Guide to Valuation of Structured Products

If you are an investor and want to make an investment in structured products then you must read through this because we have covered every aspect of the Structured Products and their valuation to provide a better understanding to you. So, let’s understand this. 

Introduction to Structured Products 

Initially, structured products originated in Europe and later in parts of the US. The main idea behind introducing these structured products was to help the companies who are in need of cheaper debts. Structured Products are that type of investment tool that includes automated packages based on derivates. It is a kind of market-linked investment that includes different types of investment tools such as bonds, debt issuance, foreign currencies etc. In simple words under the head of structured products different varieties of the derivatives lie. 

The features of a structured product are protection and the performance of the underlying assets. This is the reason that they are tied to a big basket of securities to facilitate the high return and risk and this is why it is more offered to those inventors who want to invest for a shorter duration and at the same time want protection over the initial capital. 

Components of Structured Products 

The three main components of a Structured Product are as follows:

• The Bond Component: In the type of the bond component the interest generated by the bond is utilized in purchasing the derivative strategy component. It can also be used for providing the guaranteed capital. A capital guarantee is a guarantee of redeeming the invested capital at the time of maturity unless either they default or improve the return on the non-guaranteed product. This is why it becomes essentially important to obtain the issuer’s credit rating before opting for investment in this type of category. 

• The Underlying Component: The second important derivative of the Structured Product is the underlying component which provides the return on the initial investment at maturity in addition to the payment of interest (which can be in the form of a coupon) that is also linked to the performance of the underlying assets. 

• The Derivative Component: The derivative component is the most widely used component which consists of options that determine the level of the return on the investment. The choice of derivatives is based on the level of the risk, the type of return, exposure, the preferred investment horizon and market conditions. 

Important Parties in a Structured Product Market 

• The Sellers: The Selling Side of the Structured Product Market includes bankers, investors, insurance companies, financial organizations, etc. Their role in this process is to access the fair and underlying value of the assets for managing and combating the default risk processes. But this valuation is required to be in compliance with the standards set by the IFRS, PRIIPS, UCITS, Solvency II etc. 

• The Buyers: The Buyer side of the Structured Products comprises asset managers, insurance companies, banking institutions and other institutions. Assessing the underlying value of the asset is the main reason for obtaining the valuation of the structured products for the buyers as this allows the investors to make perfect decisions. 

Importance of Structural Products Valuation 

• Regulatory Requirements: Compliance with the regulatory norms is a must for obtaining the valuation of the Structured Products. To obtain the current and future pattern of these structured products all the applicable indicators are also required to be taken into consideration. The valuation process is required to be in compliance with the IFRS, UCITS, PRIIPS, EBA, AIFM, FRTB, EMIR and Solvency II as it keeps a proper check and balance on the valuation. 

• Need of the Business: Obtaining the valuation of structured products has become a necessity for asset managers, banking institutions, investment institutions and insurance companies as valuation allows them to assess the value of multiple assets as it directly helps in assessing the default credit risk. 

Benefits of the Valuation of Structured Products 

There are a plethora of benefits to the valuation of structured products and these are as follows: 

• Management of the Risk
• Adherence to the Regulatory Compliances
• Transparency
• Accurate Pricing
• Risk Management
• Accurate and Informed Decision-Making
• Optimization of the Portfolio 

Steps in the Process of the Structured Products

• Data Collection: The first step in the process of the valuation of the structured products is the collection of the relevant and necessary data that also includes the market prices, interest rates and other relevant information. 

• Identify the Method of the Valuation: The most important tool for the valuation of structured products is the identification of the appropriate valuation method. The available valuation methods can be Pricing Models and the Monte Carlo simulations. 

• Incorporating Parameters: After selecting the appropriate valuation method all the specific and applicable parameters must be incorporated. These specific parameters can be payoff structures, notional sizes and other relevant financial parameters. 

• Calculation of the Market Value:  After selecting the mode of the structured product and incorporating all the parameters the next step in the process is calculating the market value. It is the estimate that is based on the current market conditions prevailing in society. 

• Reviewing the Bid-Ask Spread: The next step in the process is to review the bid-ask spread. A bid-ask spread is the difference between what buyers are willing to pay (bid) and what sellers are asking for a particular asset. 

• Evaluating Secondary Market Price: If there is an additional or secondary market for the structured product then the fair value of the structured product can be determined by valuing the asset value in the secondary market price. 

• Verification: After obtaining the correct data the next step in the process is to verify the available data and reconcile any discrepancies to make it more accurate data. 

• External Factors: Taking into all the external factors is a must for refining and validating the results so obtained. These external factors can be the future market expectations and credit risk assessment. 

Valuation in Practice

Valuation in Practice involves the below-mentioned points: 

• Obtaining all the relevant data from various sources.

• Analyze all the parameters of the market in determining the correct value of the structured products. These parameters can be interest rates and volatility models. 

