1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 11
Key Risks
August 2012

2. Chapter summary and outline
This chapter discusses the key risks and generic risks of
investing in structured products and other advanced derivatives
products.
Chapter outline:
• Key risks of structured products
• Generic risks
• Summary
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3. Introduction – Key Risks
• Risk is defined as the possibility of loss in an investment:
– Includes losing some or the entire principal amount.
• The greater the potential returns, greater the amount of risk:
– Rationale for this: investors are compensated for taking additional risk.
• A structured product – a combination of two or more financial instruments
where:
– The risk profile is often more complicated than a standardized financial product.
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4. Key Risks of Structured Product
1. Market Risk
2. Credit Risk
3. Structure Risk
4. Foreign Exchange Risk
5. Correlation Risk
6. Liquidity Risk
7. Legal Risk
8. Early Termination Risk
9. Risk of Incongruence to Investment Strategy / Mis-selling
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5. Market Risk
• Known as systemic risk as it affects the whole market;,
• Cannot be avoided through diversification,
• Sources of market risk include:
– changes in interest rates
– inflation
– recession
– political instability
• Structured product is exposed to the market risk of derivatives instruments:
– E.g. if the return component is the currency option premium then the source of
market risk will be the foreign exchange (“FX”) market risk
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6. Market Risk - 2
• Structured product with shorting of put
option on securities index (selling
protection against the decrease of a
securities index):
– shorting of put option on a particular
securities index, whereby the option will
be in-the-money when value of the index
decreases
– market event occurs, value of the index
will fall
– put option will be in-the-money as shown
here
– the investors of the structured
product, being the put option seller, will
have to pay out to the option
buyer, hence resulting in a reduction in
their investment returns.
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7. Market Risk - 3
• Structured product with shorting of interest rate call swaption
– receive-fixed swap option (protection against interest rate decrease)
– The seller of an interest rate call swap option (a.k.a swaption) will have to pay out
a fixed rate and receive a floating rate when the option is exercised by the buyer
of the swap
− When the interest rate declines below the strike level, swaption is “In-the-money”
for the option buyer as he will receive a pre-determined fixed rate and pay a
declining floating rate:
− The investors of the structured product, being the option seller will have to payout
to the option buyer,
− The investors are effectively selling a protection against a decrease in interest
rates.
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8. Market Risk - 4
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9. Market Risk - 5
• Structured product with shorting of
call option on commodities index
(e.g. oil index)
– selling protection against increase
in prices of the commodities
• In the event of a political instability
or war (eg. Gulf war)
– Oil price will increase and the call
option will be in-the-money.
– Investor of the structured product
(call option seller) will have to pay
put to the option buyer in Figure
11.1.1D
• Market risk profile of the structured
products is similar regardless of the
underlying instruments,
• Market risk is dependent on the
respective underlying instruments
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10. Credit Risk
• A structured product is exposed to the credit risk of the issuer or
• When underlying financial instruments involve a credit product,
• In event of a bankruptcy (or default situation):
– Borrower is unlikely to repay the loan (or fulfil the contractual obligations)
– Impact the value of the structured product adversely
Example 1:
• An investors buys a structured product which has a zero coupon bond with
long position in an option,
• This is low market risk compared to structures which has an embedded
short position in options
• Fixed income instrument (bond) is subject to a credit risk, that is possibility
that the bond issuer defaults or unable to redeem the bond or fulfil the
coupon payments
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11. Credit Risk - 2
Example 2:
• A buyer enters into a Credit Default Swap (“CDS”) which guarantees the
credit worthiness of a reference entity
– In the event of default situation of a reference entity, Investor is required to pay
out to the issuer
– Investor has sold credit protection on the reference entity
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12. Credit Risk -3
Example 2 (cont)
• Investor buys notes issued by Special Purpose Vehicle (SPV).
• The SPV uses the proceeds to buy AAA rated securities
• Investor receives enhanced interest (LIBOR + x bps) – He is selling credit
protection to the SPV issuer:
– The SPV in turn sells credit protection to the bank (by entering into a CDS) and
receives protection payment.
