Myth #7: Investors cannot make sense of a structured product's valuation
Myth: We sometimes come across structured notes that are valued below 100%, even if the underlying asset is performing well. Either the issuer is not being fair on the product’s valuation or it really is impossible to make sense of a note’s price in the secondary market.
Reality: Issuers need to abide by certain rules when providing prices on notes they have manufactured. It is often the case that issuers will provide two-way quotes on products in the secondary market, showing both bid and ask with a maximum spread, typically of 1%.
This means that they cannot show bids that are significantly below fair value, given the risk they will be forced to sell on the ask, at a loss. Additionally, there are sets of both internal and external regulation that banks nowadays need to respect when it comes to making money in the secondary market of notes.
Finally, there is no scarcity of competition in the structured products arena. If an issuer was to consistently undervalue its products in the secondary market, it would surely lose market share. There is a clear economic incentive to keep investors happy.
This means that, most often than not, when an investor does not understand the valuation of a product in his portfolio it is a matter of understanding, rather than being taken advantage of by the issuer.
In an effort to aid investors facing unexpected valuations for their products, we have listed the main drivers of price performance of structured notes in the secondary market.
Delta = Sensitivity of a product to changes in the value of the underlying asset
This is the most important and also most obvious driver. It explains how the value of my product should change for a given movement in the price of the underlying.
Let’s refer to our autocall on Apple. At issuance, the note had a delta of 0.45. This means that as Apple rises by 1%, the value of my product should increase by 0.45%.
The same applies on the way down: a 1% downside of the share should shave 0.45% of the bid of the autocall. It is important to note that the delta (as well as all other drivers we will look at) is not static.
It will change according to other metrics such as the passage of time and the distance of Apple to its initial level (strike). The movement of delta itself as Apple’ s price changes has its own name: gamma.
Vega = Sensitivity of a product to changes in implied volatility of the underlying asset
This is the second most important driver and one that is often overlooked or misunderstood. Our autocall on Apple at issuance had a vega of -0.5.
The minus sign denotes that the product is vega negative. In other words, its value moves in opposite direction to movements in implied volatility.
Our autocall will appreciate by 0.5% for each 1% decrease in Apple’s implied volatility and vice versa. As with delta, the vega is not static and will move up and down according to other parameters.
The differentiation between implied and realized volatility here is important. Implied volatility is the volatility derived from the underlying’s listed options. All else constant, the higher the premium of an option, the higher the volatility said asset is expected to have in the future. This is different from the realized volatility, which is the actual standard deviation of price movements for the underlying observed in the recent past. While realized volatility is often a good proxy for the realized parameter, at times wide gaps can exist between both measures.
When it comes to our autocall on Apple, it is Apple’s implied volatility we need to look at. Looking at the VIX (implied volatility of the wider S&P 500) might be a good indication, but at times it will do a poor job, as Apple might be performing nicely while the broader market might be struggling.
Another misconception one usually encounters is that a single daily drawdown of an underlying will translate in a pick-up in implied volatility. While this is most often than not true, consider Apple releasing its very anticipated quarterly figures. The numbers might disappoint the market, generating a daily -5% drop (which is very significant for a stock like Apple). Still, even in the face of this drawdown, we might see a lower implied volatility, as the imminent uncertainty around the quarterly results is over.
Products can be vega positive or negative, depending on their payoffs. Autocalls, like our Apple note, will typically be vega negative, meaning drops in implied volatility are good for the product’s value. That’s because the holder of the autocall has sold volatility to the product’s issuer (due to the short put at maturity). Most participation notes, on the other side, are vega positive, as the investor has bought volatility (long call at maturity). In these cases, an increase in volatility will raise the product’s value.
Rho = Sensitivity of a product to changes in interest rates
This is an interesting one. While rho will typically be a marginal driver in options pricing (unless we are facing huge interest rates shifts), changes in interest rates do have a considerable impact on structured products. That’s because they also impact the fixed income component of the note.
The sensitivity of the fixed income part of a note (often referred to as the zero coupon bond) to movements in interest rates is called duration, like with any other regular bond.
Our autocall on Apple had an initial duration of -0.4. This means that a 1% increase in interest rates would equate to a 0.4% drop in the value of our autocall. Naturally, duration risk becomes more important with longer dated notes.
A 5-years capital protected note will have an initial duration of -5. Hence, a 20 basis points shift in interest rates would mean a full 1% movement in the valuation of the investment.
There are additional sensitivities that impact the value of a structured product, but the ones explained above are the most important ones.
By understanding these, one will feel comfortable in reconciling prices of his notes. But how do I know what my current delta, vega and rho are?
Quite simply: ask Privatam.
To test our understanding, let us once more look at our Apple autocall. The product was issued at 100% and, right after issuance, we witnessed the following market movements:
+ Apple going up by 2%
+ Apple’s implied volatility going down by 1%
+ Interest rates going down by 0.2%
+ Approximately, our autocall should hence be worth:
100% + 0.45 x 2 – 0.5 x (-1) – 0.4 x (-0.2) = 100% + 0.9% + 0.5% + 0.08% = 101.48%
This brief guide is not meant as a definitive valuation toolkit. Rather, it is aimed at helping investors make sense of price swings in their investment.