Structured Products Handbook 2012-2013

Structured Products Handbook

2012-2013

In Association with RBS

2 | FVC Structured Products Handbook

Welcome 3

Introduction to FVC 4

Background to Structured Products

What is a structured product? 5

History and the Current Market 6

Common Features in Structured Products 7

How a Structured Product is Constructed 8

Analysing and Rating Structured Products 10

Key Elements

Asset Classes and Underlying Assets 11

Credit Quality of Issuers 12

Single and Multi-Asset Products 14

Dividends and the Cost of Protection 15

Different Pricing Regimes 16

Bringing Products to Market 17

Secondary Markets 18

Use of Structured Products within a Portfolio 19

Regulation and Compensation Schemes 20

How to Trade RBS Structured Products 22

Major Product Types

Introduction to Product Types 23

Capital Protected 24

Accelerated Tracker 26

Reverse Convertible 28

Autocall 30

Defensive Autocall 32

Bull Bear 34

Range Accrual 36

Synthetic Zero/Growth Certificate 38

Product Comparison 40

Five Reasons to Recommend Structured Products 41

Key Risks 42

Glossary 43

Contents

Welcome May 2012

FVC Structured Products Handbook | 3

Dear Financial Professional,

At Future Value Consultants we have sought to provide wealth managers and financial advisers with accessible and relevant services. This is the fourth version of our popular structured products handbooks and we are delighted to bring this latest edition to you in association with the Royal Bank of Scotland.

Royal Bank of Scotland selected Future Value Consultants because of our experience in the UK through our research channel as the most widely used source of analysis on structured products available to wealth managers and financial advisers.

In turn Future Value Consultants is pleased to help Royal Bank of Scotland disseminate information to wealth managers, advisers and salespeople about structured products as we believe that education has an important part to play in this industry.

This is a critical time in the investment world with the advent of RDR and other regulatory changes coupled with technology advances and product innovation. In addition, the financial climate remains turbulent and difficult.

RBS have proven themselves a major force in UK structured products over many years with a broad range of products and a commitment to innovation and service. FVC has been providing research on structured products in the UK since 1999, covering over 2000 products in that time.

This handbook aims to explain how structured products work and what they can achieve for investors. We have divided the content into fifteen individual sections covering different aspects of structured products followed by an in-depth look at some of the most important product types.

If you have any comments or feedback about this handbook please contact us, we would very much like to hear from you.

Yours faithfully,

T.M. Mortimer Managing Director, Future Value Consultants Limited [email protected] • www.futurevc.co.uk

Contact details for the Royal Bank of Scotland can be found on the back cover of this handbook.


FVC’s flagship service is its structured products research reporting service, which now covers the whole of the UK and US markets, as well as products from other markets globally. Its methodologies, analysis and web-delivered tools have been used by many thousands of professionals in the industry. It pioneered the concept of quantitative analysis of structured products in 1999 and remains the market leader.

FVC has taken the concept of consistent and independent analysis, which is common in the mutual fund and bond world, and extended those techniques to analyse structured products. Concentrating on price, returns and risk, FVC produces clear, accessible analysis that is useful to all those in the structured products market, from issuers to advisers.

These services are used by advisers and wealth managers in particular to enable them to assess structured products by using the independent research and analysis that FVC provides. In a marketplace with many different investments issued constantly such a service provides a vital role as advisers seek to provide the best service for their investors and satisfy their own compliance requirements.

In the UK over 2000 products have been assessed by a service that has a track record of over ten years. It is accessed by many thousands of advisers and features prominently in the selection process of adviser networks and wealth management groups.

FVC also performs independent valuations and index calculation services that are used by many institutional clients. It provides valuations, consultancy and support to its clients on their derivatives and structured products portfolios. FVC believes that good valuation services require a combination of reliable models, accurate data and sound business experience. This enables it to provide valuations in line with market practice and to provide reconciliation and insight when there is a discrepancy between the issuer and valuation agent. The index calculation business specialises in both algorithmic and bespoke indexes. FVC started its index calculation business in 2007 and first acted as calculation agent for complex algorithmic indexes. This leverages its expertise in complex instruments and analysis from its structured products business.

All of FVC’s services combine usability, the latest web-delivered technology and cutting-edge techniques in research and analysis in structured products, derivatives and other related areas. It is the goal to provide clients with total solutions addressing all of their requirements.

FVC supports industry conferences, education initiatives and media events, and has been selected to contribute analysis to Structured Products Magazine since 2007. It has developers and business analysts with a wide range of experience. Its clients include many of the largest global investment banks as well as product providers and institutional buyers of structured products.

Introduction to FVCFuture Value Consultants (FVC) is a research, product design and analytics consultancy specialising in structured products and algorithmic strategies.


1 What is a structured product?

Structured products are created to meet the requirements of many types of investors. This is achieved through offering different levels of exposure, risk, return and protection to a particular asset or assets to satisfy an individual investor’s requirements. These offer investors a chance to meet their specific goals, some of which cannot be achieved through investing in simpler financial products available in the market. Structured products are commonly used as a form of enhanced investment to be included in a diversified portfolio. Most UK structured products are equity-linked and offer either full capital or partial protection. On the upside they seek market-linked returns or high target levels of income. Structured products are usually subject to a certain level of participation or a maximum return which means, in certain cases, they may underperform against direct investments in strong market conditions. However, this is balanced by reduction of risk to the investor. Thus investors give up some upside in good market conditions, in return for some protection against losses in a bearish market.

Structured products also offer the investor an opportunity to invest in a range of mainstream and alternative asset classes which include the world’s major equity indices, commodities, commercial and residential property, currencies and particular industrial sector indices. It is often difficult to gain access to these markets directly, therefore structured products act as an investment vehicle to them.

They allow investors to make returns on markets over a given period of time while still maintaining a level of risk control. A structured product linked to a non-traditional asset class can also offer the investor a lower risk way of accessing that underlying. With a suitable choice of underlying assets and risk profiles, structured products extend the range of investments in a way which unlocks a whole class of investment opportunities.

Generally products are backed by major financial institutions. Listed products are traded on an exchange where they can be traded like stocks or a fund and usually become available as soon as the product terms are hedged. With retail products the issuer, distributor or plan manager will produce literature at the time of launch of each new investment into the market. The brochure identifies the terms and key features of the product. The investor should be fully aware of the features of each investment how the product fits into their portfolio.

This handbook aims to educate by breaking down the key components that go into a structured product through clear explanations and illustrated examples.

Structured products are investment products designed to offer a predefined payoff profile from the performance of an underlying asset.


The UK structured products market has been active in the retail and institutional arena since the early 1990s. Many market developments have been seen in that time.

2 History and the Current Market

During the 1990s, volatility levels were relatively low and interest rates were also quite high. This scenario led to the growth of guaranteed equity bonds as such products were then known, many issued under a life insurance wrapper. Such products were simple capital protected investments and they continued to be popular during most of the 1990s.

The next major change in UK structured products was dictated by the continued stock market volatility that started in 1997 following crises in Asia and Russia. Volatility stayed at high levels and the dot-com boom ensured rising equity markets in the period 1998-2000. This was combined with falling interest rates and so many investors sought alternative income bearing products. Necessarily these involved risk to capital and consequently reverse convertible income products grew in popularity.

The peak of issuance in these products was between 1999 and 2001 which coincided with the peak in equity markets. Unfortunately the ensuing bear market in the FTSE-100 Index and other major equity indices meant that the vast majority of these investments lost significant amounts of capital, leading them to be dubbed “precipice bonds” by the press.

Between 2003 and 2007 structured products changed again with the popularity of the “super-tracker” type accelerated return product and the growth of auto-calls. This was due to a combination of market parameters and attitudes to risk as investors sought to recoup losses in a risk controlled manner. They were happy to accept maximum returns capped at a sensible level to either boost the chance of achieving this or to control risk.

Simple capital protected products have generally been rarer with other constructions such as digitals becoming more popular.

Since 2007 the investment world has been dominated by credit worries. Major bank failures and bailouts have caused funding levels to rocket and this has impacted product terms and their associated risk. Everyone now accepts that it is vital to assess credit risk as well as market risk. There has in general been a flight to quality in the use of issuers with those with stronger credit ratings as well as increased usage of deposit wrappers which may benefit from compensation schemes. There has also been an increase in the use of collateralisation and other credit mitigating techniques. Since 2010 government stability particularly in the Eurozone has also had an impact.

