I take a philosophical, rather than mathematical, approach to structuring derivatives. This approach is accessible to everyone from derivative structurers and marketing professionals on the sell-side, to corporate risk managers and traders on the buy-side. It is also an approach that can be used across all asset classes, be it managing interest rate, commodity, currency, equity or credit risk.
This approach frames the end user's risk management objectives around the dimensions of Price, Protection, Participation, and Performance.
Questions of suitability, appropriateness, and best value, can be answered when all of these are in balance with one another. When they are not, unwanted costs can arise.
The below examples of the Knock-In Forward and the Target Accrual Redemption Forward (TARF), demonstrate how this framework can be applied.
Price refers to the entry cost of the strategy and for bought strategies will be expressed as the premium, which is typically paid upfront but could be deferred.
With many strategies marketed as zero premium, it is important to have an awareness of the component parts within that strategy and their relative values to one another to ensure that pricing is fair.
Participation is synonymous with flexibility and optionality.
Does the strategy enable the client to benefit from future favourable rate moves?
Alternatively, is the strategy one that permits the client to walk away from the hedge if it no longer were to be needed?
Protection refers to the strategy’s inherent protective qualities. For example, does it provide definitive protection ? Or is that protection conditional upon certain events?
Furthermore, relative to other available hedging products, is the protection offered in-the-money (ITM) or out-themoney (OTM)? Is it outperformance that is targeted or is rate certainty the primary risk management goal.
Performance refers to how the strategy works during its life.
Does it deliver on the original risk management objectives? Can it it be valued and restructured easily if circumstances change? What future costs might it impose were the client to find itself obligated to trade at worse rates than those prevailing in the market at the time of settlement?
Does the strategy have an entry cost? Where does the strategy protect you? Does the strategy offer flexibility? How could the strategy perform, what potential obligations might it impose?
Read the attached article which expands on this blog by including a case study that compares the knock-in forward strategy with a target accrual redemption forward.
Comments