By Chandra S Khandrika March 2014

Objective
To understand Structured note market landscape, participants and their motivations.(Investors, Issuers) Design of a structured note and pricing of its components Analyzing price sensitivity to Volatility, skew, correlation etc Due diligence around potential risks and rewards for complex products, including security or strategy performance under both normal and extreme market conditions Payoff diagrams for various notes, understand characteristics of the underlying asset like reference level, volatility and early redemption Calculating credit or default risk arising from the issuer of the Note

Contents
Market Landscape Product Taxonomy Anatomy of a Structured Note Valuation building blocks Pricing-Risk properties Conclusion

Market Landscape
Year Issuance Volume US SEC registered Structured ( $ Billion) Note markets issuance by various 2009 44.5 issuers has been around 40-50 bn over 5 year period 2010 66.7 Investor base is made up of Retail 2011 64.2 and institutional investors 2012 57.54 Investors are attracted to this market due to flexibility in 2013 40.30 designing new customized products to meet their investment needs Issuers are able to fund their cash needs for their operations effectively Rise in understanding of Financial Engineering techniques and methods implicit in these products

Product Taxonomy
Structured note market place trades a wide variety of products. These products are based on variety of asset classes ( Equity, Interest Rate, Foreign Exchange, Inflation, Hybrid and Commodity) with variety of payoffs (Digital, Buffered, Best of, Worst of and so on). These notes typically classified as Note Type Capital Guaranteed Note Yield Enhancement Performance Leverage Common products Step up Callable notes Reverse Convertibles Super Trackers Leveraged Buffered Notes Risk Very Low risk Medium risk High risk High risk

Anatomy of Structured Note

Every structured note is a vehicle to express an Investment theme. This theme can be bullish, bearish, neutral or extremely bullish on a particular asset class or stock. Designing a structured notes involves following components 1) Derivative component to represent investment theme. 2) Zero Coupon Bond component to represent the Initial Principal of the Note.
HSBC priced $103,000 of so called Buffered Accelerated market participation securities. Investors receive twice the gains in the S&P 500 Index, up to a cap of 12.5%. On the down side note protects against losses of up to 10%. If S&P 500 drops 60% , the loss is 50%.
Asset Class Issuer Underlying Pricing Date Maturity Date Up Side Participation Down Side participation Equity HSBC USA inc. (a unit of HSBC holdings Plc) The S&P 500 Index April 2, 2012 18 months 200% (12.5% cap) 100% (10% Buffer)

Anatomy of Structured Note

This notes payoff can be replicated using three European-style options on the underlying (for more details, see chart). On the upside: long on two call options at the initial level of the S&P 500 and short on two call options at the level of the cap. on the downside: short on one put option at the level where the buffers protection ceases.

Valuation Building Blocks

Each of the options underlying the Note will be valued by utilizing Black and Scholes Option pricing techniques and other Advanced techniques to model Option volatility skew.

Pricing and Risk properties

Investors in the note are exposed to three different risks. (1) Market Risk(underlying asset): Performance of the note depends on the s&P 500s returns and volatility. On the upside, the performance resembles a bullish call spread strategy. On the downside, investor participation beyond a 10 percent drop simulates a short naked put option. This is dangerous; a significant portion of the principal could be lost. (2) Credit Risk(issuer default): the note is unsecured debt. Credit risk is implied from the value of the issuers corporate bonds using z-spreads over risk-free rates. The z-spread for 18-month debt for HSBC holdings was 157 basis points on the pricing date. Z-spreads for similar-maturity debt for other issuers ranged from 31.3 basis points for Royal Bank of Canada to 210.3 for Bank of America Corp. Higher z-spreads imply higher risk of issuer default and lower the market value of the note. (3) Liquidity Risk: structured products are intended to be held until maturity, so the secondary market is small

Conclusion
Structured note market offers alternatives to harvest investment returns in the global financial markets Structured note products come in a variety of types with potential risks and rewards Structured note products should be understood by using advance option pricing tools and techniques.