Pricing and issuance dependencies in structured financial product portfolios

• Published date: 01 March 2019
• Author: Matthias Pelster,Andrea Schertler
• DOI: http://doi.org/10.1002/fut.21978
• Date: 01 March 2019

Received: 23 July 2018

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Revised: 25 September 2018

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Accepted: 5 October 2018

DOI: 10.1002/fut.21978

RESEARCH ARTICLE

Pricing and issuance dependencies in structured financial

product portfolios

Matthias Pelster

1

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Andrea Schertler

2

1

Department for Taxation, Accounting

and Finance, Paderborn University,

Paderborn, Germany

2

Economics, Econometrics & Finance,

Faculty of Economics and Business,

University of Groningen, Groningen,

The Netherlands

Correspondence

Andrea Schertler, Faculty of Economics

and Business, University of Groningen,

Nettelbosje 2, 9747 AE Groningen,

The Netherlands.

Email: a.schertler@rug.nl

Abstract

We exploit a unique sample of structured financial products (SFPs) to analyze

pricing and issuance dependencies among different types of such market‐linked

investment vehicles. Our study provides evidence of cross‐pricing between

products with complementary payoff profiles. Such dependencies may be

explained by issuers’efforts to generate order flow for products that supplement

their current SFP risk exposure. Additionally, we observe issuance patterns in

line with the argument that issuers exploit the complementarity payout profiles

when bringing SFPs to market. Our study emphasizes cross‐pricing from a

perspective not previously considered in the literature.

KEYWORDS

cross‐pricing, discount certificate, hedging, issuance decisions, put warrants,

structured financial products

JEL CLASSIFICATION

G12, G13, G14, G24

1

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INTRODUCTION

Cross‐selling (Laux & Walz, 2009; S. Li, Sun, & Wilcox, 2005; X. Li, Gu, & Liu, 2013; Santikian, 2014; Zhao, Matthews, &

Murinde, 2013) and coordinated pricing for multiple products or services (Bajwa, Sox, & Ishfaq, 2016; Calomiris &

Pornrojnangkool, 2009; Duvvuri, Ansari, & Gupta, 2007; Lepetit, Nys, Rous, & Tarazi, 2008; Odegaard & Wilson, 2016)

have a long tradition. It usually considers pricing decisions of suppliers in an effort to sell multiple products to the same

customer or investor (Calomiris & Pornrojnangkool, 2009). Dependencies between prices of different products or

services may therefore arise from the effort to sell to the same customer. We argue that cross‐selling and coordinated

pricing could also be relevant when products are sold to different customers. Suppliers may implement cross‐pricing in

an effort to exploit advantages regarding the risk‐return profile of their product range. Thus, when implementing cross‐

pricing, the supplier of the products is not primarily concerned with customer retention but instead benefits from a risk

exposure perspective. Such cross‐pricing considerations from a risk perspective are relevant in various settings. For

instance, acquirers may bid more for those targets that enhance cash flows due to earning diversification (Benston,

Hunter, & Wall, 1995). We study cross‐pricing using a unique data set of various products from financial institutions,

which allow us to study these dependencies arising from a risk management perspective within rather than between

firms.

© 2018 The Authors. The Journal of Futures Markets Published by Wiley Periodicals, Inc.

J Futures Markets. 2019;39:342–365.342

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wileyonlinelibrary.com/journal/fut

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This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non-commercial and no modifications or adaptations are made.

Investment and universal banks issue so‐called structured financial products (SFPs), defined here as products

derived from other securities traded on regular segments of financial markets.

1

These SFPs offer prepackaged

investment strategies based on derivative products to retail investors, who cannot, because of market bottlenecks,

construct the payoff structure of SFPs from components traded in regular financial market segments.

2

Several types of

SFPs are available. Put and call warrants, for instance, are very simple products that have the same payoff profiles as put

and call options; the latter but not the former are traded in regular segments of financial markets with margin calls.

More complex products are, for instance, discount certificates: Investors participate in the value development of an

underlying security up to a prespecified value, which is called the CAP. In exchange for this limited up‐side potential,

they buy the certificate at a discount relative to the current market value of the underlying security.

