, the higher the risk of the underlying asset is trading at a price below the strike at expiration. For this risk, the client is rewarded with a higher coupon. This is derived from a higher premium from the short put. On the other hand, the lower the strike when compared with the spot price, the higher the client's safety margin. This will result in the client receiving a comparatively lower yield.

Other types of reverse convertible
Instead of using equities as an underlying asset, a reverse convertible can also be structured with currencies or precious metals. These were formerly known as DOCU. They combine a fiduciary deposit, and a short call strategy on the investment (or invested) currency (or precious metal). Note: The fiduciary deposit performs the same function as a zero-coupon bond. The short call on the investment currency is equivalent to a short put, if due to market denomination conventions the currency pair is quoted in terms of the other currency.

The chart below illustrates the payoff of a reverse convertible using this structure:

Depending on the exchange rate at the expiration date of the product, the client receives the capital invested, plus interest in the investment currency, or in the second (or alternative) currency at a predetermined exchange rate: As long as the alternative currency does not depreciate vs. the investment currency beyond the strike at expiration, the client will receive the initially invested amount, including the yield, in the investment currency on the redemption date. If the alternative currency does depreciate vs. the investment currency beyond the strike at expiration then the invested capital, plus yield, will be converted into the alternative currency at the strike level.

The main benefits to the client are as follows:

Potentially higher returns than with a traditional money market investment.
They outperform direct FX investment in sideways markets.
FX and precious metal investments can enhance the client's portfolio diversification.
They can be traded on the UBS Investor tools platform. This is tailor-made for structured products and therefore offers the client a high degree of flexibility.

The main risks to the client are as follows:

The client's return potential is limited to the coupon, which is capped
In the case of a conversion into the alternative currency, further weakening of the alternative currency will result in a loss compared to the initial investment with no capital protection
The client is exposed to the default risk of the issuer

Barrier reverse convertibles
Barrier reverse convertibles (formerly known as kick-in GOALs for equity underlyings and appearing DOCU for FX underlyings) offer conditional capital protection. This is achieved by establishing a kick-in barrier level (exotic option) which at issuance date is fixed at a specific percentage below the current underlying price (e.g. 70% barrier). A barrier reverse convertible combines a zero bond with a short down-and-in put strategy and is therefore quoted as a percentage of the nominal value.

The chart below shows the payoff diagram of a barrier reverse convertible:

Just as with a reverse convertible, the barrier reverse convertible provides fixed coupons which are paid in each scenario of underlying performance. Remember this is provided the issuer does not default. In comparison to a reverse convertible, the coupons are lower but in return the client receives conditional downward protection. Including more assets (multi-assets) and setting the barrier near to the spot price of the underlying makes higher coupon payments feasible. Provided there is no barrier event, the client will be paid back 100% of their invested capital in addition to fixed coupon payments received during the lifetime of the product. If the barrier is hit, the barrier reverse convertible is converted to a reverse convertible. Therefore, the only way to prevent a loss in case of a barrier event is if the underlying asset exceeds the predefined strike level until maturity. A barrier event occurs if the price of the underlying touches or breaches the predefined barrier level during the lifetime of the product or at expiry.

There are three different types of barrier observation:

The level of the underlying is continuously monitored during the lifetime of the product. This is also referred to as an American barrier.
The official closing level of the underlying is monitored at certain times of day during the lifetime of the product. Intraday movements are not taken into account.
Only the final closing level of the underlying on the expiration date is monitored. Movements during the lifetime of the product are not taken into account. This is also referred to as a European barrier.

The main benefits to the client are as follows:

This product provides an attractive investment in flat or slightly rising or falling markets.
The client receives fixed coupon payments in any scenario.
The client receives conditional capital protection. This is up to the barrier level.
They can be traded on the UBS Investor tools platform. This is tailor-made for structured products and therefore offers the client a high degree of flexibility.

The main risks to the client are as follows:

The client's return potential is limited to the coupon, which is capped.
Redemption is linked to the negative performance of the underlying in case of a barrier event with no capital protection
The client does not receive dividends or income on the underlying
The client is exposed to the default risk of the issuer

The higher the client chooses to set the barrier compared to the current price of the underlying, the higher their risk of touching the barrier. For this risk, the client is rewarded with a higher coupon. On the other hand, the lower the client sets the barrier, the higher the client's safety cushion, which in turn will result in a lower coupon being paid to them.

