Open-End Knock-Outs on Bond Futures: Valuation, Properties and Estimation of Hidden Profit Drivers

Abstract

This paper is the first on retail Structured Financial Products (SFPs) from the fixed-income area, namely open-end knock-outs (OEKOs) on government bond futures. We develop and apply a valuation algorithm for OEKOs to analyze the issuers' profit. On the basis of a simple superhedging strategy we disclose the profit drivers for the issuers. The crucial profit drivers, the 'margin factor' and the 'rollover fee', are set by the issuers and can be regarded directly as costs to the investors. But even disregarding these drivers there exists a 'hidden' interest gain. However, asymmetric jumps in the interest rate dynamics may lead to significant gap risks which can considerably lower the issuers' benefit, even below zero. Since the crucial profit drivers of OEKOs are not directly observable, we estimate them by analyzing an extensive data set of OEKO prices. Inter alia, depending on the issuer we find that the profit drivers can take values of up to 60% p.a. on average.

Keywords: structured products, knock-out, price setting, German market, rollover

JEL Classification: G12, G13, G21, G24