The Buy Side

Buy side clients can be classified into two categories: retail and institutionals.

 

Retail Investors

Retail investors are usually asset management institutions that buy structured products from IBs and redistribute them to individuals. 

The payoff is simplified and marketed; individuals then have access to attractive payoffs. 

 

The retail investors usually request prices from several banks.

Before doing a trade, the investor will have seen indicative prices from all the counterparties and will move to a live auction. 

The investor may also spread a large notional over several of the banks with the best prices.

The categories of yield enhancement products and diversification instruments are popular among retail investors.

 

Institutional Investors

Institutional investors are more sophisticated than retail investors, they include institutions such as hedge funds and mutual funds.

Such clients often hold large portfolios and the notional sizes of their transactions can be quite significant in both size and complexity.

 

IB's will produce the business-tailored solution that will best suit the needs of institutionals.

Usually it is less competitive than the retail business but the development of the solution is a much larger part of the job.

Owing to their sophistication, the scope of products that can be marketed to them is larger and room for innovation is thus greater.

 

Credit Risk

The buyer of a financial product from an IB must pay careful attention to the seller’s credit rating.

It gives valuable information regarding the creditworthiness of an issuing financial institution.

An investor can decide to trade in a product with a top credit-rated company even if he finds a more attractive and cheaper one issued by a financial institution with a lower credit rating.

Credit risk resulting from a financial firm’s issuance of bonds can be hedged using credit default swaps (CDS).

 

Collateralized line investments are those that do not involve counterparty risk.

When we consider swaps, the way to avoid problems with default events is to structure the swap along collateralized lines.

This involves computing the value of the swap and setting aside the equivalent amount of collateral, typically with a third party.

Naturally this requirement comes at a cost to the investor.

It is expected that a larger portion of SPs in the future will be structured with some method of mitigating counterparty risk.

 

The rate used when pricing the ZC bond part of the note is essentially a reference rate plus some spread.

This spread:

- is the rate that the treasury of the bank offers on deposits.

- reflects the credit rating of the bank.

- yet the implied offered rate is typically less than the spread implied from CDS.

 

The funding rate for: 

- AAA-rated companies can be around 20 bps per annum.

- risky companis of lower credit ratings can reach levels of 600 bps (6%) and above. 

 

When building a structured note, the bonds of the bank with the lower credit rating cost less. 

Therefore there is more money remaining to put into the risky part of the note.

So the riskier bank can potentially offer a higher participation rate on a structure than the less risky bank can.

Investors know the implications of lower credit ratings on their structured note investments.

They understand why a lower-rated bank may be offering better prices on the same structure.

In times of distress there is what is known as a flight to quality --> preference for highest credit-rated firms. 

 

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