Capital Markets

& Financial Advisory

Services examination
Module 9A Life Insurance And Investment-Linked Policies II
First Edition
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LIFE INSURANCE AND
INVESTMENT-LINKED POLICIES II
1st Edition - October 2011

© 2011 by Singapore College of Insurance Limited. All rights reserved.

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1st Edition [V1.0] published in October 2011

1st Edition [V1.0] reprinted in January 2012
1st Edition [V1.6] reprinted in February 2013
Preface
Capital Markets and Financial Advisory Services Examination –
Module 9A – Life Insurance And Investment–Linked Policies II

In line with the licensing framework under the Securities and Futures Act (SFA) and
Financial Advisers Act (FAA), the Monetary Authority of Singapore (MAS) has launched
a modular examination structure, known as the Capital Markets and Financial Advisory
Services Examination (CMFAS Examination).

This study guide is designed for candidates preparing for Module 9A – Life Insurance
And Investment-Linked Policies II examination. This examination is for new and existing
representative of financial advisers who need to comply with MAS requirement to
possess the requisite knowledge to advise or sell Investment-Linked Life Insurance
Policies (ILPs).

The objectives of the CMFAS Module 9A – Life Insurance And Investment–Linked

Policies II examination are to test candidates on their knowledge and understanding of
the features, types, advantages and disadvantages of structured products, comparison
with other investment options, governance structure, documentation and risks
associated with the investment of structured products, particularly Structured ILPs, as
well as to evaluate some examples of Structured ILPs on product features, inherent
risks, and performance under various market conditions in determining product
suitability for the clients. It also discusses the various types of derivatives in the market,
both on-the-exchange and over-the-counter.

This study guide is divided into six chapters, each devoted to a specific topic that the
candidate needs to know, in order to pass the CMFAS Module 9A examination, as
outlined below.
Chapter 1: Provides an introduction to structured products in general, such as the
components and types of structured products, and their suitability to meet
the clients’ investment needs. Similarities and differences of structured
products are also covered as a whole.
Chapter 2: Provides an overview on some of the risk considerations of structured
products, such as market risk, issuer or credit risk, liquidity risk, foreign
exchange risk, structural risk and other risks.
Chapter 3: Discusses the various types of derivatives in the market, both on-the-
exchange and over-the-counter, such as futures, forwards, options,
warrants, swaps and contract for differences (CFD).

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 Chapter 4: Provides an introduction to Structured ILPs, such as the advantages and
disadvantages compared to other investment options, considerations when
investing, suitability, governance structure, documentation, risk, after sales
valuation and pricing information for Structured ILPs.
Chapter 5: Introduces one example of a Structured ILP known as “portfolio bonds”.
Using a British example, this chapter explains the product features, relative
advantages and disadvantages, and circumstances under which it is
suitable or unsuitable.
Chapter 6: Uses two examples of Structured ILPs to illustrate the analysis of product
features, inherent risks, and performance under various market conditions,
in determining product suitability.

While every effort has been made to ensure that the study guide materials are accurate
and up-to-date at the time of publishing, some information may become outdated
before the latest version is released. Hence candidates are advised to check the
“Version Control Record” found at the end of this study guide to ensure that they have
the correct version of the study guide. For examination purposes, the Singapore
College of Insurance adopts the policy of testing only those concepts and topics that
are found in the latest version of the study guide.

ii Copyright reserved by the Singapore College of Insurance Limited [M9A Version 1.16]
Acknowledgement

We would like to express our appreciation and gratitude to Mr Cheung Kwok Kei from
the Life Insurance Association of Singapore (LIA) for reviewing this study guide as well
as the Monetary Authority of Singapore for their insightful comments.

We wish to also extend our appreciation to Ms Pauline Lim, the Executive Director of
LIA and Ms Cecilia Chan who have kindly recommended and connected us to Mr
Cheung, the reviewer.

Karine Kam
Executive Director
Singapore College of Insurance
October 2011

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Study Guide Features
Several study aids have been included to help candidates master and apply the study
guide information. These include:

Chapter Outline and Key Learning Points

An outline of the chapter is provided on the first page of each chapter, after which the
key learning points are listed to help candidates gain an overview of the chapter’s
contents and the expected learning outcomes to be achieved.

Revisions And Updates

To enable candidates to check that they have the latest version of the study guide, the
“Version Control Record” at the end of this study guide will list the relevant revisions
and updates that have been made, as well as the date when the changes will apply to
the examinations.

NB: Throughout this study guide, where applicable, the masculine gender has been
used to represent both genders, in order to avoid the tedium of the continual use
of “he or she”, “his or her” or “himself or herself”.

iv Copyright reserved by the Singapore College of Insurance Limited [M9A Version 1.16]
 PREFACE ............................................................................................... i
ACKNOWLEDGEMENT ............................................................................ iii
STUDY GUIDE FEATURES........................................................................ iv
TABLE OF CONTENTS ............................................................................. v

CHAPTER 1 INTRODUCTION TO STRUCTURED PRODUCTS ......................... 1

CHAPTER 1 E-Learning

1. What Is A Structured Product?

1.1 How Does A Structured Product Work?
1.2 What Is A Wrapper?
1.3 Why Invest In Structured Products?
1.4 Challenges Facing Structured Products
2. Components Of A Structured Product
2.1 Principal Risk Versus Return Risk
2.2 Trade-off Between Risk And Return
3. Types Of Structured Products
3.1 Products Designed To Protect Capital
3.2 Yield Enhancement Products
3.3 Participation Products
4. Similarities And Differences Of Structured Products
4.1 Similarities In Features
4.2 Differences In Features
4.3 Differences In Rights
4.4 Similarities And Differences In Governance
5. Suitability
5.1 Know Your Clients

Table of Contents
5.2 Know Your Products

CHAPTER 2 RISK CONSIDERATIONS OF STRUCTURED PRODUCTS ............ 25

CHAPTER 2 E-Learning

1. Market Risk
2. Issuer Or Swap Counterparty Credit Risk
3. Liquidity Risk
4. Foreign Exchange (FX) Risk
5. Structural Risk
5.1 Safety Of Principal
5.2 Leverage
5.3 Investment In Derivatives
5.4 Investment Concentration
5.5 Collateral
6. Other Risks
6.1 Legal And Regulatory
6.2 Correlation
6.3 Modelling
6.4 Early Redemption
6.5 Examples Of Redemption Amount

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 CHAPTER 3 UNDERSTANDING DERIVATIVES ........................................... 36
CHAPTER 3 E-Learning

1. What Are Derivatives?

1.1 Practical Example Of Derivative
2. Futures And Forwards
2.1 Pricing Of Forward Contracts
2.2 Practical Examples Of Forward Contracts
2.3 Summary Of Forward Contracts
2.4 History Of Futures Contracts
2.5 Pricing Of Futures Contracts
2.6 Margin (Futures Contracts)
2.7 Market Participants
2.8 Futures Trading Strategies
3. Options And Warrants
3.1 Risk Profile Of Option / Warrant
3.2 Plain Vanilla Versus Exotic Option
3.3 Basic Option Trading Strategies
3.4 Bullish Option Strategies
3.5 Bearish Option Strategies
3.6 Neutral Option Strategies
3.7 Summary Of Options
4. Swaps
4.1 Interest Rate Swaps
4.2 Currency Swaps
4.3 Credit Default Swap (CDS)
4.4 Equity Swaps
4.5 Commodity Swaps
5. Contract For Differences (CFD)

Table of Contents
CHAPTER 4 INTRODUCTION TO STRUCTURED ILPs .................................. 68
CHAPTER 4 E-Learning

