Structured Products

Simon Benninga
Tel Aviv University
benninga@post.tau.ac.il
Lecture presented for Deans Breakfast at
Gonzaga University, January 2006

Whats a Non-Structured Product?

Stock
Bond
Future (?)
Option (?)

Structured product: Combination of

stocks, bonds, and options
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Structured Product
Combination of the above
Most common:
o Stock + option
o Bond + option

Also:
o Fancy bonds
o Other ...

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MITTS: Small Print Larger

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Merrill Lynch MITTS

(Market Index Target-Term Securities)
Issued 2 August
2000;
NASDAQ = 3521.15
Matures 2 Aug 2007
Price = $10

Nasdaq 3521.15

Payoff = $10 + Max $10 *

,0
3521.15

Percentage increase

in Nasdaq

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Why do this?? MITTS

Upside participation
No downside loss [really true?]
Fun?

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MITTS Payoff
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
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ANALYZING THE MITTS PAYOFF

Nasdaq index, 2aug07
Base Nasdaq
Initial investment
Payoff
Data table
Nasdaq at terminal date
0
500
1000
1500
2000
2500
3000
3521.15
4000
4500
5000
5500
6000

8,000
3521.15
10
22.720 <-- =10+MAX(10*(B2-B3)/B3,0)

22.720 <-- =B5, table header

10.000
10.000
18
10.000
10.000
17
10.000
16
10.000
10.000
15
10.000
14
11.360
13
12.780
14.200
12
15.620
11
17.040

MITTS Payoff Pattern

10
0

1000

2000

3000

4000

5000

6000

7000

Nasdaq on 2aug07

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Analyzing the MITTS

Nasdaq 3521.15
$10 + Max $10 *
,0 =
3521.15

10
$10
Max [ Nasdaq 3521.15,0]
N + 3521.15 
 

Bond
payoff

Call payoff

So: A MITTS is the combination of a

bond + 10/3521.15 of a call on the
Nasdaq.
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Analyzing the MITTS

Fairly priced?
What implied volatility
Can it be hedged?
Can it be replicated?

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A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
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PRICING MITTS USING BLACK SCHOLES

S
X
r
Current date
Maturity date
T
Sigma
d1
d2

2070.61
3521.15
4.00%
5-Mar-05
2-Aug-07
2.4110
30%

Value of Nasdaq on 5 March 2005

Exercise price
Risk-free rate of interest

<-- =(B6-B5)/365
Nasdaq volatility?

-0.6999 <-- (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))

-1.1657 <-- d1-sigma*SQRT(T)

N(d1)
N(d2)

0.2420 <-- Uses formula NormSDist(d1)

0.1219 <-- Uses formula NormSDist(d2)

Call price

111.42 <-- S*N(d1)-X*exp(-r*T)*N(d2)

MITT Pricing
Value of bond portion
Value of call portion
MITT Value

9.0807 <-- =10*EXP(-B7*B4)

0.3164 <-- =10/3521.15*B16
9.3971 <-- =SUM(B19:B20)

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Data table
2
3
Interest rate ?
4
2%
3%
4%
5%
9.3971
5 data table header, =B21-->
5%
9.529
9.302
9.081
8.864
6
10%
9.530
9.303
9.082
8.866
7
Nasdaq ?
15%
9.541
9.318
9.101
8.891
8
20%
9.589
9.373
9.163
8.961
9
25%
9.676
9.467
9.266
9.071
10
30%
9.796
9.593
9.397
9.208
11
35%
9.937
9.739
9.548
9.364
12
40%
10.095
9.900
9.712
9.531
13
45%
10.263
10.070
9.885
9.705
14
50%
10.437
10.247
10.062
9.884
15
16
17
MITTS Pricing: Higher Interest Rates
10.4
18
Depress MITTS Price
10.2
19
20
10.0
21
9.8
22
9.6
23
9.4
24
9.2
25
26
9.0
27
8.8
28
8.6
29
5%
10%
15%
20%
25%
30%
35%
40%
45%
30
Nasdaq volatility
31
32
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6%
8.653
8.655
8.687
8.766
8.883
9.026
9.186
9.356
9.532
9.712

50%

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MITTS Price on 4 March 2005

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Whats the Market Price Telling Us?

Use Excels Conditional Formatting

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Did We Forget Something?

MITTS are callable during August 2006 at $21.50.

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Analyzing the Call Provision

Answer: If Nasdaq > 7568.77 on 1 August

2006, the call provision
is realistic.
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Financial Modeling (MIT Press, 2000)

Chapter 14, Exercise 9

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Airbag
Same idea as MITTS, BUT:
Participates in both gains and losses

Stoxx 50 Maturity
1,000 *1.33*

Stoxx
50
Initial

1,000

payment at maturity =

Stoxx 50 Maturity
1,000 *

Stoxx 50 Initial

If Stoxx50 < 1618.50

1618.50< Stoxx50 < 2158

If Stoxx50 > 2158

Current level of Stoxx50 = 2158

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ABN=AMRO AIRBAG ON THE EURO STOXX50

Current level of Stoxx50
AirBag start
AirBag stop

2,158.0
2,158.0
1,618.5

Stoxx50 at maturity

3,000.0

Payoff

1390.176 <-- =IF(B6<B4,1000*1.33*B6/B2,IF(B6>B3,1000*B6/B2,1000))

Payoff table
0
1,200
1,618.5
1,709
1,799
1,889
1,979
2,069
2,159
2,249
2,339
2,429
2,518
2,618
2,718
2,818

0.00
739.57
1,000.00
1,000.00
1,000.00
1,000.00
1,000.00
1,000.00
1,000.23
1,041.94
1,083.64
1,125.35
1,166.82
1,213.16
1,259.50
1,305.84

AirBag Payoff Patterns

1,400
1,200

Slope = 1

1,000
Payoff

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30

800
600
400

Slope = 1.33

200
0
0

500

1,000
1,500
2,000
Stoxx50 at maturity

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2,500

3,000

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Theory of Airbags

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An Airbag is a combination of:

A bond
A short put
A long call

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Advanced Airbags?

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Contingent Conversion Bonds

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Conclusion: Why Structureds?

New return patterns

Guarantees on capital
Interesting ...
Fun ...

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