Equities are commonly represented by indices, baskets of stocks or individual stocks, whereas bond exposure is typically gained through indices or funds.
The rise in popularity of commodities has led to their increased presence in hybrid products, due to their seemingly ever-increasing number of assets, from gold and oil through to base metals and natural gas, their tangibility, their de-correlation with equities and bonds, and the additional benefits of backwardation – a scenario where forward prices are cheaper than the spot price.
Other asset classes include inflation and foreign exchange, often employed as hedging solutions and in the case of the latter, as a means to boost yield. Real estate in the form of investment funds and indices are also growing in popularity, as well as access to hedge funds, usually via indices or funds of funds. An important bonus for hybrid structured products is their ability to offer exposure to otherwise unavailable markets and underlyings, such as emerging country markets and hedge funds.
Diversification
Consider an investor with a bullish view on the Eurozone economy. This investor could invest in a simple call option on the Eurostoxx 50 index. However, given the volatility of the equity markets, this is a very risky structure. The risk-averse investor therefore has two options: he can either lower his participation in the index rise and afford to pay for some capital protection, or he can mitigate the risk of full exposure by creating a basket with additional assets, thus offsetting any concentration risk whilst still maintaining a decent return.
The simplest form of hybrid would involve purchasing an option on a basket of assets, such as a combination of Eurostoxx, Iboxx, WTI and the XAU/EUR rate (the Euro price of gold). This example is composed of loosely correlated assets and hence has low volatility. It is a much less risky structure than simply buying an option on a single asset.
To obtain a hybrid payoff adapted to their specific portfolio management needs, investors can choose more complex structures on multi-asset class baskets. For example, a Himalaya (see figure three download file) structure can provide exposure to different assets with an asset mix optimisation.
On a basket containing five categories of assets:
- Two equity indices: S&P 500 and the DJ Eurostoxx 50;
- A medium-term bond index: IBOXX Germany 5-7 year TR;
- A commodity asset: Gold;
- A global energy index: Brent futures;
- A real estate index: EPRA.
At each observation date, the performance of the best-performing asset within the basket is locked and permanently removed from the basket. The average of the locked performances is paid at maturity. This structure offers optimum diversification as only the best performances are retained. It is also priced cheaper than a full equity structure (on a basket of indices) and generates a comparable historical yield average, with less exposure to equity market downsides.
Alternatively, the Profiler provides exposure to the best investment strategy out of three risk-profiles. Fully capital protected, it is linked to a basket of diversified assets (equities, oil, gold, bonds and cash) that are spread over three portfolios with three different risk profiles (defensive, balanced and aggressive, see figure four). The mechanism is simple: the performance of each portfolio is calculated at the end of a five-year maturity (averaged over the period) and the performance of the highest portfolio is paid.
Yield enhancement
One of the most basic reasons for investing in a structured note is to obtain a higher return than is available for standard market instruments, typically achieved with more risky leveraged products and higher exposure. Hybrid products allow the investor to exploit correlation; for instance in a basket product, correlation reduces the basket volatility and makes it cheaper to buy an option on it, providing an opportunity to enhance yield, with less risk.
Consider a case in which an investor is ready to take some risk exposure on one asset class in order to obtain higher participation in another asset class. In a conservative market scenario, the investor can attain high annual coupons that outperform traditional bonds, in exchange for some exposure to the performance of three global equity indices.
A hybrid product can offer a variable coupon indexed to the Libor rate, in order to benefit from a potential upturn in interest rates during the investment period. Importantly, the variable coupon mechanism is reliant on the performance of three equity index underlyings:
- DJ Eurostoxx 50 (Eurozone)
- S&P 500 (USA)
- Nikkei 225 (Japan)
At each anniversary date, the performance of each index is compared to its initial level. The coupon level is linked to the performance of the three equity indices.
This product matches an investor’s conservative scenario, while providing a potential boost in correlation with equity markets.
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