Further YieldCoupon products include:

If the underlying trades above the strike on the observation date, an early redemption consisting of nominal plus an additional coupon amount is paid
This allows the client to obtain credit exposure to a wide variety of underlying entities in order to enhance the return on the fixed income part of the investment portfolio.

15.4.6 UBS optimization products: YieldDiscount

Discount certificates and barrier discount certificates
A discount certificate (formerly known as a BLOC) allows an investor to indirectly invest in an underlying asset at a discount in exchange for a limited or capped participation in the upside potential of the underlying asset. A discount certificate combines a LEPO with a short call strategy on the underlying asset and is quoted in absolute units of a currency.

The following chart illustrates the payoff diagram of a discount certificate:

Discount certificates provide the same payoff profile as reverse convertibles. They provide clients with an alternative to direct investments when markets are trending sideways. Besides replication, the main distinction when compared to reverse convertibles is that reverse convertibles carry fixed coupon payments and aim to maximize income returns, whereas discount certificates allow for a ‘cheaper’ entry (at a discount) into an underlying asset aiming to maximize gains. The discount is composed of the dividend payments which are given up by the client and the premium from writing call options.

The main benefits to the client are as follows:

The client can access the investment at a discount compared to direct investment in the underlying asset.
They provide the client with an attractive return when markets are trending sideways.
They can be traded on the UBS Investor tools platform. This is tailor-made for structured products and therefore offers the client a high degree of flexibility.

The main risks to the client are as follows:

The client's return potential is limited to the coupon, which is capped
Redemption linked to the negative performance of the underlying if the underlying closes at or below the strike level on the expiration date
The client does not receive dividends or income on the underlying
The client is exposed to the default risk of the issuer

It is possible to include barrier options with discount certificates to get the same payoff as barrier reverse convertibles. At UBS, these structured products are called barrier discount certificates.

15.4.7 UBS participation products

Participation products are suitable for clients with a moderate to high risk tolerance who wish to participate in the price development of an individual equity, market or market segment with minimum effort. The client has to have a rather bullish market view, want to participate in the performance of the underlying asset, and accept the loss potential, if a direct investment in the underlying is not feasible or economical. Many clients would like to participate fully in the performance of a diversified portfolio without restriction. It can, however, be very difficult and relatively expensive for private clients to buy individual parts of a broadly diversified asset, such as an index. Participation products are the means for simple and efficient access to a broadly diversified investment. They also enable investors to not only map the performance of the equity indices, but also strategic subjects, such as commodities, alternative investments or dynamic investment strategies.

Participation products can be further divided into the following:

Performance: These capture the performance of an underlying asset on a 1:1 basis for efficient access and/or diversification. Here the client's capital is at risk.
PerformancePlus: Instead of participating on a 1:1 basis on the performance of the underlying asset(s), special features enhance the risk-return profile to achieve an outperformance within a pre-defined range. This offers the client a conditional downside protection. The client's capital is at risk.

Each of these products is described in turn below.

15.4.8 UBS participation products: Performance

Tracker certificates
Tracker certificates (formerly known as PERLES) enable clients to invest simply and flexibly in broadly diversified securities markets, without having to buy individual stocks. They can also facilitate investment in underlying assets that are otherwise hard for the client to access. In a similar way to a direct investment, the client fully participates in the appreciation or depreciation of the underlying asset.

Tracker certificates are often replicated using LEPOs which allow the client to participate in the performance of an index or basket of specific individual stocks or indices. The performance of the underlying asset is tracked on a 1:1 basis. The product-specific risk of loss corresponds to that of a direct investment in the underlying asset. Such structured products are available with, or without, an expiration date (open-end) and are offered for a wide range of underlying assets. They not only allow investors to track the performance of equities, but also replicate the performance of commodity indices, for example the UBS CMCI index, in which direct investments are difficult or impossible. Strategy tracker certificates replicate the performance of a systematic investment strategy developed by UBS, which may be a growth or value strategy, or a combination of the two. The individual underlying assets are selected, weighted and can, if necessary, be switched by UBS at predetermined times according to the client's defined strategy.

