Autocallable Structured Notes - Essay Example

One issue which is more prominent since the launch of this type of security is its pricing. Pricing models have now proposed a new approach to the pricing of autoclavable structured notes by incorporating stochastic volatility by taking on the correlation between the interest and equity.

Due to the high return offered by these structured notes owing to their inherent structure as they tend to increase in value when markets go down as well as when markets are rising. The reason for the issuance of these investment securities during Oct/November 2007 was because of the fact that due to credit crunch in the financial sector at International Level and the resulting volatility in the equity markets resulted in creating opportunities for the investors to engineer instruments that provide a confirmed high return coupled with principal protection. This fact can also be corroborated in the sense that the overall credit crunch in western financial institutions resulted in an upward surge in the interest rates hence necessitating a rise in the required rate of return by the investors in the equity markets also. Since these structured notes are structured in a way that they either go in tandem with some benchmarking rates like LIBOR thus any fluctuation in benchmarking rates also pushes the returns on these instruments in a more favorable position for the investors. Apart from that autoclaves are considered as yield enhancement strategies.

Trading units and size of the issue do not seem to be having any implications on the risk-return profile of the investor however it must also be noted that the underlying currency of the asset may have some implications on the value since any changes in the interest rates will have an impact on the exchange rates and this may result in the impairment in the real rate of returns for the investor.

Apart from that since the term sheet suggest that the autoclaves can be triggered in year 1, 2 &3, therefore, the issuer has to maintain the desired level of liquidity in order to meet the higher chances of redemption. This not only also necessitates the management of the liquidity by the issuer but also has to manage the prepayment risk associated with paying the notes before their maturity.

In order to generate various payoffs from the autoclaves, there are various strategies through which this can be achieved. One method is to take on a range-bound view of the underlying by creating a zero-coupon bond, a shot put, and a long series of binary calls. In this situation, if the underlying is above the trigger level in the year before maturity. The investor receives a coupon equal to the number of years multiplied by the initial coupon level or principal level. Apart from that, a barrier autoclavable payoff can also be created moving in correlation with the underlying and the barrier.

A linear replication of the asset portfolio can be a good approximation. With an underlying basket or different variations of the underlying assets, a linear approximation can be achieved through piecewise linear replication using calls and puts.

This can be achieved as:
Max [(w1S1+---WnSn)-K, 0]

The above payoff, therefore, depends upon the weightage of individual indexes in the portfolio assuming all three underlying indexes are replicated in the portfolio.