Risk analysis of Shark notes
Payoff Description- Shark notes are short to medium capitial protected structure. The payoff comprises of a zero coupon bond (for capital protection) and an up and out call option sometimes with a rebate upon being knocked out. The shark note could be structured on a single asset or a basket of underlying stocks/indices. Depending on the where the barrier of the up and out call option is, the structure can fulfill two different motivations of the investors -
1. With little or no rebate and a large knock out barrier, this structure gives the buyer a participation in the upside movements of the underlyings. A large knock out barrier serves the purpose of making the initial investment cheaper ofcourse at the added risk of being knocked out.
2. With a large Rebate(R) (=above market yield) and a low barrier level (so that the knock out probability is large), it can be used to receive above market yield at the expense of not receiving any interest if the knock out event does not happen.
For a single asset structure, the payoff can be summarized as below. NA is the notional amount invested at inception, S(T) and K are the spot level at expiry and the strike respectively.
The KO event observation could be made on a continuous, daily, monthly, quaterly etc basis.
The risks of a shark note is dictated by implicit up and out call option. The delta of the option initially increases with the increase in the stock price (when the stock price is away from barrier) and then becomes negative as the stock price approches the barrier.
Similarly the vega of this option initially increases with the increase in volatility when the stock price is away from the barrier (similar to a European call option). When the stock approches the barrier, the vega approaches zero and becomes negative.
The position in skew is unclear and would depend on current level of spot relative to the barrier level and the level of rebate defined within the trade definition.
Multi Asset Shark notes
The payoff of a multi asset shar notes is based on performance of the basket of underlyings.
It is important to realize that the Basket performance could be lesser than the predecided barrier even when some of the underlyings individually are above the Barrier level (because the basket perf is the average of the returns). This makes the knock out event in the case of multi asset structures even more unlikely.
The risk analysis of a multi asset shark note would be similar to the single asset note. We just need to account for correlation. Correlation affects the payoff of this structure by affecting the overall volatility of the basket. Increasing the correlations increases the overall volatility of the basket and vice versa. If the current spot is far away from the barrier, increasing correlation increases the price of the structure and when the spot price is closer to the barrier it decreases the price of the structure.