CERTIFICATEThis is to certify that the project titled A Detailed Study of Structured Products has been successfully completed by Mr. Mriganka Pattnaik, IIT Guwahati, in NATIONAL STOCK EXCHANGE OF INDIA LTD as a part of his one month internship programme in the month of December, under my guidance.

Mr Johnson Joseph Chief Manager Listing Department National Stock Exchange

ACKNOWLEDGEMENTI sincerely thank Mr. Hari K(Vice President-Listing) and Mr Johnson Joseph(Chief Manager-Listing) for giving me an opportunity to work on a project in this esteemed organisation. I would also like to thank, Mrs Pramila DSouza, without whose guidance, this project would not have been possible. I would like to take this opportunity to thank the various members of the listing department for their help and support during my internship programme in the month of December.

CONTENTS1. Introduction-Structured Products 2. Interest Rate Linked Structured Products 3. Credit Derivative Products 4. Currency Linked Notes 5. Equity Linked Structures 6. Commodity Linked Structures 7. Indian Scenario

INTRODUCTION STRUCTURED PRODUCTSA structured product, also known as a market-linked product, is generally a prepackaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuances and/or foreign currencies, and to a lesser extent, swaps. The Pacific Stock Exchange defines structured products as "products that are derived from and/or based on a single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign currency, among other things" and include "index and equity linked notes, term notes and units generally consisting of a contract to purchase equity and/or debt securities at a specific time. The Pacific Stock Exchange defines structured products as "products that are derived from and/or based on a single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign currency, among other things" and include "index and equity linked notes, term notes and units generally consisting of a contract to purchase equity and/or debt securities at a specific time. Structured products are usually issued by investment banks or affiliates thereof. They have a fixed maturity, and have two components: a note and a derivative. This is how these composite products differ from plain vanilla coupon bonds. They tend to involve periodical interest payments and redemption at maturity. Both interest payments and redemption amounts depend in a rather complicated fashion on the movement of stock prices, indices, exchange rates or future interest rates. Since structured products are made up of simpler components, the easiest way to understand them is to break them down into their integral parts when we need to value them or assess their risk profile and any hedging strategies. This helps facilitate the analysis and pricing of the individual components. Although structured products are varied in nature and not homogenous, they can broadly be classified into six categories-Interest rate-linked , Equity-linked, Currency-linked, commodity-linked, and Credit-linked notes and deposits. However , this not a very rigid categorization as there are a variety of structured products and very often they are a combination of the above categories. In this report , I have briefly explained structured products on the basis of the above classification and then moved on to a examples of structured products listed on the National Stock Exchange and a few other exchanges. Also, I have tried to provide a perspective on risk management regarding structured products and how those lessons can be applied by financial institutions.

INTEREST RATE LINKED STRUCTURED PRODUCTSInterest rate linked notes are bonds with structured exposure to interest rate risk. The exposure to interest rate risk is created by linking the value of the coupon or principal repayments to an identified interest rate or prices of a specific debt security. The structures entail conventional bond structures combined with embedded with interest rate derivatives. Interest rate linked notes allow investors to assume structure exposure to specified interest rate changes. The investors objectives include enhancement of return or monetisation of anticipated interest rate movements over the term of the investment. The structures allow investors to create exposures/assume risk that is not available directly from traditional investments. Its demand is driven by investor acceptance of the structured note investment format. The derivatives used are generally standard structures traded in the derivatives market. The interest rate linked note is priced/hedged by decomposing the structure into the individual components which are then hedged and priced normally. Issuers of interest rate linked notes include natural issues(arbitrage funding entities) or special purpose repackaging vehicles. The transaction structure is designed to insulate the issuer from the impact of the embedded derivative by the dealer arranging the transaction. This is achieved by hedging the exposures of the issuer through a hedging structure that leaves it with funding at a known cost. There are several types of interest rate linked note structures: Interest Rate forward embedded structures o Inverse/reverse FRNs o Bond price/interest linked structures o Arrears reset/delayed LIBOR set notes o Constant maturity rate linked structures Interest Rate Option Embedded Structures-includes notes featuring embedded exotic interest rate options(barrier and digital options)