1. What Is A Structured ILP?

1.1 Payout Under A Structured ILP
1.2 Common Terminology
2. Advantages And Disadvantages Of Structured ILPs
2.1 Advantages Of Investing In Structured ILPs
2.2 Disadvantages Of Investing In Structured ILPs
2.3 Risk Considerations For Structured ILPs
2.4 Examples Of Structured ILPs
3. Who Would Invest In Structured ILPs?
4. When Are Structured ILPs Unsuitable?
5. Governance
5.1 Legal Structure Of ILP
5.2 Investment Guidelines For Retail Funds
6. Typical Types Of Documentation And Risks
6.1 Point-of-sale Disclosure: Product Summary, Benefit Illustration
And Product Highlights Sheet
6.2 Disclosure At Policy Inception: Policy Document
6.3 After Sales Disclosure: Policy Statements And Fund Reports

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 6.4 Risk Considerations
7. After Sales
7.1 Valuation
7.2 Pricing Information
Appendix 4A
Appendix 4B

CHAPTER 5 PORTFOLIO OF INVESTMENTS WITH AN

INSURANCE ELEMENT .......................................................................... 95
CHAPTER 5 E-Learning

1. What Is A Portfolio Of Investments With An Insurance Element?

1.1 An Example Of Portfolio Bond Marketed In The United Kingdom (UK)
2. Advantages And Disadvantages Of Portfolio Of Investments With An
Insurance Element
3. Who Would Invest In Portfolio Of Investments With An Insurance Element?
4. When Are Portfolio Of Investments With An Insurance Element Unsuitable?
5. Governance And Typical Documentation

CHAPTER 6 CASE STUDIES ................................................................. 100

1. Case Study 1 – Annual Payout Plan
1.1 Product Features
1.2 Selling Points
1.3 Risk Analysis
1.4 Performance Under Different Market Conditions
2. Case Study 2 – Lifestyle Plan
2.1 Product Features
2.2 Choice Fund - Fund Details
2.3 Selling Points

Table of Contents
2.4 Risk Analysis (Based On The Choice Fund)

E-MOCK EXAMINATION

VERSION CONTROL RECORD

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 This page is intentionally left blank.

viii Copyright reserved by the Singapore College of Insurance Limited [M9A Version 1.16]
 1. Introduction To Structured Products

Chapter

1 INTRODUCTION TO STRUCTURED
PRODUCTS

CHAPTER OUTLINE
1. What Is A Structured Product?
2. Components Of A Structured Product
3. Types Of Structured Products
4. Similarities And Differences Of Structured Products
5. Suitability

KEY LEARNING POINTS

After reading this chapter, you should be able to:
 describe what structured products are
 identify the components of structured products
 explain the types of structured products
 understand the similarities and differences of structured products
 advise clients on the suitability of structured products

NOTE:
Throughout this study guide, the words:
▪ “capital” and “principal”, and
▪ “investment fund” and “collective investment scheme (CIS)”
are used interchangeably.

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Module 9A: Life Insurance And Investment-Linked Policies II

1. WHAT IS A STRUCTURED PRODUCT?

Structured products are among the fastest growing investment classes in

global finance. As the sub-prime mortgage crisis has reminded us, structured
products bear multifaceted complex risks.

The name “structured products” comes from the fact that such products are
created by combining traditional investments (usually a fixed income
instrument such as bond or note) with financial derivatives (usually an
option). Such “structuring” allows the resulting products to achieve specific
risk-return profiles to match the investors’ needs and expectations that
cannot be met by traditional investments.

Structured products are unsecured debt securities of the issuer 1 . They are
commonly backed only by the issuer’s promise to make good on the intended
payouts. They are not equity securities, and holders of structured products
are not entitled to share the issuer’s profits. The fact that the intended
payouts from structured products may be based on equity price movements
does not make them equity securities. Structured products are also referred
to as hybrid products, because it is possible to mirror equity-like (or other
asset classes) returns using a fixed income structure.

Investors need sufficient knowledge to evaluate structured products in the

light of the more complex nature of such products.

1.1 How Does A Structured Product Work?

A bond provides regular interest payments and repayment of the par

value of the bond at maturity. Aside from the bond-issuer’s default risk,
the bond-holder has certainty of the return from his bond investment.
On the other hand, investment in stock has a higher return potential
compared to bonds, but share prices are volatile and dividends are not
guaranteed. It is desirable from the investors’ perspective if a product
can combine the characteristics of bonds and equities, to offer the
potential upside performance of stocks with the downside protection of
bonds.

Where there is demand, there is supply. An equity-linked note designed

to return at least the principal 2 is the response to the demand, by
combining a zero-coupon bond with an option on an underlying equity
asset. The underlying can be a single stock, or a basket of stocks, or
an index, depending on the investment objective.

1
Examples of exception to this are structured funds, which are discussed in greater detail in later
chapters.
2
The use of the term capital / principal protected and any other derivative of the term is disallowed
in Singapore as from September 2009.

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 1. Introduction To Structured Products

Illustration

Consider a 5-year note linked to ABC Company’s stock whose

current market price is S$100. Out of every S$100 invested, S$80
is used to buy a zero-coupon bond, with S$100 par value maturing
in five years. The remaining S$20 is used to buy a call option on
ABC shares, with a strike price of S$120.

Upon maturity five years later, the zero-coupon bond pays out
S$100, providing the return of capital portion of the note. If the ABC
share price doubles in value, the option pays off S$80. The total
return to the investor is thus S$180. By contrast, if the S$100 were
invested directly in ABC shares, the return would have been S$200,
ignoring dividends.

If the ABC shares price stays flat in value, the option expires out-of-
the-money. Hence, the total return to the investor is only the S$100
from the zero-coupon bond. Had the S$100 been invested directly in
ABC shares, the return would have been S$100 as well.

In the worst case scenario, the ABC shares decline to S$50,

rendering the option worthless. The return to investors is only the
return of capital of S$100. By contrast, if the S$100 were invested
directly in ABC shares, the investor would have lost half of his
capital.

In other words, this structured product enables the investor to

participate in the price performance of ABC shares without concern
of losing portion of his capital if the shares perform poorly. However,
the downside protection is counterbalanced by the possible loss of
some of the upside potential. Furthermore, if the zero-coupon bond
issuer defaults, the investor may not be able to recoup his original
capital investment.

A zero-coupon bond is used in the structuring because it is cheaper,

leaving more money to be invested in options for the upside
participation. Alternatively, a coupon-bearing bond can be used instead,
to provide more stability in returns, with lower participation on the
upside.

Both bonds and options have fixed maturity dates. Consequently,

structured products have expiry or maturity dates3, and are often issued
in rolling tranches or series. Although product features may be
identical, each series is likely to be priced differently, based on market
conditions at the time of issue.

3
There are a few structured products that do not have maturity dates. One such example, the
tracker certificate, is discussed in Section 3.3 of this chapter.

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Module 9A: Life Insurance And Investment-Linked Policies II

1.2 What Is A Wrapper?

Structured products can be created and marketed in different formats,

called “wrappers”. The equity-linked note illustrated above is one
possible wrapper in the form of unsecured debenture, i.e. a note. There
are others. The choice of wrapper depends on a number of factors,
including:
 regulatory restriction on issuers (e.g. only banks can take deposits,
and only insurance companies can issue insurance policies);
 the desired investment freedom (e.g. there are investment
restrictions applicable to collective investment schemes);
 desired level of transparency (e.g. structured fund allows
independent valuation with the Net Asset Valuation (NAV) published
on a regular basis;
 the targeted level of returns (e.g. some format is costlier than
others); and
 tax consideration in a particular jurisdiction.

The most common wrappers are:

(a) Structured Deposits: Only banks can take deposits. Despite the
name, it is important to note that structured deposits are
considered investment products, and are excluded from the Deposit
Insurance Scheme in Singapore.
(b) Structured Notes: These are unsecured debenture of issuers. By
purchasing the structured notes, the note-holders are lending
money to the issuer.
(c) Structured Funds: These are Collective Investment Schemes (CIS),
also known as investment funds. In Singapore, most Singapore-
domiciled investment funds are structured as trusts, while foreign-
domiciled funds are typically structured as corporations. In the case
of a fund structured as a trust, there is an independent trustee
making sure that the fund manager’s operation of the fund is in
accordance with the trust document and investment mandate. A
similar role exists for the board of directors and / or the depositary
bank for funds structured as corporations.
(d) Structured Investment-linked Life Insurance Policies (ILPs): These
are life insurance policies. As such, only life insurers can issue
structured ILPs. They operate like a term insurance plus a
structured fund, where the term insurance provides insurance
coverage, and the structured fund provides the investment return.