In 2009 the FSA published a number of regulatory directives for UK structured product business. It looked at the quality and balance of product brochures but also focused squarely on the quality of advice given to investors particularly with regards to risk. The aim of these directives was to ensure that issuers and advisors alike adopt sound selling practices.

As RDR continues to draw nearer the FSA further acted in 2011- 2012 to undertake an important review of practice of distributors. This includes making sure that products are properly assessed and scrutinized before being brought to market. The new requirements detailed in RDR apply to product providers and retail investment advisers as part of the FSAs consumer protection strategy.


Capital ProtectionSome structured products focus on capital protection while others offer greater potential returns by taking capital risk. Capital protected products achieve their protection by sacrificing some market upside and/or the dividends associated with the underlying.

BarriersCapital-at-risk products usually offer features to reduce exposure to decline in the underlying asset, for example by use of a “barrier”. The two main types of barriers used in the UK market are the final day (European) barrier, which is only observed on the final day of the investment and the daily closing or intra-day (American) barrier type, which are both observed throughout the life of the product. The intra-day barrier is more likely to be breached than the daily closing barrier because there are more opportunities to fall below. Conversely, the European barrier is the least likely to be breached because there is only once chance to be breached.

If the barrier is breached because the asset falls below the barrier level then capital will be directly at risk in some way. In the UK barriers for index linked products are often set at a level of 50% of the initial level of the underlying asset. It is often the case that a lower (deeper) barrier is present for a product linked to a more volatile asset such as an emerging market or single stock.

Market Participation and CappingParticipation or gearing is commonly used to describe the level of upside exposure to the underlying asset. Leveraged

exposure to the growth of an asset comes at the cost of reduced downside protection because it is impossible to provide both. Growth products with longer terms tend to offer higher market participation rates. This is because the cost of protection can be spread over a longer period of time thereby allowing more upside exposure to be retained.

While a provider will seek to offer high participation rates, sometimes products have a cap so that no underlying growth beyond a certain level will be passed on to the investor.

Averaging Averaging refers to the method of calculating the reference underlying’s final level. The simplest products are termed point-to- point, i.e. they depend on the relative levels on the first and last day of the investment term. The most common use of averaging is to define the final level of the underlying for calculating the product return as the average value over a certain period of time. Final index averaging can be useful as it may soften the impact of sudden falls in the last stages of the investment term. However, it can also constrain growth in a rising market.

AutocallsAn autocallable product is one that can be redeemed prior to maturity if the underlying asset(s) reach the required level on a pre-defined date during the product term. Products that include an autocall feature are commonly referred to as “kick-out” products and usually pay the investor a fixed return plus their initial capital if the auto call feature is triggered.

The three most fundamental components of a structured product are the underlying asset, the issuing entity and the maturity horizon. If an investor is uncomfortable with any of these aspects of the investment, it is highly unlikely to be suitable.

3 Common Features in Structured Products


Structured products can be bought in three ways: through a plan manager, as a securitised/ listed instrument or through a private bank.

4 How a Structured Product is Offered

The plan manager and securitised routes are similar in that products are designed for large investor bases and mostly of small to medium case sizes. Private banking distributed products tend to be more bespoke aimed at more wealthy or sophisticated investors.

Whoever is responsible for product design will need to carry out extensive research in order to match investors’ requirements and then try to assess which features can be realistically achieved in current market conditions.

In the case of a private bank or plan manager once a potential product design is reached one or more investment banks are contacted to request indicative prices for the intended product. The price of the assets will depend on market conditions, the cost of hedging and (in the case of fixed terms offered for a significant period) the uncertainty of the provider meeting the expected sales volume.

Securitised and listed instruments are brought to market by an issuing bank directly which will issue products it believes are competitive and appropriate for the target market.

StructuringCapital protected and capital at risk products are constructed quite differently from each other. Capital protected products include features to provide the return of capital at maturity, while giving the investor the opportunity to benefit from market growth. Capital protection is typically ensured through the purchase of a zero-coupon bond with the rest being spent on options or an income stream which cannot return less than zero. This requires the bulk of the investment being put into a deposit which at maturity will

reach 100% or some other target value of the amount invested. The amount of money available to purchase call options or an income stream is dependent on the interest rate and length of the investment term. Higher interest rates and longer investment terms lower the cost of capital protection which results in a higher participation rate or higher potential returns.

An alternative is to produce a capital-at-risk product in order to offer potential higher returns. In this instance, put options are sold to generate value which is used to buy more call options to increase the participation level of the product. However, capital is at risk if the market falls below some pre-defined level. The same strategy is used by high-income structured products where put options are sold to enhance the level of the income stream.

CompetitionAnother feature of the structured products markets is that more issuers will seek to compete for simpler more liquid products but a significantly fewer number of banks are willing to engage in more complex products, those of exceptional long maturity or linked to unusual underlying assets.

Managing the Sales ProcessThe case of plan managers is the only one of the three to have significant “volume risk” because of the need to offer the product at fixed terms to the investors of the plan manager. Both parties will agree the amount or range of product volume to be purchased based on expected sales figures. The bank takes on the risk of under or over selling and may incur further costs if prices move


significantly from the time of the quote to the time the product is hedged. Product providers opt for variable hedging if they do not want to commit to a pre-defined level of volume of sales. Variable hedging is, however, more expensive, often making the terms of the product less competitive.

Listed or securitised products do not carry this risk as terms are set on the day of pricing and future trading occurs at the banks bid-offer prices. Private banking trades are agreed generally with the client base already approached and demand established.

In order to manage its risk the investment bank may purchase an amount of the underlying asset or options traded on an exchange to hedge its principal exposures to the market, volatility and interest rates.

The volatility of an underlying asset is a key factor in determining the price of call options, which are sensitive to the volatility of an asset because the option benefits from market appreciation but does not suffer from losses. Call options for product linked to volatile underlying assets are more costly which results in lower participation rates. Higher volatility also makes put options more expensive.

The level of complexity in product design can be considerable for wealthier or institutional investors, but generally would be broken down into two core parts:

Counterparty SelectionThe capital return element of a structured product is generally provided by the investment bank that delivers the derivative-linked payoff as well, but this is not always the case for larger investments. Typically the product structurer would identify a bank whose credit risk profile is suitable for the investor. For example, if the structured investment forms less than 5% of a portfolio and the investor is seeking aggressive growth, a less secure institution may be suitable, but for a cautious investor allocating a large portion of their wealth, it may be more suitable to spread the risk among a number of stronger financial institutions. Alternatively, a collateralised solution may be sought where the bank puts up government bonds, or other paper of very strong credit-worthiness as collateral, on a daily basis which are available to the investor if the bank fails.

Payoff SelectionThe investment return (payoff) can deliver virtually anything the investor needs and the product structurer would normally source this from the most suitable of a number of counterparty institutions. In order to win the business, the ability of a bank to provide suitable secondary market pricing, regular valuations and other services would be taken into account in addition to a competitive price for the derivative assets. The underlying assets to which the product is linked can range from a portfolio of funds chosen for the client, through to commodities, individual stocks, equity indices or any combination of these.


FVC has pioneered research methodologies for structured products since 1999 and covers all UK structured products. FVC has developed objective and consistent methodologies that generate ratings and statistics on all structured products allowing easy comparisons of one product with another.

5 Analysing and Rating Structured Products

The first part of an FVC report contains a product summary and product description, outlining the key features and terms of the product. This description provides a clear summary of the product’s terms as well as a comprehensive review which details the advantages and disadvantages of the product compared to others currently out in the market. Important product features such as the choice of underlying asset, the investment maturity and choice of investment wrappers are shown as well as the offer period and key dates. The report usually includes the product literature and contact details supplied by the provider along with their contact details.

Many users look to the report service as an efficient way of keeping up with the market. However the real differentiator lies in the quantitative analysis. The report contains scores examining key properties of value, return and risk as well as charts to demonstrate potential returns.

Value ScoreThe value score is obtained by an independent estimate of the market price of the assets calculated by FVC. It uses prevailing market data which is used to estimate the offer price of the product components. This includes effects of interest rates, volatility and credit spreads. Because the product is valued at a time shortly after it is hedged it is possible to estimate how good or poor value the product represents. This score is updated weekly to show the effects of changing market conditions allowing the comparison of the product with those that are issued subsequently. The value score assesses implied fees in the same way that a fund would look at TER. The estimate of value is translated into a score ranging from 0 to 10 for easy comparison purposes.