INVERSE FLOATING RATE NOTESInverse FRNs(also known as reverse or bull FRNs) are fixed income structured notes that were popular amongst investors in the period 1985-1990. The inverse FRN is a floating interest rate instrument where the coupon(reset usually 3 or 6 months) is calculated as a fixed rate minus a floating money market interest rate(3 or 6 month MIBOR). If MIBOR decreases, then the return payable under the note increases. The return on the inverse FRN cannot be negative and is floored at 0%. The inverse FRN can be bundled into 3 separate components: a fixed rate bond, an interest swap where the investor receives fixed rate and pays floating rate and an interest rate cap on the floating rate index purchased by the investor from the issuer. Hence, an inverse FRN is in effect a fixed interest bond combined with an embedded interest rate swap and an interest rate cap.

Example 1: Amount Term Interest Interest Payment Minimum Interest

Rs. 1000 lakhs 5 years 17.25% less 6 months MIBOR Payable semi-annually 0% pa- at no time will there be negative interest for investor

Diagram 1 shows the decomposition of an inverse FRN

BOND PRICE/INTEREST LINKED NOTESThe concept was introduced in two issues in 1987 by Nomura International for GMAC and Mitsui and Co(USA). The basic transaction entails the issue of debt securities bearing a higher than market coupon. The redemption amount repaid to the investor at maturity is linked to price fluctuations on an identified debt instrument. In a typical transaction, the coupon was set at 10.00% pa for 3 years. The redemption of the bond was linked to formula as follows: If the benchmark 30 year US Treasury bond at the end of 3 years(the maturity of the debt instrument) is at break-even yield, then bonds are redeemed at par If the yield is above or below the break- even yield(say 7.10%), then the amount received by the investor will be lesser or greater than par respectively In any case, redemption amount will not be less than zero. Implicit in the variable redemption formula in this particular structure is a long 3 year forward position on the 30 year US Treasury bond. The position can also be restated using put call parity as (European) options with a maturity of three years. The investor grants a put option on the 30 year bond with a strike yield of 7.10% pa and

simultaneously purchases a call option with an identical strike yield(effectively a forward purchase). The forward purchase is hedged with offsetting derivative transactions, effectively insulating the issuer from the risk of variations in the redemption amount. The economic logic underlying the transaction is based on the economics of the embedded derivative position. In the example, the investor would usually be writing a put that was substantially in-the-money and buying an out-of money call. The dealer would sell the put on the 30 year bond at a higher premium than the outlay needed to purchase the call, with the difference being used to subsidise the issuers cost. Example 2-Bond Linked Notes Quatrain Co., through Nomura International, undertook a 3 year 10.00% US$100 million issue of Treasury indexed bonds on 15 May 1986. Redemption value was linked to the 9.25% 2016 US Treasury Bonds via the following formula: R= US$100,000,000 x (MIP 26.491782) / 100 Where R=redemption value in US$ MIP=market index price of the 9.25% 2016 US Treasury bond at the maturity of the issue

INTEREST RATE OPTION EMBEDDED NOTES CAPPED FRNSSCapped FRNs were initially undertaken in June 1985 in USD in the Euromarkets. Since then, the concept has been extended, with transactions in a variety of currencies. The cap is structurally a put option on the price of a short-term security, priced off the underlying short-term interest rate index. The investor sells the cap to the issuer. The premium for the cap is received by the investor in the form of higher interest rates. This cap is sold by the issuer to a dealer. The option premium is used to lower the issuers borrowing cost, usually below market rates. Where the market rates exceed the capped rate, the investors return is limited to the specified maximum rate, allowing the purchaser of the cap to receive the difference between the cap and the market rate from the issuer. EXAMPLE 3: The Banque Indosuez transaction arranged by Shearson Lehman Brothers was an issue of 12 year US$200 million FRNs carrying an interest coupon of 0.375% over three month LIMEAN(the London Interbank Mean Rate). The FRN coupon was capped at 13.0625%. It should be noted that the cap level on LIMEAN is equivalent to 12.6875%. Shearson arranged for the sale of the cap to a US corporation(with a strike of 12.6875%). Indosuez pays out LIMEAN plus 0.375% or 13.0625% to the holders of the FRNs unless 3 month LIMEAN exceeds 12.6875% pa. Shearson passes the payment on to the purchaser of the cap to compensate it for rates rising above the cap level. Indosuez is compensated for the cap by a payment of 0.375% pa of the principal amount. Indosuez receives the premium as quarterly cash flow rather than an up-front payment. This brought Indosuezs cost of funds down to LIMEAN.

