SMM503 Structured Products 2022
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SMM503
Structured Products
2022
Question 1
a. Describe the various steps involved in structuring a 5-year inverse floating rate note.
(25 marks)
b. How does the risk of an inverse floater compare to that of a fixed rate bond and traditional floating rate notes with particular reference to the bankruptcy of Orange County in 1994.
(25 marks)
c. The senior debt of XYZ Corp is frequently traded and currently trades at a spread of 40bp over risk-free bonds of the same maturity; however, the junior and subordinated debt are both illiquid.
If the expected recovery rates for senior, junior and subordinated debt are 90%, 50% and 25% respectively, what spread (in basis points) would you expect the Junior and Subordinated bonds to trade at?
(25 marks)
d. What is CDS basis? Does a negative basis imply there is a risk-free profit available?
(25 marks)
Question 2
Mr. Noble is extremely bullish about the prospects for commodity prices, he estimates that over the next 3 years they will rise by an average of 12% each year.
In an attempt to profit from this view Mr. Noble has taken out a 3-year maturity loan of $1m secured on his property at a fixed interest rate of 1.5% per annum. Though Mr. Noble can afford to pay the interest out of his other income he will be reliant upon the proceeds of his investment to repay the capital.
Mr. Noble’s private banker has proposed a 3-year 100% capital-protected structured note that pays 35% of the appreciation in Gold at the end of the 3-year period. However, Mr. Noble does not find this structure attractive because of the low participation rate.
a. Assuming that you work for a rival bank, propose 3 significantly different structured notes that would allow Mr. Noble to improve the participation rate under the above constraints.
Support your answer with graphs and/or payoffformulas.
(60 marks)
b. Which of these 3 notes would you recommend and why? Take into account
different elements including participation, downside risk, upside potential, etc .
(20 marks)
c. The chart below shows the performance of 3 different commodity indices over the last 2 years. Briefly discuss what might have caused the relative performance dispersion between these 3 indices.
|
|
.
(20 marks)
Question 3
a. Draw the profit and loss payoff diagrams and explain in words for:
i. A long position in a Digital Double knock-out Call Option with strike of 75 and barriers of 75 and 125 with a premium paid of 4.
ii. A short position in a Up and In Call Option with a strike of 100 and a barrier of
120 with a premium received of 6.
In both cases assume that the underlying is currently at 100 and the barrier is only monitored at maturity.
(20 marks)
b. How does the value of both these options change with:
i. The location of the barriers
ii. The barrier monitoring frequency
iii. Implied Volatility
iv. The price of the underlying (assume that the initial price is 100)
In each case explain why the price changes.
(60 marks)
c. Briefly outline why the realized volatility of the underlying might ultimately impact the profitability of a delta hedged long call option position.
(20 marks)
Question 4
A pension fund is considering changing their investment mix. They would like to replace their current equity allocation with an allocation to equity linked notes, specifically they would like to maintain exposure to the upside performance of equities without putting their capital at risk.
In making their decision the trustees had considered replacing the equity allocation with fixed income investments, but they were concerned that the yield curve is flat and the yields of 1.5% are too low. They are also of the view that equities could potentially provide returns of 25% to 40% over the next 3 to 5 years respectively.
The trustees seek the advice of an investment bank as to the best way to gain exposure to equities without putting their capital at risk.
a. Assuming you work for the bank and under the above constraints, structure and discuss the details and workings of 3 structured notes that will provide the pension fund with exposure to equities without risking their capital.
Support your answer with graphs and/or payoffformulas
(60 marks)
b. Which of these 3 solutions would you recommend and why? Take into account different elements, potential return, risk, etc.
(20 marks)
c. The image below shows the implied volatility surface for the FTSE100 Index as of 11th March 2022. Discuss the shape of the surface and possible reasons for this shape.
(20 marks)
Question 5
Mr. Bluespan believes that the recent market volatility will end soon and that equity markets are close to perfectly priced. He does not expect prices to move much over the next 12 months, in fact, he doesn’t see the major indices moving more than +/-5% over the next year.
Mr. Bluespan has the bulk of his assets invested in t-bills yielding 0.5%, he would like to improve this yield and is not averse to putting some of his capital at risk so he seeks the advice of his bankers as to how he can improve the yield by buying equity- linked yield notes.
a. Assuming you work for the bank, structure and discuss the details and workings of 3 significantly different yield notes that allow Mr. Bluespan to capitalize on his view of a stable equity market
Support your answer with graphs and/or payoffformulas.
(60 marks)
b. Given the following potential underlying assets for each of the three notes proposed above, which underlying would you choose and why?
|
Name |
Ticker |
Price |
Dividend Yield |
1Y Implied Vol |
1y Historical Return |
|
S&P 500 |
SPX |
4,230 |
1.60% |
24.5% |
7.3% |
|
Advanced Micro Devices |
AMD |
104.8 |
0.00% |
52.4% |
27.0% |
|
Seagate Technology |
STX |
87.1 |
3.70% |
45.1% |
-7.1% |
|
Costco |
COST |
527 |
0.70% |
29.3% |
59.0% |
(20 marks)
c. Which of these 3 solutions would you recommend and why? Take into account different elements including price, downside risk, upside potential, etc.
(20 marks)
2022-07-28