Pricing products

A structured product is designed to capture a market view or investment strategy within a single package. In purchasing a structured product, an investor is effectively buying a bundle of different components and the price of the product reflects the total price of the bundle in a particular set of market conditions.

Structured products can be constructed to offer a defined level of capital protection. This is provided by the purchase of a zero coupon bond, which requires most of the investment to be put on deposit with the counterparty so that when it matures, the original capital value can be returned to the investor. The amount left over after the purchase of the zero coupon bond is the amount which is used to pay for running costs, commission and the cost of the options, which provide the returns of the plan. Interest rates significantly affect the cost of a zero coupon bond and in periods where interest rates are high the cost of the coupon bond decreases, leaving more available to spend on options. 

The options provide the pre-defined returns of a structured product.  For example, a kick-out plan (autocall) is a structure which will terminate automatically in the event that a particular set of conditions are met. The option used to create the kick-out function is known as a ‘call’. The call provides a pre-defined investment return dependant upon market conditions and/or the performance of the underlying asset.  In order to achieve higher pre-defined returns, some risk to capital can be assumed by selling a ‘put’. The put will only be activated in the event that the underlying asset falls below a fixed percentage of its opening level.  If a structure has a 50% American barrier, capital will be affected if the underlying trades below 50% on any day during the investment term. This could be read at close of business or ‘intra-day’ (which means continuously throughout the term). If the underlying does not recover to its opening level by the maturity date of the plan, capital will be reduced by the same percentage that the underlying asset is below its opening level. Using a European barrier, where the underlying asset is observed only at its start date and end date, reduces the risk to capital. However, the sale of a European put will generate less than an American put, leaving less to spend on the upside and reducing the pre-defined investment return.

The same structure will price completely differently at different times, depending on the economic conditions and the effect they are having on various factors. The major factors that determine the pricing of a structured product are:

Interest rates

Interest rates affect the cost of the main component part of a ‘capital-at-risk’ structured product, the zero coupon bond. This is the part of the product which allows the full capital to be returned either at maturity, or if the conditions of the product are met and the plan matures early. A higher interest rate means less needs to be set aside to ensure the full return of capital and leaves more to spend on the options, generally making the investment return more favourable.

Credit ratings and CDS

Following the events of 2008, the perceived risk of counterparties has never been more important for investors and their advisers. 

The CDS rates of an issuer affect how the product is funded. Usually, the relationship between CDS and the credit rating of an issuer is inversely correlated. Consequently, it is often counterparties with a lower credit rating that have a higher CDS and these institutions will generally fund at a higher rate than those with a higher credit rating and lower CDS,  although this is not always the case. In the majority of cases, the higher a counterparty’s funding the better the investment return offered.  At Meteor, we combine competitive investment returns with counterparties with a high level of financial strength.

For more information, please see our piece on Counterparties in our education section.

Volatility of the underlying asset

The extent to which the long term volatility of the underlying asset impacts overall pricing depends on the type of structure. As a rule, individual stocks and shares are more volatile than indices and consequently they offer a higher return within a structure. Volatility can be driven by any number of factors including market confidence, political turmoil, policy changes, terrorism, and major environmental disasters. However, it is important to recognise that short term volatility often has very little impact on long term volatility and consequently pricing may not improve until a sustained period of volatility is experienced.

Creating a structure within the limitations discussed means that it is necessary to balance the investor’s appetite for risk and reward as well as considering all of the other fundamental factors including volatility, the choice of underlying asset, and the choice of counterparty.

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