To avoid any credit risk, the purchaser of the cap paid Shearson a lump sum that was reinvested inTreasury zero coupon securities which produced the quarterly income stream equivalent to 0.375% pa. The structure of the transaction is laid out below.

COLLARED FRNSSThe basic structure of the collared FRN entails a normal FRN structure with an interest coupon related to overnite inter-bank rates. The interest rate coupon is subject to a minimum and maximum interest rate level(say 5% and 10% respectively). The initial issues were undertaken for maturities of 10 years. Basically, the collared FRN combines a standard FRN transaction with an overnite inter-bank rate(Eg: US$ LIBOR) cap and floor. The investor purchases a package consisting of the following elements: 10 year US$ LIBOR based coupon FRN. Sells a cap on US$ LIBOR at the maximum interest rate level(10% pa) Purchases a US$ interest rate floor at the minimum interest rate level(5% pa) Diagram 2 sets out the various components of a collared FRN and Example 4 sets out the term of the JP Morgan issue

Diagram 2

Example 4 Issuer Amount Maturity Interest Rate Fixed re-offer price Minimum Interest Maximum Interest Call Option

JP Morgan & Co Inc. US $200 million 10 years 3 month LIBID 99.85 5% 10% None

EXOTIC INTEREST RATE EMBEDDED NOTES BARRIER OPTION EMBEDDED STRUCTURESBarrier options are exotic options where a particular knock in or knock out condition is imposed. In the knock out condition, a particular option/condition is extinguished upon achievement of the relevant price level. In the knock in condition, a particular option/condition is activated upon the relevant asset price level being reached. The economic benefit of the barrier option structure derives from the fact that it usually has lower premiums relative to conventional options. The lower premium amount reflects the possibility that the option will be extinguished or not activated. The lower premium is used in structured interest rate linked notes to reduce the cost of an embedded option. The lower option premium allows a higher degree of participation in the movement in the relevant asset to be created for a given coupon or principal sacrifice. The structure is most attractive where the investor expects a modest market move(at least less than the barrier level) to achieve the maximum benefits from the incorporation of this type of exotic optionality. Example 5 sets out the terms of an FRN incorporating embedded interest rate barrier options on a short term interest rate index. Example 5 Amount US $100 million Maturity 3 years Issue Price 100 Floating Coupon 3 month LIBOR plus 37.5 bps pa payable quarterly Barrier Coupon 1.50% payable quarterly Commencement Level 40 bps over current 3 month LIBOR Current 3 month LIBOR 3.50% Analysis The return to the investor under this structure is predicated on the interaction of the spread, the barrier level and the conversion coupon. Where the barrier is not reached, the coupon payable is the floating coupon. The barrier coupon is the fixed rate payable where the barrier is reached. In effect, the security behaves like a high margin FRN unless LIBOR reaches the barrier level, when it becomes a fixed rate note with a 1.50% pa coupon.

CREDIT DERIVATIVE PRODUCTSCredit derivatives are defined as a class of financial instrument, the value of which is derived from an underlying market value driven by the credit risk of private or government entities other than the counterparties to the credit derivative transaction itself. The principal feature of these instruments are the separation and isolation of credit risk, facilitating the trading of credit risk with the purpose of replicating, transferring and hedging credit risk. Investor demand is motivated by the following factors: Ability to add value to the portfolios through trading in credit as a separate dimension. Opportunity to manage the credit risk of investments. Inability of traditional institutional investors and asset managers to participate in the loan markets. Ability to arbitrage the pricing of credit risk in and between separate market sectors. The principal credit derivative structures encompass total return swaps and credit default swaps.

