Interest Rate Structured Products: Can They Improve the Risk-return Profile?

Abstract

In this paper we investigate the contribution of interest rate structured bonds to portfolios of risk-averse retail investors. We conduct our analysis by simulating the term structure according to a multifactor no-arbitrage interest rate model and comparing the performance of a portfolio consisting of basic products (zero-coupon bonds, coupon bonds and floating rate notes) with a portfolio containing more sophisticated exotic products (like constant maturity swaps, collars, spread and volatility notes). Our analysis, performed under different market environments, as well as volatility and correlation levels, takes into account the combined effects of risk-premiums required by investors and fees that they have to pay. Our results show that capital protected interest rate structured products allow investors to improve risk-return trade-off if no fees are considered. With fees, our simulations show that structured products add value to the basic portfolio in a very limited number of cases. We believe our paper contributes to understanding the role of structured products in investors portfolios also in light of the current regulatory debate on the use of complex financial products by retail investors.

Keywords: Structured products, efficient frontier, risk-return trade-off, Monte Carlo simulation, Interest rate modelling

JEL Classification: G11, G17, E47