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These are simple questions, i know what is a structured product and how you price it but i'm a bit confused regarding the process.

Let's say client buys a simple product for 1Y, guaranteed capital and 100% of the upside. So as a structurer you receive 100 from the client, you put 95 in the ZC, you will have 100 in 1 year. Then you give the 5 to the trading desk for the call but :

  • Does the trader buy on the market the call the client will have, then he is in the same position than the client ? But in this case he can't hedge as a call seller and it's what he does from what I understood.
  • Does he create a selling call position in his book and use the 5 to hedge himself ?
  • Why then would it matter for the pricing desk to have the good price of the call on the market if he doesn't use it to buy a call and only needs to hedge as a seller ?
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If a structured product trader can directly hedge in the market, he will usually do it. Here your example is a little too simplified, many structured products have features that cannot be easily hedged in the market because they are path dependant (barriers), or illiquid (typically a 5 years 60% put on a single stock).

Let's take your product, but imagine it's on a single stock that doesn't have any options. The structured product trader will have to buy the delta of an imaginary at-the-money call then manage it (buy more stocks if stock goes up, sell them if stock goes down). If he sold you the call at 5 (margin included) thinking the vol would be 30% and the realized vol turns out to be 60% (meaning the call should have been worth 12 for instance), buying and selling stocks to hedge his delta will cost him 12 dollars on average on the life of the product, and he will end up losing 7 dollars.

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  • $\begingroup$ ok so the 5 is used for the hedging part ? when you say buy the delta of the call, it's because it's negative delta for selling the call then to be delta neutral, you buy the delta right ? $\endgroup$ – TmSmth Mar 13 at 11:47
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    $\begingroup$ Yes exactly, you sell a call to the client through the product, so you delta hedge it, to know how much your delta is, you need to forecast the volatility, and that should also give you the price for that call, and this price should be < 5 in your exemple. Of course as you can see with negative rates it's now difficult to finance the call with a ZC, that's why these upside participation products have a barrier at 60%-70%, where the client sells a put to the issuer to finance the call. $\endgroup$ – Lliane Mar 13 at 12:27
  • $\begingroup$ Ok i see thanks ! And last thing, i never heard that the premium on the average of a call for example would represent the cost of hedge, where does it come from ? $\endgroup$ – TmSmth Mar 13 at 13:39
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    $\begingroup$ That's the no-arbitrage condition, the price of the call has to be equal to the market estimate of the price (cost) of replicating the call. If a call costs 5 USD at 30% vol, you replicate it using stocks and the same parameters, and the realized vol is 30%, on average it will cost you 5 USD. So that if you sold the call and replicated it you will be at 0 profit. financialmathmodels.wordpress.com/tag/hedge-ratio $\endgroup$ – Lliane Mar 13 at 15:06
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    $\begingroup$ If the client is short the put the bank still needs to hedge it (sell a put or replicate it) because that put is paying for the coupon (for a standard reverse) or the downside protection (for a barrier reverse). $\endgroup$ – Lliane May 26 at 0:34
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In the simplest case, he books the structured product as a sale of the call at 5, he then enters the market and buys a call at 3, so he pockets 2 on the trade.

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  • $\begingroup$ so he hedges the position with a call and not the underlying ? $\endgroup$ – TmSmth Mar 13 at 11:44

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