15.4.9 UBS participation products: PerformancePlus

Bonus certificates (formerly known as PERLES Plus) products offer an additional safety buffer in comparison to standard tracker certificates. In case of falling prices, the safety buffer can provide a certain degree of protection. They are replicated using a LEPO and a long down-and-out put option. The put option is financed by the forfeiture of dividends in the underlying asset by the client. The bullish version of a bonus certificate is a product for clients who expect the underlying asset to increase in value but at the same time prefer to have conditional protection against small drops in value.

If the barrier is touched at least once during the life of the product, then the protection will cease to apply and the redemption value will be equal to the value of the underlying asset at expiry. This is assuming a continuous barrier observation. If the barrier is not touched during the life of the product, the client will receive a value equivalent to the strike price, set at a bonus level, or higher. In case of a sharp rise in the underlying, the client’s participation will be unlimited.

The following chart illustrates the payoff of a bonus certificate (with strike price and barrier level).

Further PerformancePlus products include:

(formerly known as Leveraged PERLES/Speeder): This type of certificate provides a disproportionate participation (outperformance) in the positive performance of the underlying asset above the strike. It also reflects the underlying asset's price movement on a 1:1 basis when the underlying asset is priced below the strike price. The upside can be capped.
(formerly known as Leveraged PERLES Plus/Speeder Plus): This type of certificate provides a disproportionate participation (outperformance) in positive performance of the underlying asset above the strike. The minimum redemption value is equal to strike, provided the barrier has not been breached. The upside can be capped.

15.4.10 UBS leveraged products

Leveraged products are suitable for clients with a high risk tolerance who are willing to increase their return potential by increasing their exposure to an underlying asset with limited capital expenditures at the cost of higher risk. The maximum loss of leveraged products is limited to the invested amount of capital. If the client has a clear market view and wants to leverage their investment for higher returns, accepting higher-risk leverage products might be suitable. Such products would include call warrants, for example.

Alternatively, the client might want to efficiently hedge their portfolio against price fluctuations with such products, for example, by using put warrants. There are leveraged products with and without knock-out levels. In the case of knock-out levels, clients will immediately lose all their invested money as soon as the barrier is touched. Leveraged products can be further divided into:

These products provide leveraged exposure to the underlying using options. Daily loss of time value and volatility of the underlying asset leads to an increased risk of total loss.
These provide leveraged exposure to the underlying asset by financing only a fraction of its value. Early termination after knock-out, referred to as path dependency, leads to an increased risk of total loss.

15.4.11 UBS leveraged products: Options

Call/put warrants
Leveraged products without knock-out are securitized vanilla options called warrants. By using warrants, the client has a high return potential in relation to the capital invested. This is the leverage effect. However, on the downside, the client must be prepared to accept the risk of losing the full amount of their investment.

Call warrants are used to capitalize on rises in the price of the underlying asset, whereas put warrants can be used not only for speculating on bear markets, but also for specific hedging purposes. The profit made by the client on the put warrant potentially compensates for the loss in value of the underlying asset. If, however, the underlying asset performs as well as expected, then the put warrant loses its value or simply expires worthless. The pricing of warrants and options is affected not only by the performance of the underlying asset, but also by several other influencing factors. These include implied volatility of the underlying asset and the remaining time to maturity of the warrant.

This means that these financial instruments should only be used by experienced clients who fully understand their nature and behavior, and who are comfortable with and able to take on higher risks. It is also important that the investor has the time and opportunity to actively follow market developments during the term of the product.

Knock-out warrants
Products in this category additionally include what is referred to as a ‘knock-out barrier’ or ‘stop-loss limit’. Once the knock-out barrier or ‘top-loss limit is reached, it closes out the product immediately. This makes it impossible to participate in any subsequent counter-movement in the price of the underlying asset. Thus, for example, a knock-out warrant expires immediately without value if the underlying asset is trading at, above or below the knock-out barrier, respectively. On the other hand, such exotic options are cheaper than plain vanilla warrants and are less influenced by changes in implied volatility of the underlying asset.

