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Structured products: Taking the alternative route

Equity derivatives dealers responding to difficult trading environment; New products to cope with volatility and counterparty risk

Equity derivatives and structured products desks have had to be especially nimble over the past year. For the first time, bank counterparty credit risk became a real concern for investors, while market fundamentals – low interest rates and sky-high equity market volatility – have made it difficult to offer traditional principal-protected equity-linked notes. The banks have responded. They have tweaked their usual equity-linked offerings to make them more economic, and they have been busy coming up with products linked to systematic, absolute-return-type strategies. Some have overlaid their regular investments with volatility control mechanisms (see global structured products award), while dealers have responded to the counterparty issue by wrapping their offerings as Ucits III funds or offering collateralized investments.

Go back a few years and the dealers had it easy. With interest rates in the US and Europe up around 4% or 5%, conditions were favourable for pricing the typical instrument used to provide a capital guarantee, the zero-coupon bond, which is priced below par and rises, at a rate of Libor plus a spread, to par at maturity. When an investor buys a principal-protected, equity-linked product, some of their money goes towards buying a zero-coupon bond, with the cash left over used to purchase call options on an equity basket.

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