An Introduction to Structured Financial

Instruments
Massimo Guidolin Manuela Pedio
Bocconi University Bocconi University

May 3, 2015

1. Structured Products: from linear to asymmetric payoffs

Structured products are financial instruments that allow one to build highly customized risk-return
profiles. These products are obtained by combining a Zero Coupon Bond (ZCB) with simple
and/or exotic options. A simple example of structured product is an Equity Linked Bond (ELB).
Although there are a variety of different payoffs that may characterize an ELB, in its simplest form
this bond pays back at maturity the invested capital plus the performance of the underlying asset.
The underlying may be a share, an index, a basket of shares, a basket of indexes (just to mention
the standard types of underlying assets, although the set can be easily expanded to everything you
can write an option on - e.g. an ETF, a commodity index, etc.).
An ELB’s payoff can be easily constructed as a combination of a ZCB and an European vanilla
call option. For example, let’s consider a 5-year bond that at maturity pays the principal plus the
performance of the Eurostoxx 50. To pay the capital back to the client you have to buy a 5-year
ZCB, which you can buy at a discount now to get 100 in 5 year’s time. If the cost of the bond
now is 92 Euro, you have 8 Euro (8% of the notional) to buy an at-the-money (ATM) call option
on the Eurostoxx 50.1

  5 = 100 × [1 + 05 ×  {5 0 − 1; 0}]

where  is the price of the underlying asset at time t. If the premium for an ATM call on
Eurostoxx 50 is 16% of the notional, you can only afford a half of the options needed to receive
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Recall that in the market the premium of an option is generally expressed as a percentage of the notional and
the Strike as a percentage of the spot. As an example, if the spot price of Fiat is Eur 15.00, a call with Strike Eur
17.00 is said to have Strike 113.3%. If we want the option to buy 10,000 shares, our Notional Amount (NA) will
be Eur 170,000 (i.e. Eur 170 × 10 000). If the option to buy one share of Fiat at Eur 17.00 costs Eur 3, one will
spend Eur 30,000 to get the option to buy 10,000 shares at Eur 17.00. It will be said that the premium of the call
is 17.65%.
the performance of the underlying at maturity. Accordingly, at maturity the client will realize the
below payoff: The possible scenarios at maturity are:
The Eurostoxx 50 has a negative performance. The ZCB pays back 100 Euro, so the investor
gets its capital back. The call option is out-of-money so the investor will get zero from the option.
The Eurostoxx 50 has a positive performance equal to 10%. The ZCB pays back 100 Euro, so
the investor receives its capital back. The call option is in-the-money so the investor will get 5% (
the option is 10% in-the-money, but you afford to buy 1/2 of the options needed to get the total
performance of the underlying).
There can be a lot of variations on this structure, e.g., instead of buying a standard at the
money call, you can buy an Asian option, with yearly observation. An understanding of exotic
options will be important for the rest of this course, so we shall shortly review them.

2. Exotic Options

2.1. Digital Options

Digital options are options than can pay either zero (if the underlying is below the Strike level) or
a fixed amount (if the underlying is above the Strike level). Let’s provide an example: consider the
Equity Linked Bond described above. Instead of paying the performance of the index Eurostoxx 50
(if positive), the bond may pay every year a fixed amount, if and only if the value of the Eurostoxx
50 at the end of every year is above a certain value. Let’s suppose that at the beginning of the
life of the ELB the value of Eurostoxx 50 is 3,656 basis points. A bond with digital coupons pays
a fixed amount at the end of each year if the value of the Eurostoxx 50 is equal or above 3,656
basis points. Consequently, instead of buying a 5-year at the money call option, we will invest
our 8 Euros to buy 5 European digital options (a 1-year digital option, a 2-year digital option, a
3-year digital option, a 4-year digital option, and a 5-year digital option). The pricing of a digital
option is straightforward, because it depends on the probability that the underlying will be above
the Strike at maturity:
 = Fixed Amount ×  (2 ) × 

where  (2 ) is the probability that the Eurostoxx 50 will exceed 3,656 at the expiry of the option
and  is the discount factor. At this point, if you recall BS formula, you know that:
¡ ¢
ln 
 p +  12  2 ( − ) √
2 = 2
−  2  − 
 ( − )

If you have 8 euros to spend, now you have to solve the following problem: which fixed amount
do I afford to pay every year? Consequently, you calculate the price of each digital option paying

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a fixed amount of 1 euro and then you divide 8 by the cost of the options to get the fixed amount
you can pay.