– This payment received by the issuer will be used to subsidies the enhanced
interest paid to the investor
• If Reference entity defaults
– The SPV issuer (being the protection seller to the bank) has to liquidate the AAA-
rated securities and pay the bank
– The investor (being the protection seller to the issuer) pays the contingent
payment to the SPV and recovers the remaining sum (par minus losses)
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13. Structure Risk
• Benefits and liabilities of the structured product are highly dependent on
how the product is structured
• In structured products that use financial instruments that do not limit losses,
the entire amount invested could be lost
Example: Receive fixed interest rate call swaption
• The structured product involves shorting an interest rate (swaption)
• Investors of the structured product are liable to pay out a fixed fixed rate
when the option is exercised (i.e. selling protection against decrease in
interest rates) while receiving the floating rate in the swap,
• The loss to the swaption seller is limited to the fixed rate when the floating
rate declines to zero when the option is exercised by the swaption buyer
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14. Structure Risk - 2
Example: Pay fixed swap option (protection against interest rate increase):
• Shorting an interest rate put swaption:
• Investors are liable to pay out a floating rate when the option is exercised
• Pay-fixed swaption buyer will exercise the swaption when the market rate is
higher than the strike rate
• The losses to the swaption seller are unlimited and dependent on how high
the floating rate is when the option is exercised
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15. Foreign Exchange Risk Risk
• In most cases, the underlying financial instruments purchased are not
denominated in the same currency as the structured product
• The investment returns will be affected depending on the exchange rates
when transactions are carried out.
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16. Correlation Risk
• Refers to the likelihood of an event of any kind having a direct impact on
another
• A structured product is exposed to correlation risk when underlying
instruments that are correlated with each other
• Example: Embedded Quanto FX option
– Option strike price and payout are denominated in different currencies;
– Currency of the option price is different from the strike price and the payout
– As such returns of the structured product are dependent on the interaction
among the three currencies
• Example: Credit default swap
– For a basket of companies that are highly correlated to one another
– Scenarios which causes high correlation:
• Companies being in the same industry
• Dependent on the same customers
• The companies having credit relationship with one another
– This CDS is subject to high correlation risk because when one of the companies
defaults, it is likely that the other companies will be affected as well.
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17. Liquidity Risk
• Is a result of the lack of marketability e.g. due to market disruptions:
– Sudden lack of buyers or sellers for certain financial instruments
– When this happens, there is inability to buy or sell
– May result in loss of investment returns or inability to invest for higher returns
• Another example: mismatch of maturity date between the structured product
and the underlying financial instrument
– Example: A basket of high yield bonds
– High yield bonds will have to be sold to the
market when product matures
– A purchaser of the bond may not be readily
available (due to say, financial turmoil)
– The bond is likely to be sold at a huge
discount
– Resulting in a reduction to the investment
returns
– Eg bonds 1, 3 and 4 in the diagram
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18. Liquidity Risk - 2
• Liquidity risk may be mitigated if the products used are exchange traded
instruments.
– E.g. S&P 500 index future contract which has high liquidity (not a problem)
• Investors need to be aware of lock up period
– Funds deposited by the investor cannot be pre-maturely withdrawn until the
expiry of the lock-up date;
– This can range from a few months to a few years.
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19. Legal Risk
• The way in which legal contracts relating to the financial instruments are
drafted has great impact in investments
• E.g. ownership or legal rights to the underlying financial instruments in the
event of default by the issuer do not automatically go to the investor
– In most cases, investors only own units of the structured products and not the
underlying financial instruments
– Depending how its structured investors may have the first right to the instruments
before the other creditors of the issuer
– Investors would suffer losses if other creditors of the issuer have priority over the
underlying instruments.