15.4.12 UBS leveraged products: Forwards

UBS mini futures behave in a similar way upon reaching the knock-out barrier. In this case, an automatic termination order is activated at the next tradable price and any potential residual value is reimbursed to the client. A mini futures long is suitable for capitalizing on an upward trend, whereas a mini futures short increases in value when the price of the underlying asset falls. The pricing of these instruments is less complex than for warrants and is less dependent on option-specific influencing factors such as the implied volatility of the underlying asset and the time to maturity of the futures contract. This is because, in absolute terms, mini futures move on a 1:1 basis with the change in the price of the underlying asset, either in the same or opposite direction.

The leverage effect is achieved by the fact that only a fraction of the price of the underlying asset is paid and, accordingly, the mini futures move faster than their underlying asset in relative terms. An investment in mini futures is suitable for experienced clients who are comfortable taking on higher risks. A disadvantage of mini-futures is that the leverage effect decreases daily, as the underlying moves in the expected direction. Constant leverage products, which in German are referred to as ‘Faktorzertifikate’, can solve this problem since they apply a constant leverage. Mini futures and constant leverage products are unavailable in some countries.

15.5 UBS structured products client advice process

A much clearer understanding of how a product can, or cannot, assist the client is obtained from the product term or fact sheet. Advisors need to fully understand, and be able to explain, key aspects of the term sheet, including the risks, before proceeding. This section will also look at the process for structured product issuance and the secondary market landscape.

15.5.1 UBS primary and secondary market offering and tools

This section describes the UBS offering for structured products and tools in relation to the lifecycle of a product.

The first step in the issuance of most structured products is to set up the product in the relevant systems with indicative terms. After this, the product is available for subscription for a certain period, referred to as the subscription period. During this time, client advisors can subscribe for the product on behalf of their clients. This is referred to as the primary market for the product.

After the allocation and settlement of primary market structured products, they can be traded on the secondary market. Some structured products pay interest during their lifetime, whereas others do not. The redemption details will be fixed two to five days before the redemption date. This is commonly referred to as the fixing date.

The timeline of a UBS structured product is shown in the diagram below:

For the UBS Structured Products (SP) Investor tool suite, the issuance process for products is different, as UBS SP Investor products are created directly by the client advisor in the tool suite. Currently there is the FX Investor, Equity Investor as well as the SP Investor tool suite. SP Investor is the new multi-issuer platform, multi-asset structured product platform, which will fully replace the current FX Investor and EQ Investor standalone and single issuer solution. For UBS SP Investor products, the transformation of indicative terms into an ‘issued’ and allocated product happens within seconds. There is no subscription period as such.

Instead of subscribing to a structured product or obtaining a bespoke product through UBS SP Investor, clients can also buy structured products in the secondary market directly.

15.5.2 UBS primary market products

New issues that are open for subscription are visible in Syros. These can be accessed via ‘Quotes → New Issues’ or via the IPS AS SP intranet. All relevant information is found here, including documents and selling restrictions for the new issues.

After subscription, the client advisor is informed about the successful subscription with a link to the final term sheet. More details can be found in the ‘Syros Factsheet’ and the ‘Syros Manual’.

Besides Syros, UBS SP Investor is a very efficient tool to buy tailor-made structured products.

UBS SP Investor
There are many benefits of UBS SP for both clients and client advisors. It is a web-based application allowing client advisors to price, propose, execute and monitor tailor-made structured products on EQ (single stocks, baskets and indices), foreign exchange (FX) and precious metals (PM) underlying assets. It provides a fully automated F2B solution across the value chain (pre-, at- and post-trade).

It provides multi-issuer capability issuer risk and offers competitive pricing from different issuers as well as balance-sheet optimizing solutions when issuing products from third-party issuers. It provides high flexibility with regards to product parameters, underlying assets, and risk-return profiles with no subscription deadlines.

Decision support is enabled with onscreen functions, such as GRID, payoff diagrams, historical price charts, Chief Investment Office Wealth Management Research (CIO WMR) forecasts, FX Reverse Convertible (DOCU) Top List*, Barrier Reverse Convertible (Kick-In GOAL) List* etc.

