Todd James Head of Structured Products HSBC Private Bank Hong Kong Aug 08, 2007

Todd is responsible for the delivery and development of structured products (flow and non-flow products) within HSBC Private Banking Hong Kong. His team works closely with the HSBC Private Banking relationship managers to structure and deliver suitable investment related products for the HSBC private bank's clients. Todd has made it to this column because we found him to be one of those rare private bankers who can explain a product in English to a customer and in the same breath talk about the same product using Math to an Investment Bank. Team Latte's Rahul Bhattacharya recently caught up with Todd for a chat.

Team Latte :
We have found you are one of those rare private bankers who have both a deep and lateral understanding of financial derivatives and structured products across asset classes. And at the same time, you are quite high up the learning curve as far as the understanding of the pricing and modeling of these products is concerned. That is a rarity of the nth order!

Is it because you came from more mainstream front office global markets banking and had exposure to either trading or structuring of some of these products?

Todd James:
Actually I think the reason is two fold, the first as you have just mentioned is that I did come from the more technical trading and structuring side of the business. But more importantly when I started off in the business I did not have the expensive systems and black box pricing models to do the complicated calculations we now have available today. In fact I had to develop my own spreadsheets to price and structure interest rate, foreign exchange and equity options and swaps. I think it is an invaluable lesson for anyone to get into the details of pricing options and more importantly be able to use excel to its full potential. When graduates ask me for advice I tell them to learn excel (and VBA programming), learn how to price options using excel, and finally find interesting articles online to read, learn and develop your understanding of options and structured products.

Team Latte:
There are now a plethora of products and assets classes to choose from while making investment decisions for clients. How do go about making these decisions, what kind of quantitative models do you use, what kind of selection and performance benchmarks, if any, are used?

Todd James :
When deciding on a new product, the first thing we do is look at the underlying investment view, rather than the (high) headline coupon or complexity of the structure. If we like the view we will then work on an appropriate structure to enhance the investment or provide the required payoff profile. Structure Products purpose is to enhance the return, build in some buffer against capital loss or get access to a market which is unavailable via the cash market.

It is hard to have a benchmark for structured products but the underlying priority is the volatility and returns, the goal is to add additional returns to a portfolio without adding a significant amount of more risk, in other works we want to increase the sharp ratio of an investor's portfolio. We also must consider the basic fundamentals of the underlying such as PE ratios for equity or implied forward rates for interest rates.

We also need to make sure that we can easily explain the product to our sales staff and more importantly we must ensure that our end clients can understand the payoff and risk/rewards quickly and easily.

Team Latte:
Structured products have become enormously popular in the last five to seven years and private banks have turned out to be one of the biggest buyers of these products for their clients. But we are not sure that many of the private bankers in Asia - especially those on the client relationship side - really understand these products well, if at all. We have found that even many of those on the investment advisory side of private banking have a very perfunctory understanding of these complex products. Is that a fair statement to make?

And is it because there is so much money and demand from the high net worth clients that no banker really bothers about understanding and then explaining the product to the client; as long as they can flog the products it is more than enough.

Todd James :
I really do not think that is a fair statement. While it is true the average banker or investor will not understand some of the complex mathematics behind the options, they do understand the risk and rewards of the products they are offering or buying, not to mention the detailed mechanisms of the payoff. Some of the products we offer are so common that it may seem very perfunctory, but that is a function of a successful product and a long-term bull market. But to be fair to the bankers and the investors do understand the key variable that effect pricing and potential payoffs, such as term, volatility and even correlation.

I also think structured products have evolved over the last several years. The early stages were about the structure and the potential high returns, in fact the structures were becoming more and more complex. Today however it is more common to focus on the underlying investment view in order to generate the positive returns and relatively on a simple structured product to enhance the return or provide principal protection, depending on the investor's view and risk appetite.

I sometimes think it is the investment banks that do not understand the underlying or the target investors, they focus too much on the potential returns and "back testing' to sell products.

Saying all that I think we still need to do more work to educate bankers and investors on the potential valuations over the life of a product. We need to do more to explain what delta and Vega is and how structured products are constructed in order for them to fully understand how valuations can change over time. To me it is not the return or principal at risk which is the major concern, but the change in valuations over time.

Team Latte:
These days some products, such as equity linked callable range accrual notes or accumulators are extremely popular with private banking clients. Is there any particular reason for that?

