Target accrual redemption forwards

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<ol><li> 1. Copyright 2015 CapitaLogic Limited Target Accrual Redemption Forwards Date Tuesday 7 July 2015 Time 6:30 pm to 7:15 pm By Dr. LAM Yat-fai, Doctor of Business Administration (Finance) CFA, CAIA, FRM, PRM E-mail address: faiylam@caplogic.com </li><li> 2. Copyright 2013 CapitaLogic Limited 2 </li><li> 3. Copyright 2013 CapitaLogic Limited 3 Characteristics of the TARFs Analytics of the TARFs Case study: Citic Pacific 2008 Outline </li><li> 4. Copyright 2013 CapitaLogic Limited 4 Simple financial products Spot Linear derivatives Forwards and futures Vanilla options European and American, call and put Trading strategies Bull spread, bear spread, butterfly, straddle </li><li> 5. Copyright 2013 CapitaLogic Limited 5 Complex financial products First generation exotic options Binary, one-touch, no-touch, barrier options Second generation exotic options Corridors, faders, step-up, step-down options Fixed income with embedded options Currency linked deposits Principal protected notes Multiple fixings Accumulator, decumulator, TARF </li><li> 6. Copyright 2013 CapitaLogic Limited 6 An ideal financal product Investor Large upside potential Small downside loss No initial cash outflow Issuer Large commission income Low hedging cost </li><li> 7. Copyright 2013 CapitaLogic Limited 7 Functional purposes Investor To hedge a currency exposure at a lower initial cost To speculate in the direction of a currency rate with a lower upfront cash outflow Issuer To earn a high profit at origination To exit the position in a sure loss situation </li><li> 8. Copyright 2013 CapitaLogic Limited 8 Structuring A series of call options with payoff function Max[Current rate - Strike rate, 0] Call notional principal A series of put options with payoff function Max[Strike rate - Current rate, 0] Put notional principal An early termination feature </li><li> 9. Copyright 2013 CapitaLogic Limited 9 Bull TARF </li><li> 10. Copyright 2013 CapitaLogic Limited 10 Multiple fixing </li><li> 11. Copyright 2013 CapitaLogic Limited 11 Bonus target Bonus target Cash inflows from call options </li><li> 12. Copyright 2013 CapitaLogic Limited 12 TARF specification Full paymentTreatment to termination bonus10. USD 136,000Bonus target9. MonthlyFixing frequency8. 19 December 2014Maturity date7. USD 1.3500 per EURStrike rate6. Domestic currencySettlement approach5. EUR 2,000,000Put notional principal4. EUR 1,000,000Call notional principal3. EURForeign currency2. USDDomestic currency1. ValueParameter </li><li> 13. Copyright 2013 CapitaLogic Limited 13 Zero value TARF A TARF with zero value at origination is most welcome No cash outflow from acquirer No cash outflow from issuer Long in-the-money (ITM) option Moderate cost x 1 Short out-of-the-money (OTM) option Small revenue x N </li><li> 14. Copyright 2013 CapitaLogic Limited 14 Zero-value TARF Loss probability Lossamount </li><li> 15. Copyright 2013 CapitaLogic Limited 15 Revenue model Investment bank Synthesize a TARF with vanilla call and put options Mark up a profit Sell to a commercial bank Commercial bank Acquire a TARF from investment bank Mark up a profit Sell to an investor </li><li> 16. Copyright 2013 CapitaLogic Limited 16 Sales and marketing The attractive product features of a TARF The professional sales team which performs the marketing The price of a TARF The post sales customer services </li><li> 17. Copyright 2013 CapitaLogic Limited 17 Bull and bear TARFs </li><li> 18. Copyright 2013 CapitaLogic Limited 18 Dual-strike and survival gap TARFs </li><li> 19. Copyright 2013 CapitaLogic Limited 19 Pivot TARFs </li><li> 20. Copyright 2013 CapitaLogic Limited 20 Characteristics of the TARFs Analytics of the TARFs Case study: Citic Pacific 2008 Outline </li><li> 21. Copyright 2013 CapitaLogic Limited 21 Valuation TARFs are custom-made instruments have no liquid secondary market have no market price Price of a