Beyond Payoff Diagrams: How to Present Risk and Return Characteristics of Structured Products

Abstract:     
The market for structured products in Germany and Switzerland experienced a decade of rapid growth before the financial crisis. When Lehman bank failed, however, it became apparent that many private investors had not been aware of the risks involved in these instruments. There is evidence that the success of some of the most popular products had been due to behavioral biases of investors. There is also concern that the complexity and diversity of the products came along with low transparency. In practice, the information provided to investors is still often focused on payoff diagrams. For the future development of the market, it is important to improve information and understanding of investors. To this end, this paper analyzes the information requirements and proposes a risk and return survey to provide relevant and comprehensive information on market risk (excluding credit risk). Specifically, we propose (1) to illustrate the return probability distribution in three different ways, (2) to apply the Leland model to specify the risk and return tradeoff and (3) to include a specific measure of active risk. We illustrate these measures and information tools for a sample of stylized products.

Number of Pages in PDF File: 32

Keywords: Structured products, retail derivatives, risk measurement, risk return tradeoff, investment decisions, information tools

JEL Classification: G11, G14, G24

working papers series