Return ScoreThe return score is based on a different methodology. Five market scenarios are selected representing high and low market growth and high and low volatility as well as a central “neutral” assumption. The probability distribution of the product is calculated under each of these scenarios and a risk adjusted average return value is calculated. The higher the best of these numbers compared to the distribution of market peers will lead to a higher assessment of returns. These numbers are also converted to a scale of 0 to 10 for benchmarking purposes.

RiskThe risk score (riskmap) calculates the expected total shortfall of the product below the risk-free rate taking into account both the effect of product market volatility and the effect of issuer credit. The riskmap is also expressed on a scale of 0 to 10, and the risk number is decomposed into the contribution from market risk and credit risk.

Probability ChartsThe use of probability charts show how the product might be expected to perform under the same five market assumptions used in the return score calculation. Charts of probabilities of various absolute returns as well as performance compared to cash returns are also shown as are the probabilities with and without the effect of credit risk taken into account.


Equity IndicesMost structured products in the UK market are linked to major global equity indices. The FTSE 100 Index has always been the most popular choice of underlying asset used in structured products in the UK market. Other regular choices include US market index S&P-500, Eurostoxx-50 (representing Europe) and the Japanese Nikkei-225. Major indices are the most liquid of the asset classes and therefore dealing in the underlying shares, futures and options is cheaper and more easily achieved. Additionally equity indices are by definition more representative and less volatile than a small basket of stocks, which is why they may be seen as a more sensible investment option. They are also the most natural and recognisable choice for investors.

BasketsA basket usually incorporates several equity indices, stocks or other assets in one product. Each asset is allocated a specific initial weight in the basket. A basket is sometimes used as a bespoke choice to achieve a certain positioning or allocation, for example, using ten stocks in the same sector.

CommoditiesCommodities and commodity index-linked products can be used to diversify an investor’s portfolio. Commodities also offer investors an opportunity to invest in an asset class which has historically had lower correlation to equities and bonds but have obvious rationale particularly in times of demand led inflation.

InflationProducts linked to the performance of inflation can be used within a portfolio to provide real returns that preserve spending power. Whilst the standard equity linked growth and income products issued in the UK offer a means to generate high headline returns there is no guarantee that they will keep pace with inflation.

Commercial and Residential PropertyInvesting in property is another way to diversify a portfolio. Like commodities, the value of property does not necessarily correlate with equities, so it can help to spread risk. Both types of property are generally less liquid than other asset classes and dealing costs can be higher for anyone trying to invest directly.

FundsFunds are essentially a portfolio of stocks or other instruments. These are either actively managed by fund managers with a view to outperforming benchmarks or lower-cost tracker funds to simply mirror the performance of indices, regions or sectors.

Proprietary IndicesThere has been a rise in the amount of structured products linked to proprietary indices. These types of indices are designed to provide exposure to a particular underlying or asset class following a rules-based strategy to either control risk (such as volatility controlled strategies) or to generate outperformance (e.g. momentum or relative value based strategies).

6 Asset Classes and Underlying AssetsThe most common types of underlying asset classes used in the UK structured product market are equity indices, equity baskets, commodities, mutual funds and commercial & residential property indices. Less frequently used underlyings include hedge funds, currencies, ETFs and custom indices.


The construction of a structured product involves the purchase of assets by the product provider from the issuing entity (an investment bank). Credit quality is the ability of the counterparty to honour its obligations, that is remain solvent until the product’s maturity.

Lehman Brothers CollapsePrior to the financial crises of 2007 and 2008, relatively little attention was paid to the credit quality of issuers, (certainly those of “A” rating or above) as it was assumed that all issuers were stable institutions representing little risk. Funding levels were low meaning that banks did not have to offer much higher than the risk-free rate when seeking to raise funds. In the last few years that has changed and today credit considerations are critically important and will likely remain so for the foreseeable future.

Credit rating agencies such as Standard and Poor’s, Moody’s and Fitch assign ratings which vary from AAA to D (definitions and naming vary a little between agencies). These are used as a guide to indicate the likelihood of default. These ratings have long been used in assessing the financial stability of a company, however agencies have come under criticism for the accuracy and relevance of their ratings following the collapse of many financial institutions and other companies with reasonable ratings.

Credit Default SwapsThere has been an increasing trend towards using credit default swaps (CDS) levels to reflect the credit quality of the issuer. The CDS of a company is expressed as a number which indicates the size of the credit risk involved in investing with a particular company.

The CDS level represents the market level for institutions to insure against credit events from the issuing entity. This may be used as an estimate of the return investors should expect to earn over the risk-free rate by investing with a particular issuer as a fair compensation for the credit risk taken on.

For this reason, providers may choose issuers further down the credit risk curve to enable them to produce a product that has optically more attractive terms. It is important for advisers to be aware of the identity of the issuer and judge their credit quality to assess whether the returns are in line with risk involved in investing in the product.

An issuer with a high credit spread may offer higher returns on product than an issuer with a low credit spread, as the investor should get adequate compensation for the credit risk taken on.

CollateralisationSome investors place very high importance on capital protection and therefore may be uncomfortable taking direct issuer credit risk. Collateralisation has emerged as the process used to back products for such investors. Assets held independently by a custodian are used as collateral to pay out returns in the event of issuer default. There are different collateralisation mechanisms but generally because of the additional costs incurred with this process and the lower rate of interest earned collateralised products generally offer less attractive terms.

7 Credit Quality of IssuersThe credit quality of the issuer is an important aspect to be taken into account when analysing the risk in a structured product. In today’s turbulent investment world, it is widely accepted to be at least as important as market risk.


The graph illustrates the effect global market events have had on the financial stability of these major institutions which include:

• Barclays Bank Plc

• HSBC Bank Plc

• Lloyds TSB Bank Plc

• Morgan Stanley

• Royal Bank of Scotland Plc

• UBS AG

The first spike in the graph was around the time that Bear Stearns was sold to JP Morgan Chase in March 2008. The sale was as a result of Bear Stearns’ over exposure to the sub-prime mortgage crisis.

The next significant peak was in September 2008 after the collapse of Lehman Brothers. Unlike the Bear Stearns situation, the US government let the bank file for bankruptcy which subsequently sent shockwaves throughout the financial system. The CDS levels of major banks rose significantly during this period.

September 2008 also saw AIG being bailed out by the US government causing more market panic. CDS levels began to fall but remained volatile during the last quarter of 2008.

In March 2009, AIG announced huge losses for the last quarter of 2008. This caused major international indices, including the FTSE 100, to fall sharply. There were signs of slow recovery beginning in April 2009 which caused a fall in CDS levels and the FTSE 100 began a recovery.

The rise in CDS levels and subsequent decline in the FTSE 100 from March 2010 can be attributed to the effect of the debt crisis in Greece. During this period, Greece requested a bail out and S&P downgraded Greece to BB+ causing stock markets to plummet.

Global stock markets fell in August 2011 amid growing concerns over the European Sovereign debt crisis, in particular towards Spain and Italy. Additionally United States treasuries lost their AAA credit rating. This caused panic in stock markets which remained volatile for the rest of the year.

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Average CDS

The graph below displays the average five year CDS of six major issuers of structured products in the UK.

Source: Reuters


Products linked to multiple assets provide investors with the opportunity to diversify the risk in their portfolio and can offer more targeted strategies for return. We define single asset products as those linked to a single index or strategy even though that underlying may itself be quite bespoke. Multi-asset products can be divided into two fundamental types.

Firstly we consider “baskets” of assets. A basket is a collection of assets with given weightings. The payoff of the product is a function of the basket value. For these types of products, the performance of individual elements in the basket does not have any (direct) bearing on the product payoff, except through its influence on the basket return.

Secondly we consider what might be termed true multi-asset structured products. These refer to products which look at each asset’s performance individually in some way rather than calculating a payoff which is simply a function of the basket (average) performance. These types of products are generally more complicated than simple basket products both from an investor’s point of view and also from a risk management perspective.

The returns of many multi-asset products are based upon either the best or worst performing asset. Examples of this type of product include rainbow products, worst of kick-out and worst of reverse convertibles. The correlation between each asset plays a crucial role in such products.

