Market Pricing of Exotic Structured Products: The Case of Multi-Asset Barrier Reverse Convertibles in Switzerland

Abstract

The market for structured financial products in Switzerland ranks among the largest in the world. A unique characteristic of the Swiss market is that its most successful products are reverse convertibles on multiple assets with conditional capital protection (multiple barrier reverse convertibles, MBRC). In other countries, an active market only exists for simpler types of reverse convertibles. The valuation of MBRCs is not straightforward, and pricing tools are not yet publicly available. Thus, transparency with respect to fair values might be poor, and it is not obvious that the competition between issuers is strong enough to ensure "fair" pricing. We provide the first empirical study on market pricing of MBRCs based on a comprehensive database of 468 certificates outstanding in April 2007. Using a numerical, tree-based valuation method, we obtain an average overpricing of at least 3.4%. This premium on the entire product corresponds to a price discount of 29% on the embedded short put. The overpricing is positively related to the coupon level, indicating that investors tend to overweight the sure coupon and underestimate the risk involved. This behavioral bias appears to be important in explaining the success of the product.

Pricing and upper price bounds of relax certificates

“…First, we may conclude that relax certificates are overpriced in the market. This is in line with the empirical results of Wallmeier and Diethelm (2008) for the swiss certificate market. Furthermore, the mispricing is the higher the higher the bonus payments (and thus also the higher the discount due to the knock-out feature of the bond).…”

“…In particular, we analyze the pricing, upper price bounds, and risk management. Related literature includes Wallmeier and Diethelm (2008) and Lindauer and Seiz (2008). They analyze (multi) barrier reverse convertibles which are traded in Switzerland and are similar to the German relax certificates.…”

“…Lindauer and Seiz (2008) rely on Monte Carlo simulations to price these contracts in a standard Black-Scholes framework with correlated assets. Wallmeier and Diethelm (2008) extend a multinomial tree introduced by Chen, Chung, and Yang (2002) to value barrier reverse convertibles on three underlyings. In contrast, our main focus is on closed-form or semi-closed form solutions.…”

Can utility optimization explain the demand for structured investment products?

“…Elaborate pricing techniques have been developed for increasingly complicated structured products. In addition to this enormous technical literature, several interesting empirical studies have recently been published on the actual market prices of structured products in the US (Benet, et al 2006) and in Europe (Wilkens, et al 2003, Grünbichler & Wohlwend 2005, Stoimenov & Wilkens 2005, Szymanowska, et al 2007, Wilkens & Stoimenov 2007, Wallmeier & Diethelm 2008 . However, no comprehensive studies have yet attempted to understand which types of structured products are attractive for private investors and for what motives, although this topic has recently drawn much attention from a number of papers addressing specific puzzles in this field: Henderson & Pearson (2007) studied empirical differences in popular payoff diagrams between structured products with single stocks and stock market indices as underlying assets.…”

Beyond Payoff Diagrams: How to Present Risk and Return Characteristics of Structured Products

“…There is some evidence that investors typically underestimate the probability of hitting the barrier (see Rieger, 2011;Lindauer and Seiz, 2008). In addition, they generally seem to focus on the sure coupon and tend to neglect the fact that a high coupon is just one side of the coin, the other side being engraved high downside risk (see Wallmeier and Diethelm, 2009). Thus, investor behavioral biases seem important, and may indeed play a part in the design of structured products such that the products might be customized to take advantage of these behavioral biases.…”