Market Pricing of Exotic Structured Products: The Case of Multi-Asset Barrier Reverse Convertibles in Switzerland

Abstract

The market for structured financial products in Switzerland ranks among the largest in the world. A unique characteristic of the Swiss market is that its most successful products are reverse convertibles on multiple assets with conditional capital protection (multiple barrier reverse convertibles, MBRC). In other countries, an active market only exists for simpler types of reverse convertibles. The valuation of MBRCs is not straightforward, and pricing tools are not yet publicly available. Thus, transparency with respect to fair values might be poor, and it is not obvious that the competition between issuers is strong enough to ensure "fair" pricing. We provide the first empirical study on market pricing of MBRCs based on a comprehensive database of 468 certificates outstanding in April 2007. Using a numerical, tree-based valuation method, we obtain an average overpricing of at least 3.4%. This premium on the entire product corresponds to a price discount of 29% on the embedded short put. The overpricing is positively related to the coupon level, indicating that investors tend to overweight the sure coupon and underestimate the risk involved. This behavioral bias appears to be important in explaining the success of the product.

Pricing effects when competitors arrive: The case of discount certificates in Germany

“…Such overpricing has been observed for both simple products (e.g., Ruf 2011) and complex products (e.g., Baule and Tallau, 2011;Stoimenov and Wilkens, 2005;Wallmeier and Diethelm, 2009). It has also been observed for financial market segments in countries such as Austria (Fischer, Keber, and Schuster, 2001), Germany (Baule and Tallau, 2011;Wilkens, Erner, and Röder, 2003;Wilkens and Stoimenov, 2007), the Netherlands (Szymanowska, Horst, and Veld, 2009), Switzerland (Burth, Kraus, and Wohlwend, 2001;Grünbichler and Wohlwend, 2005), and the United States (Benet, Giannetti, and Pissaris, 2006;Henderson and Pearson, 2011).…”

Multivariate Downside Risk: Normal Versus Variance Gamma

“…Although the product has passed the test of acceptance by the investing public long ago, it is still not clear which valuation model to use and how to consider heavy tails. Most investors in multiple barrier reverse convertibles (MBRC) incurred unexpected losses during the recent financial crisis, and there is some evidence that they had underestimated the risk involved in the instruments (Lindauer & Seiz, 2008;Wallmeier & Diethelm, 2009). 1 The weaknesses of the standard normal valuation approach have become more obvious than ever during the last 2 years.…”

Warrant price responses to credit spread changes: Fact or fiction?

“…The approach we propose here focuses on price changes instead of margins, the measure used in recent studies (e.g. Baule, 2011;Baule & Blonski, 2015;Benet et al, 2006;Chang et al, 2012;Henderson & Pearson, 2011;Schertler & Stoerch, 2015;Stoimenov & Wilkens, 2005;Wallmeier & Diethelm, 2009). An exception is the study by Schertler (2016), who uses difference-in-differences estimations on margins of discount certificates.…”

“…Our study differs from the recent literature, since we use price changes to examine issuers' pricing patterns, whereas recent studies investigate margins of SFPs to examine the price setting behavior (e.g. Baule, 2011;Baule & Blonski, 2015;Benet, Giannetti, & Pissaris, 2006;Chang, Luo, Shi, & Zhang, 2012;Henderson & Pearson, 2011;Schertler & Stoerch, 2015;Stoimenov & Wilkens, 2005;Wallmeier & Diethelm, 2009). Margin is the relative difference between a product's market price and its theoretical value.…”