Structured products offer investors clearly stated target capital or income returns with a specified degree of capital protection, linked to a variety of equity indices, stocks, ETFs and other asset classes. To deliver this contractually defined payoff an investment bank will construct, trade and hedge the product as a combination of derivatives to be sold to a distributor or other sales channel which in turn can market these via advisers or brokers to individual investors. In this article I will examine the role of independent valuations in the structured products market.
Structured product markets exist because of the ability of the investment bank to deliver the required product profile and characteristics. It must address the choice of underlying asset, precise payoff formula, hedging long dated maturities, and accommodate the investment sales period and potentially large issue size.
Because of the way products are created the role of valuations and the existence of a functioning secondary market are critical. As far as investors are concerned only the two “ends” of the investment are known. The initial issue price (usually par) defines the product and allows comparison with other offerings in the market and investment types. The final payoff amount paid at maturity will follow the contractual obligations of the product and therefore is a known outcome given the evolution of the market over that period. This may be a simple formula such as for a capital protected or digital product, consist of several moving parts such as a regular auto-call or consist of a more complicated path dependent payoff such as a range accrual or cliquet.
Why valuations are important
Investors naturally expect regular valuations of structured products during their lifetime to connect these start and end points. This serves two main functions, portfolio reporting and reacting to market conditions if an early sale becomes desirable.
For most retail Investors structured products will form part of a portfolio that will also include direct equities, mutual funds, ETFs, deposits and bonds. These other asset classes have simple regular pricing, available real-time and end-of-day. If structured products could not match this it would present major challenges to their appeal if an investor was unable to see their contribution and evolution in the portfolio.
The majority of structured products tend to be held to maturity, and this is generally the right course of action for investors to benefit from the defined returns. However secondary market dealing is almost always offered by investment banks and this is important to allow early sale either for an investor’s own reasons, to take profits or to reposition a portfolio. A secondary market also boosts confidence in the sector. It is still almost universally the case that sale is only allowed back to the issuing investment bank rather than on the open market, this development has yet to become mainstream.
The bank’s responsibilities
During the lifetime of a structured product an investment bank will provide regular valuations to its investor base. These should reflect the total market value of the instruments while also taking the bank’s funding position into account. However this process does vary in its effectiveness. Some banks will seek to keep prices within a bid-offer that spans the fair value, however at other times prices can be quite low because of funding implications, lack of appetite for dealing or slow updates applied to price feeds.
Independent valuations for good governance
To ensure good governance around the structured products that they have placed and to reduce reliance on the banks a third party is often engaged to provide independent valuations on a regular basis by distributors, buy-side firms or fund administrators. The two most common valuation frequencies are daily for regular trading and fund or portfolio reporting purposes or monthly for an auditing based approach. While some buy-side firms have the capacity to perform such duties in-house they can still prefer the independence and arm’s length approach of a third party as it provides stronger regulatory comfort of a robust governance process.
The duties and workflow of the independent valuation provider consist of several stages. Firstly, the set of products to be valued are agreed, typically consisting of an initial portfolio supplemented by new instruments on a regular basis and subject to maturities or cancellations. The likely composition of the portfolio (Equity, Fixed Income, FX, Credit, Commodities etc) is agreed along with the range and complexity of the product set. Some portfolios consist of relatively few product types, others are more varied. The mechanism by which product details are sent is also important. It can be by client upload, client export by spreadsheet or file, or manual entry from product termsheets by the valuation agent.
Models, data and market knowledge
Valuing structured products requires a flexible model suite and accurate market data. For equity products the main choices are Black Scholes for simple European structures linked to one underlying, through to local and stochastic volatility models to handle multi asset and correlation regimes and the creation of volatility skew and smile surfaces. A knowledge of market practice is important to understand how trading desks make reserves for particular risk points such as barriers, auto-call points and digital events. Deriving volatility, dividends and correlation pricing curves is a process done at least daily taking into account traded options, certificates and other pricing feeds and sources. All of these issues have come up regularly in the valuations services that FVC has performed for over twenty years.
It is well known that different banks can have varying risk appetites and views of the market at times with the result that they can quote prices significantly apart. This is particularly true for more complex or long dated products. Once a product is in its lifetime, these differences can become larger due to the sensitivity of products to different situations such as approaching a barrier or auto-call date.
Seeking fair arms length valuations
Because of this phenomenon, the best approach for a valuation agent is to provide prices that represent where they think the middle of the market is. We can also deduce that on occasion material divergences are to be expected. A formal price difference tolerance (of up to 5%) is generally agreed so that price differences in excess of this level are properly investigated. In practice differences are closely monitored before a full breach occurs and under such circumstances it is important to understand where the variance is coming from. Typical causes are differences in pricing curves, risk buffers and the bank’s current pricing policy. Giving buyside clients confidence in the reconciliation process means that they can rely on a valuation service being fit for purpose for their business obligations.
Monitoring a portfolio and investigating price differences is a continuous process to protect and inform investors and to provide distributors and advisers with regular accurate technical insight into the valuation and risk of the structured products.
A version of this article has also appeared on www.structuredretailproducts.com
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