The market for SFPs is confined to a small number of large financial institutions, which simultaneously act as

market makers (Baule, 2011). Selling SFPs, which are also known as a market‐linked investment, exposes the

financial institutions to market risk. Issuers manage the market risk of their sales in various ways: First, the

financial institutions oftentimes create and set up hedging programs through their derivative trading desks.

AlthoughSFPsarewrittenonanunderlyingsecurityforwhich different derivative contracts are traded in the

market, this type of hedging program can be conveniently implemented with these derivatives; second, issuers of

SFPs commonly use delta‐hedging programs when writing these contracts, similar to what market makers do in

option markets. Third, these financial institutions may choose not to hedge their market risk exposure for certain

products (i.e., out‐of‐the‐money [OTM] put options in a bullish period).

In addition to these hedging strategies, and this is the core contribution of our paper, issuers of SFPs may use cross‐

pricing and cross‐issuance to manage their market risk. We argue that the choice of pricing and product range can serve

as valuable risk management methods to complement conventional hedging.

3

In more detail, some SFPs yield positive

payoffs during market downturns, whereas other SFPs yield positive payoffs during bull markets. Thus, a well‐

grounded combination of various types of SFPs creates a riskless payoff. Moreover, SFPs are particularly suitable for this

type of risk management strategy, as the expansion of the product range is simple and issuance costs for all products are

similarly small. Although we are particularly interested in the potential risk management dimension of the

dependencies, we also have to rule out other reasons that motivate the existence of pricing and issuance dependencies

in SFP portfolios. These are (a) the values for all products depend on a market index and this may drive cross‐pricing

and cross‐issuance patterns; (b) retail investors may prefer products with particular characteristics such that cross‐

pricing and cross‐issuance patterns may be created by investors’preferences and their demand behavior.

We study pricing and issuance dependencies between various products belonging to the same SFP portfolio. We

consider all SFPs outstanding in the German market between January 2008 and June 2010 with the German

performance index (DAX) as the underlying security.

4

We selected this time period because only put and call warrants

and discount certificates were issued in substantial number. Therefore, our study design has to address only a limited

number of complementary product combinations. Some product combinations yield very simple payoff structures. For

instance, an issuer that offers a large number of OTM put warrants faces high payouts during market downturns. This

issuer can reduce the volatility of its payouts by also selling discount certificates with CAP’s similar to the strikes of the

put warrants. Similarly, an issuer that offers discount certificates can reduce the volatility of its payouts by also offering

put warrants with strikes similar to the CAP’s of the discount certificates. In both cases, the risk exposure of the

resulting portfolio is reduced. All other product type combinations do not yield a risk reduction, which is why the put–

discount combination is our working horse.

To identify cross‐product pricing dependencies, we start with a difference‐in‐differences approach, with which

we determine whether issuers change product prices when they intensely sell products with complementary

payout profiles. Recent literature already suggests that issuers change their pricing behavior when retail investors

intensely purchase products (Baule, 2011), but it does not consider pricing implications initiated by the demand for

1

We provide a brief introduction to SFPs in Appendix A.

2

In addition to rational motives for purchasing these products, which are known to be sold at considerable premiums over their theoretical values(TVs; Carlin, 2009; Henderson & Pearson, 2011), the

behavioral literature brings forth additional motivations for investors to purchase SFPs. For example, Das and Statman (2013) argue that SFPs have substantial roles in behavioral portfolios that are

composed of mental account subportfolios. Similarly, using prospect theory, Hens and Rieger (2014) show that investors can obtain a sizable utility gainfrom investing in SFPs (see also, e.g., Breuer &

Perst, 2007; Vandenbroucke, 2015). Moreover, Bernard, Boyle, and Gornall (2009) argue that SFPs in the United States often contain unreasonably optimistic hypothetical scenarios in their

prospectuses, which may contribute to their popularity with uninformed investors. In a similar direction, Döbeli and Vanini (2010) analyze what types of SFP product descriptions motivate investors to

purchase SFPs.

3

Former employees of a financial institution engaging in the market for SFPs confirmed that issuers indeed rely on the described strategy to complement their risk management efforts.

4

Issuers also offer other SFPs that are not listed on an official regulated market for SFPs (see Célérier & Vallée, 2016), which we do not consider in our analysis.

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