Abstract
In this paper we introduce a new financial product named Outperformance Certificates. We study the €43 billion sample by examining 1,507 issues of the certificates outstanding in August 2005 issued by banks in Europe. We present formulas to price the certificates and empirically examine the profits in the primary market for issuing the certificates. We find that issuance of the certificates is profitable for the issuers in our sample. Issuers sell the certificate at prices 3–5 % above the fair value based upon the components of the underlying assets. We also find that the dividend yields and ex-dividend dates play an important role in the profitability of the certificates. The underlying securities tend to have high dividend yield and large market capitalization. We also find the certificates tend to mature soon after the ex-dividend dates of the underlying assets.
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Notes
For detailed reports on how technical expertise, investment in information technology infrastructure, and especially the quantitative capabilities of product developers play an important role in the success in the development of new products and in deterring potential imitators to replicate the products, see Simmons (2006), and Mollenkamp and Fleming (2006).
The participation rate is always greater than 100 %—that is why the instruments are termed as “Outperformance” Certificates.
It turns out the cash dividends play a very important role in certificate issuers’ profits. As we will show the underlying assets tend to have higher dividend yields than other stocks in the industry, and a major portion of certificate issuers’ profits come from the dividend payment.
For most cases in the sample the exercise prices and the valuation prices are the closing prices on the fixing date and the expiration date respectively. In a few cases, the opening prices or the average prices during the previous three trading days are used as strike prices or valuation prices.
Cheung and Chung (1996) suggest a complex financial instrument’s market value is to be “synthetically” approximated as the sum of its building blocks.
The banks’ websites are available from the authors upon request.
These websites include OnVista (Germany http://www.onvista.de/), the Yahoo (Germany http://de.yahoo.com/), ZertifikateWeb (Germany http://www.zertifikateweb.de/), TradeJet (http://www.tradejet.ch), Berlim-Bremen Boerse Stock Exchange (http://www.berlinerboerse.de), Stuttgart Boerse Stock Exchange (http://www.boerse-stuttgart.de/), and Swiss Stock Exchange (http://www.swx.com).
When we cannot find a government bond that matches the term of maturity for a particular certificate, we use the linear interpolation of the yields from two government bonds that have the closest maturity dates surrounding that of the certificate.
The implied volatility calculated by the Bloomberg System is the weighted average of the implied volatilities for the three call options that have the closest at-the-money strike prices. The weights assigned to each implied volatility are linearly proportional to the “degree of near-the-moneyness” (i.e. the difference between the underlying asset price and the strike price) with the options which are closer-to-the-money receive more weight.
For alternative formulas to compute implied standard deviations, see Ang et al. (2009).
The sample of certificates finally priced in the study is smaller than the original sample of securities because not all data needed for pricing was available. In this process, 16 uncapped certificates were dropped and no particular pattern is observed. For capped certificates, 254 cases were dropped and most of them (245 cases) are from the BNP Bank. We do not know the exact impact of those cases on the results; however, we know that BNP Bank, on average, made a profit of 0.66 % on the uncapped certificates. Bearing this in mind, we can estimate that the profitability of capped certificates could be around the same values as the uncapped certificates, 3.3 %.
An alternative approach suggested in the literature is to consider transaction costs. Leland (1985) derives a modified version of the Black–Scholes formula to account for transaction costs and Boyle and Vorst (1992) price the options based upon a discrete time tree model when there are proportional transaction costs. The analyses based upon these models, however, require the availability of transaction costs which we cannot obtain for the bond issues.
As shown in Table 1, both the median and the mean of the selling price of the certificate, P, as a percentage of the underlying asset price on the issue date, I0, are equal to or very close to 1.00.
That is because (γ − 1) < γ, but \( {\text{c}}_{1} ({\text{I}}_{0} ,{\text{T}},{\text{X}},{\text{q}},{\text{r}},\sigma^{2} ) > {\text{c}}_{2} ({\text{I}}_{0} ,{\text{T}},{\text{X}},{\text{q}},{\text{r}},\sigma^{2} ) \) due to that the former is a call with an exercise price of X, while the latter is a call with a higher exercise price of IC.
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Acknowledgments
We are thankful to the seminar participants at Marshall University, Radford University, University of Arkansas, the conference participants at the 5th INFINITI Conference, the 2007 EFMA Conference, the 2007 Asian FA/FMA Conference, the 2007 FMA Conference, and the 2007 SFA Conference for their comments and suggestions. We acknowledge the financial support provided by the Bank of America Research Fund honoring James H. Penick, the Alice Walton Chair, the Garrison Chair, the Harold A. Dulan Chair, and the Robert E. Kennedy Chair at the Finance Department, Sam M. Walton College of Business and the 2008 Summer Research Grant at the College of Business and Economics, Radford University. A previous version of this paper circulated under the title The Market and Pricing of Outperformance Certificates.