It enables full integration into the systematic advisory process with both the portfolio and client suitability being aligned, it provides convenient expiry management with automated roll-over functions, and creates a positive client experience.
*can be subscribed for under goto/cio

15.5.3 Applying the UBS investor offering in a client portfolio

Each of these four steps is explored in greater detail below
1. Screen the client portfolio
2. Leverage the CIO WMR content
3. Identify a bespoke structured product opportunity suitable for the client
4. Price the product, propose the product to the client, execute their instruction to purchase the product and monitor the product.

Screen the client portfolio
The advisor firstly takes a close look at the existing client portfolio to spot potential imbalances or deviations from the ideal portfolio which would be consistent with the client's risk profile and views.

Below is a summary of some of different cases. Note that this is not an exhaustive list, and you may encounter other situations:

Case: Clients with excess cash
1. Generate above money market yields by rolling short-term FX reverse convertibles/discount certificates To avoid negative real returns and loss of purchasing power, FX reverse convertibles/discount certificates can be beneficial for clients who are looking for yield enhancement solutions but prefer to be invested in a cash-like solution with a return target of 2-3% p.a. above money market yields. Clients must be willing to be converted into an alternative currency.
2. Exploit the equity yield potential to generate above money market yields by rolling short-term barrier reverse convertibles
Clients with big cash positions who are willing to take on contingent equity risk can generate above money market yields with barrier reverse convertibles and thereby avoid negative real returns and a loss of purchasing power. Clients should ideally also have a portfolio position which is equity underweighted, with the structured product having the effect of moving them closer to their target asset allocation.

Case: Manage existing equity positions
For stocks where upside to price target plus dividend yield is limited, a switch into a barrier reverse convertible can be considered. Clients will receive a fixed coupon and add a barrier protection. They will achieve an outperformance compared to the direct investment when the coupon is greater than the upside in the movement of the underlying asset plus the dividend yield.

Case: Optimize currency allocation
Use FX yield enhancement strategies (FX reverse convertibles/discount certificates) to diversify into a wider range of currencies in line with the tactical currency allocation recommended by CIO Research. Whatever the outcome is, the client either achieves a yield enhancement, or improves their currency allocation.

Leverage CIO content
UBS CIO WMR is a global network of seasoned economists, strategists, analysts and experts with a profound knowledge of local markets. Advisors need to leverage the CIO house view per market, the tactical and strategic asset allocation as well as the research view on individual asset levels before proposing a suitable structured product. The FX Reverse Convertible Top List* as well as the Equity Barrier Reverse Convertible List* are good instruments to screen for suitable underlying assets.
*can be subscribed for under goto/cio

Case: Manage excess cash with EQ barrier reverse convertibles
Advisors need to check the EQ Barrier Reverse Convertible List for suitable equity underlyings. All underlying equities on the list can be traded in quanto. For example, if a client's reference currency is CHF, you can trade a USD underlying asset in quanto CHF to avoid currency risk.

Identifying a tailor-made structured product opportunity
The next step involves identifying a tailor-made structured product opportunity. Again, we look at this stage in relation to different cases.

Case: Manage excess cash with FX reverse convertible/discount certificate
Propose an alternative currency that the client is prepared to temporarily hold with the sole aim of improving the long-term return on the primary investment currency. For cash management purposes, we recommend short-term FX reverse convertibles (DOCU)/discount certificates (BLOC) with a tenor of around a month and a defensive yield of around 2-3% p.a. above the money market rate to avoid undesirable conversions (solve for strike). At expiry, the trade can be easily rolled over with the roll-over button in UBS SP Investor or on the expiry email notification button in UBS SP Investor.

Case: Manage excess cash with EQ barrier reverse convertibles
Propose stocks that the client is prepared to temporarily hold with the sole aim of improving the long-term return on their cash positions. With barrier reverse convertibles (kick-in GOALs) the client is taking equity risk for which they will be compensated. A coupon of at least 3.5 to 5.0% p.a. above the money market rate is therefore recommended, even for defensive structures. When solving for the barrier, at least a 20% barrier protection is needed to avoid a barrier event. As the client is selling options, shorter tenors of around 6 months that can be easily rolled over at expiry should be recommended.

Price, propose, implement and monitor in UBS SP Investor (goto/spinvestor) UBS SP Investor enables the advisor to calculate and execute tailor-made products with a few simple clicks and provides a lot of flexibility in terms of setting parameters like tenor, yield, strike, barrier etc. There are three brokers on the platform (UBS, Vontobel and Barclays) allowing for price benchmarking and issuer diversification.

