CopyrightC2006 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England. To properly frame the material, we also provide an outline of the structure of the following chapters.
DEVELOPMENT OF STRUCTURED AND SYNTHETIC ASSETS
It is of course worth noting that the synthetic and structured assets resulting from the financial construction process do not have the same degree of market liquidity as the underlying assets. However, the ability of intermediaries to use financial techniques to create entirely new contracts has helped the market develop successfully.
DRIVERS OF MARKET ACTIVITY
An institution may require a very specific asset or liability profile to meet risk, funding or investment mandates. An institution that is trying to build a balanced portfolio of risk exposures may find that it can do so more effectively by using tools that can pool and diversify risks through a single transaction.
NEW PRODUCT DESIGN
In fact, regulatory issues have had, and are likely to continue to have, a significant impact on new product design and aftermarket activities. After a certain level of experience is gained, changes can be made to the basic structure to solve problems, reduce costs, or improve efficiency.
OVERVIEW OF THE TEXT
Much of what we wrote above applies to the product development process in any current or immediate period. With this background, we are now ready to begin the discussion of synthetic and structured assets by examining the basic tools used to create unique contracts.
INTRODUCTION
CONCEPTS
Risks
Market risk is the risk of loss due to adverse movements of markets or market references. Operational risk is the risk of losses due to the failure of operational procedures, technologies or processes.
Time value of money and interest rates
Some firms try to eliminate or minimize certain types of risk in order to stabilize the cash flows affecting their businesses. The higher the discount rate, the higher the discounted cash flows and the lower the resulting PVs.
DERIVATIVE INSTRUMENTS
Derivatives
Market price < Forward price, loss to forward buyer, gain to forward seller. If the cost of funding increases, the forward price must also increase.
HOST SECURITIES/LIABILITIES
Public notes/shelf registrations
Long futures call Buyer acquires futures contract at strike price Long futures put Buyer sells futures contract at strike price. Short futures calls The seller is obligated to sell the futures contract at the strike price. The short futures put seller is obligated to acquire futures contracts at the strike price.
Private placements
The limited disclosure and lack of registration means that private placements can only be distributed to a small number of sophisticated institutional investors (qualified institutional buyers, or QIBs). Most private placements are designed as "hold to maturity" transactions, with no possibility to sell the securities on a secondary basis.
Transferable loans
Issuers choosing to raise capital through a private placement are usually required to file an information memorandum with investors, detailing the financial condition and terms of the transaction; however, this information is less detailed than required for a standard public transaction.
ISSUING/REPACKAGING VEHICLES
Special purpose entities
Multi-purpose entities, which have become standard in the market in recent years, can be created as program issuers or multiple issuers. 20 Corporate scandals, such as those involving Enron, demonstrated how SPEs can be used to mislead investors and regulators about relationships between and within companies.
Trusts
The rights between the trustee (as the legal owner) and the investors (as the beneficial owners) are communicated through the trust deed. The terms of the trust itself are agreed between the settlor and the trustee; investors have no input, although the terms must be in their favor or else they will have no incentive to participate.
Investment companies and partnerships
We distinguish, at common law, between legal ownership (a party who holds title to certain assets and is recognized as the owner) and beneficial ownership (a party who does not hold title but obtains the benefits associated with legal ownership ); thus, at common law, a party may legally own property for "possession purposes". Placing a trustee between the issuer and investors eliminates problems associated with perfecting security interests, since interests then do not have to be renegotiated with each secondary sale; the trustee effectively negotiates rights for the benefit of any future investors.21 The trustee also works in close partnership with other service providers, which may include a listing agent, service provider, administrator, paying agent and/or custodial agent22 (in some cases, the trustee also acts as the conservation agent).
FINANCIAL ENGINEERING AND PRODUCT DESIGN
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
The program has proved very successful and OAT strips now constitute the single largest government program in the Eurozone. Some governments have chosen to place limits on the types of instruments that are eligible for removal in order to focus activity on a relatively narrow set of securities—which helps build critical mass.
PRODUCT MECHANICS AND APPLICATIONS
Callable bonds
Once the notional value of the option is determined, the equation can be reversed to see if the non-convertible bond price is accurate (eg if the bond is risky, a spread must be introduced to compensate for the risky nature of the cash flows.
Puttable bonds
The option to deposit money at the guaranteed interest rate will therefore be exercised when the market interest rate falls below the guaranteed (i.e. exercise) interest rate; this is exactly the same as a call option on an interest-bearing note. Conversely, the option to withdraw will be exercised when interest rates rise above the guaranteed (strike) rate, leaving the investor with a put.