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Appendices
Appendix 1: Example of an uncapped performance certificate
The uncapped certificate in Appendix 1 was issued by investment bank UBS using Daimler-Chrysler as the underlying asset. The fixing date UBS set for the certificate was March 24, 2006 and the issue price of the certificate (i.e. the stock price on the fixing date) was €46.85. The date that an investor must make the payment for the purchase of the certificate (known as the payment date) was March 31, 2006. The expiration date (i.e. the date on which the closing price of the underlying asset will be used as the valuation price) was set on May 11, 2009 and the performance ratio for the certificate was set 150 %.
UBS Investment Bank | |
UBS Outperformance Certificates on DAIMLERCHRYSLER | |
Underlying: Valor: 945657; ISIN: DE0007100000; Reuters: DCXGn.DE; Bloomberg: DCX GY | |
Product details | |
Underlying | DAIMLERCHRYSLER |
Ratio | 1:1 |
Reference price | EUR 46.85 |
Issue price | EUR 46.85 |
Strike price (Pb) | EUR 46.85 |
Participation rate (PR) | 150.00 % |
Security identification codes | ISIN: CH0024234764 |
Dates | |
Issue date | 27.02.2006 |
Subscription period | 27.02–24.03.2006 |
Fixing date | 24.03.2006 |
Initial payment date | 31.03.2006 |
Last trading day | 07.05.2009 |
Expiration date | 11.05.2009 |
Redemption date | 18.05.2009 |
General information | |
Issuer | UBS AG, London Branch |
Lead manager | UBS Limited, London |
Issue Size | 500,000 |
Structure | Long Underlying + At-the-money Strike Call |
Redemption | The Holder of 1 UBS Outperformance Certificate has the right to receive at the Redemption Date the Redemption Amount in Euro which is calculated according to the following formulae: |
\( 1)\;{\text{If}}\,{\text{Pv}} > {\text{Pb}}\quad {\text{R}} = [{\text{Pb}} + ({\text{Pv}}-{\text{Pb}})*{\text{PR}}]*{\text{Ratio}} \) | |
\( 2)\;{\text{If}}\,{\text{Pv}} \le {\text{Pb}}\quad {\text{R}} = {\text{Pv}}*{\text{Ratio}} \) | |
With: | |
R = redemption amount | |
Pv = valuation price | |
Pb = strike price | |
PR = participation rate | |
Valuation price | Closing price of the underlying on the expiration date |
Listing | Frankfurt, Stuttgart (third section) |
Appendix 2: Example of a capped performance certificate
The example of the capped certificate in Appendix 2 was issued by UBS using Nokia as the underlying asset. The fixing date (or pricing date) UBS set for the certificate was July 12, 2004 and the issue price of the certificate (i.e. the closing stock price on the pricing date) was €11.59. The date that an investor must make the payment for the purchase of the certificate (known as the payment date) was July 14, 2004. The expiration date (i.e. the date on which the closing price of the underlying asset will be used as the valuation price) was set on July 14, 2006 with a term to expiration of 2 years. The performance factor for the certificate was set 200 %. The cap level (the maximum valuation price to be used for calculating the redemption value (also known as settlement amount) of the certificate) was set at €14.80, which would generate a net return of 55.39 %.
UBS Investment Bank | |
Speeder on NOKIA OYJ | |
Underlying: Valor: 945657; ISIN: DE0007100000; Reuters: DCXGn.DE; Bloomberg: DCX GY | |
Product details | |
Underlying | NOKIA OYJ |
Reference price | EUR 11.59 |
Issue price | EUR 11.59 |
Strike price (Pb) | EUR 11.59 |
Cap level (C) | EUR 14.80 |
Conversion | 1:1 |
Maximum return | 55.3925798 % |
Security no. | ISIN: CH0018906567 |
Dates | |
Issue date | 28.06.2004 |
Pricing date | 12.07.2004 |
Payment date | 14.07.2004 |
Last trading day | 12.07.2006 |
Expiration date | 14.07.2006 |
Redemption date | 21.07.2006 |
General information | |
Issuer | UBS AG, London Branch |
Lead manager | UBS Limited |
Issue size | 500,000 |
Redemption | Physical settlement of underlying if underlying at expiration closes lower than strike price |
If the closing price of the Underlying at expiration is higher than or to the strike price but lower than the Cap level, the holder of 1 certificate receives a settlement amount which is calculated as follows: | |
\( {\text{A}} = [{\text{S}} + 2* ( {\text{CP}}-{\text{S) }}]*{\text{R}} \) | |
where: A = Settlement Amount; S = Strike Price; CP = Closing Price of the | |
Underlying on the Expiration Date; R = Ratio. | |
If the underlying Share at Expiration closes higher than or at the Cap Level, the Holder of 1 Certificate receives a settlement amount which is calculated as follows: | |
\( {\text{A}} = [{\text{S}} + 2*({\text{C}}-{\text{S}})]*{\text{R}} \) | |
where C = Cap Level | |
Listing | Frankfurt, Stuttgart (third section) |
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Hernández, R., Lee, W.Y., Liu, P. et al. Outperformance Certificates: analysis, pricing, interpretation, and performance. Rev Quant Finan Acc 40, 691–713 (2013). https://doi.org/10.1007/s11156-012-0294-z
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DOI: https://doi.org/10.1007/s11156-012-0294-z