Supplementary case study: Barrier reverse convertibles

Footnotes

Why invest in BRC?: Detailed CIO Report can be downloaded under goto /cio: Volatility: Why invest with barrier reverse convertibles? (17 January 2017)
How to select your BRC?: Detailed CIO Report can be downloaded under goto /cio: Volatility: How to select your BRC (6 January 2017)
SP EQ trading opportunities list: Weekly Barrier Reverse Convertible List can be subscribed for under goto/spinvestor

15.5.4 UBS secondary market products

UBS secondary market products are accessible through Workbench or Quotes:

You can use the product finder under the ‘structured products’ section to view structured products by criteria, such as optimizer category, instrument type, underlying, new issues, etc.
Quoted products can be included in virtual portfolios. Limits can be set in these portfolios with automatic notification, which facilitates the tracking of instruments in the market.
Updated term sheets and product descriptions are available.

For the secondary market trading of listed products at SIX Swiss Exchange, ensure that the prices in UBS Quotes are reasonable and check volumes, bid/ask spreads and sources (lead manager or investors). Always place orders with a price limit when listed at SIX. The limit determines the maximum price for buy orders and the minimum price for sell orders. For large tickets of CHF1m or more, it may be advisable to contact IPS Sales or the specific structured products contact.

For SP Investor trades, daily market valuations are posted to Quotes/client accounts.

15.6 UBS client promise framework

The UBS client promise (‘Together we help protect and grow your wealth over generations’), incorporates the UBS investment process as follows:

Understand
Propose
Implement
Monitor

This section, looks at how structured products are employed for clients within the investment process, to meet the UBS client promise.

Throughout this process, client advisors are supported by Cornerstone, a unique technology at UBS providing clients with customized investment ideas linked to investment preferences and needs. Structured Products ideas are sent daily through the engine that will optimize client portfolios and that are in line with the latest market insights and opinions from UBS Research and the capital market experts.

15.6.1 Understanding client needs and investor typology related to structured products

Client needs and structured products
The client must understand the characteristics of structured products and their risks. As structured products are continuously developed, features may be added or removed. Therefore, it is important to look up the instrument in question using the product's term sheet and to make sure that the client is aware of any such changes.

Client suitability and risk disclosures are important, as is viewing the structured product within a portfolio context. A client who is unfamiliar with structured products might be disappointed with secondary market behavior, or the movement of the value of a structured product due to certain events/cases. They may then hold a negative view of structured products.

The investor profile supports the client advisor in leading a structured discussion with the client and gathering information on their knowledge and experience with different asset classes and products. This allows the client advisor to offer the right level of explanation and information for advice and investment proposals.

With regard to structured products, the following information is important:

Investor needs: Before investing in structured products, investors should have a clear idea of their personal investment goals and individual risk tolerance (see respective sections of the investor profile). They should also have a definite view in advance concerning the market for the underlying asset. The implicit market view of a structured product must conform to the client’s market view.

No entitlement/rights to dividends: Investors should be aware that any dividend payments are already factored into structured products tied to equities, so there is (generally) no dividend entitlement.

Individual risk profile: Every structured product has its own risk profile. The risks associated with the individual underlying assets are either reduced or increased. Depending on the product, the investor can benefit from rising, flat or falling prices of the underlying assets.

Issuer risk/concentration risk/bulk risk: Concentration risk (or bulk risk) arises if one/only a few financial instruments make up a significant part of the total portfolio. When buying a structured product, it is therefore important to consider the overall portfolio structure with regards to issuer concentration and underlying asset concentration, and make sure that any investment results in a sufficiently diversified portfolio.

Relationship with the investor profile
Whilst the optimizer concept can be aligned with the investor profile, it cannot be translated 1:1. The investor profile describes the average risk profile, therefore a different risk profile can still be used for a proportion of strategic asset allocation or a tactical investment. For example:

A moderate risk tolerance can still accommodate a limited investment in a performance structured product
An aggressive risk tolerance does not exclude the use of lower-risk structured products – either as tactical investments or because the client’s view on markets merits respective adjustments
An income investor with a low risk tolerance may use a leverage structured product to hedge interest rate risk

The UBS advisory approach
The UBS advisory approach links up the knowledge of professional investment specialists and client advisors in a systematic value chain.