Maturity   (2) Premium

1 0.9949 0.52 0.5174
2 0.9816 0.51 0.5006
Example 1 3 0.9623 0.50 0.4811
4 0.9403 0.49 0.4608
5 0.9178 0.48 0.4406
Sum 2.4000
This means that with 8 euro you can pay a fixed amount of 3.33 euros each year.

°
R
Exercise 1 It is easy to write down the formula in an Excel spreadsheet. Try to play with it and
see what happens when you change the parameters, e.g., volatility. Which underlying will allow
you to pay a higher coupon? A highly volatile or a low-volatility one?

2.2. Asian Options

An Asian option has a payoff that depends on the average value of the underlying at some deter-
mined dates - i.e. the Observation Dates - (or during the whole life of the option). For instance,
the payoff of an Asian call option with  observation dates is:
½ P ¾ ½ ¾
1 =1  
   =   × ×   −  0 =   ×   − 1 0
  

where  is the strike price and  is the value of the underlying at of the observation dates,  = 1
2, ..., . Let’s consider again the ELB considered above. Instead of paying-out the performance of
the underlying, it can pay-out the average performance of the underlying. Let’s consider an Asian
option on the Eurostoxx 50 with strike equal to 3,656 and five yearly Observation Dates:

t 
1 3,700
2 3,860
Example 2 3 3,850
4 3800
5 3,750
Average 3,792

The payoff of the Asian option at maturity will be:

½ ¾ ½ ¾
 3 792
 5 =   ×   − 1 0 =   ×   − 1 0 =   × 372%
 3 656

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If the premium of the Asian option is equal to 10% and we have 8% to spend, we can afford 80%
participation to the return (if positive) of the underlying. Consequently, at maturity, the ELB will
pay:
 = 100 × [1 + 08 × 372%] = 103

Obviously, an Asian call will always be cheaper than the equivalent European call option. Asian
options are strongly path-dependent options, i.e., their value before expiry depends on the path
taken and not only where the price of their underlying has settled at maturity. As such their
no-arbitrage price is expected not to exceed the prices of a corresponding European call.

2.3. Barrier Options

There are many types of barrier options, but the most common ones are the Knock-In and Knock-
Out options. A Knock-In option is an option that comes into existence if the price of the underlying
crosses the barrier. On the contrary, a Knock-Out option is an option that is terminated if the
price of the underlying crosses the barrier. According to the location of the barrier, we distinguish
up-and-out, down-and-out, up-and-in, and up-and-out options (see the table below).

Type Barrier Location Description

Price has to decrease below the barrier for the
Down&In Below
option to come into life
Price has to increase above the barrier for the option
Up&In Above
to come into life
Price has not to decrease below the barrier for the
Down&Out Below
option to stay alive
Price has not to increase above the barrier for the
Up&Out Above
option to stay alive

In addition, the barrier can be observed only at maturity (European barrier) or during the
whole life of the option (American barrier). As an example, consider an ATM call option on
Fiat (Spot price = Strike price = Eur 15) with an Up&Out barrier at Eur 19, observed only at
maturity. If at maturity the price of Fiat is equal to Eur 19 the option will expire (be terminated)
and nothing will be paid, as the price is above the barrier. Instead, if the price at maturity is
equal to Eur 17, the pay-out of the option will be equal to:

   =  −  = 17 − 15 = 2

From the table below, it is evident that a barrier option with a barrier  = 19 should be cheaper
then a standard, plain vanilla option (even if  = 15 for both options):

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 Payoff
S Knock-Out=19 Call Standard Call
14 0 0
15 0 0
16 1 1
17 2 2
18 3 3
19 0 4
20 0 5
This difference is exactly the reason why someone may wish to buy a barrier option. Suppose,
as an example, that you believe that Fiat (Spot price = Eur 15) will slightly increase in the next
three months (suppose that your target price is 17 Eur). You have three options to bet on this
increase of Fiat:
a) buy Fiat at 15 Eur and sell it in three months time; if you have 1,500 Eur to invest you will
buy 100 shares and then sell them in three months;
b) buy an ATM option with three months maturity; if the premium of the option is 1.5 Eur
and you have 1,500 Eur to invest then he can underwrite an option on a notional of 15,000 Eur
(1,000 shares);
c) buy an ATM option with Up&Out barrier (barrier equal to 18 Eur) with three months
maturity; if the premium of the option is 1 Eur and you have1,500 Eur to invest you can underwrite
an option on a notional of 22,500 Eur (1,500 shares).
The table below considers the possible scenarios at maturity:
S P&L(a) P&L(b) P&L(c)
13 -200 -1500 -1500
14 -100 -1500 -1500
15 0 -1500 -1500
16 100 -500 0
17 200 500 1500
18 300 1500 0
19 400 2500 0
Strategy c) is the one maximizing the outcome in case your target price is accurate. In essence,
if you are not interested in the upside of the share above 18 Eur, the Up&Out option allows you
not to pay for it. Clearly, the closer the barrier, the higher the probability that it will be knocked,
the lower the option price. Conversely, an Up&In option will be bought by a client that believes
that the price increase will be higher than a certain level. If the client strongly believes that Fiat
will quote higher than 18 Eur in three months, buying an ATM Up&In call option with barrier
equal to 18 Eur will be cheaper and more convenient than buying a plain vanilla ATM option.