TARF Value of a TARF Value of a TARF The raw material cost for synthesizing a TARF in the currency market with the underlying currency, forwards and/or options Price of a TARF Value of a TARF + Mark up profit </li><li> 22. Copyright 2013 CapitaLogic Limited 22 Major valuation factors - (for the common construction where the put notional principal is substantially larger than the call notional principal) Volatility +Spot currency rate -Aggregated bonus +Bonus target -Strike rate -Put notional principal +Call notional principal Bull TARF </li><li> 23. Copyright 2013 CapitaLogic Limited 23 Valuation with Monte Carlo simulation </li><li> 24. Copyright 2013 CapitaLogic Limited 24 Theoretical value The raw material cost of synthesize a TARF with vanilla call and put options under certain model assumptions TV = Average(Simulated TARF values) </li><li> 25. Copyright 2013 CapitaLogic Limited 25 Market risk of investor Capped upside potential Unbound downside loss Present value-at-risk (PVaR) PVaR = Average(Simulated TARF values) - Percentile(Simulated TARF values, 1%) </li><li> 26. Copyright 2013 CapitaLogic Limited 26 Credit risk of issuer The risk that an investor fails to pay the issuer on a payment day when the investor is subject to a loss Margin as a credit risk control What is the margin amount on portfolio basis? Too small, insufficient protection Too large, losing customer A very difficult topic </li><li> 27. Copyright 2013 CapitaLogic Limited 27 Standardized portfolio analysis of risk Standardized portfolio analysis of risk (SPAN) Used by many derivatives exchanges All TARFs with the same foreign currency grouped into one sub- portfolio A worst scenario approach A = The maximum potential change of the rate of the underlying currency between two margin calculation days B = The maximum potential change of the volatility of the underlying currency between two margin calculation days </li><li> 28. Copyright 2013 CapitaLogic Limited 28 Scenario values (1) Currency volatility - BSpot rate + 2A/38. Currency volatility + BSpot rate + 2A/37. Currency volatility - BSpot rate - A/36. Currency volatility + BSpot rate - A/35. Currency volatility - BSpot rate + A/34. Currency volatility + BSpot rate + A/33. Currency volatility - BSpot rate2. Currency volatility + BSpot rate1. VolatilityCurrency rate </li><li> 29. Copyright 2013 CapitaLogic Limited 29 Scenario values (2) Currency volatilitySpot rate - 3A16. Currency volatilitySpot rate + 3A15. Currency volatility - BSpot rate - A14. Currency volatility + BSpot rate + A13. Currency volatility - BSpot rate + A12. Currency volatility + BSpot rate + A11. Currency volatility - BSpot rate - 2A/310. Currency volatility + BSpot rate - 2A/39. VolatilityCurrency rate </li><li> 30. Copyright 2013 CapitaLogic Limited 30 Maximum scenario loss Scenario loss = Scenario value origination value Margin = Maximum of Scenario losses for scenario 1 to 14; and 32% of scenario losses for scenarios 15 and 16 </li><li> 31. Copyright 2013 CapitaLogic Limited 31 Other risks and analytics Operational risk Liquidity risk Legal risk Derivative accounting </li><li> 32. Copyright 2013 CapitaLogic Limited 32 Characteristics of the TARFs Analytics of the TARFs Case study: Citic Pacific 2008 Outline </li><li> 33. Copyright 2013 CapitaLogic Limited 33 2008 AUD losses controversy Prospective expenditure AUD 1.6 bn TARFs AUD 9 bn Loss USD 2 bn </li><li> 34. Copyright 2013 CapitaLogic Limited 34 2008 AUD losses controversy Share price dropped 55% to HKD 6.52 from HKD14.52 SFC sought compensation up to 4,500 investors Chairman Mr. Larry YUNG stepped down General manager Mr. Henry FAN stepped down </li><li> 35. Copyright 2013 CapitaLogic Limited 35 </li><li> 36. Copyright 2013 CapitaLogic Limited 36 </li><li> 37. Copyright 2013 CapitaLogic Limited 37 Suitability assessment Suitability assessment Investor profiling Product assessment Product risk level Product features Risk tolerance level Know your client </li></ol>