Essential Sales & Trading Interview Prep: Step by Step guide to structure an exotic derivatives product

This is a popular question in S&T interviews that students must be prepared to answer: “How to structure derivatives products?"

Acing this answer will also set you apart from your peers as someone with strong product knowledge! 

The underlying assets in Exotic Derivatives products can include equities, indices (basket or single), commodities, forex, funds, interest rates, inflation and ‘hidden assets’ depending on the Investor Goals (Principal protection, hedging, tax efficiency, etc.) and Distributor goals (Target fees, sustainability, product preference and experience, etc). 

Factors for structuring exotic derivatives:

✅ Current Market Outlook: Impacts both the Objectives in terms of the Investor and Distributor Goals as well as the product design. 

✅ Investor and Distributor Goals: Involves selecting the appropriate Underlying Assets, Payoff Structures and Legal Wrappers. This interlinked process allows Structured Products to be tailor-made to the investor and market needs.

Capital protected exotic derivatives have 2 components: 

1️⃣ An FI security (typically a zero coupon bond that protects a part or all of the invested principal at maturity). 

2️⃣ An option-like instrument to provide a payoff in addition to the FI payment. The additional payoff is linked to the underlying asset’s performance (regular coupons or a one-off gain at maturity). 

For instance, if an investor wants to invest USD 100 over 5 years, with full capital protection and exposure to the S&P 500 index upside; with a five-year US Treasury rate of 2.5% p.a., a five-year zero coupon bond is worth 88.4 now (100 in five years).

The structure provider will have 11.6 (100 – 88.4) to purchase an option on the S&P 500 and pay for admin costs and commission. If the S&P 500 hikes by 30% over the five years, the investor will achieve a return of 24% (80% x 30%) on top of his initial capital. 

Hit 👍 if you found this article helpful for #salesandtrading interview prep!

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