Financial products with capital protection barrier - part 1

General Introduction

Abstract

In this post and following ones, I am going to show a way to evaluate the expected performance of structured financial products providing with capital protection barrier. They are those kind of products having soft protection features. Soft protected products return investors' capital in full at maturity provided the underlying asset does not fall below a pre-determined barrier. This barrier is usually observed either daily throughout the investment term (an American barrier), or on the maturity date only (a European barrier).

If the barrier is breached, investors' return of capital at maturity will reflect any negative performance of the underlying asset on a 1:1 basis.

As the American barrier could potentially be breached daily throughout the term, it is higher risk than the European version and therefore the payoff for a product with an American barrier will be higher than a product with a European barrier, all else being equal.

The value of the barrier is in the most cases set between 50% and 80% of the underlying value observed when the structured product is introduced in the market.

The gross yield is determined as a fixed percentage per observation window, and the observation window may be set forth on a yearly or six months basis. The observation is a fixed duration time window whereby at its end the underlying market price is compared with its initial value. If the underlying market price is greater than its initial value at observation time, the fixed gross yield is paid off to the investor and the structured product eventually expires. At that moment, profits for investors are determined.

The Problem

Let us soppose an ordinary investor has the opportunity to choose among one or more of such kind of structured products. The questions are:

1. what are the chances our investment ends up with a gain ?

2. what are the chances choosen structured product breaks its barrier, losing then capital protection ?

3. what are the rational criterias to choose a structured product ?

4. what to care about for in portfolio structured products ?

All those questions translates in terms of data analysis in the following actionables:

1. exploratory analysis of the structured product underlying historical price time series

2. definition of a model to represent price time series evolution

3. simulation of the underlying future prices and their analysis in order to determine:

\(\ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \) a. gains vs losses

\(\ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \) b. barrier breaks events

\(\ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \ \) c. investment preferences among structured products

4. definition of in portfolio structured products underlying market price monitoring approaches

The rest of this discussion is organized in the following sections:

1. Exploratory analysis, whereby various tests are applied to underlying historical data in order to properly drive the model selection

2. Model definition, whereby a model capable of gathering underlying price time structure is defined

3. Simulations, whereby simulation results are shown and sample probabilities of success vs failure at the observation windows are computed

Further sections may be planned.

The overall discussion comprises the following planned posts:

Posts series break-out

post.no	posts
1	General Introduction
2	Scenario
3	Exploratory Analysis - Structural Changes
4	Exploratory Analysis - Outliers Detection
5	Exploratory Analysis - Autocorrelation Analysis
6	Exploratory Analysis - Homoscedasticity Test
7	Exploratory Analysis - Unit Root and Stationarity Tests
8	Exploratory Analysis - Normality Tests
9	Exploratory Analysis - Fractional ARIMA Test
10	Model Definition
11	Simulation
12	Simulation results discussion

Conclusions

After having set up a quite ambitious plan, in my next post I will outline the scenario I am going to analyze.