TOTAL RETURN SWAPSThe central concept of a total return swap is the replication of the total performance of a loan asset. The defining characteristic of these structures is that they are off-balance sheet and do not necessitate entry into loan or bond purchase arrangements. The key elements include: The majority of total return swap transactions are on traded bonds and loans as the underlying asset. The investor assumes all risk and cash flow of the underlying asset. The bank passes through all payments of the underlying asset. The investor, in return, effectively makes a payment akin to a funding cost. The investor bears the full risk of capital price fluctuations on the underlying asset. The risk is structured as payments by the investor to the bank where the price of the underlying asset decreases and payments by the bank to the investor where the price of the underlying asset increases. This adjustment is made at specified times through the life of the transaction in accordance with an agreed mechanism based on the actual market price of the underlying security.

Under the total return swap structure, the investor receives interest payments and any fees including commitment fees and pays MIBOR plus or minus an agreed margin. All payments are calculated on the notional principal adjusted for any amortisation or repayments on the underlying bond.

Diagram 3:Total Return Swap

CREDIT DEFAULT SWAPSCredit default swaps are designed to isolate the risk of default on credit obligations. They are structured as instruments which make an agreed payoff(either fixed or calculated with reference to a specific mechanism) upon the occurrence of a credit event(default of reference credit). It would operate as follows: The bank seeking protection pays a fee to the bank providing protection on an identified reference entity. If there is a credit event in respect of the reference entity, then the bank providing protection would make an agreed payment to the bank seeking protection to cover any loss suffered because of the credit exposure to reference entity. If there is a no credit event, then there are no payments by the bank selling protection. The credit default swap is analogous to the following transactions: Guaranteed or letters of credit covering the performance of the reference entity. Credit insurance covering the performance of the reference entity. EXAMPLE 6 Assume an investor has a position in long maturity bonds issued by a company(ABC Company). The credit spread on the bond has widened. The investor is concerned

with short term default risk. The investor hedges the credit risk with the following credit default swap. Buyer of Protection Seller of Protection Maturity Reference Entity Reference Bond Credit Event Default payment Default Swap Premium Payment of Default Payment Investor Dealer 3 years ABC Company Reference Entitys 10 year 8.50% coupon bond Bankruptcy or insolvency event Notional Amount X[100%- Fair market value of Reference Bond after Credit Event] 1.25% pa payable by Buyer of Protection to Seller of Protection Payable by Seller of Protection to the Buyer of Protection upon occurrence of credit event

Diagram 4: Credit Default Swap

CURRENCY LINKED NOTESCurrency linked notes are bonds where the coupon and/or the principal payments are linked to currency movements. The structures entail conventional bonds with embedded currency derivatives. The derivates used are generally standard structures traded in the derivatives market. There are several types of currency notes, the more important types being dual currency structures and currency linked structures.

DUAL CURRENCY NOTESA dual currency bond involves an issue where the interest coupon is denominated in a different currency to the underlying principal of the bond. There are two basic structures: Dual Currency Bonds-this is usually a bond structured with coupons payable in the currency of the investor and the principal payable in a foreign currency. Reverse Dual Currency Bonds-this is usually a bond structured with coupons payable in a foreign currency and the principal payable in the currency of the investor. The structure of a dual currency bond effectively combines the following elements: A fixed interest bond A single or series of currency forward contracts to convert the principal or coupon flows into the desired currency. Example 7 sets out an example of a dual currency bond. The transaction is a Yen/US$ dual currency bond, undertaken in around the 1980s. In the example, the investor makes a Yen investment and receives Yen coupons. The principal of the bond is redeemed in US$. The implied exchange rate(US$1:Yen215.60) on redemption was below the prevailing spot rate(US$1:Yen235) Example 7 Principal Amount Term Coupon Redemption Amount

