Academic journal article Academy of Accounting and Financial Studies Journal

Contingent Claim Valuation: The Case of Advanced Index Certificates

Academic journal article Academy of Accounting and Financial Studies Journal

Contingent Claim Valuation: The Case of Advanced Index Certificates

Article excerpt


The constant and accelerating development of new structured products--that is to create new securities through the combination of fixed income securities, equities and derivative securities--permanently challenges practitioners, academicians, and regulators. Regulators are concern with the sophistication of the products and the targeting of individual investors as primary customers (Laise, 2006; Maxey, 2006). Regulators worry about the investors' inability to understand these products (Ricks, 1988; Lyon, 2005; NASD, 2005; Simmons, 2006; Isakov, 2007).

In this paper, we study a new financial product known as "Advanced Index Certificates" (to be referred to as AIC henceforth), one of the equity-linked "structured products" issued by major banks in Europe. AICs are also known by the commercial names of "PartProtect TRACKER", "AIRBAG Notes", "Protector", "Power Pro Certificates", or "S2MART". The rate of return on the investment in the certificates is contingent upon the performance of a pre-specified underlying equity or equity index over a pre-specified period (known as term to maturity). If the price of the underlying asset goes up during the term to maturity, the investors of the certificates will receive a return equal to the return on the underlying asset. The returns on the certificates may or may not be subject to a maximum limit. If the returns on the certificates are subject to a maximum limit, they are referred to as capped certificates; otherwise, they are known as uncapped certificates. If the price of the underlying asset goes down during the term to maturity the investors of the certificates will receive a guaranteed minimum redemption amount at maturity, as long as the underlying asset price did not close on maturity date below a predetermined level referred to as the knock-in level. The guaranteed minimum redemption amount may be the same as or higher than the par amount of the certificates. Usually the knock-in level is set up as a percentage of the initial price (e.g. 75% of the initial price). A certificate with a knock-in level of, for example, 75% of the initial price, is also referred to as having a 25% downside protection.

If, however, the price of the underlying asset closes on maturity date below the knock-in level, the investor is partially exposed to the decline in the underlying asset. In calculating the return on the underlying asset, the certificate issuers will use only the change in the asset price; the cash dividends paid during the period are not included. In other words, investors in the AICs do not receive cash dividends even though the underlying assets pay dividends during the term to maturity.

The banks that issue these certificates are usually well-recognized large banks in Europe: Bayerische Hypo- und Vereinsbank AG, Dresdner Bank AG, DZ Bank AG, Goldman Sachs, ING Bank NV, UBS Investment AG, and Westdeutsche Landesbank.

The purpose of the paper is to provide an in-depth economic analysis for the AICs to explore how the principles of financial engineering are applied to the creation of such newly structured products. We also develop pricing models for the certificates by using option pricing formulas. In addition, we present an example of an uncapped AIC issued on March 14, 2003 by Bayerische Hypo- und Vereinsbank AG (to be referred to as HVB Bank henceforth), a well-recognized large bank in Germany. In this example, we price the certificate by calculating the cost of a portfolio with a payoff similar to the payoff of the certificate. Finally, we empirically examine all outstanding AICs in August 2005 and test if issuers make a profit in the primary market. We also compare the mispricing of ICs in this study with the sample of Out performance Certificates in the Hernandez et al. (2007) study and the sample of Bonus Certificates in the Hernandez et al. (2008) study. All three samples are composed of securities outstanding in August 2005. …

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