The most common examples of multi-asset products in the UK market are worst of auto-calls or reverse convertibles. The downside risk taken on by the investor is linked to the worst performing of two or more indices over the investment period. Although the indices may be major indices with which the investor is comfortable, clearly the downside risk is greater than that of any of them individually. The product’s return cannot be expressed as a simple basket combination of the indices.

Another example of a multi-asset product is the “rainbow”. The performance of each asset is calculated at maturity and the weights are calculated by giving higher weights to the best performing assets according to a pre-defined formula.

The correlation between assets affects the pricing and prospects of all multi-asset products. For reverse convertibles or auto-calls a higher coupon or return is offered as compensation for taking a capital return linked to the worst performing index. The investor is hoping for high correlation so that the lower or lowest asset is not much worse than the average of all the assets.

Conversely for rainbow products assets that have little or no correlation to one another make this product more attractive as the investor would need one asset to significantly outperform another in order to achieve a better return than would have been offered by the conventional basket product.

In the UK, the majority of structured products are linked to a single asset such as an index, equity, or commodity. The popularity of these products comes from the fact that they are easier for the provider to construct and generally easier to understand from an investor’s perspective.

8 Single and Multi-Asset Products


In bull markets, some commentators may argue that buying capital protection is unnecessary as markets are rising. Conversely these same commentators are likely to say that in a bear market either asset levels have bottomed out making further protection unnecessary or that capital protected products will “only” return full capital at maturity even though this represents outperformance over a direct investment.

Both these arguments are illogical and misleading. There is no such thing as markets going up or down, only that they have already gone up or down. Therefore capital protection is likely to remain an important feature for many investors in any market environment. However different pricing regimes (particularly high volatility levels) can make the cost of protection very expensive hence making the structured product solution unattractive.

If an investor is risk-averse for some reason, for example because they are approaching retirement or feel that their current portfolio is too risky, or they change their mind about market sentiment then they would be unlikely to consider investing directly into equities or other risky assets. In such cases looking for a capital protected investment is the number one priority.

As long as investors are aware that all protection carries a cost but represents a decision they wish to make then they ought to understand that there is some opportunity cost if markets perform strongly and that the protection with hindsight proves unnecessary.

The Cost of ProtectionTo study the typical cost and implications of purchasing capital protection, we compare a capital protected FTSE-100 linked structured product with a direct investment into the equity market of a FTSE-100 tracker fund or ETF. Apart from the fact that only the structured product offers capital protection the two investments differ in that dividends are received by the fund.

If the FTSE-100 shows a fall in capital terms over the investment horizon, the structured product will still return full capital at maturity. However a tracker fund would show a capital loss offset in full or part by the dividend income. If the size of the market fall exceeded the value of the dividends then it is possible for a tracker fund to show a significant loss in value. Over the last ten years there have been several cycles where the decline of the FTSE-100 would easily justify the premium implicitly paid.

Although the price paid for capital protection is a fair market value for what is being offered it does nonetheless represent a significant cost. Therefore, if capital protection is not required by an investor it makes no sense to seek a product which provides it. However, if the client requires capital protection but also seeks the opportunity of equity linked returns rather than interest then a capital protected structured product may be the best choice.

A very common feature of structured products in the UK market is capital protection. Products offering full capital protection at maturity help neutralise market risk. In this case investors receive full capital return at maturity regardless of the performance of the underlying asset. However, these products are still subject to credit risk from exposure to the issuing institution.

9 Dividends and the Cost of Protection


Structured products are a popular and an important investment class in just about every set of market conditions. However, the different points in the economic cycle affect individual structured product constructions in different ways, just as they differ in their consequences for equities, bonds, cash and any other investment sector.

10 Different Pricing Regimes

There are two main factors of the economic environment which affect the pricing and suitability of structured products at any given time. The first are simple market conditions – whether equity markets can be said to be bull, bear, or range-bound. Also of key importance is the level of interest rates which has a bearing on the relative attractiveness of equity and cash or bonds. The second factor is the level of the different pricing parameters which affect structured products. The most important of these are levels of volatility, but dividend levels are also significant as well as the shape of the interest rate yield curve over different maturities. Issuer funding levels and credit risk has also significantly affected pricing conditions since 2007.

We shall concentrate on the effects of the levels of interest rates and volatility. For any market environment there are usually two opposing considerations. The first is the perceived attractiveness of any product that can be constructed in terms of participation rates, income levels etc. The second is the likely future performance and prospects of the product in such an environment. There is a natural conflict between these two which shall now be explained.

We will consider markets with high and low volatility levels.

High Volatility MarketsThe case of high volatility combined with high interest rates arguably favours reverse convertible products.

In such situations the fixed coupon looks attractive, benefiting from both high interest rates and the downside risk taken which increases in high volatility markets. The high levels of volatility

mean that the investor (who is effectively selling a put option) generates a healthy extra coupon and so the product is a high yielding investment. However, although the income looks attractive, it should be remembered that the high levels of volatility indicate the market’s pricing of a sizeable amount of risk and therefore the income offered is far from risk-free.

If however interest rates are low this is usually the best situation for auto-call products. In such situations the fixed return available in the case of product calling looks attractive, benefiting from the downside risk taken in the event of kick-out not occurring.

Low Volatility MarketsThe case of low market volatility tends to favour other types of structured products. If volatility levels are low and interest rates are high, capital protected products make the most sense. This is because the high levels of interest rates allow for a favourable swap of interest payments for an option related return and the low levels of volatility mean that options prices are relatively low. Participation rates are high and may even exceed 100%. When low volatility is coupled with low interest rates this favours accelerated products because they are in fact relatively invariant to changes in both interest rates and volatility levels due to the combination of options that they purchase and therefore look attractive compared to cash or direct equities.


A structured product goes through a series of stages from its initial concept and design to its strike date. Structured product providers and structurers carry out extensive research and analysis to enable them to design a product to meet the needs of their target investors.

11 Bringing Products to Market

Once the structured product design has been decided the structurer or product provider will seek to confirm indicative or final terms. Sometimes this is an open market process involving several issuers, sometimes more than one for each offer. Typically a provider would then agree a deal for the product to be hedged with a particular bank, either based on indicative terms or fixed terms based on expected sales volumes. The product structurer would normally organise the trade directly with the bank or banks selected, with no offering period needed.

SecuritiesSecuritised products are either privately placed or publicly offered. They can either be listed on an exchange or the issuing entity provides two way pricing. The terms for products that are to be listed on an exchange platform are confirmed closer to the strike date. In this case the product can usually become available as soon as the product terms are hedged, and is listed on an exchange where it can be traded like a stock or a fund. Unlike plan based retail products, there is no offer period and the product can be bought and sold daily throughout its life up to maturity.

FundsSome structured products are now offered within UCITS funds and are available both for direct investment (like a Plan) and via platforms, insurance bonds and other arrangements. Although the cost of delivering a product in this format can be high, the additional flexibility they afford can be critical to some investors.

One of the great benefits of the fund route is the ease of dealing in the secondary market, both selling and buying, allowing investors to take advantage of changing views on market expectations, as well as being able to use the same product across a number of client portfolios.

PlansIn the case of plans that are to be distributed in the retail market, the bank usually fixes the terms around six weeks before the strike date. Once the product has been hedged, a brochure detailing the features of the product is produced. During this time, providers attempt to promote the product to groups of advisers. The product goes on sale during the offer period during which time the advisers research on products to fit their clients’ portfolios. The offer period of a structured product refers to the time the product is offered for sale to the public. The sales period usually lasts between six to eight weeks.


The intermediate value of a structured product at any time between its launch and its maturity is known as its secondary market value, which is an ongoing valuation of the options and other components of the investment.

12 Secondary Markets

At the start of any product the level of its market value is the issue price less declared fees and at maturity it will equal the product payoff. The secondary market value during the life of the product is the sum of the value of the individual product components. The value of each component varies continuously during the lifetime of the product and therefore so does the market value of the product. Each component of the product has a sensitivity to market parameters such as underlying spot levels, interest rates, credit spreads and volatility. Fixed income components such as capital repayment and coupons decrease in value when either interest rates or credit spreads increase. Options generally increase in value when volatility increases and “call” options increase in value when the spot level goes up whereas “put” options decrease.

