The Market

Issuing a Structured Product

IBs can raise capital through issuing structured products at a specific price expressed in percentage of the notional size. 

For big sizes, investors may prefer to cut the notional into separate tranches.

This enables the investor not to be fully dependent on the bid–ask of a unique bank if he wants to close/decrease his exposure.

This method can also help to spread some of the risk of having just one counterparty.

 

The size of transactions is important in the valuation of the options composing the structured product.

In some cases where the notional of a transaction is large and the product carries a large amount of unhedgeable risk, one will see a substantial dispersion in the prices offered by different banks. 

 

From the banks’ perspective, the advantage of having one big size transaction, compared to many smaller ones is two-fold.

1) There is cost involved in terms of hours spent.

2) The profit is a percentage of the transaction’s notional; then a big size issue can imply a large dollar amount of P&L.

 

In competitive auctions, sellers cannot charge high levels of P&L, but typically have priority if the investor wishes to unwind.

If the seller is offering a two-way market, they can potentially charge if the trade is unwound.

 

The contractual agreement explaining the features of the issue of a specific SP is referred to as a term sheet (TS).

As structured products are sold OTC, the term sheet must be a sound legal contract.

 

Liquidity and a Two-way Market

An important factor that allowed SPs to be sold is the two- way market the sell side offers, providing the investor with liquidity.

Financial institutions issuing SPs are aware that the banking system is based on confidence.

They are willing to gain more clients by: 

- offering them enough liquidity.

- enabling them to close their investment positions or unwind partial notionals.

 

Traders estimate the market value of structured products and make bid and ask quotes that are available for investors. 

If IB's issuing SPs face problems in risk-managing a specific product, they will increase the bid–ask spreads. I

To produce a consistent valuation for an OTC SP, the trader must mark-to-market so that the valuation reflects current market data.

 

Valuation teams help the salespeople to provide the investors with quotes.

This is again important since the clients may want to:

- decrease their exposure to the structure by selling a part of their notional at the bank’s bid price.

- increase their exposure by buying more notional at the bank’s offer price.

 

Additionally, illiquid parameters that cannot be implied easily, such as correlation, will need to be monitored more closely.

These can greatly impact valuations and the whole value of the trading books that are exposed to them.

Market consensus data providing firms can be utilized so that illiquid parameters impacting the value of trading books are at least marked at some market consensus between participating firms (totem).

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