Are structured products ‘fairly’ priced? An analysis of the German market for equity-linked instruments

Abstract

Based on a unique data set, this paper examines the pricing of equity-linked structured products in the German market. The daily closing prices of a large variety of structured products are compared to theoretical values derived from the prices of options traded on the Eurex (European Exchange). For the majority of products, the study reveals large implicit premiums charged by the issuing banks in the primary market. A set of driving factors behind the issuers’ pricing policies is identified, for example, underlying and type of implicit derivative(s). For the secondary market, the product life cycle is found to be an important pricing parameter.

Introduction

Structured financial products combine elementary instruments from the spot and futures markets (e.g., stocks, interest rate products, derivatives) and promise tailor-made risk/return profiles for investors. These securities, issued and sold by banks, became popular in the US in the 1980s and found their way to Europe in the mid-1990s during a period of low interest rates. In recent years, ‘financial engineering’ has become indispensable in most financial institutions. Structured products offer the feature of facilitating complex positions in options without the need for access to options exchanges. In the case of net short positions, there are no explicit margin requirements, since the products’ nominal values serve as collateral for the issuer. Thus, these securities, designed for retail investors, are an easy means of implementing complex investment strategies. When trading structured products, transactions costs (e.g., bid–ask spreads) and commissions for the private investor are usually lower than those for the corresponding single trades. In addition, structured products offer lifetimes ranging from a few months to several years, which thus often exceed those of exchange-traded options. Therefore, this product category generally constitutes a useful extension to the capital markets. Due to the large number of products and very heterogeneous nomenclature, however, the German market for structured products can hardly be described as transparent. A particularly important issue is the valuation of these instruments.

Despite the large size and rapid growth of the market for structured products, very little empirical research on the pricing has been undertaken. For a period of two months in 1988 and 1989, Chen and Kensinger (1990) analyze ‘Market-Index-Certificates of Deposit’ (MICD) in the US market, which pay a guaranteed minimum interest rate and a variable interest rate pegged to the performance of the S&P 500. A comparison of the implied volatility of the S&P 500 option with the implied volatility of the MICDs’ option components reveals significant positive and negative differences between theoretical and market values, as well as inconsistencies in the pricing among issuers and products with different maturities and types offered by the same institution. Chen and Sears (1990) investigate the ‘S&P 500 Index Note’ (SPIN) issued by Salomon Brothers, which is very similar to the MICDs, but exchange-traded. Computing the differences between market and model prices for the period from 1986 to 1987 (using ex post, average implied and long-term implied volatilities), they diagnose overpricing in the first sub-period and underpricing in the second and third sub-periods. Baubonis et al. (1993) analyze the cost structure of equity-linked certificates of deposit and demonstrate, using a Citicorp product as an example, that the bank can earn a gross fee of 2.5–4% of the selling price in the primary market. Wasserfallen and Schenk (1996) examine the pricing of capital-protected products issued in 1991/1992 in the Swiss market. The comparison of the products’ option components with those derived from historical and implied volatility of the Swiss Market Index shows that the securities are sold slightly above their theoretical values. In the secondary market, model values exceed observed prices. Another study of the Swiss market was conducted by Burth et al. (2001), who, employing exchange-traded options, assess the initial pricing of reverse convertibles and discount certificates outstanding in August 1999. The ‘mispricing’, generally in favor of the issuing institution, differs among the issuers as well as between fixed-coupon reverse convertibles and discount certificates. In addition, the existence of a co-lead manager is identified as a significant factor influencing product prices at issuance.

To the best of our knowledge, there is only one empirical study for the German market. Wilkens et al. (2003) analyze a large data set of ‘classic’ structured products, with and without coupon payments, on a variety of German stocks traded in November 2001. Extracting implied volatilities from comparable call options traded on the Eurex (European Exchange), fictitious product values are calculated and compared to prices quoted in the secondary market. The authors find evidence of an overpricing of structured products, which can mostly be interpreted as in favor of the issuing institution. In assessing the driving factors of pricing policies, Wilkens et al. (2003) conclude that issuers orient their pricing towards the product lifetime and the incorporated risk of a redemption by shares (given by the moneyness of the implicit options), bearing in mind the volumes of sales and repurchases to be expected from issuance until maturity.

The purpose of this study is to undertake the first investigation of the full range of equity-linked structured products in the German private retail banking sector. Based on a large and unique data set, we provide an innovative in-depth pricing analysis in both primary and secondary markets. Our study is also the first to incorporate structured products with implicit exotic option components, namely barrier and rainbow options. From a methodological point of view, the main technique consists in comparing product prices with theoretical (‘fair’) values using prices of exchange-traded options.

Our results suggest that, in the primary market, all types of equity-linked structured products are, on average, priced above their theoretical values and thus favor the issuing institution. However, the overpricing varies with underlying and product type. In general, more complex products incorporate higher implicit premiums. In the secondary market, the diagnosed overpricing decreases as the products approach maturity. This supports our ‘life cycle hypothesis’ according to which issuers orient their pricing to the remaining product lifetime in order to earn additional profit.

The paper is organized as follows: In Section 2, we develop a classification of equity-linked structured products in the German market and discuss the products’ main characteristics, payout profiles, and valuation approaches by duplication. Section 3 describes the objectives and hypotheses of the empirical analysis, while our methodology and data are given in Section 4. Section 5 presents the empirical results. The final Section 6 summarizes and provides an outlook for further research.