• The factors such as notional sizes, payoff structures, credit ratings etc.

• Protection against the potential risks which includes correlation risk, credit risk, and foreign exchange exposure. 

• Using specialized data methodologies to provide accurate valuations.

• For an extra layer of expertise coordinating with the valuation experts and outsourcing the valuation process to a third party.

• Ensure the following of all the above-mentioned regulatory compliances. 

• Maintaining a handsome portfolio of IT infrastructure for efficient management of the process along with correct valuation.

• Accessing the performance under different conditions using stress tests, performance scenario analysis and P&L explainers. 
• Obtaining opinions and collaborating with different stakeholders helps to ensure the alignment process in structured product valuation. These stakeholders can be traders, sales teams or structures. 

What are the types of Structured Products?

• Leveraged Structure Products: A leveraged product is also known as an accelerated investment because it involves the taking of an increased degree of capital investment. The accelerated returns are achieved by the use of the premium derived from the sale of an option. 

• Capital Protected Products: In these types of structured products a minimum return on the invested initial capital along with the interest linked to the equity market. Capital Protected Products uses two types of pricing alternatives 1) interest rate swap plus rolling short-term deposits including an option combination and 2) zero coupon bond including an option combination

• Yield Enhancement Products: These types of enhancement are obtained in the traditional type of products through leverage. This can also be achieved by limiting the degree of the investment risk. 

Returns

Returns are the outcome of the underlying asset paid to the buyer by the issuers. In simple words, it is that amount that is contingent and depends totally upon the performance of the underlying asset. If an underlying asset is performing A amount then the buyer will obtain the B as a return on that investment because structured products always follow the traditional method of pricing but the only difference between them is that they also include other derivatives such as swaps, features, or other embedded features. 

Liquidity 

Liquidity is the other important aspect of a structuted product because the structured products lack liquidity as it works more upon the buy-and hold method rather than the getting in and out method. The extent of the returns cannot be utilised until the maturity date arrives. 

The Rainbow Note 

A Rainbow Note is the condition or the facility that allows an inventor to customise different variety of assumptions in a single instrument. In simple words, it offers a wide range of exposure to more than one underlying asset. 

Structured Products Valuation Approach

 

Valuation of the Structured Products can be done by following the below-mentioned approaches which are as:

• In-house Valuation: In the in-house approach to the valuation of the structured products the firm has control over the process. They can make any adjustments to it as and when the need arises. The cost of the in-house approach to structured product valuation is on the costlier side as a dedicated team for this purpose is required to be hired. This type of approach requires the best training and knowledge and this is one of the reasons that this approach is on the higher side. The firm’s evaluating the structured products also requires adhering to regulatory compliances which is difficult to adhere to as these compliances are at the bay of constant change. Biases in the employees of the organization can lead to hampering its growth. 

• External Approach: In the case of the external approach the firm has little control over the process and the firm cannot make any adjustments according to their needs. It is best suitable for firms that have very limited resources to engage a dedicated team to fulfill this purpose. It is cheaper because the firm is not required to employ its resources in providing the training and the knowledge to the individuals. The experts already bring their knowledge and experience to the table thus they also in turn help in fulfilling all the applicable regulatory compliances.  

Conclusion 

The valuation of the structured products is a must whether you are at the sell side or are at the buy side of the transaction. These valuation reports help in understanding not only the current market scenarios but also the future of different options and the methods of minimizing all the associated risks. 

Frequently Asked Questions on Valuation of Structured Products

Q1. What is the structure of valuation?

Ans1. The structure of valuation is classified into different categories such as Land and Building Methods, Comparative Sales methods, Income Capitalisation Methods and Profit Capitalisation Methods. 

Q2. What are the 4 types of structured products?

Ans2. The four objectives upon which the structure products work are income protection, income, return structuring and optionality.

Q3. How to price a structure note?

Ans3. A structured note’s price is based on different factors such as the interest rate, market rates, liquidity in the market, volatility, underlying prices of the assets etc. 

Q4. How is valuation calculated?

Ans4. Valuation is calculated by multiplying the Share Price by the Total Number of the Shares. 

Q5. What are the two components of a Structured Product?

Ans5. The two components of a Structured Product are derivative and note. 

Q6. Are structured products high-risk?

Ans6. Yes, structured products definitely carry a high risk to the investors. 

Q7. Is a Structured Product a derivative?

Ans7. Structured Products are those pre-packaged investments that include the assets attached to interest including one or more derivates. 

Q8. What is the best formula for valuation?

Ans8. The best and easiest formula for the valuation of a structured product is subtracting the total liabilities from the total assets. 

Q9. How to approach a valuation?

Ans9. For approaching validation there are three methodologies the Market Approach, Income Approach and Asset Approach. 

Q10. Is a Warrant a Structured Product?

Ans10. Yes, in-line warrants are also a type of structured product.