A secondary market exists when a bank market quotes bid and offer prices on its own product during its lifetime. In most situations we would expect the bank’s estimate of fair value to lie between the bid and offer price but supply and demand sometimes mean that this is not the case.

Increasingly a secondary market with reasonable bid-offer spreads has become commonplace in retail structured products. Currently, generally only the issuer makes a market in its own products, however in principle structured products could become more widely traded between third parties on the secondary market.

Many investors view a structured product as primarily a buy and hold investment. For them the existence of a reasonable secondary market acts as an exit strategy in case the funds are needed urgently. For all investors a meaningful secondary market allows accurate valuations to be made and used in product or portfolio reporting statements during the investment’s life.

More sophisticated investors or active managers will seek to trade either in or out of a listed structured product. This enables them to choose an appropriate risk profile but potentially also benefit from timing the market in some way. For example an investor who seeks high yield in return for controlled risk through a reverse convertible or auto-callable might sell the investment back before maturity if markets are sufficiently high since most of the yield will have been earned and the product will be trading like cash. They can then re-invest into a longer dated product and seek that yield enhancement again.

Products listed on a stock exchange such as the London Stock Exchange are typically more liquid than most retail structured products and in most cases will have continuous trading. Issuers of listed products on an exchange have to adhere to the market making terms of that exchange under normal market conditions.


Structured products can be considered to have three main uses in an investor’s portfolio.

Core HoldingsThe first is as a core holding. As structured products are constructed using derivatives, many wealth managers and advisers feel that structured products rank alongside such niche or alternative investments as commodities, property, hedge funds and other complex or illiquid investments. However, one of the most important features of structured products is that they aim to control risk. Therefore a structured product is a natural choice for a lower risk investor who wishes to retain market exposure or income generation opportunities while reducing or eliminating market (and credit) risk as much as possible. For an investor to do this without structured products it would be necessary to convert a large part of the portfolio to cash or bonds and potentially miss out on market returns.

Access to New UnderlyingsThe second use of structured products is to allow an investment into a new market or underlying asset with better transparency, diversification, lower costs and typically some risk reduction as well as currency protection. Many investors would not consider any direct holding into some markets or underlyings because

of the associated risk yet consider them to offer interesting potential returns. A capital protected structured product linked to an overseas stock market index for example gives a safer way to allocate a few per cent of an investor’s portfolio.

Improving Risk ProfileThe third use we consider here is to fundamentally shape the risk profile of an investment to take account of market conditions as well as the investor’s risk appetite. Products such as accelerated growth products or kick-outs allow an investor to capture a good return from equities in the event of modestly performing markets. This allows them to keep or increase exposure to their target markets or asset classes but also offers them the opportunity of a greater return than a direct investment in the event of modest market growth. Popular and appealing in recent years have been the auto-calls which seek to generate high fixed returns without requiring any market growth and therefore are the perfect choice for expected range-bound markets. The use of such tactical investments would mimic many active fund managers’ strategies of core holdings plus specific overlays in order to enhance return. For securitised products the opportunity to buy and sell to take account of changing market conditions or strong performances in the underlying allows extra possibilities to shape risk and boost returns.

Structured products have a place in many investors’ portfolios. The variety of asset classes and risk profiles on offer mean that they provide solutions to many investors of different risk profiles and investment aims.

13 Use of Structured Products within a Portfolio


The regulatory landscape for structured products is undergoing significant change as a result of the credit crises and the collapse of Lehman Brothers. There is a renewed focus on compliance, especially in relation to the retail structured products space. As a result, this is an area which must be considered carefully for structured products.

14 Regulation and Compensation Schemes

FSA Involvement The FSA conducted a review of the marketing and distribution of structured products following the collapse of Lehman Brothers. The FSA has noted that it will take direct action to ensure that investors in structured products are treated fairly. Specifically, the FSA has set out the standards that it expects firms to meet when providing advice on marketing and designing structured products and has produced a “Good and poor practice guide” to assist firms in conforming the promotion of structured products to the required standards.

In November 2011, the FSA produced a guidance paper to structured products providers highlighting their product design, development, approvals processes, distribution processes and post sales responsibilities in particular. Its main focus was to ensure that firms were adopting suitable procedures in order to avoid the risk of poorly designed products which lead to mis-buying and mis-selling. The regulator found a number of weaknesses in these areas and has set guidelines into how firms should manufacture and distribute structured products. The regulator produced the finalised guidance paper in March 2012 making no amendments other than to clarify points raised in the earlier paper.

Retail Structured ProductsOf particular relevance, on a Europe wide basis, is the proposed European legislation on Packaged Retail Investment Products (PRIPs). The driving force behind the forthcoming PRIPs legislation

is the desire to create a level playing field for investment products that take a variety of legal forms – investment funds, structured securities, unit-linked life insurance products and structured term deposits – but provide broadly comparable functions for investors. This will be achieved through a two-pronged European level approach: rules as to the form and content of key investor disclosures and associated marketing materials; and selling rules which would include the management and disclosure of conflicts of interest.

Credit Rating AgenciesThe 2009 EC Credit Rating Agencies Regulation introduced a restriction on credit rating agencies providing consultancy/advisory services or making proposals or recommendations in relation to the design of structured finance instruments and a requirement that an extra symbol be used to differentiate structured finance credit ratings from other credit ratings.

Retail Distribution ReviewAs part of its Retail Distribution Review, the FSA has published proposed rules that will diminish the bias towards the sales of certain products. Amongst other things, the FSA intend to ban independent financial advisors from accepting commissions in return for recommending specific products. The FSA has also stated that it intends, in future, to prevent platforms from receiving payments from product providers and to ban cash rebates where


the provider credits the customer’s account with a portion of the product costs. The FSA has also published a template for assessing suitability. In the accompanying notes the FSA points out that whilst disclosure is a very important element of structured product sales, it cannot ultimately make an unsuitable product suitable.

“In its business plan for 2012/13 published in March 2012, the FSA noted that it will intervene earlier in the development of retail product where it considers this appropriate as part of delivering consumer protection. The FSA states that the intervention in retail products would occur where it sees unsuitable products that have a high probability of being mis-sold, where the firms have inadequate product design and sales processes.”

CompensationDeposit based structured deposits may be covered under the FSCS. Previously, it was thought that deposit based structured products would automatically fall under the FSCS guaranteeing the investor’s capital up to the prevailing limit. However, since the events of 2008, such as Lehman Brothers going into administration, regulatory outcomes have become less certain. The compensation limit for bank deposits is now £85,000 per eligible claimant per authorised institution.

“The Financial Services Compensation Scheme (FSCS) is the UK’s statutory fund of last resort for customers of authorised financial services firms. Compensation is paid if the firm is unable, or likely to be unable, to pay claims against it. The FSCS protects deposits, insurance policies, insurance broking, investment business and mortgage advice and arranging.”

Other DevelopmentsFinally, it is worth noting that the FSA has raised the prospect of actual product regulation, although at the time of writing no concrete proposals had been issued in this regard.


How to Trade RBS Structured Products

One of the key advantages of the RBS proposition is the breadth and depth of our listed structured product business. RBS operates across Europe, Asia, Australia and the Americas. The investor products and equity derivatives business lists and trades products on multiple exchanges worldwide, providing liquidity and transparency for investors. In total we have almost 40,000 listed products available. RBS exchange traded products can be listed in London, Amsterdam, Frankfurt, Zurich, New York, Hong Kong and Sydney.

In the UK and Ireland, many of these products are listed and also market-made primarily on the London Stock Exchange. Exchange market-making comes with some advantages including efficient dealing through the exchange, electronically via Retail Service Providers (RSP) or on the telephone via our dedicated client execution team. Settlement, through CREST, is also very familiar and operates in the same manner as trading shares.

RBS quotes live bids and offers, in normal market conditions, on each exchange business day under the rules of the London Stock Exchange. These prices allow for investors to trade in and out as the market moves. Prices are also published on the RBS institutional website (www.rbs.co.uk/markets) throughout the trading day.

Investors should note that the value of investments can rise as well as fall. Investors are subject to the credit risk of RBS. In the unlikely event that RBS were to default or go bankrupt, investors may lose some or all of their money.

For further information please contact the team at [email protected]

Introduction to Product Types


This section of the handbook describes the most popular product types in the current UK structured products market. It aims to provide an insight into each product type through clear descriptions and examples detailing the key elements of each product.

