Overview of Exotic Equity Products

A dealer that structures equity structured notes hedges the risk of the puts it has bought from investors through the notes. A company that sells the notes is expected to explain their costs and returns to customers.

Structured notes: who takes the investor's other side

A structured note combines a bond with a derivative such as an option¹. How investors take the selling side of options in general is covered in Overview of Exotic Options. Equity structured notes linked to stock indexes or to individual stock prices have been sold to investors².

An investor who buys an equity structured note with a knock-in condition, such as an exchangeable bond (EB), sells a put option on the reference stock through the note. The buyer of that put is the financial institution that structures the note³. The structuring institution (the dealer) hedges the risk of the put it has bought by buying and selling options and the stock that is the underlying asset⁴.

Figure description

Consider a hypothetical example in which Z Securities structures and issues a note linked to the stock of Company X with a knock-in condition. The investor pays the principal to Z Securities and receives a relatively high coupon and the redemption amount from Z Securities. Through the note, the investor has sold a put option to Z Securities, and if Company X's stock price falls sharply, the redemption amount falls below the principal. To limit that risk, Z Securities buys and sells Company X's stock and equity options with counterparties such as other financial institutions (the figure shows the case of buying).

Autocall and knock-in

An autocallable is a feature under which a structured note is redeemed before maturity if the price of the underlying asset is at or above a set level on a predetermined observation date. On redemption, the investor receives the principal and a predefined coupon⁵. Unlike a callable feature, which lets the issuer choose whether to redeem, the redemption depends only on the price of the underlying asset⁶.

Some equity structured notes combine an autocallable feature with a knock-in condition. Many EBs linked to an individual stock price have the following terms. If the stock price rises to a set level on an observation date (for example, quarterly), the note is redeemed early at that point. If the reference stock price falls sharply even once during the term (knocks in) and the stock price at maturity is below its initial level, the note is redeemed in shares or similar, with the number of shares equal to the face value divided by the initial stock price. If neither applies, the note is redeemed at face value at maturity³.

The main source of an EB's relatively high coupon is compensation for the risk of a large loss that the investor bears if the note knocks in, which corresponds to an option premium. It is also partly compensation for giving up gains from a rise in the stock price³.

Some Nikkei Stock Average-linked notes also have knock-in and early redemption clauses. The closer the knock-in price is to the current stock price, the more likely a knock-in becomes, and the higher the coupon rate is set⁷.

Consider a hypothetical example in which Z Securities issues a note linked to the stock of Company X. The face value is 1 million yen, the term is three years, and there are three observation dates: after one year, after two years, and after three years (maturity). Company X's initial stock price is 1,000 yen. An EB may be redeemed in shares, but this example shows the amount calculated at the stock price at maturity.

In cases A, B, and C, the investor receives the principal of 1 million yen plus the coupons. In C, the stock price at maturity is below the initial level, but the note has not knocked in, so it is redeemed at the principal. In D, the price falls to 550 yen during the term and the note knocks in, and because the stock price at maturity is 700 yen, the redemption is 700,000 yen. Even with the three coupons of 150,000 yen in total, the investor receives 850,000 yen and loses 150,000 yen. In A, the stock price has risen 30%, but the investor gains only one year's coupon of 50,000 yen above the principal, and the rise in the stock price is not included in what the investor receives. This is what giving up gains from a rise in the stock price means above⁸.

Redemption of a structured note depends not only on the stock price but also on the issuer's credit. Depending on the issuer's financial condition, payments of principal or interest may be delayed or missed⁹.

Worst-of and cliquet

A worst-of product sets its payoff by reference to whichever of several stocks or stock indexes performs worst. For example, if it references the stocks of Company X and Company Y, and at maturity Company X has risen 10% while Company Y has fallen 20%, the payoff depends on the fall in Company Y, not the rise in Company X. With a worst-of structured note, if any of the reference indexes falls by a set percentage (for example, 30%), the principal may not be returned at maturity¹⁰. There is also a form in which, after a fall, the shares of the worst-performing stock are delivered¹¹.

A cliquet is an option that divides the term into periods, such as one year each, and sets the payoff by the rise in each period. The seller guarantees a minimum payout each year and in return caps each year's payout. Cliquets have been embedded in pension products to meet the demand for exposure to stock prices with limited downside risk¹². Because the payoff is set on each observation date, a cliquet is a type of path-dependent option¹³.