With respect to structured products, the following aspects are relevant in the individual phases:

Client profiling: In this phase, the client advisor must find out the client’s reasons for investing in structured products. In addition to establishing the client’s risk tolerance and market view, the client advisor must select the suitable category of structured products, as well as the adequate asset class of the underlying assets.
Investment solutions: In this phase, the client advisor recommends an appropriate structured product to the client. It is important to make sure that the client understands the characteristics, risks and return potential of the recommended structured product. The client must decide which structured product they want to buy to implement a certain investment strategy.
Portfolio management: The client advisor monitors and tracks the performance of the structured product during its lifetime. During the client review meeting, the client advisor must find out whether the structured product is still suitable for the client.

Understanding product fact sheets
As stated above, it is imperative that clients understand what they are buying. They should be made aware of both the benefits and risks of the structured product. The nature of particular products can only be fully understood from their fact or term sheets.

At UBS, the fact sheet is filtered into clearly defined product features to describe the product in detail (clustered in six groups).

Consider these term sheet extracts of a capped outperformance (‘Speeder’) certificate (ISIN: CH0306270841):

Here the client can buy a minimum of one certificate (unit) for a cost of CHF1,000 (100% initial investment), which is equivalent to buying: 1,000 / 73.75 = 13.5593 shares at the strike level in terms of performance.

The client receives 150% of the positive returns of Nestlé (capped to a rise in Nestlé of 13%), or 100% of the negative returns (plus a 6% coupon rebate) should Nestlé fall from the initial reference price of 73.75.

The performance period (to measure returns) begins on December 10 2015 with a reference price of 73.75, and ends on June 12 2017 at 5.15pm CET. Settlement does not occur on these dates. The client must physically pay for the product by Dec 17 2015, and they receive their redemption on June 19 2017.

According to the redemption formulae, three outcomes are possible for Nestle on June 12 2017:

This product is being issued by UBS, who are:

Arranging the issue itself (as lead manager)
Calculating the performance and redemption (as calculation agent)
Handling the settlement/issuance and redemption proceeds directly (as paying agent)

The product will not be listed on an exchange, but UBS will make a secondary market in the product under normal conditions. The investor will pay a fee for investment of 0.17 p.a., but this has already been included in the issue price of 100%. As a general rule, fees at UBS are disclosed on a p.a. basis for tenors >1 year, and on an absolute basis for tenors < 1 year.

Here, investors are exposed to the risk of UBS failing (issuer risk), and the product does not offer specific investor protection under Swiss law.

This product is only suitable for investors who have a view that Nestlé rises by no more than 13% over the product life, or that the stock falls no more than 6%. The product offers 6% coupon if Nestlé falls, so this is equivalent to a soft amount of capital protection – though this is not explicitly described as such.

Only clients who understand derivatives should invest in this product, and the investment needs to be suitable for their own particular circumstances.

In theory, the client could lose their entire investment and there is no stop-loss – as would be the case where a product could redeem – should it fall a certain price distance.

UBS has no right to buy the product back from the investor (no call risk). However, they could redeem it in ‘extraordinary circumstances’ for its secondary market value, which may be below the value calculated by the scenario redemption formulae (since redemption formulae will only ever apply at expiry/maturity).

This shows that the product is subject to adjustment risk. If, for example, Nestlé was subject to a takeover, the product terms may have to be amended, which could negatively affect the product price.

Though UBS will try to make a secondary market price, they are under no obligation to do so. Even if UBS make a price, the client may suffer unexpected costs of liquidation in certain circumstances.

The client should not rely on being able to sell/redeem the product before expiry.

Once again, clients are exposed to the risk of UBS failing (issuer risk), and can assess this risk with the help of public ratings from S&P, Moody’s and Fitch.

In the event of issuer insolvency, how much the client could recover will depend on the ranking of the investment on the issuer’s balance sheet. This product is unsecured and has no specific claim against any one UBS asset, but is unsubordinated. In other words, it is senior to, and therefore ranks above, subordinated debt issued by the same issuer.

