I just got off the phone with a guy trying to get us to use structured notes, an ‘M’ note in particular(principal protected, by issuer, with 30% up, 15% down knockouts). I understand the note and how it is supposed to work, but I still don’t understand how they structure the derivative in order to become worthless over/under the knockout number. I asked him to explain it a little better and he basically told me it’s too complicated for me to understand, which is a great sales technique by the way. Can anyone explain this in simple terms? It just seems very counterintuitive to have something be worth 19 but the minute it goes to 20 it is worth nothing.
dpjohn00: So I’m interested in buying some structured notes. Broker: SOLD!!! Seriously though has this thread been bumped from 2006 somehow?
Don’t buy structured notes. They’re structured to make the sctructurers rich and you not. Just make your own note and capture the extra 2% yourself. That’s why we’re CFAs, don’t listen to salespeople. Just protect an etf with an option and you’re good. That’s all the product sounds like, a long straddle on a portfolio. Ps. Gotta love how the guy justifies the product by saying its too complicated for YOU to understand when its the sales guy that has no idea what he’s selling… you should have made him tell you what it is, saying that you were the originator of the product. He probably would have hung up.
It was almost like he had a script there with answers to certain questions with the main purpose being don’t answer any questions. He also was telling me how he has been in cash since Oct 07. It’s amazing how many people have been all cash for about a year.
He probably held a portfolio consisting of only investment banks because of they’re great track record 
It’s difficult to know exactly what he was trying to sell you, but it’s easy to construct this stuff. 1) The “principal protected” stuff is that you give them 100 and they invest 70 in zeros that will be worth 100. The rest of the 30 is what’s used for the index bet. 2) “Knock-in” and “Knock-out” options are pretty standard fare derivatives. A “knock-in” + “knock out” = standard option so you can split up an option and sell each piece separately. You can read up on these in numerous places, but “It just seems very counterintuitive to have something be worth 19 but the minute it goes to 20 it is worth nothing” is probably not right. Suppose that you have a knock-out call that knocks out at 20 but has a strike at 15. Valuing these things is not too tough (see Shreve, for example) but if there is a long time to expiration, the option will not be worth very much if the price is at 19 because the knock-out probability is very high. If it’s 5 minutes before expiration, it will be worth 4. In between, there’s time value of the option and knockout probability working in opposite directions. Note that if I also sell a call that “knocks-in” at 20 (i.e., doesn’t become active until the stock price reaches 20) one or the other of these pays off if S > 15 at expiration and both are worthlessif S < 15 so combined they make a 15 call. 3) “he basically told me it’s too complicated for me to understand” would get quite a response from me coming from any salesman.
Thx Joey. Makes a little more sense describing it with the knock out/in features on the options. He didn’t really do a good job explaining how the knockout feature in the note related to the knock out/in features of the options, even though it is implied in the product payoff. I saw in a previous post you think they are too pricey. What is the max cost you would use one, if at all?
Did I say they were too pricey? If I did (it’s because I believe it) it’s because I would bet that the vol is almost always higher on the barrier options than the corresponding plain vanilla option. I can’t imagine that I would ever have a view about the barrier that justified paying more for it (in vol terms because the barrier options will obviously be cheaper in $ terms). I think these structured products are always about selling expensive derivatives to people who won’t price them. Next time someone calls you about such a product and says it’s too complicated, say “OK, my Bloomberg says implied vol on the ATM options for this tenor is [blah]. So, can you save me a few minutes and tell me what the OAS is on the bond using that vol?”