Variance swaps

Variance swaps and volatility swaps are OTC derivatives that trade the size of price moves itself rather than whether stock prices rise or fall. At maturity, a volatility swap exchanges the actual volatility of the underlying asset over the term (historical volatility) for a rate set when the contract is made. A variance swap exchanges the square of volatility (variance)¹⁴.

Volatility tends to rise sharply when stock prices plunge and market anxiety grows. For this reason, an equity investor who buys volatility through a volatility swap can expect it to limit the portfolio's loss when the stock market plunges¹⁵. The party that receives the actual volatility and pays the set rate (the buyer of volatility) receives the difference if actual volatility exceeds the rate, and pays the difference if it falls short¹⁵.

Dividend swaps and dividend futures, which trade dividends

Dividend swaps and dividend futures trade the amount of dividends paid on stocks rather than stock price moves¹⁶. In Europe, dividend derivatives have been traded since the early 2000s. The dividend swap market grew out of banks' need to manage the dividend risk they held from structured products, and the demand of hedge funds that took on that risk¹⁷.

In Japan, Nikkei 225 Dividend Index Futures are listed on Osaka Exchange. Their underlying is an index that accumulates the dividends of the stocks in the Nikkei Stock Average. They can be used by investors who hold stocks to hedge changes in the dividends they receive, or to invest only in the dividend portion without holding the stocks¹⁸.

Risks left with the dealer

In principle, a dealer that has structured a note can pass its risk on unchanged by buying a product with the same payoff as the note. In practice, many banks that act as dealers manage the market risk of structured notes together with their other trading positions⁴. They buy and sell the underlying asset and options to limit the first- and second-order sensitivities to the price of the underlying asset (delta and gamma) and the sensitivity to volatility (vega)⁴¹⁹. Rebalancing of the hedge usually targets these three, and higher-order risks are rarely hedged¹⁹. Because the instruments available for hedging are limited and higher-order risks are also mostly left unhedged, the dealer is left with the following risks.

Exchange-traded products can hedge only some short-dated trades for volatility, and long-dated options (including exotics such as barrier options) can carry large volatility risk²⁰. When individual stocks or baskets of stocks are hedged with stock index futures or options, prices may not move together as expected and the hedge may not work²¹. Valuing a product that references several stocks requires the correlation between the stocks' price moves²². Dividends have a large effect on the value of stocks and derivatives, and the future dividends embedded in structured products and equity options can be hedged with dividend derivatives¹⁶.

With cliquets, volatility risk tends to be underestimated, and the valuation depends heavily on the model of the underlying asset's price moves. Even if a cliquet is valued with a model calibrated to vanilla option prices, the value may not be close to the value under other models²³.

Dividend risk can also amplify market moves. In Europe, structured product desks have been forced to sell dividend futures when dividend futures prices were falling, which deepened the fall²⁴.

The FSA's findings on sales of structured notes in Japan

In its monitoring results of June 2022, the Financial Services Agency (FSA) took up EBs with terms like those in the example above as a typical structured note linked to an individual stock price. It found that, once the fees at the structuring and sales stages are included, investors do not earn returns commensurate with the risk. It concluded that EBs are "difficult to regard as suitable products for the needs of general customers aiming to build assets over the medium to long term" (our translation)²⁶.

In its results of June 2023, the FSA reported that sales of structured notes by major banks and regional banks in the first half of fiscal 2022 fell because of weak stock markets and the suspension or reduction of sales²⁷. Many of the financial institutions with which it held focused dialogue concluded that not only EBs but also index-linked notes tied to a stock index, such as Nikkei Stock Average-linked notes, do not deliver returns commensurate with their risk²⁸. In April 2023, the Japan Securities Dealers Association published amendments to its rules on soliciting sales of complex structured notes and similar products²⁹.

