The Pricing of Structured Products in Germany

Abstract

The payoff patterns on basic combination option positions, such as writing covered calls, are often very attractive to retail investors. But lack of sophistication about options, the difficulty in buying shares in an index portfolio on which to write options, and a wide variety of other regulatory and institutional constraints can make creating those payoffs very difficult for a small investor. This has created a market for retail banking products with the preferred payoff patterns. This article examine two such products that are actively traded in Germany, based on the DAX and the NEMAX indexes. Both “reverse convertibles” and “discount certificates” make a cash payment at maturity equal to either the market value of the index, if the underlying index is below a specified strike price, or a fixed cash amount, if the index is above the strike. That is, their payoffs resemble writing covered calls on the index. Wilkens, Erner, and Röder look at the pricing of these structured products and find a fairly wide range across issuers, but nearly all involve a substantial premium over the cost of replication using exchange-traded options on the Eurex. The size of the premium varies with moneyness, and there is a “life cycle” effect, as well, because the issuers make secondary markets in their securities and investors may sell them back prior to maturity.