Different wrappers have their distinct advantages and disadvantages

from investment and distribution points of view, as outlined in Table
1.1.

It should be kept in mind that advantages and disadvantages are

relative. For example, the potential lower return from structured
deposits is a disadvantage for investment purposes, but it provides the

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 1. Introduction To Structured Products

advantage of security of capital. By the same token, while the lower

administrative cost associated with structured deposits may make such
products advantageous in terms of investment returns, it is limited in
terms of product sophistication and flexibility.

Table 1.1: Advantages & Disadvantages Of Different Wrappers

Wrapper Advantages Disadvantages

Structured  Lower administrative  Returns are lower (in
Deposits cost as the bank general) owing to the cost
structuring the product of providing return of
also performs the capital.
distribution.  Investors are unsecured
 The bank usually creditors of the issuer in
guarantees return of the event of liquidation.
capital.
Structured  Full flexibility in  Investors are unsecured
Notes product design. creditors of the issuer in
the event of liquidation.
 Prospectus is required,
resulting in higher issuing
cost.
Structured  A wide and ready  Administrative cost is
Funds distribution network higher due to operating
through existing fund cost of the fund.
distribution channels.  Prospectus is required,
 In a trust structure, resulting in higher issuing
there is greater cost.
transparency of  Product design may be
charges and investment affected by investment
performance. The restrictions due to
trustee also acts in the regulatory requirements
investors’ best interest. designed to protect
 In a trust structure, customers.
assets are held in trust
for the benefit of the
investors.
Structured  A wide and ready  Insurers typically outsource
ILPs distribution network the structuring, which adds
through existing an additional layer of cost.
insurance distribution  Similar to funds,
channels. investment restrictions may
 Insurance coverage apply.
being provided, albeit
typically very small.

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Module 9A: Life Insurance And Investment-Linked Policies II

1.3 Why Invest In Structured Products?

Structured products can be used as an alternative to a direct

investment in traditional asset classes, especially in markets where
direct access is restricted. For example, when a market is closed to
foreign investors, structured products may be the only way to replicate
the performance of that market, without directly investing in securities
of that market.

Structured products can offer access to exotic asset classes typically

out of reach for individual investors. They are extremely versatile, and
can be tailor-made to deliver specific risk / return profile to suit the
investor’s needs, such as leveraged returns, guaranteed return of
capital, or conditional capital protection.

Structured products can be used as part of the asset allocation process

to reduce risk exposure of a portfolio.

Investment banks typically can issue structured products quickly,

enabling investors to swiftly respond to market trends.

While structured products may suit investors’ particular investment

needs, there are associated risks which may not be immediately
apparent to investors. These risk factors are discussed in Chapter 2.

1.4 Challenges Facing Structured Products

Owing to increasing product complexity, correct pricing, liquidity and

efficient risk management are two challenges facing financial
institutions.

The difficulty with pricing is that markets for instruments used to

construct structured products may not be liquid enough to achieve
meaningful mark-to-market values. The lack of transparency on the
hedging and transaction costs implicit in the structure also contributes
to the difficulty in getting the price right. Moreover, pricing is done by
pricing software. Depending on the sophistication of the model and the
accuracy of input parameters, the outcome of the pricing software is
only as reliable as the built-in modelling techniques and assumptions
adopted.

Pricing and risk management go hand-in-hand. If financial institutions

find it difficult to price the products correctly, then it is understandable
that they find it difficult to quantify and monitor the associated risks.
Similar to pricing models, the mathematical models used in risk
management may not be able to fully capture the dynamics, risks and
cost structure of complex products. The likelihood of hidden risks not
being detected early enough is increasing with the growing complexity
of structured products.

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 1. Introduction To Structured Products

2. COMPONENTS OF A STRUCTURED PRODUCT

There are two components in every investment transaction, namely the

principal invested, and the investment return generated. The purpose of
investment is to maximise return, while safeguarding principal. An ambitious
investor may be willing to do so at the risk of losing all or a portion of his
principal. A more conservative investor may be willing to accept a lower
return in order to protect his principal.

Figure 1.1: Components Of A Structured Product

Upside Investment
Potential
Return

Option

Return
Principal

of
Fixed Principal
Income

At Issue At Maturity

Structured products are no exception; they consist of the same two

components of principal and return. As illustrated in Figure 1.1, the return of
principal is achieved through a fixed income instrument, which provides
periodic interest payments (if a coupon-bearing instrument is used) and the
return of principal on maturity. The investment return is delivered through a
derivative instrument, which provides additional return based on the price
performance of the underlying assets, namely equities, fixed income,
currencies, or commodities. The underlying assets can be a single security,
or a mixture of securities, depending on the investment target.

2.1 Principal Risk Versus Return Risk

Since different financial instruments are used for the principal and the
return components, they are subject to different primary risk factors.

The risk to principal is the credit risk to the fixed income instrument
used, which are usually senior, unsecured debts. Should the issuer
default, the investor is one of many general creditors of the issuer.
Consequently, the credit worthiness of the issuer of the fixed income
instrument, which may be different from the issuer of the structured
product itself, is the primary risk to the principal component of
structured products. To mitigate this risk, the issuer of the structured
products may provide a guarantee, either by itself or by a third party,
enhancing the credit security of the products. However, investors
should note that the cost of risk mitigation can affect the potential
returns.

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Module 9A: Life Insurance And Investment-Linked Policies II

The primary risk to the return component is market volatility. All

derivative contracts have specified expiry dates. It is the contractual
value of the underlying assets on the expiry date that determines the
amount of return, if the rights under the contract have not been
exercised before expiry. A sudden fall in the value of underlying assets
on expiry date may wipe out the entire cumulative gain throughout the
life of the contract. As the contract expires after expiry date, the
investor has no chance to ride out the sudden downturn. This is unlike
a direct investment in stocks, where the investors may choose to hold
on to the stocks in hope of price recovery at a later date.

For example, a product promised to deliver a return equals to 50% of

the STI performance measured from the Inception Date to the Maturity
Date. Despite the bull market during the whole investment period, if STI
registers a negative performance on the Maturity Date, the product is
not able to deliver any performance. This is the case, even if the STI
enjoys a miraculous recovery on the day after the Maturity Date.

The return component is also subject to the credit risk of the

counterparty to the derivative contract. That is, the counterparty may
not be able to deliver the contractual value when due.

There is a trade-off between safety of principal and participation in an

upside performance. The degree of safety can be reduced in exchange
for a greater participation in performance. For example, a product may
be designed to provide for return of 75% of principal, by reducing the
investment in fixed income instrument by 25%, permitting a larger
investment in derivatives, and thus a greater upside potential. This
product still provides a downside protection, although not 100% of
principal.

Figure 1.2: Trade-off Between Safety Of Principal And

Participation In Performance
Return

Upside
Potential

Option
Option
75% Principal
Principal

Fixed Principal
income Fixed Protection
income

At Issue At Maturity

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 1. Introduction To Structured Products

2.2 Trade-off Between Risk And Return

In the realm of finance, risk refers to uncertainty. When it is said that

an investment is of high risk, it means that the probability of the
anticipated return which may not be realised is higher as compared to
other investments. It also means that all or part of the principal may be
lost. Naturally, investors demand to be properly compensated for the
risk that they take on. This is the reason why investors expect higher
returns from risky investments, i.e. compensate for the higher
probability that the returns may not materialise.

However, this does not mean that all risky investments have the
potential of high returns. There are bad investments that offer low pay-
off for high risk taken. By the same token, it is conceivable, though
rare, that there are opportunities offering high return at low risk. The
art of investment is to correctly assess the risk-return profile of each
opportunity and decide whether the trade-off between risk and return is
acceptable.