The product sections include a detailed description of each structure as well as providing an example to illustrate the typical terms available for each product. Each example product has been analysed with FVC models and data at the time this handbook was produced. It includes a pricing breakdown illustrating the typical cost of the key components that go into a structured product.

Each example product is analysed on a like for like basis. All have the same market pricing parameters, length of product term, underlying asset and the overall cost of the structure. All of our example products are linked to an equity index assumed to have similar properties to the FTSE 100 Index and analysed assuming the following parameters:

• Term of five years

• A flat implied volatility of 20%

• Total fees of 2%

• Counterparty credit strength approximately equivalent to S&Ps A rating

• Probability of default over five year term is 12.7%

• In the event of default, 75% of the investment will be lost

• Counterparty funding level of 200bps

The volatility level used is 20% which is broadly in line with index volatility in moderate market conditions. Similarly the CDS is assumed to be 200 basis points which is approximately the average of the major issuers in the UK market. The probability of default is derived from the CDS and the assumed recovery rate in the event of default of 75%.

Each product analysed includes charts displaying probability of return outcomes over the investment term. These have been calculated using a forward looking simulation with the same volatility assumption for the underlying asset (FTSE-100) as used in the pricing analysis. The range of outcomes for the underlying are fed through the risk profile of the product to project how it might perform.

We show the range of possible returns with and without credit risk taken account. These are shown against an absolute scale with 5% intervals.

We also show a scatter chart of simulated values of index performance and product performance. These give an indication of the range and frequency of possible outcomes. More description of FVC’s research methodology can be found on our website www.futurevc.co.uk.

This section of the handbook describes the most popular product types in the current UK structured products market. It aims to provide an insight into each product type through clear descriptions and examples detailing the key elements of each product.


Capital protected products offer the investor an opportunity to participate in the upside performance of the underlying asset whilst protecting their initial investment against market risk.

Capital Protected

A simple growth product offers the investor participation in the growth of the underlying asset which is not subject to any cap (limit) on returns. A capped growth product will instead offer a higher participation in the growth of the asset but subject to a maximum return.

Capital protected products are often subject to final level averaging which can restrict growth in a rising market, however this helps protect against late falls in the value of the underlying asset.

Capital protected products usually refer to those that aim to return full capital regardless of the underlying asset performance. However the FSA in 2009 made it clear that a product could not be called capital protected if it was backed by an issuer of low credit quality. Please note that all capital protected securities are still subject to issuer credit risk.

Example: This product has capital protection at maturity and 135% participation in the rise of the index. There is no cap on returns.

PricingThe pricing for this product is broken down into two components. The most significant component by price is the zero coupon bond to repay 100% at maturity. The pricing of this reflects discounting

from both the risk free interest rate and also the credit spread of the issuer. The amount left to spend on the upside is then 14.7% in this example. We calculate that 100% participation in the index would cost 10.9%. Since the amount of funds available is higher than this the most common solution is to simply purchase more of the option resulting in a geared product. In this case the gearing is 1.35% of index growth. An alternative could be to structure the product with a higher minimum return or higher gearing with a cap on returns.

Component No. Type Maturity (years) Price Unit Price Description

1 Zero-Coupon Bond Five 83.30% Payment of 100%

2 Call Option Five 14.70% 10.90% 135% Participation in Index Growth

Fees 2%

Total 100%

FVC Structured Products Handbook | 25 FVC Structured Products Handbook | 25

This type of product is likely to appeal to a cautious investor who wants capital protection plus the opportunity to participate in some of the growth of the index.

The charts show that if issuer credit risk is ignored then the product cannot lose capital. Once issuer credit risk is taken into account there is a significant chance of losing capital.

The most likely return for the product is in the 0%-5% bracket showing that this product is aiming to beat cash returns.

The scatter chart shows the range of product returns (ignoring credit risk). This demonstrates the capital protection.

3 Exposure to growth of the asset with capital protection.

7 The product can underperform the index return. The product does not pay dividends unlike tracker funds.

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2 Call Option Five 29.40% 5.88% 5x Geared Call Spread 100%-116.5%

3 American Knock-In Put Five -14.70% Short Put Option with 50% Closing Day Barrier

Fees 2%

Total 100%

Accelerated tracker products offer the investor leveraged exposure to the upside performance of the underlying asset.

Accelerated Tracker

An accelerated tracker product generally offers multiple times index growth up to a cap level. Capital is at risk. Accelerated products are intended to capture magnified performance in the event of moderate index growth and in this scenario will outperform both the index and cash. These products have been

popular for many years as they offer enhanced returns and generally have some protection against capital loss. They are often touted as recovery investments to try to capture gains after a bear market has occurred.

Example: This product has five times index growth up to an index limit of 16.5%. Thus the maximum return is 82.5%. Capital is at risk and will be lost if the index closes below the 50% barrier on any day throughout the life of the product and finishes below the starting level.

PricingThe pricing for this product is broken down into three components. The zero coupon bond is the “base” payment of 100%. Added to this is the five times geared call spread which can provide the return. For index growth up to 16.5% the product will pay five times index growth up to a limit of 82.5% return. For index growth above this level the product pays the maximum 82.5% return. The geared return is funded by the sale of a knock-in put which means that capital is at risk and therefore if the index falls (having hit the barrier) the proceeds of the put are deducted from the investor’s capital.


3 Outperforms the underlying under moderate index growth.

7 Capital is at risk if the 50% barrier is breached, and returns are capped at 82.5%.

This type of product is aimed at an investor who expects some moderate index growth and is prepared to take capital risk.

There is a good chance that the product will return at or near its full amount as this only requires modest index growth.

There is also a significant chance that the product will lose some capital, potentially a large amount.

The scatter chart shows the range of likely outcomes, with hardly any showing small capital loss.

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A reverse convertible offers fixed income on generally an annual or monthly basis. Capital is at risk and if the index falls (and hits any barrier present) then capital will be reduced in line with the index fall. If the index rises then the investor does not receive any extra return. The maximum that can be received is the income

stream which is generally above the risk free rate plus full capital. If volatility levels are high then the amount of extra income that can be generated is higher but this comes with increased capital risk. Given the amount of extra income offered an investor expects the risk to capital to be moderate.

Reverse Convertible

Example: This product pays 6.5% income per annum. Capital is at risk and will be lost if the index closes below the 50% barrier on any day throughout the life of the product and finishes below the starting level.

PricingThe pricing for this product is broken down into three components, just as for the accelerated product. The zero coupon bond is the “base” payment of 100%. Added to this is the coupon stream of 6.5% p.a.. This above risk-free rate income is funded by the sale of a knock-in put which means that capital is at risk and therefore if the index falls (having hit the barrier) the proceeds of the put are deducted from the investor’s capital. Note that in our examples the value of the coupon stream is same as the upside amount for the accelerated product since the products are otherwise identical.

Reverse convertible or income generating products offer fixed income above the risk free rate by taking on risk to capital.



2 Coupon Stream Five 29.40% 4.52% per 1% p.a. 6.5% Income p.a.

3 American Knock-In Put Five -14.70% Short Put Option with 50% Closing Day Barrier

Fees 2%

Total 100%


3 Income above the risk free rate is paid.

7 Capital is usually at risk which can significantly reduce the overall return.

This type of product is aimed at an investor who wants fixed income in excess of the risk-free rate and is prepared to take on capital risk

There is a chance that the product will return at or near its full amount of capital plus income as this does not require any index growth. As for the accelerated product, risk to capital comes from market risk and credit risk.

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Example: The product can be called annually from the first anniversary that the index is at or above its initial level. This product offers a return of 12.75% times the number of years elapsed when the autocall occurs. If the product is not called then capital is at risk and will be lost if the index closes below the 50% barrier on any day throughout the life of the product and finishes below the starting level.

PricingBecause of the nature of autocall products with multiple maturities, it is not possible to split the pricing into components as for the other products in this section. The value of the autocall product depends on the fixed returns, their likelihood and the downside risk if autocall does not occur.

Autocall

An autocall product has a series of dates and a target index level for each of those dates. For the first date that the index has finished at or above its target level, the product matures with a given return. These tests are applied for each date in succession. If the product is not called on any date then it runs to its full term and pays according to the formula at maturity. The most common type of autocall pays a return proportional to the length of time it takes for the product to be called and usually does not require index growth. However if the product is not called, capital is at risk. Alternatively

an autocall product may be capital protected but offer a fixed return part-way through the investment term if the index rises sufficiently.