What other products are popular these days with private banking clients and what are the reasons for that?

Todd James :
Several reasons, the first being "success fuels success". For structured products to succeed they need to work (provide the enhanced returns they are designed to do if the underlying view is correct), and the products you just mentioned are basically selling volatility and long the equity markets, both views have been correct more or less for several years now. It has actually been a 'win win' situation for both the bankers and investors.

The product you have mentioned have become a familiar investment tool for investors, thus they are easy to understand and investors are comfortable with the underlying risks (since most of the products are non principal protected).

Other products that are popular today are theme-based products. As mentioned before we need to sell an investment view rather than a structured product and using a popular theme is an easy and simple way to sell to investors. Common investment themes such as energy efficiency, infrastructure or water are commonly accepted investment views and we can use structured products to provide investors with tailored payoffs to a specific theme.

Other products that are popular are outperfomance trades, where investors are taking the view that one market (or sector) will outperform another. This trade has become more popular as investors have become more cautious on the underlying equity markets.

Also more conservative trades are coming back into demand, given the recent volatility in the markets investors are looking to protect their returns but at the same time keeping some exposure to the underlying equity markets (short term cautious long term bullish). Therefore, principal protected or partially protected structures are becoming relatively more popular these days.

On the interest rate linked structures, callable range accruals are becoming more popular again, as the potential coupons have improved while investors are becoming more conservative.

Team Latte:
When you advise your clients on investment in derivatives and structured products what kind of a metric do you use to analyze and recommend them?

Todd James:
The most important thing is to understand the risk and reward of the product. If the product is not principal protected make sure they understand the magnitude of the potential losses. If the product is principal protected, what are they giving up in order to achieve that protection? Normally protected products provide a "watered" down return, so if the market rallies the investor may get less than 100% of the gains or an average of the return. Sometimes this is harder to understand than the principal at risk products.

The last and most important metric I talk about is probability theory. If a term deposit rate is 5% for 1 year, and a structured product is offering a "potential" headline rate of 20% investors need to weigh the probability of earning 20%. The expected returns are more or less the same so how can you earn 20%? Investors are actually using a specific investment view to increase the probability of earning a higher return. This is one of the least understood measurements of investing, particularly forgotten during long-term bull markets.

Team Latte:
Can you explain a bit more about "Accumulators" and "Daily Range Accruals" - two category of products that have become quite popular with investors these days?

Todd James:
Accumulators are typically in OTC form, zero cost option, where investors have an option to buy a share of a company (on a daily basis) at a discount from current spot, however if the share falls below the discount strike they still need to buy the shares which is then at a premium (in most cases the structure is geared on the downside, which means they need to buy two shares). The typical term is 1 year but typically they also have a knock out feature.

Simple example:

• ABC shares are currently trading at $100,
• Investor buys 100 shares every day at $88, every day that the price is above $88
• Investor buys 200 shares every day at $88, every day that the price is below $88
• If ABC ever trades (closing observation) at $105, the trade knocks out and the investor realizes all positive gains

Daily range accruals (sold as a note) pay investors an enhanced coupon every day that the underlying share price is above a certain strike. If the share price falls below the strike the investor is put the shares (at the discount strike) rather than receiving cash at maturity. The term of these structures are anywhere from 6 months to 3 years but are autocallable if the underlying share (or worse of share) price is above a call strike on any observation date.

Simple example:

• ABC Shares are currently trading at $100
• Every day ABC shares trade above $85 the investor accrues a 15% coupon, payable quarterly.
• If on a quarterly observation ABC share price is $95 or greater the note is called and the investor get the accrued coupon plus their original principal back.
• At maturity if ABC share price is below $85 the investor receives 1 share rather than their principal back.

There are many minor variations on the above products but the basic structure is the same.

Team Latte:
How important are pricing and valuation of products for you and your team. Do you try to value a product periodically and then report the mark to market (MTM) value to your clients?

Todd James :
It is very important. We provide investors with a regular valuation, at least on a monthly basis. One of the key success factors for structured products is the liquidity and the transparency on pricing, without reliable valuations investors will stop investing in structured products. Also given the shear number of products (volume and variety) we need a greater ability to value these products fast and easily. Valuations have become a very important part of the whole business process for many private and retail banks. The requirement to provide reliable pricing is forcing many to review how they manage these valuations.

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