Stripped securities
To increase the liquidity of the strip product, most advanced national systems allow the use of strips in the repurchase/reverse repurchase agreement markets. For example, if the redemption yield is set at 5%, the number of days from the settlement date to the next coupon date is 180, the number of days in the coupon period in which the settlement date falls is 360, and the number of days in the coupon period in which the settlement date falls is 360. remaining coupon periods (after the current period) are five, the fair price of the strip is: 87.30 (i.e.
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
The recovery of the US commercial real estate market during the mid-1990s led to even greater primary and secondary activity. These advances have led to interest and growth in the ABS market, which is largely based on shorter-term assets.
PRODUCT MECHANICS AND APPLICATIONS
Mortgage-backed securities
Negative convexity arises as a result of the prepayment option that the MBS investor gives to the mortgage borrower. The Scheduled Amortization Class (PAC) bond and its companion (or backer) bond are the primary instruments of the CMO market.
Asset-backed securities
Repayment patterns, embedded in the MPR, are a critical component of the analysis process. The service provider's purchases are in turn affected by the start of the accumulation period (ie the end of the revolving balance period) and the trust's termination date.
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
Strong bull markets in the US, Europe and Japan during the latter part of the 1980s/early 1990s generated significant issuance. MITTS, a popular retail investment vehicle, is structured as five-year bonds where the principal protection pays 100% of the increase in value in the target market.
PRODUCT MECHANICS AND APPLICATIONS
- General structural issues
- Interest-rate-linked notes
- Currency-linked notes
- Commodity-linked notes and loans
- Equity-linked notes
- Credit-linked notes
Investors receive the positive or negative side of the commodity if it moves in the money. As with the TRS-based note above, leverage can be added by increasing the face value of the structure;.
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
After the loans and bonds were successfully securitized, intermediaries began to repackage structured financial assets using the same technologies; although the first deal hit the market in 1995, significant growth didn't really begin until the turn of the millennium. Indeed, as financial institutions have become adept at using credit derivatives to manage their exposure levels, some of the initial risk/capital motivations have begun to wane.
PRODUCT MECHANICS AND APPLICATIONS
- General structural issues
- Cash flow CDOs and market value CDOs
- Balance sheet and arbitrage CDOs
- Structured and synthetic CDOs
Each asset in the pool has a forward rate that is linked to a target rating based on the structure of the deal and the composition of the portfolio. The economics of an arbitrage CDO are ultimately driven by the returns paid on the equity tranche.
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
One of the most attractive factors in the development of ILS and contingent capital structures has been the ability for institutions to link the insurance and capital markets – allowing the insurance sector to tap into the vast supply of capital held by investors. Not surprisingly, most ILS and contingent capital issuers are insurers and reinsurers looking for alternative instruments to manage their risk portfolios.
PRODUCT MECHANICS AND APPLICATIONS
Insurance-linked securities
Under the terms of the bond, which has a maturity date of two years (and a further loss development period of one year, during which additional claims can be made for any damage), the installments will pay reduced principal based on the Property Claims Service (PCS) index. This provides protection against future residual value at the end of the lease term.
Contingent capital structures
If the insurer violates a predetermined loss trigger (eg the option moves in the money), it issues CSNs to the trust. We consider two different forms of contingent equity – the loss equity put and put protected equity.
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
3Unfortunately, the subsequent bursting of the economic bubble in the early 1990s caused stock prices to fall and warrants to expire unexercised. Although the earliest versions of the buy/write tool appeared in real activity, it did not take off until the late 1980s.
PRODUCT MECHANICS AND APPLICATIONS
- Convertible bonds and variations
- Bonds with warrants
- Buy/write (covered call) securities
- Other equity hybrids
For example, if the issuer's common stock is trading at $17 and the conversion ratio is 50, then the conversion value of the convertible bond is $850. Soft call protection, on the other hand, protects the investor until the price of the issuer's common stock reaches a certain percentage of the conversion price (eg
INTRODUCTION
DEVELOPMENT AND MARKET DRIVERS
While closed-end funds benefit from some of the same factors as open-end funds (diversification, efficiency, for example), growth in the industry is more measured – largely because they are more rigidly structured, as we'll discuss below. Hedge funds are a more recent creation, developed in the 1940s and 1950s,3 but only really gained popularity in the 1970s (when over 150 funds were established).
PRODUCT MECHANICS AND APPLICATIONS
Structure, diversification, and management
Highly leveraged hedge funds exist at the other end of the spectrum and are suitable for investors with a high level of risk tolerance and a desire to maximize potential returns. In between are a range of open-end and closed-end funds and ETFs that cater to various other risk-return trade-offs.
