In our previous article, we embarked on a delightful journey through the fundamentals of Vanilla Options, exploring an array of strategies to unlock their potential. Now, prepare yourself to be enchanted as we dive into the mesmerizing world of Exotic Options and their intriguing variations. In this new series, we’ll unravel how these exotic options are intricately woven into structured products through the captivating tales of Scarlett and Julie, two investment-savvy gals eager to expand their knowledge and investment horizons. Under the wise guidance of their trusted friends, Mars and Mark, they are ready to navigate the thrilling and rewarding exploration into the realm of Exotic Options (as listed below)!

• Digital Call = Binary Call (OTC)
• Barrier options: Kick-In / Knock-Out
• Worst / Best - Of Options

Scarlett's Investment Journey – Understanding Digital Options and Range Accrual Notes (“RANs”)

Amid the backdrop of cooling U.S. inflation, Scarlett, a savvy investor, finds herself navigating the complex waters of global finance. June's core CPI has risen by just 0.1% month-over-month, falling below the 0.2% forecast and marking the smallest increase in three years. Fed Chair Powell's dovish commentary suggests that rate cuts may not necessarily depend on inflation falling below 2%. This dovish pivot has sparked expectations for two to three rate cuts this year, causing the dollar to weaken.

Consequently, the Japanese yen, previously in a slump, begins to recover. This resurgence is fueled by speculation that the Japanese government may have intervened in the foreign exchange market by purchasing yen. Meanwhile, the U.S. political scene adds another layer of complexity. Following a dramatic incident involving former President Trump—think of it as a political plot twist—his rising election prospects and potential tariff policies could bolster the dollar and weaken the yen. It’s like a soap opera, but with more economic jargon.

Astute to these shifting dynamics, Scarlett formulates a strategic view: The forces supporting the yen and those exerting downward pressure will stabilize the USD/JPY exchange rate within the 152 to 168 range. However, Scarlett is uncertain which financial product would best capitalize on these market conditions while ensuring a principal-protected strategy. Seeking expert advice, she turns to Mars, a seasoned investment professional with the wisdom and the charisma, who she deeply believes in.

Mars, always ready to drop some knowledge, explains:

"Scarlett, RAN is a structured product embedded with digital options. It is particularly suitable for you given your view and preference for a principal-protected strategy. Let me explain what digital options are first. A digital option, also known as a binary option, is a type of options contract that pays a fixed amount if the underlying asset meets a specific condition at expiration. For instance, if you purchase a cash-or-nothing call digital option on a stock with a strike price of $100 and a fixed payoff of $1,000, you will receive $1,000 if the stock price is $100 or higher at expiration; otherwise, you receive nothing."

Features of binary options

• ‍Fixed Payoff: the payoff is predetermined and does not depend on the extent to which the underlying asset's price exceeds the strike price.‍
• Binary Outcome: The outcome is binary, meaning the option either pays the fixed amount or nothing.‍
• Simpler Pricing: The pricing of digital options is simpler compared to traditional options, as it is based on the probability of the underlying asset meeting the condition.‍
• Leverage: Higher leverage effect than normal options‍
• Potential profit and risk: Higher profits are possible with a larger gap between the strike price and the market price. However, as this gap increases, so does the risk.

Mars then describes how these options integrate into RANs:

"RAN is a structured product by shorting Binary Call and Binary Put options simultaneously with different strike prices, offering a strategic way to leverage the stability of the underlying asset's price. Investors can earn interest (coupon) based on the performance of an underlying asset, such as a stock index, interest rate, or foreign exchange rate. The interest accrues only on days when the asset's value stays within a certain range. However, investors must forgo coupon payments if the asset moves outside this range on those days."

Scarlett’s eyes widen as Mars continues. This structure allows her to potentially benefit from the anticipated stability of the USD/JPY exchange rate within the 152 to 168 range. It’s like betting on a horse race where you’re pretty sure the horses will stay on the track.

For illustrative purposes, Mars describes a USD/JPY Range Accrual Note offering an annualized coupon rate of 5%. The predefined range for this note is set between 152 and 168. The period under consideration consists of 250 days, and the notional investment amount is US$5,000,000. The profit could be calculated based on the number of days when the exchange rate is within the range as shown in the below table. Investors would only lose the coupon when USD/JPY either exceeds 168 or falls below 152, which is attractive for those seeking an enhanced yield on their capital. It’s like having a safety net while walking a financial tightrope.

Convinced by Mars’s keen insight and extensive experience, Scarlett feels ready to tackle the financial markets. With Mars’s wisdom and a touch of humor, she sets off on her financial adventure, eager to see where her latest investment journey will take her.

Julie’s Stock Market Adventures: Exploring Structured Products with Kick-In and Knock-Out Features

Julie, a bright and determined student, was eagerly preparing to enter the world of investment advisory after graduation. However, she recently found herself worried that the U.S. stock market is overheating, especially the technology sector. Despite the recent gains, she sensed a storm brewing—a shift in capital that could lead to a pullback in tech stocks. Recent positive events, such as better-than-expected earnings reports (e.g., Tesla's Q2 deliveries report causing a 10% share price surge) and new product launches (e.g., Apple's unveiling of Apple Intelligence), have already been priced in. Similarly, macroeconomic impacts like future rate hikes and Japan's hawkish monetary policy have been reflected in the shares of companies like MUFG in Japanese market.

Feeling uncertain, Julie decided to reach out to her senior, Mark, who had once attended her university and had already made a name for himself as an experienced portfolio manager. Mark had always been a reliable source of wisdom, and Julie hoped he could help her navigate these choppy waters.

