The price-setting behavior of banks: An analysis of open-end leverage certificates on the German market

Abstract

a b s t r a c tThis paper presents the first analysis of open-end leverage certificates on the German market. The major innovations of these certificates are twofold. First, issuers announce a price-setting formula according to which they are willing to buy and sell the certificates over time. Second, the product's lifetime is potentially endless. Our main findings are that the price-setting formula is (i) designed to strongly favor the issuer and (ii) is consistent with the main outcome of the 'life cycle hypothesis' for structured financial products [Stoimenov, P.A., Wilkens, S., 2005. Are structured products 'fairly' priced? An analysis of the German market for equity-linked instruments. Journal of Banking and Finance 29, 2971-2993]. (iii) This holds for different product features and also in the presence of issuers' credit risk and jump risk in the underlying.

Pricing effects when competitors arrive: The case of discount certificates in Germany

“…As such, an investor that bought a certificate can sell it to the issuer from whom s/he bought it in either an OTC transaction or secondary markets. Both sales and buybacks are carried out at prices that are often above theoretical values, but the premium included when selling certificates to retail investors exceeds that when rebuying the certificates from investors (Entrop, Scholz, and Wilkens, 2009). Therefore, issuers gain by decreasing the implicit premiums over the lifetime of the certificates (Wilkens and Stoimenov, 2007).…”

The order flow of discount certificates and issuer pricing behavior

“…Indeed, Muck (2006) does not find evidence for the life-cycle hypothesis in his sample of knock-out certificates on the German market. Entrop et al (2009) demonstrate theoretically, based on issuer pricing formulas, how issuers earn margins over the life of these products. 7 Similar to options, the characteristics of a product are not driven by its absolute strike price (or cap), but by its moneyness, i.e., the extent to which a product is ''in the money'' or ''out of the money.''…”

Endless leverage certificates

“…This implies that exercisable ELCs on 'jump-free', continuously traded underlyings should not exist. Entrop et al (2009) take this view and assume that ELC holders exogenously choose holding periods. They show that in the absence of gap risk the arbitrage profits for the issuers increase in the holding period without bound.…”

“…The only other paper on ELCs to our knowledge is Entrop et al (2009). They value ELCs under the assumption that the underlying is continuously traded and that investors have exogenous holding periods.…”