This product, like most structured products, is subject to complex selling restrictions and may not be marketed to all clients. A common example of this is where the client is based in the United States, or is a United States person, as seen in the following warning: “This product may not be sold or offered within the United States or to U.S. persons”.

15.6.2 Proposing tailored and suitable derivatives solutions to the client

Any proposed structured product needs to be suitable and contain risk disclosures. If a client is not familiar with the product, they might be surprised about secondary market behavior or overall performance. This puts the advisor at risk; either in terms of their reputation or legally (or both). Advisors will need to adhere to the relevant regulatory suitability rules.

The example below follows FINRA’s approach.

Reasonable basis suitability

Does the advisor have enough information about the product to assume that it is a reasonable investment choice for some clients?
The advisor needs to perform reasonable due diligence and ensure that they entirely understand the complexity, risks and selling restrictions of the product before proceeding.

Customer-specific suitability

Has the advisor obtained enough information about the client to ensure that the product is suitable to them – i.e. do they have a reasonable basis for a recommendation to that client in particular?
The advisor needs to use reasonable diligence to obtain as much relevant information as the client is willing to supply.
This will include the client’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information in connection with such a recommendation.

Is the product suitable, given the supplied information? The advisor cannot simply make assumptions about information not supplied, since those assumptions may be wrong.
Quantification suitability

This requires the advisor who has control over the client's account to ensure that they have a reasonable basis for a set of transactions which, even if suitable in isolation, are not excessive and unsuitable for the client when viewed together.
Excessive activity can be assessed in relation to matters such as turnover rates, cost-to-equity ratios and in-and-out trading This is also referred to as ‘churning’ and, in contravention to regulations, involves trading with an undue level of frequency, not merited by the client's objectives, to generate advisor/broker commissions

The table below summarizes the characteristics of three different clients and suggests products that may be of interest to them.

Suitability example

Implementing tailored derivatives solutions involves the following three steps:

Step 1
- Documentation
- Pricing transparency
- Client suitability

Step 2
- Order management
- Trade execution
- Confirmation, clearing and settlement

Step 3
- Margin and collateral requirements
- MTM and valuation
- Secondary market liquidity

Finally, the client advisor needs to monitor that the structured product performs in line with expectations and in such a way that the client's objectives are being met.

For support, questions, errors and omissions please raise a ticket at: https://wmc-fitchlearning.zendesk.com/hc/en-us

Text copyright Fitch Learning 2018, UBS 2018

Version 1.8.1.2018.09.20.Narrow

Wealth Management Certification INVEST – Instruments: Structured Products

Introduction

Learning outcomes

15.1 Introduction to structured products

15.1.1 Benefits of structured products

15.1.2 Risks of structured products

15.1.3 Components of structured products

15.2 Categorization of structured products

15.2.1 Capital (or principal protection)

15.2.2 Yield enhancement

15.2.3 Participation

15.2.4 Leverage

15.3 Influencing factors and secondary market

15.3.1 Secondary market effects: Influencing the trading price of the product

15.3.2 Primary market effects: Setting the initial participation rate

15.3.3 Secondary market effects on other components

15.4 The UBS structured product shelf

15.4.1 UBS capital protection products

15.4.2 UBS capital protection products: Income (protection with coupon)

15.4.3 UBS capital protection products: IncomePlus (protection with participation)

Capital protected certificates with participation

15.4.4 UBS optimization products

15.4.5 UBS optimization products: YieldCoupon

15.4.6 UBS optimization products: YieldDiscount

15.4.7 UBS participation products

15.4.8 UBS participation products: Performance

15.4.9 UBS participation products: PerformancePlus

15.4.10 UBS leveraged products

15.4.11 UBS leveraged products: Options

15.4.12 UBS leveraged products: Forwards

15.5 UBS structured products client advice process

15.5.1 UBS primary and secondary market offering and tools

15.5.2 UBS primary market products

15.5.3 Applying the UBS investor offering in a client portfolio

15.5.4 UBS secondary market products

15.6 UBS client promise framework

15.6.1 Understanding client needs and investor typology related to structured products

15.6.2 Proposing tailored and suitable derivatives solutions to the client

Wealth Management Certification
INVEST – Instruments: Structured Products