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 3. A Few Examples of Structured Products: Reverse Convertibles

In the previous sections, we have reviewed some example of exotic options that can be used to
build structured payoffs. In this section, we review one famous example of structured products:
the Reverse Convertible.

3.1. A standard Reverse Convertible

The standard Reverse Convertible is a note that pays an unconditional coupon at maturity (e.g.,
10%) regardless of the behavior of the underlying. In addition, if the price of the underlying has not
declined, the note also pays back its notional. On the contrary, if the underlying has depreciated,
the investor obtains a number of shares equal to the notional divided by the Strike Price (also
known as Conversion Price). As an example, consider a 1-year Reverse Convertible note on Fiat:

Reverse Convertible Term Sheet/Features

Tenor 1 year
Underlying Fiat
Strike Price (conversion price) 16 Euro
Coupon 10%
Notional 100 Euro (equal to 6.25 Fiat shares)
Payoff in case Fiat ≥ 16 Euro 110 Euro
Payoff in case Fiat  16 Euro 6.25 shares plus 10 Euro

If at maturity the value of Fiat is equal of higher than 16 Euro the investor will receive back
the notional plus the 10% coupon. If instead the value of Fiat is below 16 Euro (e.g. 10 Euro),
the investor will receive 10% coupon, plus 6.25 shares (i.e. 62.5 Euro).
This payoff is replicated with a purchase of a Zero Coupon Bond plus the sale of a put option
with 100% strike. Indeed, the payoff of the ZCB at maturity is equal to 100 Euro. If the value of
Fiat is below 16 Euro the put option will be exercised and the payoff is: −( − ). Consequently
the total payoff will be: 100 − 100 +  = . Instead, if Fiat is above 16 Euro, the put option will
be OTM, so it will not be exercised. The proceeds from the sale of the put are invested at the risk
free rate to delivery a fixed coupon at maturity which is higher than the one that could be simply
obtained from investing in a ZCB. In practice, the investor is buying downside risk to achieve a
higher coupon at maturity. Notice that, instead of having a coupon at maturity, the investor may
prefer to buy the note at a discounted price (i.e., the proceeds from the sale of the put are used to
decrease the price of the note). In this case we talk about Discount Certificates.

Exercise 2 Look at the two tables below: which underlying will deliver the highest coupon?

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 Figure 1:

Eurostoxx Banks FTSE MIB

1. a)  25% b)  17%
Dividend Yield 2% Dividend Yield 5%

Select Dividend Eurostoxx 50

c)  25% d)  17%
Dividend Yield 5% Dividend Yield 2%

The correct answer is a). Indeed, the higher the premium of the put, the higher will be the
coupon. As the premium of an option increases with volatility and decreases with the dividend
yield, to maximize the coupon you should find an underlying which has high volatility and low
dividend yield.

3.1.1. Different types of Reverse Convertibles: Bonus Certificates

The classical version of a Reverse Convertible does not imply the use of exotic options. In this
section we review a possible variation of the Reverse Convertible: Bonus Cap Certificates. A
Bonus Cap Certificate offers a conditional protection to the downside, i.e., the investor will receive
back the capital plus a coupon unless the barrier is touched/crossed. The barrier can be European
(observed only at maturity) or American (observed in continuos time). Let’ discuss in details how
a Bonus Cap is structured and in particular, let’s examine first a Bonus Cap with a European
barrier. Let’s consider the following characteristics:

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 Bonus Certificate Term Sheet/Features
Tenor 1 year
Strike 100% (15 Euro)
Underlying Fiat
Barrier 80% (12 Euro)
Notional 100 Euro
Bonus Amount 110 Euro
Cap Amount 110 Euro

