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Asia-PacificMay 1 2005

Exotic options

Whereas us and European retail investors are used to investing in more traditional investment products such as mutual funds, Asian investors demand something rather more exciting. This has led to great innovation in exotic options and UBS is one bank creating innovative new structures to be sold direct to investors or wholesale through private banks.
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One set of products uses Constant Proportion Portfolio Techniques (CPPT), another uses Variable Maturity Laggard Structures (VMLS). CPPT works by using investment funds to buy stocks/indices or funds (hedge funds and mutual) with the majority of the funds initially, say 80%. The remaining funds will be invested in zero coupon bonds.

“If the underlying goes up we buy more underlying, if it goes down we sell underlying and buy bonds. There is a trigger by which we leverage up or deleverage,” says Min Park, head of Asian equity risk management products for UBS.

“In the worst case scenario we turn the whole portfolio into bonds and then the portfolio would recover 100% of the capital at maturity.

“However, this would happen rarely and we select the underlying carefully to avoid the worst-case scenario. Sometimes we may give the investor more than 100% of the upside by leveraging to increase returns. It’s formula driven, that's why it's called constant proportion.”

VMLS uses the value embedded in stock volatility and lack of correlation between different shares to create fixed income like returns. Using a basket of stocks, returns are set according to the variations in stock prices. In a two-year maturity structure, if after six months all the stocks are higher than the original prices , the issue will be called and the investors repaid: 100% of notional plus a chunk of coupon depending on the underlying. If, on the other hand, there is a laggard stock that falls lower than the initial price, the structure continues another six months. If the issue is not called until maturity, issue will be redeemed at 100% if the laggard underlying stays between 80% and 100% of initial price or will be redeemed at 125% of final price of laggard underlying at maturity. In recent offers, such as UBS Asian Treasures II Super Notes and UBS Super Notes IX coupons of 8% to 11.5% have been targeted, well above average bond returns.

“Effectively clients are selling underlying volatility and going long correlation. The higher underlying volatility and the less correlation would pay higher coupon in general,” says Mr Park.

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