Asian Option or Style
Asian options are options that use averaging of a pre-determined number of asset price observations to determine either the strike price or the final settlement price.
A term used to describe any option that has its strike price close to the current price of the underlying asset.
Many structured products measure either the starting index level or the final index level (or both) using the average of a pre-determined number of observations. This means that the index levels used in the calculation of the product’s final return are the average index levels calculated during some pre-specified period.
For example, Instreet products often use a final index level that is the average taken on a monthly basis over the last 3 months for the life of the product. This means that the closing level of the index is recorded every month during the last 3 months and then averaged. It is this average index level that is used in the final value calculation.
Marketing material used to promote products often includes illustrations of how the product would have performed if it had been available at some time in the past. This analysis using historical data is called backtesting.
A barrier or trigger level is a pre-specified level for the underlying that if hit or exceeded may trigger a change in the return from the product.
Typically a barrier level is a feature of reverse convertible product. In these products it means that if the barrier level is reached during the term of the product, the investor is then exposed to a risk of capital loss if the underlying index finishes below its initial level.
In general barrier options are options that can only be exercised if the barrier level has either been reached or not been reached, depending on the condition of the contract, during the term of the option (see also knockout/knockin).
A basket option is an option where the underlying comprises more than one index or stock. So for example an option with a pay-out based on the performance of the BHP, Westpac and Telstra would be called a basket option.
This is the name given to an option trading strategy that is designed to benefit from a fall in the price of the underlying asset. The strategy involves buying a put option and selling a put option with a lower strike price where typically both have the same maturity date.
A best-of option is an option that is exercisable against the best performing of a given number of underlying shares or indices. For example a call option on the best of the S&P/ASX200 and S&P500 would pay out on the index that rose the most during the term of the option. See also Worst-of option.
The issuer who provides the bond for a financial product and who an investor has a credit risk to for performance of the obligations of the bond such as coupon payments.
A bond is debt issued by either a government or corporate entity. Most bonds pay a coupon and have a finite term. The chance of a bond defaulting is often indicated by the credit rating given to the bond issuer.
This is the name given to an option trading strategy that is designed to benefit from a rise in the market. The strategy involves buying a call option and selling a call option with a higher strike price where typically both have the same maturity date.
A callable product is one that may redeem before its stated maturity date. For example, a product may offer a minimum return of 100% of the amount invested and a potential coupon equal to 20% p.a. as long as the S&P/ASX200 rises at the end of five years.
However an additional condition might be set that if the S&P/ASX200 index has risen by 15% after three years, the product would pay out early, so that investors would receive their original investment back in full plus the 20% p.a. coupon at that time.
Callable products may be called early when a pre-specified event occurs, such as the index rising to a given level by a fixed date. Alternatively, the product may be callable at the discretion of the product issuer.
Some Structured Products may specify a maximum payout when the market rises. Such a maximum payout is often called a cap and such products may be called capped.
For example a product might provide a cap at 30%. For example, if the index rises by 20%, the payout from the product would be 20%. However if the index rises by 40% the payout from the product would be capped at 30%.
A capital protected type of structured product is one that provides for a prescribed minimum return at maturity. Typically, this is equal to the original sum invested.
It should be noted that a product of this type will only provide this minimum return if the product issuer does not default, and there is no default in the hedge underlying the issue.
Closing index level
This is the level of the index at the time the market closes for the day. As it is the final published level of the index and it is often used for reference and valuation purposes.
Providers of structured products typically enter into derivative hedging contracts to ensure that they are able pay the return that is being offered to their investors. Since the term of structured products may go out many years, there is a risk that the derivative counterparties may default during the life of the product.
To mitigate this risk, in many cases the hedge counterparty will post collateral in the form of cash, bonds or even shares, with a third party or custodian. The value of this collateral will be adjusted so that it is always equivalent to the cost of replacing the hedge should the hedge counterparty go into default.
When this approach is utilised, the product provider knows that if the hedge counterparty defaults, he will have access to sufficient liquid assets, via the third party or custodian, to purchase another derivative contract to cover the remaining term of the product.
Constant Proportion Portfolio Insurance (CPPI)
Constant Proportion Portfolio Insurance (CPPI) is the name given to a trading strategy that is designed to ensure that a fixed minimum return is achieved either at all times or more typically, at a pre-determined future date.
This strategy involves continuously re-balancing the portfolio of investments during the term of the product between so-called risky assets (usually shares) and non-risky assets (usually bonds or cash).
As the value of the risky assets increases, an increasing amount of the portfolio is placed in these assets but conversely as they fall in value, more of the portfolio is placed in the non-risky assets. By following the rules set out by the strategy, the minimum return can be achieved as long as the value of the risky assets does not fall too sharply.