Yen 25,000 million 5 years 7.75% pa payable annually in Yen US$115.956 million(payable in US$)

CURRENCY LINKED STRUCTURES

This includes a wide range of note structures entailing structured currency risk. The notes feature a bond combined with a currency derivative(forward or option). The derivative is used to alter the coupon or principal payments of a conventional bond to create specific exposure to currency movements. Example 8 Heaven and Hell Notes The first issue of Heaven and Hell Notes was arranged by Nomura International for IBM Credit Corporation. The IBM issue raised US$50 million for 10 years with a maturity date of 4 December 1995. To entice investors aboard IBM paid a high coupon of 10.75% pa in US$. The redemption amount for the issue payable in US$ varied according to the following formula: R=US$50,000,000[1+((S-169)/S)] Where: R=Redemption value in US$ S=Yen/US$ spot exchange rate on 21 November 1995 If the Yen/US$ exchange rate at maturity was stronger than Yen 84.5/US$1, investors would get no principal return.

EQUITY LINKED NOTESEquity linked structured notes are fixed income securities where the interest coupons and/or principal of the instrument is linked to the movements in equity prices(single stocks or equity market indices). The major differentiating features of equity linked notes include: The issuer is not usually the entity whose equity securities are the basis of the transaction, and the structure is not designed to facilitate the raising of equity capital to the issuer. The exposure to the underlying equity element is specifically hedged through derivative transactions to immunise the issuer from the equity price exposure. Equity linked notes are usually constituted from a number of identifiable building blocks. The key elements of this structure include: A fixed income security, typically a zero coupon bond An equity derivative, generally a forward on the relevant stock/equity index or an option on the stock/equity index. Equity linked notes fall into two types of transaction structures: Yield enhancement structures and principal protected structures.

YIELD ENHANCEMENT STRUCTURESThese structures entail the use of equity forwards or options in combination with fixed income securities to enhance the coupon return. The major attraction of the structure is the higher yield. The higher return is typically generated through the use of offmarket prices on the forwards to create a future cash flow or the premium on a sold option. The value extracted from the derivative is then used to increase the coupon. Yield enhancement structures are generally targeted at institutional investors and aggressive high net worth individual investors. Bull-Bear Structures One specific type of transaction entails the issue of bull-bear bonds. Bull and bear bonds in all currencies have been structured to include offsetting tranches, with the redemption value of each tranche being directly linked either positively(bull bond) or negatively(bear bond) to the value of the relevant equity price. From the view point of the investor, the fact that the redemption value upon maturity is determined by the level of the relevant index at some point of time in the future allows the investor to participate in index movements consistent with its expectations. It is important to note that all bull and bear bonds embody a cap on the final payout as well as the floor. From the perspective of the issuer, there is no underlying risk to

movements in the relevant index. This is because the two tranches are designed to be perfectly offsetting and to provide the issuer with a known fixed stream of cash flow payments into the future. The issuer effectively assumes no risk to movements in the relevant index, as changes in the redemption value of one tranche(for example the bull tranche) are offset by asymmetric changes in the redemption value generates by the other tranche(the bear tranche) Example 9 illustrates the type of stock index bull-bear issue involving the Nikkei Index on the Tokyo Stock Exchange. Example 9 AB Svensk Exportkredit on 25 July, 1986, issued a series of Yen bull and bear bonds. The SEK issue involved two tranches each for five years. The bull tranche involved an issue of Yen 10,000 million and paid a high coupon of 8.00% pa to compensate investors for the additional risks they had undertaken. The redemption value of the bonds was indexed to the Nikkei index in the following manner: For bull bonds: R=Yen 10,000,000,000(I + ((I-26,067)/22720) For bear bonds: R=Yen 10,000,000,000(I + ((I-19,373)/22720) Where R=Redemption value in Yen I=Nikkei stock average at maturity of the bonds R is also subject to the following constraint: If I is greater than 28,461 at maturity, R=Yen 6,000,000,000 If I is less than 16,769 at maturity, R= Yen 11,054,000,000

