target accrual redemption forwards
TRANSCRIPT
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: [email protected]
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� Characteristics of the TARFs
� Analytics of the TARFs
� Case study: Citic Pacific 2008
Outline
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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
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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
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An ideal financal product
� Investor
� Large upside potential
� Small downside loss
� No initial cash outflow
� Issuer
� Large commission income
� Low hedging cost
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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
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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
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Bull TARF
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Multiple fixing
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Bonus target
Bonus target
Cash inflows from
call options
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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
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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
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Zero-value TARF
Loss probability
Lo
ss amo
unt
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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
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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
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Bull and bear TARFs
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Dual-strike and survival gap TARFs
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Pivot TARFs
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� Characteristics of the TARFs
� Analytics of the TARFs
� Case study: Citic Pacific 2008
Outline
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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
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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
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Valuation with
Monte Carlo simulation
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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)
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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%)
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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
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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
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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
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Scenario values (2)
Currency volatility Spot 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
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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
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Other risks and analytics
� Operational risk
� Liquidity risk
� Legal risk
� Derivative accounting
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� Characteristics of the TARFs
� Analytics of the TARFs
� Case study: Citic Pacific 2008
Outline
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2008 AUD losses controversy
� Prospective expenditure AUD 1.6 bn
� TARFs AUD 9 bn
� Loss USD 2 bn
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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
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Suitability assessmentSuitability
assessment
Investor profiling Product assessment
Product risk level
Product features
Risk tolerance level
Know your client