The key features of CPPI based capital protected products as opposed to option-based products are:
- The participation in any rise in the underlying is not fixed upfront
- It is possible to have a higher initial participation than with an equivalent option-based product
- A substantial fall in the value of the risky asset may cause the strategy to become ‘cash locked’ and remain fully invested in non-risky assets until maturity. This would even be the case if the value of the risky assets subsequently increases.
Continuous products (also called open-ended products) are products which have no fixed subscription period or maturity date.
A digital type structured product is one that pays out a pre-determined fixed amount if the underlying is above (or below) a specified level on a given date, usually the maturity date of the product.
A typical example is a product that pays a minimum return at maturity of 100% of the amount invested plus a bonus of 20% if the final level of the S&P/ASX200 is above its initial level at maturity. In this case, the bonus is paid as long as the index has risen by any amount at maturity. The 20% bonus is paid even if the index rises by 1% or 50% over period.
The exercise date is another name for the maturity date of an option i.e. the date on which the holder can exercise the option (or the last such date for an American style option).
The exercise price for an option is another name for the strike price.
A return based on a sophisticated type of option. They include a wide variety of options with non-standard payout structures or other unusual features.
Final index level
This is the final level of the underlying index used in calculating the return from a structured product.
Often the final index level is the average level of the index calculated over, say the final 3 months of the term of the product (see averaging).
In most structured products the calculation of the final return is based on the movement of some underlying price or index. In order to determine this movement the level of the underlying must be taken at specific times (usually at the start and end of the product’s term). These price or index levels, used in calculating the return, are sometimes called fixings.
The term gearing refers to the leverage or exposure that a product has to movements in the underlying index.
A product with 100% gearing would generate a return exactly equal to any rise of the underlying index i.e. a 45% rise in the index would produce a 45% return from the product. A product with only 75% gearing would produce a return equal to only 75% of the return produced by the underlying index and similarly a product with 200% gearing would produce a return equal to twice any rise in the index.
Sometimes the term participation is also used to refer to the level of gearing in a product. See also gearing.
A growth product is a type of structured product that produces all its return at maturity with no payments of income during the product term.
The historic volatility of an asset is simply a mathematical measure of its price variability during a given historical period, for example the last 3 months.
The most common form of measure is the standard deviation of the daily returns.
Historic volatility is usually quoted as a percentage figure and is simply a means of measuring the relative riskiness, in terms of price variability, for different shares, indices, assets, etc. Thus a share or index with a higher historical volatility will be regarded as more risky than one with a lower volatility.
The implied volatility of an asset is the name given to the expected volatility that this asset is anticipated to have over some future period (see Historic Volatility).
This term derives from the pricing of financial options as it is the number used by option traders to calculate the price of any option when all the other factors involved are known.
This is the term used to describe any option which has a strike price that is far below (for a call option) or above (for a put option) the current level of the underlying.
This is the name given to any type of structured product that provides a periodic payment of income. Often the rate of income is higher than the general rate of interest available of fixed rate term deposits.
Initial index level
With most structured products, the performance of the investment is linked to the movement of an underlying index or share. In order to measure this performance the level of the underlying is recorded at the start of the investment term. This recording is called the initial index level.
There are a wide variety of methods for calculating this level. It may simply be the level of the index at the close of business on one specific day or in other cases it could be the average level calculated over a period of months.
This is a term used when describing the premium of an option. The intrinsic value of an option is that element of the option’s premium that represents the value that the option would have were it to be exercised immediately.
The value of an option i.e. its premium, is always at least equal to its intrinsic value.
A financial institution that raises capital, trades in securities and advises on mergers and acquisitions.
ISDA stands for the International Swaps Dealers Association. ISDA is a trade body that represents participants in the wholesale over-the-counter (OTC) derivatives market. ISDA has been primarily involved in standardising the documentation used for OTC derivative products. The ISDA master agreement and its associated documentation, has become the industry standard.
A kicker is a term sometimes used to describe an additional bonus payment that is received at maturity of a structured product if the underlying rises by a significant amount.
For example, a growth product might offer a kicker equal to an extra 10% return payable if the underlying doubles over the term of the investment.
A knockout call product is a structured product which matures early if the underlying has risen to a specified level on a fixed date during the term. See Callable.
A knockout or knockin feature is a characteristic of a structured product whereby the return is dependent on the underlying reaching, or not reaching, a pre-specified level at some time during the term of the investment.
A product that is listed on a stock exchange can be bought/sold there.
A “long” position is the term used to describe a situation where one is holding (i.e. one has purchased), a quantity of some financial asset for example a share, bond or derivative.