Figure 1.3 illustrates the relationship between risk and return. The
northeast quadrant represents investments that offer high return at high
risk. These are for ambitious investors who can afford to take the
maximum loss under the worst-case scenario. By contrast, the
southwest quadrant represents investments that offer low return for
low risk. These are for investors who are willing to accept a lower
expected return in exchange for higher assurance of the return of their
principals.

Figure 1.3: Risk And Return Trade-off

Too good to be true: Low risk

with high potential return.

Return

Bold The principal may

Rare Gems Investments be at risk; the
potential return is
high, but not
certain.

Safe Unworthy
Investments Investments

Risk

The principal is relatively safe; the

return is low, but is relatively certain.

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While it is intuitive to avoid unworthy investments represented in the

southeast quadrant, it takes proper analysis to identify them. At the
opposite corner, there may be rare opportunities out there, offering high
potential returns at low risk. Typically, these opportunities can be at
the beginning stage of a breakthrough technology or emerging industry.
However, they often turn out to be “too good to be true”.

3. TYPES OF STRUCTURED PRODUCTS

Structured products are by nature not homogeneous - as a large number of

derivatives and underlying can be used. However, the more popular ones can
be classified into the categories as described below.
 Interest Rate-linked: Structured product designed to be linked to interest
rates such as Libor or Euribor.
 Equity-linked: It refers to an investment instrument that combines the
characteristics of a zero, or low coupon bond or note with a return
component, based on the performance of a single equity security, a
basket of equity securities, or an equity index.
 FX (Foreign Exchange) and Commodity-linked: This involves an investment
instrument linked to the performance of a specific commodity, a basket of
commodities, some foreign exchange rate, or a basket of foreign exchange
rates.
 Hybrid-linked: It is a structured note, sometimes called "hybrid debt". It is
an intermediate term debt security, whose interest payments are
determined by some type of formula tied to the movement of an interest
rate, stock, stock index, commodity, or currency.
 Credit-linked: A form of funded credit derivative. It is structured as a
security with an embedded credit default swap allowing the issuer to
transfer a specific credit risk to credit investors. The issuer is not obligated
to repay the debt if a specified event occurs. This eliminates a third-party
insurance provider.
 Market-linked: A structured product that is linked to a certain or a basket
of market indices.

Structured products are versatile in the sense that they can be linked to
single or multiple securities, in any or a combination of asset classes, of
short or long durations, denominated in any currencies, providing full or no
return of capital. Thus, it is easy to understand why there is a wide range of
structured products, both traded on the exchange and off the exchange.

According to a survey of European distributors of structured products4, 70%

of structured products were linked to equities, 22% fixed income, 3%
foreign currency and 2% commodities. While the global figures may differ
from the European experience, it is safe to say that structured products are
predominantly based on equities as the underlying assets.

4
“Structured products: Double your guess for retail market’s size”, Euromoney, September 2008.

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There is no universal way of classifying financial products. Traditional

investments such as CIS and ILPs can be classified in a number of ways: by
geographical focus; by asset class; by maturity; etc. Likewise, structured
products can be classified in different ways, e.g. by underlying asset classes;
by risk-return profiles; or by investment objectives. We have discussed about
structured products based on their underlying asset classes. Now, we will
discuss structured products based on their investment objectives, which
correspond to their risk levels:
(a) products designed to protect capital;
(b) yield enhancement products; and
(c) performance participation products.

For example, there are structured deposits based on equities or currencies

designed to preserve capital; structured notes linked to equities or bonds
designed to preserve capital; and structured funds or ILPs aimed at
preserving capital. Similarly, yield enhancement and performance
participation products can also use different underlying asset classes for
different investment objectives.

Figure 1.4: Risk-Return Profile Of Structured Products

Expected
Returns
Performance
Participation

Yield
Enhancement
Designed to
Protect Capital

Risk

The risk-return profile is different for these three types of structured

products. Products designed to preserve capital carries the lowest degree
risk, and correspondingly lower expected return, because part of the
investments goes to protecting the downside. The yield enhancement
products are riskier with higher return potential relative to products aimed to
preserve capital, because a greater portion of investments goes to delivering
upside potential. Participation products are the riskiest of the three, as they
often provide no downside protection at all; the entire investments are put to
pursuing performance.

Investors are often attracted by high potential payout products. However, a

structured product delivers return to investors only when the:
(a) anticipated market view is correct;
(b) strategy or structure to capture the market view is appropriate; and
(c) pricing on the structure is reasonable.

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3.1 Products Designed To Protect Capital

These products are designed using a fixed income instrument to preserve

all or majority of the principal component at maturity, so that the
investors are protected to a certain degree if the return component of the
products does not perform well under adverse market conditions.

These products are structured by combining a bond or a note with a call

option on the underlying assets. A zero-coupon bond is typically used for
the principal component. The underlying is most commonly a single
stock, a basket of stocks, or an index.

Some examples of this type of products include:

 Structured deposits;
 Equity or credit-linked notes, to the extent that the fixed income
component of the product is structured to provide the return of
capital; and
 Capital guaranteed funds.

However, downside protection is only as good as the credit worthiness of

the party providing the protection. The credit standing of the protection-
giver is a major consideration in the risk-return analysis, especially for
long duration products, where the financial position is more prone to
change.

The protection in a structured product is provided by the underlying fixed

income instrument. Therefore, the protection-giver is the issuer of the
bond used in the structuring. If the bond-issuer defaults, the issuer of the
structured product is not obligated to step in to make good, unless the
product-issuer has given its guarantee to the investors. For this reason,
investors need to consider the credit worthiness of the bond-issuer, rather
than the product-issuer, in assessing the strength of the downside
protection.

Even if the bond-issuer does not default, the principal may still be at risk,
despite the best intention of the product design. This is because the
return of principal is only applicable at maturity. Similar to the plight of a
depositor breaking a fixed deposit, an investor wishing to cash-in his
structured investments before maturity date often suffers losses of
amount dependent on the mark-to-market adjustments. Therefore,
investors should take into account their investment time horizon when
choosing a product to avoid timing mismatches. For longer-term products,
the possibility of early cash-in resulting from unforeseen circumstances is
higher. Thus, the early redemption risk and market volatility risk are
correspondingly higher.

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3.2 Yield Enhancement Products

Some investors have higher risk tolerance, and seek returns higher than
those from traditional fixed income instruments, at slightly higher risk.
This is not possible to achieve with traditional investment vehicles,
without taking on excessive credit risk. In response to such demand, yield
enhancing structured products have been engineered to achieve just that.

The most common of such products are reverse convertible bonds and
discount certificates.

(a) Reverse Convertible Bonds

Like all other structured products, a reverse convertible bond is an
unsecured debt instrument. It is issued as a note that is linked to a
single stock. It has features of a fixed income instrument under
normal circumstances: periodic interest payments (if the note so
provides), and payment of the par value of the note upon maturity.
However, if the price of the underlying stock falls below a
predetermined level, called the "kick-in" level, the investor receives
a pre-determined number of shares of the underlying stock in lieu of
the par value of the note at maturity. The kick-in level is usually
20% to 30% below the price of the underlying stock on issue date.

In terms of structure, a reverse convertible bond consists of:

 a bond, providing the periodic interest payments (if any) and par
value at maturity; and
 a written put option (i.e. the investor is selling a put option),
providing the shares in lieu of par value at maturity if the kick-in
level is breached.

The upside return to investors is capped at the yield on the note,

while there is no protection on the downside as the value of the
stock falls. To compensate for the capped upside, the yield is
higher than that for traditional bonds.

While most reverse convertible bonds are linked to single stocks,

they can also be linked to other classes of assets or baskets of
assets.

(b) Discount Certificates

A discount certificate has the same risk-return profile as a reverse
convertible, except it is structured differently.

