How structural products can harness volatility

One of the benefits of structured products is their ability to harness the volatility of their underlying assets and profit from pricing opportunities.

Those familiar with retail structured products will know that providers launch new tranches of products on a regular basis, and that these products are only available for subscription for a limited period. More often than not, the products on offer stay the same, but perhaps with a slight difference in the returns available.

So what drives the difference in returns available from one tranche to the next?

Why would a product launched at the start of this year have better or worse terms than the same product launched in the middle of 2011?

There are a number of factors that affect the potential returns available from a structured product – for example, interest rates, the level of the underlying asset and the creditworthiness of the issuer.

The factor driving many of the current differences from one launch to the next, however, is volatility. This article will look at what volatility is, and how it can affect the payoffs available from structured products.

Volatility measures the rate of change in the value of an underlying asset such as the FTSE 100 index. Low volatility means prices are relatively stable, whereas high volatility means prices are moving considerably, regardless of direction.

It therefore makes sense that market uncertainty and high volatility go hand in hand. As future market trends become unclear, one would expect prices to be more sensitive and movements to be more severe.

In fact, we have seen that during periods in which markets fall strongly, such as in August 2011, volatility rises considerably as macroeconomic concerns tend to be accompanied by above average market drops.

What does this mean for the pricing of structured products?

Many structured products are made up of a zero-coupon bond to provide an element of capital protection, and an option – or combination of options – to provide the potential return.

It is the option component of a structured product that is affected by volatility – in fact, volatility is one of the main factors in determining the price of options.

But the effect that volatility has on a structured product will depend on the actual payout – for some, an increase in volatility will improve the terms available, and for others, it will have the opposite effect.

For example, it makes sense that a product that fully protects investors’ capital and pays out any positive returns of an underlying asset becomes more expensive as volatility increases. Higher volatility means there is a greater likelihood that the underlying asset will fall below the initial level, and therefore the capital protection is more valuable to the investor.