After hearing Julie’s concerns, Mark suggested she consider Fixed Coupon Notes (FCNs) as a potential investment strategy (introduced in our previous article Understanding Structured Products: An Introduction for Investors Series 1). “FCNs are a solid choice,” he explained. “They combine a Zero-Coupon Bond (ZCB) with a sell put option, offering a stable flat coupon derived from the premium of the sell put option.”

Julie listened intently as Mark continued. “Given your belief that tech stocks won’t decline significantly and might even see slight increases, we can enhance these FCNs with Kick-In and Knock-Out features to boost your potential profits.” Curiously, Julie asked Mark to elaborate. He began with the basics:

• ‍Kick-In: This is a condition where the structured product becomes active or “kicks in” when the underlying asset's price hits a predetermined barrier level. It typically results in a more favorable coupon rate for the investor due to the increased risk of the barrier being breached.‍
• Knock-Out: Conversely, a knock-out feature will terminate the structured product when the underlying asset's price hits a certain barrier level, often returning the principal and a predetermined coupon to the investor.

Mark explained that these features could reduce the cost of options and enhance coupon yields of structured products by the increasing risk and limited profit when a barrier event occurs. “In practical trading scenarios,” he elaborated further,

"In practical trading scenarios, structured products embedded with options frequently incorporate kick-in and knock-out features. These features effectively reduce the cost of options since they limit the potential profit or risk for investors when a barrier event occurs. Another reason could be the conditions attached to these options (activation or deactivation at specific levels) reduce the risk for the issuer, which in turn reduces the premium that buyers need to pay. For example, in the case of an FCN, the inclusion of kick-in/ knock-out features can lead to higher associated coupons or lower strike prices, enhancing the coupon yield and offering even more attractive returns."

To make things clearer, Mark compared three types of FCNs: a general FCN, an FCN with a knock-out barrier at 100% of initial performance, and an FCN with both a knock-out at 100% and a kick-in at 55% with below table.

He pointed out that Julie could secure higher coupon payments by investing in FCNs with kick-in features if the underlying asset’s price didn’t breach the 55% threshold. The inherent risk associated with the kick-in feature translates to elevated coupon rates, rewarding Julie for her willingness to accept this potential downside. If the price hit the knock-out level, she could redeem her investment early and receive the coupon sooner. This early redemption allows her to receive the coupon payment sooner and offers the flexibility to reinvest in a new FCN, thereby compounding her earnings.

Basket Case: Navigating Worst-Of and Best-Of Options

As mentioned before, Julie was also intrigued by the potential of using a basket of stocks as the underlying assets for her FCNs. Mark then explained the concepts of Worst-Of and Best-Of options:

When you're dealing with a basket of underlying assets, it's crucial to use a reference price to compare against the strike price or the kick-in/knock-out barrier. This comparison determines whether the option should be exercised, activated, or deemed worthless. There are two distinct methodologies for this: the Worst-Of and Best-Of rules.

Worst-of Options: hinge on the performance of the least favorable asset within the basket.

Best-of Options: rely on the performance of the most favorable asset within the basket.

Mark noted that Best-Of options, while carrying a higher premium due to reduced risk, offered lower yields. On the other hand, Worst-Of options are less expensive, carrying increased risk due to their reliance on the worst-performing asset in the basket."

Julie nodded, absorbing the information. "So, despite the higher risk, many yield enhancement products incorporate the Worst-Of feature to offer higher coupon payments which is similar to the kick-in and knock-out features?" she asked.

"Exactly," Mark confirmed, “This added risk translates into more attractive yields, making such products appealing to investors seeking enhanced returns. Shorting kick-in options is common in structured products. For such options, the value of a kick-in put increases with lower correlation among the basket of underlying assets. This is due to the higher likelihood of a kick-in event—when the price of any underlying asset falls below the kick-in barrier during the tenor—and the option ending in-the-money (ITM), where the final price of the underlying asset is lower than the strike price.”

“Since we are shorting this put option”, Mark continues, “we inversely assume greater risk if the kick-in event occurs or the option ends ITM, so that the higher coupon or lower strike would be provided for investors. Thus, investors are astutely advised to select assets with lower correlation as the underlying components of FCNs or other structured products that incorporate shorting put options, which enhances portfolio robustness and yield potential.”

Seeing Julie's puzzled expression, Mark chuckled and simplified his explanation. “Alright, imagine you’re at a carnival, holding a basket of rubber ducks. Each duck represents a stock. If they all float in the same direction, meaning they’re highly correlated, they either sink or stay afloat together. But if they float independently, meaning they’re low correlated, one duck might stay afloat while another might sink, increasing the chances of one sinking. For us, if one duck sinks, it’s bad news because we’re betting it won’t sink, which means a knock-in event won’t occur. So, choosing ducks that don’t follow each other too closely might be riskier, but it also means we can get a better prize, which is a higher coupon. Got it?”

Julie laughed. “I think I get it now! Less synchronized ducks, more potential prizes, but also a bit more risk if one sinks.”

“Exactly!” Mark said, grinning. “And with that knowledge, you’re ready to dive into the world of FCNs and make some smart investment choices.”

With Mark’s guidance, Julie felt more confident in her understanding of FCNs and structured products. She was ready to apply this knowledge, taking her first step toward a promising career in investment advisory, armed with the tools to navigate the complexities of the financial markets.

Ending

In the final chapter of their financial journey, Scarlett and Julie have both grown professionally under Mars and Mark's guidance. Scarlett, with her Range Accrual Notes (RANs), has learned to navigate the foreign exchange market, using fixed payoffs and binary outcomes to manage the USD/JPY exchange rate efficiently. Meanwhile, Julie has become adept with Fixed Coupon Notes (FCNs) and their kick-in/knock-out and Best/Worst-Of features, allowing her to handle the stock market's fluctuations and preparing her well for a future in the investment advisory industry.