A discount certificate allows the investors to participate in the

performance of the underlying stock up to a pre-determined
maximum level, called the “cap-strike” or simply “cap”. The product
is sold at a discount to compensate for the capped upside. At

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maturity, the investor receives either a cash settlement or the

underlying shares, depending on the underlying share price such as:
 Scenario 1: The price of the underlying stock is above the cap-
strike – The investor receives a cash settlement equal to the
cap-strike and realises the maximum possible profit; or
 Scenario 2: The price of the underlying stock is at or below the
cap-strike – The investor receives the underlying stock.

Both reverse convertible bonds and discount certificates offer capped

upside potential without a downside protection. They share the same
risk-return profiles, although they are structured very differently.
Discount certificates are structured by combining two different types
of options. (Transaction cost may reduce the actual return from the
product.)

Figure 1.5: Payoff Of A Yield Enhancement Structured Product

Profit Price of
Underlying Stock

Payoff to Investors

Kick-in Level
or Cap-Strike

Loss

Something To Keep In Mind

Yield enhancement products (in general) do not provide downside
protection. The investor’s risk exposure follows exactly that of the
underlying stock when the stock price falls below the kick-in level.
Investors considering these products should consider and be comfortable
with the downside risk of the underlying stock.

Financial advisers and sales representatives should clearly explain the

risks to investors. They should never suggest that a yield enhancement
product could be a substitute for conventional bond, because the risk-
return profiles are fundamentally different, as the figure above illustrates.

3.3 Participation Products

“Participation” refers to participation in the price performance of the

underlying assets. These products typically offer full upside potential with

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no downside protection. There are variations where there are capped

upside potential, and / or limited or conditional downside protection,
depending on investors’ desired risk-return profile. Compared to the
previous two types of structured products, participation products
generally carry higher degrees of risk, with corresponding higher levels of
potential return, because of their more aggressive pursuit of upside
potentials.

Participation products are legally unsecured debentures. They are

commonly marketed under the name of “certificates” or “notes”. They
are not to be confused with “certificate of deposits”5.

Without any downside protection element in participation products, there

is typically no need to involve fixed income instruments for the principal
component of these products. Instead, derivatives contracts are used for
both principal and return components to achieve the desired risk-return
pattern.

There are many examples of products in this category. Three are

discussed below, as an illustration of the versatility of product design of
participation products, namely tracker certificate, bonus certificate and
airbag certificate.

(a) Tracker Certificate

A tracker certificate tracks the performance of an underlying asset. It
has neither upside cap nor downside protection. Its risk profile is
identical to the underlying asset that it tracks. The reason for its
creation is to give investors access to investments otherwise not
possible or not economically feasible, such as a tailored-made index.

A tracker certificate is one of the few structured products that may

have no maturity date.

Figure 1.6: Payoff Of A Tracker Certificate

Profit

Payout to Investors

Loss Price of Underlying

Assets

5
Certificate of Deposits (CDs) are bank deposits covered by the Deposit Insurance Scheme in
Singapore.

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(b) Bonus Certificate

Bonus certificates are tracker certificates with the conditional
downside protection which hinges on a pre-determined barrier. They
are designed to give the downside protection only to the level of the
barrier. So long as the price of the underlying asset does not drop
below the barrier, the payoff to the investor at maturity is no lower
than an agreed amount (the “bonus”). However, if the barrier is
crossed during any point during the life of the certificate, the
protection is off, and the investor is paid the value of the underlying
asset at maturity.

The feature where the protection no longer applies is called “knock-

out”. The knock-out feature is inherent from the barrier options
(down and out options) used in their structures. (See Chapter 3 for a
discussion on exotic options.)

Depending on the product design, a bonus certificate may be

knocked-out anytime during its life, or may be knocked-out only at
maturity. In the first case, once the knock-out is triggered, the
protection is gone for the remainder life of the certificate, even if the
stock price subsequently recovers above the barrier level before the
expiry date.

Figure below illustrates the payoff pattern of a bonus certificate. As

can be seen, there is a discontinuity, representing a sudden drop in
the payoff, at the barrier level where the knock-out takes place. At or
above the barrier level, the investor gets paid at least the bonus
amount. Below the barrier level, the investor bears the full downside
of the underlying asset.

Figure 1.7: Payoff Of A Bonus Certificate

Profit
Barrier level:
Knock-out
takes place.

Payout to Investors

Price of Underlying
Loss Assets

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(c) Airbag Certificate

With a bonus certificate, a “disaster” occurs at the barrier level,
when the protection against price decline is knocked-out. Like a
motorist in a car accident, an investor may want to have some
protection against such disastrous situations. An airbag certificate
was created to reduce the impact of knock-out, extending the
downside protection up to a pre-determined airbag level.

The downside protection is still knocked-out at the airbag level.

However, investors have downside protection to the specified airbag
level, and there is no sudden drop in payoff at that level. Below the
airbag level, the payoff remains above the price of the underlying
asset until it loses all value.

One advantage of an airbag certificate over a bonus certificate is that

it gives the underlying stock a chance to rebound during the life of
the certificate.

Airbag certificates can be designed to have different airbag level to

suit an investor’s particular risk tolerance. Naturally, higher the level
of protection, lower the return potential.

Figure 1.8: Payoff Of An Airbag Certificate

Profit
Airbag Level:
e.g. 35% of
Spot Price.

Payout to Investors

Price of Underlying
Loss Assets

4. SIMILARITIES AND DIFFERENCES OF STRUCTURED PRODUCTS

4.1 Similarities In Features

One commonality among structured products is the use of financial

derivatives to either amplify gains, or hedge away risks, or both. While
the types of derivatives instruments used vary widely depending on
investment objectives, structured products that aim to preserve capital
typically use bonds as the underlying structure to provide return of all
or part of capital at maturity.

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There are different ways to achieve the same risk-return profiles, using
different financial instruments. Examples which we have seen earlier
are the reverse convertible bonds and discount certificates in Section
3.2: reverse convertible is constructed by using a bond and a put
option; discount certificate is constructed by using a call option and a
down-and-out option.

Why do issuers adopt different structures? The most common answer

is tax. Dividend income and capital gains have different tax treatments
in most countries. Different structures may achieve the same
investment objectives, but returns to investors may be different,
depending on the investor’s tax domicile.

4.2 Differences In Features

Structured products with the same structure and wrapper may have
different features. One notable example is the call feature. A debt
security with an “issuer callable” feature may be redeemed (or “called”)
before its maturity date, at the issuer’s discretion. The debt security
usually specifies a minimum period before the debt can be called, and
the call price is typically higher than the par value on a sliding scale,
depending on how early the debt is called.

The issuer is likely to exercise his right to “call” when the interest rate
has declined, so that he can re-finance his debt at a lower rate. When
the interest rate is low, the price of debt securities is high. The lender
(i.e. investor) may be unable to replace his investment at the same rate
of return. Consequently, callable securities expose investors to interest
rate risk and reinvestment risk.

The performance of structured products using callable securities in their

structures is affected when the callable securities are called. Does it
mean that callable securities are undesirable and should be avoided at
all times? Not necessarily so, there are certain benefits to callable
securities to compensate for the additional risks.

Callable securities are cheaper than straight, non-callable securities, and

pay higher coupons. This is comparable to selling (writing) an option;
the option writer gets a premium upfront, but has a downside risk if the
option is exercised. In fact, the price of a callable bond is the price of
straight bond, less the price of a call option. A decision to invest in a
callable bond is an investment decision, after weighing the associated
benefits and risks.

Debt securities are not the only ones that may be called. There are
callable (also known as “redeemable”) preference shares as well.

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4.3 Differences In Rights

Not all bondholders are created equal. Depending on the type of bonds
that they hold, they have different rights even though they are creditors
of the same issuer.

There are two types of bonds, namely senior bonds and subordinated
bonds. In case of liquidation, holders of senior bonds have priority over
shares and subordinated bonds. Repayment for subordinated bonds, on
the other hand, takes place after all other creditors with higher priority
have been paid. As a result, subordinated bonds usually have a lower
credit rating than senior bonds, and may pay a higher interest rate to
compensate the higher risk.