Notes

1. Center for Advanced Financial Technology, Financial System and Bank Examination Department, Bank of Japan, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), page 3, "１．仕組商品とは" (1. What structured products are). ↩

2. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (Results of monitoring customer-oriented business conduct by distributors of investment trusts and other products, in Japanese) (June 2022), page 27, "（１）仕組債" ((1) Structured notes). ↩

3. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), pages 28–30, "① 商品性に関する問題点" (① Problems with product characteristics), notes 25–27, and Chart 22. ↩ ↩² ↩³

4. The Options Industry Council, "Analysis on Structured Products and Listed Equity Options in Europe (Part 1)" (SRP, 2015), page 21, "Hedging." ↩ ↩² ↩³

5. The same report, page 39, "Autocallable" in the Glossary of Terms. ↩

6. The same report, page 41, "Callable" in the Glossary of Terms. ↩

7. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (What are the features and risks of Nikkei Stock Average-linked notes?, in Japanese), pages 1 and 3, "１．そもそも日経平均リンク債とは？" (1. What is a Nikkei Stock Average-linked note?) and the note on "利率（クーポン）" (Interest rate (coupon)). ↩

8. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), pages 29–30. ↩

9. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 3, "発行者の信用リスク" (The issuer's credit risk). ↩

10. FINRA, "Regulatory Notice 12-03" (January 2012), page 4, the "worst-of" example. ↩

11. The Options Industry Council, "Analysis on Structured Products and Listed Equity Options in Europe (Part 1)" (SRP, 2015), page 41, "Worst of" in the Glossary of Terms. ↩

12. H. A. Windcliff, P. A. Forsyth, and K. R. Vetzal, "Numerical Methods and Volatility Models for Valuing Cliquet Options," pages 1–2, "1 Introduction." ↩

13. The same paper, page 2, the paragraph beginning "Cliquets are discretely observed path-dependent contracts." ↩

14. Yoshihiko Sugihara, "わが国株式市場のモデルフリー・インプライド・ボラティリティ" (Model-free implied volatility in Japan's stock market), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2010, in Japanese), page 117, "補論 3．ボラティリティ・デリバティブ" (Appendix 3. Volatility derivatives). ↩

15. The same paper, pages 74–75, note 1. ↩ ↩²

16. Eurex, "Dividend Derivatives (Factsheet)," page 1, "Trade the dividends of single stocks or entire stock indexes" and "Hedge dividend risk." ↩ ↩²

17. Eurex, "Dividend derivatives look to the future" (2022), page 2. ↩

18. Osaka Exchange, "日経平均・配当指数先物 商品概要" (Nikkei 225 Dividend Index Futures: product overview, in Japanese). ↩

19. The Options Industry Council, "Analysis on Structured Products and Listed Equity Options in Europe (Part 1)" (SRP, 2015), page 22, "Dynamic hedging." ↩ ↩²

20. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual," Section 4345.1 "Equity Derivatives" (page dated April 2003, page 3), "Volatility Risk." ↩

21. The same manual, Section 4345.1 "Equity Derivatives" (page dated April 2003, page 3), "Hedging" and "Market Risk." ↩

22. Tatsuya Ishikawa and Yoshihiko Uchida, "モンテカルロ法によるプライシングとリスク量の算出について" (Pricing and risk measurement with the Monte Carlo method), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (June 2002, in Japanese), Section 5 (1) "バスケット型オプションのプライシング" (Pricing basket options) (page 66). The paper values a call on the sum of the prices of 32 stocks using the variance-covariance matrix of the stocks' returns. ↩

23. H. A. Windcliff, P. A. Forsyth, and K. R. Vetzal, "Numerical Methods and Volatility Models for Valuing Cliquet Options," page 2 and note 2. ↩

24. Eurex, "Dividend derivatives look to the future" (2022), page 8. ↩

25. Eurex, "Dividend derivatives look to the future" (2022), page 5. ↩

26. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), pages 28–30, "① 商品性に関する問題点" (① Problems with product characteristics). ↩

27. Financial Services Agency, "リスク性金融商品の販売会社による顧客本位の業務運営のモニタリング結果" (Results of monitoring customer-oriented business conduct by distributors of risk-bearing financial products, in Japanese) (June 2023), page 6, "（イ）仕組債" ((a) Structured notes). ↩

28. The same material, page 8, "（ロ）対話・モニタリングで判明した課題" ((b) Issues identified through dialogue and monitoring) under "① 仕組債" (① Structured notes). ↩

29. Financial Services Agency, "リスク性金融商品の販売会社による顧客本位の業務運営のモニタリング結果" (in Japanese) (June 2023), page 8, "（イ）商品導入・販売に際して販売会社に求められる事項" ((a) What distributors are required to do when introducing and selling products) under "① 仕組債" (① Structured notes). ↩ ↩² ↩³