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Hybrid Products

David Besançon27 mars 2008

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What are Hybrid Products ?

A hybrid product is a financial structure whose payoff combines different assets, market sectors and/or sub-sectors

“Explicit” hybrids: when multiple asset classes enter into payoff (termsheet) of product

Call on baskets and variation Multi-asset CPPI

“Implicit” hybrids: when pricing (valuation) depends on more than one asset class without being explicit

Equity capital protected notes Early redemption products (TARN / Callable)

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Why use Hybrid Products ?

To gain simultaneous exposure to different asset classes “best of many worlds”

To reduce cost (risks) through (de-)correlation e.g. basket option on lowly correlated components

To increase leverage or enhance yield e.g. equity option whose payoff increases under FX/IR/Credit scenarios (joint probabilities)

To reduce hedging cost by creating returns offsetting liabilities e.g. commodity producer financing optimisation

etc...

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Main Asset Classes

7 main asset classes: Equities Fixed Income FX Inflation Commodities Credit Alternatives

Each class has its own characteristics and own market conventions

Modeling of each class is highly specific and can be (very) complex

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Main Asset Classes (2)

Equities Cash

Forwar

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Volatili

ty

Corre

lation

s

Major Stock IndicesMajor Singles Stocks (and baskets of)Sector or Regional Indices (emerging markets, real estate)Mutual Funds (and baskets of)Hedge Funds

Fixed IncomeLibor rates (1M, 3M, …, 12M)CMS rates (2Y, 5Y,…)Bond Indices (EuroMTS, Iboxx)Bond Futures or Yields (10Y Treasury, Bund, Gilt…)

FXMajor Pairs (EURUSD, USDJPY, GBPUSD)Emerging Markets (Asia, Eastern Europe, Latin America)Precious Metal (Gold, Silver,…)

CommoditiesEnergy (Oil, Refined Oil Products, Gas, Electricity)Base Metals (Copper, Aluminium, Nickel,…)Indices ( GSCI, GSCIER, AIG)

InflationCPI indicesInflation linked bonds

CreditDefaultable BondsCDS (single names or basket - iTraxx)CDO

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Valuing Hybrids: the 3Cs challenge

Calibrate: be able to model precisely each individual asset class specific behavior, market specificity and liquidity (if any)

Correlate: be able to model assets interplay specific modeling and techniques, correlation definition is model dependent

Compute: be able to provide valuation numerical recipes (MC, PDE, ..) many non-observable data stable / robust / meaningful / speedy pricing exposures to be mapped to tradable assets (for hedging)