Autocall products can also be linked to more than one index or asset. In such cases generally all relevant indices have to be above the target level for the product to successfully be called. Because this is less likely to occur the corresponding return is higher.

Autocall products offer the investor a pre-determined rate of return if the underlying asset performs sufficiently well on one of a given series of dates.


1 Full Product Payoff One to Five 98% 98% Autocall Product

Fees 2%

Total 100%


This type of product is aimed at an investor who wants to achieve a pre-determined return in the event that the index performs to target.

The charts show there is a risk to capital but that there is a decent chance of the product being called on one of the observation dates. The scatter chart shows the range of product returns (ignoring credit risk). The index level refers to the index level at the time the product is called or at maturity if the product is not called throughout the five year term. This helps convey the multi-maturity nature of such products.

The values above 100 are in a series of horizontal lines representing the returns at different maturities. There are increasingly fewer higher up as reaching the trigger level on an observation date late in the product term is generally less likely.

Note that the effect of including credit in the return charts is less than in the other example products as the expected duration of this product is less than 5 years.

3 Opportunity to make an early return above the risk-free rate if product requirements are met.

7 Uncertainty of product maturity and re-investment opportunities.

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The defensive autocall is a lower risk, lower return version of the autocall product. The trigger levels which need to be met for the product to be called and pay the fixed return are set below the strike level which makes it more likely that the product will mature early and therefore pay the outlined return. As the chance of return is higher, these products offer a lower fixed payment in exchange for the reduced risk.

Defensive autocall products can be structured with decreasing trigger levels which can make it more likely that the product will be called in the later stages of the term.

As with standard autocall products these can be linked to more than one index or asset. In general all of the underlying assets are required to be at or above the required trigger level which decreases the probability that the product will be called but would consequently increase the potential returns.

The table shows the probability of the example defensive autocall product being called at each anniversary. It also shows the same probabilities for the example standard autocall product (shown on the previous page). The overall probability of the product being called is 91% for the defensive and 79% for the standard autocall. The potential return for the standard autocall is 5.25% higher for each year that the product has been live. The higher return is possible due to the smaller probability of the product being called.

Example: The product can be called annually from the first anniversary that the index is at or above the trigger level compared to the initial index level. The trigger levels for years 1,2,3,4 and 5 are 100%, 90%, 80%, 70% and 60% respectively. This product offers a return of 7.5% times the number of years elapsed when the product is called. If the product is not called then capital is at risk and will be lost if the index finishes below the European barrier of 50% of the starting level.

Defensive AutocallDefensive autocall products offer the investor a pre-determined rate of return in a similar way to standard autocall products. The significant difference between the product types is that the trigger level of the defensive version is below the strike level, increasing the likelihood of early maturity.


1 Full Product Payoff One to Five 98% 98% Defensive Autocall Product

Fees 2%

Total 100%

1 2 3 4 5 Total

Standard Autocall 54.1% 13.9% 5.8% 3.1% 2% 78.9%

Defensive Autocall 54.1% 21.7% 8.4% 4% 2.4% 90.6%


3 Defensive trigger levels mean that returns can be made even in index decline.

7 If the index performs well only the fixed return will be paid.

This type of product is aimed at an investor who wants a pre-determined return even during some market decline.

The charts show there is a risk to capital but there is a decent chance of the product being called on one of the observation dates.

The scatter chart shows the range of product returns (ignoring credit risk). The index level refers to the index level at the time the product is called or at maturity if the product is not called throughout the five year term. This helps convey the multi-maturity nature of such products.

The values above 90 are in a series of horizontal lines representing the returns at different maturities. There are increasingly fewer higher up as reaching the trigger level on an observation date late in the product term is generally less likely.

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A bull bear product allows an investor to profit from moderate up or downward movement in the underlying asset. This is achieved by the purchase of both a call option (to provide upside if markets rise) and a put option (if markets fall). In order to achieve decent rates of participation it is common to put a barrier and/or a cap in place. If a barrier is used, if the underlying falls severely, then the

chance for any return is lost and capital is placed at risk. If a cap is included investors do not participate in underlying growth above the maximum level. The investor therefore needs the asset to move as far as possible from the initial level but not past either barrier or a cap.

Bull Bear

Example: This product pays two times growth in the index up to a maximum 100% return. It also pays returns of 1.5 times index decline up to a maximum of 45% which is paid if the index falls by 30% or more. If the final level of the index is less than 55% of its initial level 1% of capital will be lost for every 1% fall from the initial index level.

PricingThe pricing of this product is broken down into four components. The first is a zero coupon bond, the “base” payment of 100%. Returns are then provided by a geared call spread and a geared put spread. The dual directional returns are paid for by the sale of a knock-in European put with a 55% barrier. The barrier is observed at maturity only.



2 Call Spread Five 21.20% 10.6% 2x Geared Call Spread 100%-150%

3 Put Spread Five 13.50% 9% 1.5x Geared Put Spread 100%-70%

4 European Barrier -20% Knock-In European Put with a Barrier at 55%

Fees 2%

Total 100%

A typical bull bear product offers the investor an opportunity to make returns regardless of the direction of movement of the underlying asset from its initial level. Products generally offer a fixed participation rate of the absolute performance of the underlying. Capital is at risk and usually subject to barrier conditions.


3 Dual directional returns.

7 Capital is at risk and returns are capped in both directions.

The payoff chart shows the huge shift in returns between the index finishing at or below 55% of its initial level and above this level. The asymmetrical gearing of the call spread and the put spread can be seen through the different gradients of the graph either side of index starting level of 100.

The probability tables show that there is a reasonable chance of earning high annualised returns, there is also considerable risk to capital.

This type of product is designed for investors who have no particular market view but are happy to assume that any movement in the underlying will be rather steady than dramatic.

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18.7

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28.2 26.3

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A typical range accrual product pays a fixed return multiplied by the number of days that the underlying asset closed within a certain range and divided by the number of days occurring during

the observation period. Capital is at risk if the barrier is breached and will be reduced in line with the fall of the underlying.

Range Accrual

Example: This product pays a fixed semi-annual return of 3.69% multiplied by the number of trading days the index closes above the range accrual barrier of 60% and divided by all days during the six month period. Capital is at risk and will be lost if the closing level barrier of 50% is breached on any day throughout the product term and finishes below its starting level.

Pricing The pricing of this product is calculated using the expected proportion of the daily observations that the underlying closes within the range. The structure can be broken down into a zero coupon bond, a series of digital options with a strike at 60% to calculated the value of each accrual based coupon and an American put option with a knock-in barrier of 50% and gearing of -100%.

A range accrual product offers the potential to receive periodic coupons of which the amount depends on how many trading days during the measurement period the underlying finishes within the specified range.

Component No. Type Maturity (years) Price Description


2 Income Stream Five 29.40% Accrual Based Coupon Stream

3 American Knock-In Put Five -14.70% Put Option with 50% Closing Day Barrier and the Gearing of -100%

Fees 2%

Total 100%


3 If the index finishes within the range on every measurement day, investors receive the maximum periodic coupon above the risk free rate.

7 Capital is at risk if the 50% barrier is breached and the underlying asset finishes below its initial level.

The probability of return charts show the maximum return for this product falls into the 5 to 10 per cent per annum category. The actual maximum return is achieved if the index remains above 60% of its initial level throughout the life of the product.

The maximum coupon is more likely to be paid at the end of the periods closer to the start of the product than in the final periods as the chance of the underlying being below 60% of its initial level increases over time.

This product is suitable for an investor who wants to receive income in excess of the risk free rate and is prepared to take on capital risk.

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400


These types of products usually have one of two possible ways to generate upside returns. The first way is that the product will return full capital plus a fixed bonus amount if the index has reached the required level at maturity. Capital may or may not be at risk.

The second is that fixed returns are locked-in throughout the product term and paid at maturity if the index reaches the required

level on the relevant observation dates. Capital is at risk and repayment of capital is sometimes treated independently to the payment of the fixed returns on the upside.

The product provides a reasonable return even on moderate market growth. However, investors do not benefit from any further index growth and cannot receive more than the fixed amount.