Subordinated bonds may be issued in tranches. The holders of senior

tranches are paid back first, the subordinated tranches later. Issuers
may have rating agencies to rate the tranches separately. It is
important to remember that a senior tranche of a subordinated bond
still ranks lower than other senior bonds. That is, a AAA rated tranche
of a junk bond is still a junk bond.

4.4 Similarities And Differences In Governance

The governance of structured products depends on the wrapper used.

Some products may be listed on a stock exchange, in which case, they
are governed by additional requirements as imposed by the listing
exchange.

(a) Listed Products

Structured notes and structured funds can be listed. There are a
number of structured notes listed on the Singapore Exchange
(SGX), under the categories of Exchange-Traded Notes (ETNs) and
Certificates.

Listed structured funds come under the generic umbrella of

Exchange-Traded Funds (ETFs). Keep in mind that not all ETFs are
structured funds. Although majority of ETFs are tracker funds,
some ETFs make direct investments, while others use derivatives,
to replicate the underlying index. Only those ETFs that use
derivatives are structured funds. They are also known as “synthetic
ETFs”.

Listed products in Singapore are subject to the oversight of SGX. In

evaluating a structured product’s eligibility to list, SGX considers
the reputation of the financial institutions issuing the securities, its
financial strength, and the liquidity of the proposed listed securities.

To ensure liquidity, SGX requires that at least 75% of the securities

must be spread out to a minimum of 100 investors in the case of
ETNs and certificates. In the case of ETFs, the fund size must be at
least S$20 million, and at least 25% of the fund's total number of

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issued shares, excluding treasury shares is held by at least 500

public shareholders (100 in the case of a venture capital fund). The
minimum investor spread requirement does not apply if a
Designated-Market Maker6 has been appointed to provide liquidity.

Liquidity is the main advantage of listed structured products over

other structured products. Nonetheless, a listing does not
guarantee liquidity, as the trading can be thin due to the lack of
market demand. Even with a Designated Market-Maker, there is no
guarantee that the investor will be able to dispose off his
investment at a price which he considers reasonable7.

(b) Collective Investment Scheme (CIS)

A CIS is a pooled investment vehicle, where individual investors
invest in a common fund, and a professional investment manager
directs the investments and daily operation of the fund. A
structured fund is a CIS and must follow the regulatory
requirements for CIS, in particular, the Code on CIS (the “Code”)
issued by the MAS.

A CIS offered in Singapore to the public must be either authorised or

recognised by the MAS.

The legal form of a CIS is typically either a trust or a corporation. In

Singapore, most authorised CIS take the trust structure, known as
unit trusts. Investors, as unit-holders, are beneficiary owners of the
trust. A trustee is appointed to safeguard the beneficiary owners’
interests. In contrast, most recognised CIS in Singapore take the
structure of a corporation.

The assets of a CIS are held by a third-party custodian such as the

trustee. Thus, investors in structured funds need not be concerned
about the credit risk of the product-issuer, although they are still
subject to credit risk of the CIS’ investments. By contrast, investors
in structured deposits and structured notes are general creditors of
the financial institutions issuing the products, in case of bankruptcy.

(c) ILPs
An ILP is a life insurance policy, regulated under the Insurance Act
(Cap. 142). The regulatory framework for ILPs is, therefore, different

6
A market maker’s duty is to make sure that investors can readily buy and sell their investments.
When an investor want to sell (buy) his investments, but there is no one willing to buy (sell) from
him, the market-maker steps in and completes the trade. In doing so, the market-makers literally
"make a market.”

7
There is a market-maker pricing practice known as “stub quotes”, where market-makers submit
bid and offer prices at extremely high or low levels which are not expected to be taken. For
example, the stub quotes can be a bid of a penny to buy (from investors) or an offer of a
thousand dollars to sell (to investors). Since 6 December 2010, the US Securities & Exchange
Commission has banned the practice of stub quotes, and required market-makers to quote within
8% of the national best bid or offer. In Singapore, the maximum bid-offer spread is individually
agreed upon between the Designated Market-maker and SGX for each listed structured product.

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from that for CIS which is governed by the Securities and Futures
Act (Cap. 289), although both Acts are administered by the MAS.
Only life insurers licensed under the Insurance Act (Cap. 142) may
issue ILPs. Similarly, only fund managers licensed under the
Securities and Futures Act (Cap. 289) may manage authorised CIS.

All life insurance products, aside from Term Insurance, Personal

Accident and Health Insurance policies, contain a protection
element and an investment element. An ILP is the only type of life
insurance product that allows the policy owner to choose the
investment options for the investment portion of his policy, from a
list of funds.

The available funds may be linked to an external CIS, or may be

internal funds managed by the insurer. Each internal ILP fund must
be kept separate from any of the insurer’s other businesses. Such
in-house ILP funds are “insurance funds”. Insurance funds are not
trusts, but they have quasi trust status, because the Insurance Act
(Cap. 142) provides policy owners priority claim on insurance fund
assets over general creditors in case of bankruptcy.

The investment portion of a structured ILP is a CIS by nature,

although not by legal structure. To ensure consistent regulatory
treatment of ILPs and CIS, Notice No. MAS 307 issued under the
Insurance Act (Cap. 142) specifies that the investment guidelines
under the Code on CIS apply to ILP funds as well.

For further details on the rules and regulations, refer to the CMFAS
Module 5: Capital Markets & Financial Advisory Services study
guide published by the Singapore College of Insurance.

5. SUITABILITY

There is a great variety of structured products with full spectrum of risk-return

profiles. It should be apparent to readers by now that they are not categorically
more risky, or offer higher returns compared to traditional investments.
However, their structures are without doubt more complex. With the exception
of a few basic products, many structured products may be too complicated for
the average investors to fully grasp how the products perform relative to direct
investments in the underlying assets.

MAS Guidelines on Fair Dealing, issued in April 2009 have outlined five desired
outcomes of fair dealing with clients. Outcome 2 requires financial institutions
to offer products and services that are suitable for their target customer
segments. Apart from regulatory requirements, professional ethics also dictate
that financial advisers and representatives of financial institutions (collectively
known as “Advisers”) take into account suitability of products in their
recommendations. Given the complexity of structured products, the challenge
is how to determine suitability.

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Determination of suitability begins with knowing your client - his investment

objectives, risk appetite, time horizon, financial position, investment knowledge
and experience. The second step is for the Adviser to know the products under
consideration, so that the product features and risk factors can be explained to
the client in a way that he can understand. While it is not necessary (nor
possible sometimes) for the client to understand the technical details of a
structured product, he must know, at the very least, the payoffs under
different circumstances (including the worst case scenario) and the risk factors
affecting the payoffs, so that he has the right expectation of product
performance, when market condition changes.

5.1 Know Your Clients

(a) Investment Objectives

Investors have three basic investment objectives, namely safety of
principal, stability of investment income, and potential for capital
appreciation. In addition, the investor wants to be able to convert his
investments into cash at a reasonable price, when the need arises.
Although liquidity does not directly relate to investment return, it is
nonetheless an important consideration, and reasonable expectation.

These four objectives (safety, income, growth and liquidity) are not
mutually exclusive. For example, it is not uncommon for a client to
wish to protect his capital, and seek capital appreciation
opportunity in investments that can be easily converted to cash,
when needed. However, there are trade-offs among these
objectives. To pursue capital appreciation, the client must sacrifice
some degree of safety. To achieve the desired degree of liquidity,
certain potentially high-yielding, but illiquid asset classes are
precluded.

Most investment strategies are guided by one pre-eminent

objective, with other objectives being less significant in the overall
scheme.

Advisers should help clients to determine their investment

objectives based on their personal circumstances and risk
appetites8. The pool of structured products is wide enough to suit
most combinations of safety, income and growth objectives.
However, most structured products are not liquid, and the market
“fair” value is difficult to determine. They are suited for clients with
low liquidity requirements, intending to hold the products to
maturity.