If at maturity Fiat is above 12 Euro, the investor receives a Bonus Amount equal to 110 Euros
(which is also the maximum amount that the investor can get, i.e., the “Cap”). Otherwise the
investor gets an amount proportional to the performance of Fiat, i.e.,
½ ¾

   = 100 ×  [  
0

A Bonus Cap certificate is replicated with a ZCB plus a short Down&In put option. Consider the
case in which the 1-year discount factor is equal to 99% and a Down&In put with 80% barrier
and  = 110% has a premium equal to 9.9%.Given the discount factor, today we can invest 108.9
Euro in ZC bonds with 1-year to expiry to get 110 Euro at maturity. At maturity we can have the
two scenarios below:

Fiat ≥ 12 Euro Fiat  12 Euro

ZC 110 Euro 110 Euro
Put D&I Not triggered −( − ) = −110 + 
Total 110 Euro 

Notice that in the case of an American Barrier, the payoff will be the same, but the barrier of
the Down&In put will be observed during the whole life of the structured product and not only at
maturity.

Exercise 3 Everything else being equal, which structured security will display a higher Bonus
Amount: a) a Bonus Cap with European Barrier; b) a Bonus Cap with American Barrier?

A Bonus Certificate may also not have a Cap. In this case the Bonus Certificate will pay a
Euro amount equal to ½ ¾

100 ×    
0
if the barrier has not been touched, and Eur 100 × ( 0 ) otherwise.
A Bonus Certificate without Cap is replicated with a Zero Coupon Bond, a short Down&In
put with strike Bonus Amount% and a long call with strike Bonus Amount%. If we consider the
previous example, we have:

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 Underlying Payoff

180
160
140
120
100
80
60
40
20
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170

Figure 2:

Fiat =16.5 Euro 12 EuroFiat16.5 Euro Fiat12 Euro

ZC 108 Euro 108 Euro 108 Euro
Put D&I Not triggered Not triggered −( − ) = −108 +  .
Call K=110%  − 108 Not exercised Not exercised
Total  110 Euro 

Clearly, as the payoff is replicated by buying a call option in addition to selling a put, the Bonus
that can be afforded will be lower, because part of the premium received from the put should be
used to buy the call.

3.2. The Autocallability Feature

Autocallable Certificates, generally known as “Express” are certificates which are characterized by
the possibility of early redemption if the underlying is higher than a certain level (usually equal
to the Strike). In case they are redeemed early, they pay their notional amount plus a coupon,
multiplied by the number of observation periods elapsed. In case they are not redeemed early, at
maturity the capital is protected if the underlying is above some threshold level, called the barrier.

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 Autocallable Certificate Term Sheet/Features
Maturity 3 years
Underlying Fiat
Strike 15 Euro
Observation Dates End of each year
Trigger 100% of the Strike
Barrier 70% of the Strike
Coupon 6%

In the above example, the certificate can be redeemed early at the end of year 1 and at the end
of year 2, if the price of Fiat is equal to or higher than the trigger level (15 Euro): if redeemed at
the end of year 1 the certificate will pay 107 Euro; if redeemed at the end of year 2 the certificate
will pay 114 Euro. If instead the product reaches maturity, the certificate will pay 121 Euros, if
the underlying is above the trigger level, 100 Euro if the underlying is below the trigger level, but
above the barrier and Eur 100 × ( 0 ) otherwise.

3.3. How do you price an autocallable certificate?

Because autocallable certificates are path-dependent, given that its maturity depends itself on the
price of the underlying at some future dates (the Observation Dates), they are priced using Monte
Carlo simulations. While most popular pricing assumptions take volatility as constant, this is
feature is at odds with market experience. Consequently, a stochastic volatility model is in general
needed to capture the probability of kickout, and to asses the remaining value of the structure if
no kickout has occurred. Stochastic volatility models extend the usual random-walk equation for
the underlying asset price by incorporating the random nature of volatility. For instance, in one
typical model, the underlying price is influenced by volatility changes. In practice, the price of the
share  follows the process
p
+1 =  + ( −  − 05 ×   )∆ +   ∆1 

while the variance is modeled as

p 2
 +1 =   + (̄ − )∆ +    ∆2 + + ∆(22 − 1)
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where 1 and 2 are both Gaussian IID shocks. The underlying price is simulated over the life of
the structure and at each Observation Date, its price is compared to the trigger level. From this
simulation one can also get the probability of each scenario and compute the expected life of the
product.

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