Possibly even autocallable notes. Suppose we are an invesment bank, and sell the zero-bond plus the call option to the market. Thus we set up a structured product. As far as I know, such products can have an embedded call option with autocall barriers, and something like that.

So, why we sell it? Will we hedge it? Here, perhaps I misunderstand the essence of hedging, but this way we come up to a more or less flat position; so, what is the motivation to have it? Finally, how we hope to have a profit with the structure described? Thanks in advance!


1 Answer 1


When the issuer bank sells to its client a note expressing some view, the bank is on the other side of the client's bet. But this is not the view most banks want, so generally they will try to hedge the unwanted market exposures arising from client trades, and will be near-flat where they want to be flat.

If during the origination the bank decides that it can't hedge away some risk, then it needs to charge the client appropriately for holding this risk.

The bank makes money in the following ways:

The client pays fees during origination.

Sometimes, the note may be paying out less than what its hedges pay to the bank, who earns this spread. If the hedges are static, then this is easy to construct. If the payout needs dynamic hedging, then simulations estimate the possible hedging costs, and sometimes the hedges may end up costing more than initially predicted.

Sometimes clients use leverage: the client only has \$2 to invest, borrows another \$1 from the bank to invest $3 in a note. In additionn to the above fees and spreads, the bank earns interest on the \$1 loan.


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