(b) Investment Time Horizon

With a few exceptions, structured products have fixed maturity
dates. Cashing-in before maturity date may not be allowed and, if
allowed, often comes with substantial mark-to-market adjustments.

8
It is outside the scope of this module to discuss the steps involving financial planning and needs
analysis.

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Hence, it is important to choose a product that fits the investor’s

investment time horizon.

Some structured funds which are open-ended in nature, improves the

liquidity. Nonetheless, the unit redemption is often restricted under
severe market conditions.

(c) Investment Knowledge And Experience

Structured products are highly complex. The extent to which the
clients are able to understand the products depends on their
investment experience and level of financial literacy. It is difficult for
the clients, without prior experience with derivatives, for example, to
grasp the workings of structured products. In advising the clients
with little investment experience or financial knowledge, Advisers
should take extra steps in assessing the clients’ understanding of the
recommended products before implementing the recommendation.
Financial institutions should have internal policies and procedures in
place to guide their Advisers on the steps to take when dealing with
inexperienced clients.

5.2 Know Your Products

(a) Understanding The Products

Financial institutions are required to train their Advisers on the
features and risk-return profile of any investment products that they
recommend. Although the financial institutions have the duty to
provide the training, the responsibility of product knowledge resides
with the Advisers.

All financial products have trade-offs between risk and return.

Advisers should present products in a balanced way, highlighting the
benefits, as well as the risks. Each product has been designed to
meet a particular combination of investment objectives (safety,
income and growth). Advisers should understand the targeted client
segment of each product, and know how each product responds to
different market conditions.

(b) Explaining To Clients

The financial institution should provide every customer with all
relevant information, such as prospectus, pricing statement, Product
Highlights Sheet, fact-sheet and marketing materials, before the
customer makes a financial decision. It should be noted that the
quality of information provided is more important than the quantity.
More information is not necessarily better. On the contrary, the
customers might become inundated and confused by voluminous
amount of information given.

Clarity of information contributes greatly to the client’s understanding

of a financial product. The Fair Dealing Guidelines require disclosures
to customers to be in plain language, avoiding technical and

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misleading terms, and presented in a format that is simple to read

and easy to understand.

The client’s financial experience and literacy affect what is deemed

“clear”. For example, an investor who is not familiar with the
financial derivatives contracts may not understand the significance of
the expiry date.

It is not easy to explain a complex product in simple language. One

way to meet the Fair Dealing Outcome is to explain the product
features by presenting a range of possible outcomes for the
product. For example, two scenarios should be highlighted for yield
enhancement type of structured products as follows:
(a) the best case scenario, where the underlying outperforms, and
the return to the customer is capped at the cap-strike level; and
(b) the worst case scenario, where the underlying underperforms,
and the customer loses a portion or all of his principal sum.

This is especially important when customers are opting for such

products as an alternative to traditional fixed income investments.
The worst case scenario should sufficiently demonstrate to
customers that yield-enhancing structured products are
fundamentally different from traditional bonds and notes.

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Chapter

2 RISK CONSIDERATIONS
OF STRUCTURED PRODUCTS

CHAPTER OUTLINE
1. Market Risk
2. Issuer Or Swap Counterparty Credit Risk
3. Liquidity Risk
4. Foreign Exchange (FX) Risk
5. Structural Risk
6. Other Risks

KEY LEARNING POINTS

After reading this chapter, you should be able to:
 understand the key risk factors of a structured product
 identify and explain the various risks of structured products

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1. MARKET RISK

Market risk refers to the price volatility that comes from the fluctuation in
market prices of the underlying assets.

Market price of a security is the current price at which the security can be
bought or sold. In theory, market price is the present value of the issuer’s
future profits. Factors affecting the profitability – present and future – affect
the current market price. In practice, market price is determined by supply and
demand, to a large extent.

Many factors can cause price fluctuation. Two key factors are described
below.

(a) General Market Risk

Financial investments do not exist outside of the economy. They are
affected by the general economic conditions and market outlook. Given
the global connectivity that exists today, market prices are affected not
only by domestic conditions, but also global environment.

Factors such as interest rates, inflation, exchange rate, commodity prices,

and others can cause prices to fluctuate, as they directly affect
profitability. For example, consider the stock price of a company. When
interest rate goes up, the cost of borrowing goes up, and the profit
comes down. When local currency appreciates, the cost of imported
materials is cheaper after conversion, and the profit goes up if the goods
are sold locally at the same price. However, for an export-oriented
company the profit may come down, as the revenue is in foreign currency
which is now lower after converting back to local currency.

These factors are correlated, and their combined impact on prices is

sometimes difficult to anticipate.

(b) Issuer-specific Risk

While general market risks affect the prices of all securities, there are risk
factors that only affect the price of a particular issuer’s security. An
obvious example is a downgrade in credit rating of a company, which
creates downward pressure on the prices of its shares and bonds. This in
turn causes certain derivative contracts based on that company’s shares
or bonds to lose value.

Other examples of issuer-specific risks include operational risk, business

risk, litigation and regulatory action.

Issuer-specific risks can affect an entire industry sector. For example, a

large court award for liability lawsuits against one tobacco company may
affect tobacco manufacturers as a whole, leading to price fluctuation for
securities and derivatives based on tobacco companies.

For a particular structured product, it is important to identify the risk drivers

that influence its market price. As mentioned in the previous chapter, there

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are two components in any structured product. The main risk drivers for the
fixed income component are interest rate and credit standing of the issuer.

The risk drivers for the derivatives component are linked to the underlying
assets of the derivatives contracts, as the price movement of the derivatives
contracts follows the price movement of the underlying assets, be it an equity
index, or a specific commodity, or a basket of stocks or currencies. The price
of the derivatives is also influenced by the credit worthiness of the
counterparty. The price of the derivative contract goes down when the
counterparty’s ability to fulfil his contractual obligation is in doubt.

Foreign exchange rate is another risk driver, to the extent that foreign
currencies are involved in either component.

2. ISSUER OR SWAP COUNTERPARTY CREDIT RISK

Counterparty is a party with whom a transaction is done. Using a crude oil

forward contract as an example, A agrees to buy crude oil from B at an
agreed price on a future date. A and B are counterparties to each other. The
counterparty risk to A is that B will not deliver the amount and the grade of
crude oil as promised. The counterparty risk to B is that A will not pay the
amount as agreed.

The counterparty’s inability to meet contractual obligation is called “default”.

The word “default” encompasses a range of failure to meet obligations, such
as paying interest when due, making futures delivery, repayment of loan, etc.
It does not necessarily mean a full blown legal bankruptcy of the
counterparty. There are many possible causes of defaults, ranging from short-
term liquidity crunch due to temporary business or operational tribulation, to
more permanent changes in financial position leading to loss of funding
facilities. Regulatory action or prohibition may also prevent a counterparty
from meeting his commitments.

As investment return from structured products is mainly supported by

derivative contracts, failure of the counterparties to deliver their commitments
results in losses to investors in the structured products. There are two ways
to mitigate the counterparty risk.

One mitigation method is to use publicly traded derivative products. The

counterparty risk is minimised when the transaction takes place on an
exchange, because the exchange provides the guarantee that contractual
obligations are fulfilled through the concept of central clearing party. Note
that there is still a risk that the exchange itself may default, although the risk
may be low.

For non-publicly traded, i.e. over the counter (OTC) derivatives products, it is
increasingly common to require counterparty to put up collaterals to back the
promises. The International Swaps and Derivatives Association (ISDA), the
trade association representing participants in the OTC derivatives industry,
has developed a standardised legal document which regulates collaterals for

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Module 9A: Life Insurance And Investment-Linked Policies II

derivative transactions. It is available for consideration in negotiating

collaterals for OTC derivatives contracts.