Synthetic Zero/Growth Certificate

Example: This product pays a fixed return of 43% if the index finishes above 60% of its initial level. Capital is at risk and will be lost if the final level of the index is below 60% of its initial level. In this case 1% of capital will be lost for every 1% fall in the index.

PricingThe pricing for this product is broken down into three components. These are the zero coupon bond component for capital protection, digital option and the European knock-in put. The cost of the zero is 83.3% which is calculated using the current risk free rate and the funding rate of the issuer. The price of the digital option is 0.66 per unit or 28.4% to pay a 43% return if the final level of the index is above 60% of the initial level. The European knock-in put option with a barrier of 60% is worth 13.7%.

Synthetic zero and growth certificates offer a fixed return on the investment providing the particular product’s requirements are met. This product type typically pays a fixed return if the final level of the underlying asset is above a specific level on a pre-determined observation date. Capital is usually at risk subject to barrier conditions.



2 Digital Option Five 28.40% 0.66% Payment of 43% if Index Finished Above 60%

3 European Knock-In Put Five -13.70% Short Put Option with 50% Closing Day Barrier

Fees 2%

Total 100%


3 Receive a fixed return unless the index falls by 40% or more.

7 No return beyond the fixed amount even if the index has performed strongly.

The charts show that the most likely outcome is for the product to return capital plus the fixed return of 43% which falls in the 5 to 10% per annum bracket.

If capital is lost the investor will lose at least 40% of capital due to the final day barrier. There is no chance of small losses.

This type of product is likely to appeal to an investor looking for a fixed return even given moderate market decline.

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product comparisonsThe table below displays the key aspects found in the major product types explained earlier in this handbook.


Product Protected/At Risk Growth/Income Participation/Gearing Barrier

Capital Protected Protected Growth 3 7

Reverse Convertible At Risk Income 7 3

Leveraged Tracker At Risk Growth 3 3

Autocall At Risk Growth 7 3

Defensive Autocall At Risk Growth 7 3

Bull Bear At Risk Growth 3 3

Range Accrual At Risk Income 7 3

Synthetic Zero/Certificate At Risk Growth 7 3

1 Risk Control and Capital ProtectionInvestors are able to select a product that meets their risk-return requirements. Because a wide variety of structured products exist at all points in the risk spectrum, there will be suitable choices for any type of investor.

2 Clearly Defined Return ProfilesUnlike some other investment vehicles and even mainstream investments such as actively managed funds, structured products provide the investor with a clear view of how well their product will perform given performance in the underlying asset(s) on which they depend.

3 Access to a Variety of Markets and UnderlyingsStructured products allow the investor access to various underlying assets and markets from all over the world which may otherwise be difficult to access.

4 Low CostStructured products generally involve lower costs in comparison to other investment products in the market. They typically have a total embedded fee structure between 1% and 1.5% per annum. This compares favourably with hedge funds, venture capital trusts and active unit trusts which can all charge much in excess of these levels. Additionally the majority of structured products specify the product’s return net of all charges, unlike bond funds for example, which quote a gross yield which is not achieved once charges are deducted.

5 Tax and WrappersTax efficiency is important to investors. Structured products allow individuals to benefit from lower tax costs by providing investors with various tax wrappers from which to choose from. In particular, returns on some products are subject to capital gains tax as opposed to income tax. Products can also be sold as ISAs for which returns are tax-free. Other investors prefer the deposit wrapper that is also available for structured products.

Five reasons to recommend structured products


key risksThe following list of risk factors does not purport to be a complete enumeration or explanation of all the risks associated with structured products. All persons should seek such advice as they consider necessary from their professional advisors, legal, tax or otherwise, in connection with any investment in structured products.

• Where products are not capital protected, investors’ initial investment amount shall be at risk. This means that investors could lose some or all of their investment.

• If the issuing entity defaults or goes bankrupt, investors may lose some or all of their investment.

• During the life of an investment, the market value at which the investment trades and can be sold may be significantly less than the price at which it was bought.

• The value of investments can go down as well as up and investors may not get back the full amount invested.

• Prospective investors should understand that investments in products relating to equity markets may be negatively affected by global economic, financial and political developments


Glossary

American Barrier – Observed on every trading day throughout the product term. This barrier is observed either at the close of trading (closing day barrier), or throughout the day (intra-day barrier). If breached, the investor’s capital is at risk and will be lost unless the underlying asset recovers to at least 100% of its initial level at maturity.

Autocall – A feature within a product that allows it to mature early, often with a fixed return on offer, if the asset(s) reaches a specified level on a pre-defined date.

Averaging – Refers to the underlying’s performance being averaged over a period of time and is usually used to determine the starting or final level of the underlying.

Basket – Refers to a collection of underlying assets which are grouped together and given specific weightings.

Coupons – Often refers to the level of income on offer in a product.

Credit Default Swaps (CDS) – A number which indicates the size of the credit risk involved in investing with a particular company taken from the annual cost of insuring against a credit event for a specified time period, for example 5 years.

European Barrier – Observed on the final day of the investment. If breached, the investor will lose a significant amount of capital depending on the barrier level.

Funding – The funding level of an issuing institution is the amount above the risk-free rate that it offers to bond-holders and other investors in its paper to compensate for the credit risk of the issuer.

Lock-in – Typically refers to a fixed amount that is recorded and paid at maturity if the underlying reaches a pre-defined level at a specific time during the product term.

Return Cap – The maximum return achievable in the best case scenario.

Participation/Gearing – Term used to describe the level of upside exposure to the underlying asset.

Strike Level – Usually refers to the initial level of the underlying assets(s) and is used as a base measure for the performance of the underlying throughout its life.

Worst Of – Refers to a feature in a multi-asset product where the performance of the product is dependent on the lowest performing underlying.

Zero Coupon Bond – A bond which is bought at a lower price than its face value and is redeemed at its face value at maturity. These bonds can be used to provide capital protection in structured products.


Notes




Contact us:Investor Product Sales, UK & IrelandRBS Markets & International Banking0800 121 [email protected]/markets


This handbook has been prepared for information purposes only. It shall not be construed as, and does not form part of an offer, nor invitation to offer, nor a solicitation or recommendation to enter into any transaction or an offer to sell or a solicitation to buy any security or other financial instrument. No representation, warranty or assurance of any kind, express or implied, is made as to the accuracy or completeness of the information contained herein and RBS and each of its affiliates disclaim all liability for any use you or any other party may make of the contents of this handbook. The contents of this handbook are subject to change without notice and RBS does not accept any obligation to any recipient to update or correct any such information. Views expressed herein are not intended to be and should not be viewed as advice or as a recommendation. RBS makes no representation and gives no advice in respect of any tax, legal or accounting matters in any applicable jurisdiction. This handbook is not intended for distribution to, or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to local law or regulation. The information contained herein is being provided to selected recipients and may not be given (in whole or in part) or otherwise distributed to any other third party without the prior written consent of RBS.

RBS and its affiliates, connected companies, employees or clients may have an interest in financial instruments of the type described in this handbook and/or in related financial instruments. Such interest may include dealing in, trading, holding or acting as market-makers in such instruments and may include providing banking, credit and other financial services to any company or issuer of securities or financial instruments referred to herein.

The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. The Royal Bank of Scotland plc is authorised and regulated in the U.K. by the Financial Services Authority.

© 2012 The Royal Bank of Scotland plc. All rights reserved. The DAISY Device logo, RBS, BUILDING TOMORROW and THE ROYAL BANK OF SCOTLAND are trade marks of The Royal Bank of Scotland Group plc. This handbook is for the use of intended recipients only and the contents may not be reproduced, redistributed, or copied in whole or in part for any purpose without The Royal Bank of Scotland plc.’s prior express consent.

Future Value Consultants151 Sheen Lane London SW14 8LR

T: +44 (0)20 3384 1450 E: [email protected] W: www.futurevc.co.uk

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Specialists in structured product research, analysis and valuations

This handbook is intended for financial professionals only and should not be distributed to private investors. The information in this handbook has been compiled in good faith but no guarantee is made that the information is complete or accurate and it should not be relied upon as such. Any statements of market practice, regulatory or tax positions and all product illustrations are believed to be correct at the date of publication but are subject to change. No liability whatsoever is accepted for any loss or expense incurred from using this handbook. All material in this handbook remains copyright Future Value Consultants Limited.

Documents

Structured Products Handbook 2012-2013