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20. Early Termination Risk
• Structured products designed in such way that full extent of the investment
returns will only be realised upon maturity
• Using a zero coupon bond for principal preservation
– Preservation will only be realised upon maturity
– In the event of an early termination, the bond is likely to be sold at a discount
• Similarly for underlying derivatives instruments
– In event of early withdrawal, there is risk of incurring unwinding costs of the
embedded derivatives contract
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21. Risk of Incongruence to Investment Strategy /
Mis-selling
• The risk of product may not be adequately disclosed by the issuer
– Prospectus and product highlights sheet are important documents to ensure
proper disclosure
• There is a risk that investors may misunderstand investment strategy
– Hence, may not achieve the investment objectives
– Distributors and representatives play an important role in guiding and educating
investors
• When the product is formed with underlying financial instruments
– The purpose may not be obvious especially when product is sold to investors
after the issue date
• E.g. if investors want a fixed income product with “100% principal
preservation”
– May misconstrue a product with underlying bonds used as collaterals in a credit
default swap as a suitable investment
– Not aware that Risk involved is vastly different and hence, investment objectives
may not be met.
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22. Generic Risks
• Risks described here are not peculiar to only structured products but to
most financial instruments:
• Examples of generic risks:
– Country and Political Risk
– Transactional Risk
– Counterparty Risk
– Reinvestment Risk
– Operational Risk
– Concentration Risk
– Market Disruption Risk
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23. Country and Political Risk
• A structured product may have underlying financial instruments that are
from other countries or based on market conditions in other economies
other than the country that the structured product is issued
– As such it will be exposed to country and political risk of the countries that the
underlying financial instruments are domiciled in
• Country risk relates to risk due to the stability of their economies. Various
factors can affect stability:
– Social unrest
– Natural disasters
– Major financial scams
• Political risk often the result of government actions in the country, e.g.:
– Implementation of new policies
– Change in government
– Political instability of the country
– Economies that implement capital controls during periods of financial turmoil –
affects confidence of investors
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24. Transactional Risk
• Risk resulting from the time difference between the commencement of a
financial instrument contract and settlement of the contract
• Especially so when there is difference in currencies between structured
products and the financial instruments that it will enter into
• Investors may have to bear any price fluctuations that occur between the
contract commencement date and the settlement date
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25. Counterparty Risk
• Some financial instruments involve contracts between counter-parties
• Hence there is risk that parties do not live up to the contractual obligations
• Counterparty risk in turn is determined by various risk factors such as:
– Credit risk
– Business risk
– Operational risk
– Risk due to the regulatory environment the counterparty is subject to
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26. Reinvestment Risk
• In some structured products investment returns are realised before the
maturity,
• Depending on structured, the returns may be reinvested instead of
distributed to the investors
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27. Operational Risk
• Summarises the risks due to the operations of the issuer and
– Not inherent to the financial risk relating to the product or underlying financial
instruments
• It is the risk of business operations failing as a result of human errors or
breakdown of internal procedures and systems
• Examples:
– Failure to make timely investment or redemption on financial instruments due to
cumbersome internal procedures
– Failure to renew investments due to change of staff
– Breakdown of the company’s computer system resulting in the loss of databases
• In order to mitigate operational risk
– Chose issuer with proper track record
– Firm with robust internal procedures and systems to cut down human interaction
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28. Concentration Risk
• Generally applicable to principal component of the fund
• Occurs when pool of funds received from investors by the issuer is
unevenly distributed over a small number of assets type of class
– It is a risk that should one asset type or class turn bad, the entire portfolio might
suffer more than anticipated
• Investors should be cognizant and advised to check how assets are
managed and whether they have requirements related to:
– Product, credit and counterparty concentration limits
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29. Market Disruption Risk
• Defined as the effects of a large and rapid change in the market price levels
causing the market to cease functioning in a regular manner
– Usually characterised by declines which cause widespread panic and results in
disorderly market conditions
• To mitigate this risk, regulators and securities exchanges put in place:
– Circuit breakers – systems in trading infrastructure of Cash and derivative market
that triggers trading halt
– Shock absorbers- to slow down trading when significant volatility in market but
doesn’t halt trading completely
– Price limits - Session or daily price limits can be imposed to limit price volatility
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30. Summary of Key Risks
• The risk of a structured product is potentially higher than a standardised
product due to the complexity of product formation,
• With the various components that adds to non-transparency of the
structured products – lead to potential hidden risks
• Regardless of the potential returns represented by issuer, investors must be
prepared to lose part or all of their investment, when they choose to invest
in a structured products.
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