The maturity date of a product is the date on which the investment terminates and return calculations are concluded.
Medium Term Note (MTN)
A Medium Term Note (or MTN) is a type of bond. They are usually issued by regular borrowers in the capital markets such as banks, large corporations and supranational bodies.
MTNs are designed to be very quick and cheap to issue compared to normal bonds. This is because much of the legal and regulatory expense is incurred when the MTN program is set up and so each individual issue of MTNs has a relatively small amount of documentation required.
Most structured products are only available for a limited period. This period, which is usually around 4 to 8 weeks, is called the offer period and is the period during which the product is available for investment.
Some structured products are open-ended, meaning that they are available for investment for an unlimited period
Opening index level
This is the level of an equity index calculated at the start of the trading day. It is not necessarily the same as the initial index level used in calculating the return on a structured product.
An option is a form of derivative contract. The owner of an option has the right, but not the obligation, to buy (call) or sell (put) a fixed quantity of some underlying asset or index, at a fixed price, on or before a given future date (see call option and put option).
This is the term used to describe any option which has a strike price that is far above (for a call option) or below (for a put option) the current level of the underlying.
Many structured products provide a return calculated by multiplying any rise in the underlying index by a fixed or variable percentage. This percentage is often called the participation or participation rate.
This is a general term often used to describe the payment that is provided by a structured product or an option.
This term has a similar meaning to payoff.
See Constant Proportion Portfolio Insurance (CPPI).
This is another word for the price paid for a financial option.
Private Bank or Wealth Manager
A financial institution that focuses on private banking and high net-worth clients.
A quanto option is the name given to a type of option that is denominated in a currency other than the natural currency of the underlying. In particular, the payout of a quanto option does not depend upon the movement of the exchange rate between the two currencies.
For example, an option on the S&P500 index that is denominated in Australian Dollars is a quanto option if the return is simply based on the movement of the index and not the movement of the index and the movement of the AUD/USD exchange rate.
A range accrual product is a type of structured product in which the return is based on the number of days that the underlying asset price is within pre-set levels. The longer that the underlying stays in the range then the higher the return produced.
A secondary market is used to describe the market in any financial product that allows investors to sell or buy more of their investment after making the original purchase.
In the case of many structured products, the bespoke nature of the investment means that secondary markets do not often exist, and even if they do, liquidity is often poor. For this reason, investors are usually advised to hold their structured product for the term of the investment.
A “short” position is the term used to describe a situation where one has sold a quantity of some financial asset i.e. a share, bond or derivative, without actually owning it in the first place. In order to do this, one usually borrows the asset initially or else would anticipate buying it before the original sale was settled.
Special Purpose Company or Vehicle
A special purpose company (SPC) or special purpose vehicle (SPV) is any legal entity (usually a company or a fund) that is created specifically to create a structured product.
Starting index level
See initial index level.
A straddle is the name given to a position in two financial options whereby one is simultaneously long (or short) of both a call option and put option with the same strike price.
The object of such a position is to make a profit (if one is long) from any movement, up or down, in the underlying.
A strangle is similar to a straddle position except that the strike price of the call option is higher than the strike price of the put option.
This is the date on which the initial index level is fixed
Strike price or level
This is the price or index level that is set in an option contract. The option buyer has the right to buy (for a call Option) or sell (for a put option) the underlying at this price level.
The term of a structured product is the name given to the duration of the investment. Structured products typically have fixed terms between 18 months and six years but can be shorter or longer.
This is a term used when describing the premium of an option. The time value of an option is that element of the option’s premium that represents the difference between the option’s intrinsic value and the premium.
All structured products provide a return based on the performance of some underlying price or index. The most popular underlyings used are equity indices such as the S&P/ASX200, S&P500, etc.
Other underlyings however can be baskets of individual shares, indices of commodities, the prices of managed funds including hedge funds, and a variety of other financial assets.
See Historic Volatility and Implied volatility.
A worst-of option is an option that is exercisable against the worst performing of a given number of underlying shares or indices. For example a call option on the worst of the S&P/ASX200 and S&P500 would pay out on the index that rose the least during the term of the option. See also Best-of option.
The term yield is used to describe the return produced by any financial asset and paid as a distribution. So for example the dividend yield of a share is the return produced by that share through the payment of dividends.
A yield curve is a term used to describe a set of yields for bonds of different maturities. There are many kinds of yield curves, for example, the government bond curve, corporate bond curve, the swaps curve, etc
Zero Coupon Bond
A zero coupon bond is a bond that pays no coupons or periodic interest payments. The price of such a bond is therefore at a discount to its final maturity value.