Tuesday, July 9, 2013

Similar Structured Product Premia in US and Europe

By Tim Dulaney, PhD and Tim Husson, PhD

One point we've made again and again in our research is that structured products -- debt securities with market-contingent payoffs -- tend to be priced at a premium to face value.  We have documented premia in reverse convertibles, autocallables, absolute return barrier notes, principal-protected notes, dual directionals, and over 17,000 individual products freely available in our searchable structured product database.

Recently, the SEC has required structured product issuers to disclose an estimate of the intrinsic value of their notes.  Bloomberg's Keven Dugan in the June 20 Structured Notes Brief collected 896 products and found that, according to issuers, the average instrinsic value in US structured notes ranges between 92-98% of face-value depending on product type.  Longer term notes and range accruals tended to have the lowest estimated initial values.

Kevin analyzed how much of the discount (face-value minus initial value) is due to stated expenses.  He came up with the following figure.
Importantly, the blue section and the red section don't level off at 100 cents on the dollar.  This means that stated expenses are one reason that structured products are expensive, but not the whole story.  Additional profit is priced into the notes, resulting in further mispricing.

In addition, he compared the reported values of four products to those produced by Bloomberg's own valuation service, BVAL.  For those four products, there were pricing discrepancies of 0.7%, 1.2%, 1.7%, and 2.4%, suggesting that issuers may be using non-standard techniques for arriving at their product values.

The European Securities and Markets Authority (ESMA) recently conducted an empirical study of structured product pricing (PDF) in the European market.  ESMA looked at a sample of 76 products issued in 13 countries.  They find that the average structured product premium in the European market is approximately 5.5%.

These studies, combined with the growing body of academic work on structured products (including our own), strongly suggest that structured products have large upfront costs embedded in their derivative positions -- often beyond the stated fees.

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