PRINCIPAL PROTECTED STRUCTURESThis structure entails the creation of structured equity exposures by combining purchased options on the relevant equity with a fixed income instrument. The option premium is typically funded by foregone income(the interest coupon) or risking a small portion of the principal of the transaction. The primary objective of the structure is the creation of limited risk exposure to the equity market, typically in a highly structured format. The principal protected structures are targeted at individual retail investment accounts that are concerned with the preservation of invested capital. The structures are also attractive to the capital stable investment funds and portfolio insured investment asset managers. In effect, the principal protected equity structure is similar to the purchase of a zero coupon bond where the discount from the face value is used to purchase the option. Diagram 4- Structural Components of Principal Protected Structures

At present, structured products listed on NSE and BSE are all principal protected as a result of the latest SEBI order to all rating agencies according to which non principal protected products shall not be given a rating.

COMMODITY LINKED PRODUCTSThe underlying asset in commodity derivatives is a commodity or index.Typical commodities include energy(crude oil, natural gas, electricity etc), metals(gold, copper, aluminium) and agricultural products(grains, livestock etc) . Commodity derivatives and commodity hedging are similar to equivalent activity in other asset classes. However, the major differences are: Consumption Goods-Commodities are primarily consumption goods rather than investment products. Thus, demand is not purely price dependent. Non Standardised Structure- This reflects the heterogenous nature of commodity production in terms of quality or grade. Other financial assets are homogenous. Cost of Production-Prices frequently gravitate towards the cost of production. This is because the market will adjust over time. Price Behaviour- Commodity prices display seasonality and may change over different phases of the commodity life.

INDIAN SCENARIOGlobally, structured product is a $700 billion industry, while the Indian market is estimated to be $1 billion. Inspite of their complexity, the advantage of structured products lies in the fact that they can be customised to hedge specific risks as well as provide unlimited high returns. Hence, High net worth investors (HNI) in India have been showing an increase interest in structured products. Banks such as ICICI Bank, Citibank, SG Private Banking, BNP Paribas, Standard Chartered, ASK Wealth Advisors etc offer structured products. Primarily Equity Linked Structured Products are listed in Indias National Stock Exchange. Earlier both principal protected and non principal protected structured products were listed in the NSE. The following extract shows SEBIs earlier policy regarding structured products: A CRA may undertake rating of structured finance products, namely, instruments / pay-outs resulting from securitization transactions (under SARFAESI Act, 2002 read with SEBI (POLSDI) Regulations, 2008). In such cases, apart from following all the applicable requirements in case of non-structured ratings, few other additional requirements shall also be complied with. The rating symbols shall clearly indicate that the ratings are for structured finance products. A CRA shall also disclose at least once in every six months, the performance of the rated pool, i.e., collection efficiency, delinquencies of the Structured Finance Products. Source: SEBI CIR/MIRSD/CRA/6/2010 dated 3rd May 2010 However, recently SEBI has asked credit rating agencies not to rate non-capital protected structured products, putting an end to issuance of these instruments. This is because a non-capital protected structured product carries both credit and market risk. When a CRA rates these products, we comment only on the credit risk. Because of this, there is a possibility of misunderstanding among investors

About 80% of the structured products issued in the country are pegged to the Nifty index. The top issuers of these products in India among foreign companies are Citigroup Inc. and Merrill Lynch and Co. Inc. The top local issuers include Kotak Securities Ltd and Edelweiss Capital Ltd

BIBLIOGRAPHY Das, Satyajit(2006), Structured Products Volume 1; Wiley Finance Das, Satyajit(2006), Structured Products Volume 2; Wiley Finance http://www.hsbcnet.com/treasury/structured-products http://en.wikipedia.org/wiki/Structured_product http://www.oenb.at/en/img/phb_internet_tcm16-11173.pdf www.economist.com