Since the financial crisis started in 2007, the use of collateralisation has
gained popularity. Based on the latest ISDA survey results released in April
2010, 78% of all OTC derivatives transactions by large dealers in 2009 were
supported by collaterals. The figure is 97% for credit derivatives specifically.
The total amount of collateral in circulation was US$4 trillion in 2008 (the
most recent figure available at time of writing), nearly doubled from US$2.1
trillion in 2007, and tripled from US$1.3 trillion in 2006.

Payment netting is also commonly used to reduce counterparty risk for both
OTC and exchange-traded products. Payment netting minimises the need
for funds and securities to change hands, whereby maximises the likelihood
that, at the end of the day, every party receives what it should get.

3. LIQUIDITY RISK

Liquidity from an institution’s perspective refers to insufficient cash to meet

its cash flow requirements. This can be a temporary problem and does not
indicate a systemic issue. For example, market losses can result in margin
calls on futures contracts, causing the institution a temporary cash crunch. A
financially strong institution is able to borrow money or sell assets to meet a
temporary surge in demand for cash payment or collateral.

Liquidity shortfall can also be the result of a fundamental change in the

institution’s financial position. For example, a negative change in its credit
rating leads to its inability to borrow money, or results in an increase in
collaterals required by lenders. If poorly managed, liquidity risk can lead to
bankruptcy.

When an institution is exposed to liquidity risk, its financial position and

resulting credit standing are inevitably affected, leading to a possible
downgrade in its securities and loss of values to their investors.

Liquidity from investor’s perspective refers to the ease of converting his

investments into cash. Publicly traded products tend to have greater liquidity
over products traded OTC, because there is a ready market. However, just
because a product is listed on an exchange, it does not guarantee liquidity, as
the investor may be unable to sell his investments for a reasonable price due
to lack of demand. There are examples of illiquid shares listed on the
exchange, where the trading volume is very thin each day.

Products invested in illiquid assets often have lock-up periods, during which
the investors cannot liquidate or cash-out their investment holdings. For
example, some hedge funds have lock-up periods of one to three years. Some
investment funds do not have lock-up periods per se, but the asset valuation
is only done monthly or quarterly. In effect, investors cannot exit these funds
in between valuation dates.

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 2. Risk Considerations Of Structured Products

Some products depend on market-makers to provide liquidity. A market

maker’s duty is to make sure that investors can readily buy and sell their
investments. When an investor wants to sell his investments, but there is no
one in the market willing to buy from him, the market-maker is obligated to
step in and be the counterparty. In doing so, the market-maker literally
"makes a market".

4. FOREIGN EXCHANGE (FX) RISK

Investors in structured products are exposed to FX risk in two ways.

First, if his investments are denominated in a foreign currency, he may suffer

a loss on principal when he converts the maturity payment (made in foreign
currency) back into local currency.

For example, US$1 was worth S$1.5336 in 2006, but is only worth
S$1.2875 in 20101. A US$1,000 investment made in 2006 cost S$1,533.6.
When it matured in 2010, the principal repayment of US$1,000 was only
worth S$1,287.5 when converted back to S$. Even though the product had
delivered protection of principal in US$, the investor nonetheless suffered a
loss of part of his principal in S$ terms, due to the FX risk. The total return on
the investment will need to be at least 19.12% for this particular investment
to compensate the FX loss.

The second source of FX risk relates to investment performance. If the

underlying assets are denominated in foreign currency, the investment return
is dependent on the FX rate as applied to the performance measurement.
Consider an investment denominated in Singapore dollars, but invested in
USD-denominated assets. The performance of this investment differs
depending on whether it is measured in S$ or US$.

Table 2.1: Effect Of FX On Investment Performance

S$ FX: US$1 =S$ US$

At Issue 1,000 1.50 666.67
Investment Income 56 1.40 40.00
Rate of Return in Each Currency 5.6% 6.0%

In evaluating the return potential of a financial product, be mindful of how

the returns are measured for foreign current denominated assets.

1
Monthly Statistical Bulletin, Monetary Authority of Singapore, April 2011.

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5. STRUCTURAL RISK

5.1 Safety Of Principal

Given the trade-offs in risk and return, products are structured to

provide different degrees of principal protection versus capital
appreciation. Each product is structured to provide full, partial or no
return of principal upon maturity. Investors should understand the
design of the product to evaluate their tolerance for possible loss of
principal.

However, there is no guarantee that the intended protection will

materialise. As discussed above, the credit risk of the protection-
provider affects the reliability of the protection given. Another reminder
is that structured deposits are considered investment products and NOT
subject to the protection of Deposit Insurance Scheme in Singapore.

5.2 Leverage

“Leverage” (also called “gearing”) refers to techniques used to increase

the potential rate of return. Such techniques include trading on margin,
use of derivatives to trade on price differentials, and borrowing money
to trade. Keep in mind that it works both ways. While “leverage”
multiplies gains, it also magnifies losses.

Most derivative contracts are leveraged, or geared, by design. (See

illustration below.) Consequently, a structured product is leveraged if it
uses leveraged derivatives. The price volatility of leveraged products can
be significantly greater than direct investments. Some leveraged
transactions may result in losses in excess of the amount invested, as is
the case in futures contracts.

Futures contracts are traded on margin, i.e. investors need to put up

only a fraction of the value of the contract to enjoy the full price
appreciation, or sustain the full decline in price. Trading on margin is
akin to securities financing, where the investor is essentially borrowing
from the broker. Interest is charged on margin accounts, which affects
the total investment returns. (See Chapter 3 Section 2.6 for further
explanation of how margin accounts work.)

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 2. Risk Considerations Of Structured Products

Illustration Of The Effect Of Leverage

Consider an option to buy ABC Company’s shares. The intrinsic value

of the option is the difference between the spot price and the exercise
price.

If the shares are currently trading at S$15, an option to buy it at S$10

has an intrinsic value of S$5. Let’s examine what happens in the three
scenarios as illustrated in the Table below.

Table 2.2: Effect Of Leveraging

%
Exercise Spot Intrinsic Change
Scenario Price Price Value From
(S$) (S$) (S$) Base
Case

Base Case: At Issue 10 15 5 --

Scenario 1: Stock
10 18 8 +60
Price rises 20%.
Scenario 2: Stock
10 12 2 -60
Price falls 20%.
Scenario 3: Stock
Price falls below 10 9 0 -100
Exercise Price.

A 20% fluctuation in the underlying share price results in 60% change

in the intrinsic value of the option. This is the leveraging (or gearing)
effect of a derivative product.

When the share price falls below the exercise price (out-of-the-money),
the option has no value, even though the shares still have value. This
is why derivatives are riskier than direct investments.

NOTE: The actual price of the option is the intrinsic value plus time
value. Time value is ignored for illustrative purposes here.

5.3 Investment In Derivatives

Besides leverage, there are other features in derivatives contracts that

investors should consider. For example, the kick-in and knock-out
features as discussed in Chapter 1 expose the investors to potentially
unlimited downside risks.

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5.4 Investment Concentration

To put it simply, this is the risk of putting all eggs in one basket. The
solution to concentration risk is diversification.

Unfortunately, diversification is not easy for an individual investor on his

own. It takes substantial resources to research and screen the universe
of stocks to diversify one’s equity portfolio, for example. For this
reason, the typical advice is for individual investors to invest in
diversified unit trusts.

Diversification is not just within an asset class, but across asset classes
via asset allocation, namely a mix of cash, equities, fixed income, and
risk-tolerance permitting, alternative investments such as derivatives,
commodities and structured products.

Too much of a good thing may not be good in the long run. If all risks
are diversified away, leaving no risk in the portfolio, the potential return
is probably also completely depleted. The art of investment is not in
taking no risk (which gives no return or achieves the risk free rate at
best), but to manage the risk to within an acceptable level.

5.5 Collateral

Requiring collateral is a common method in managing counterparty

risk. Note that having collaterals does not fully eliminate the risk.
While collaterals reduce counterparty risk, they introduce another risk
factor – the collateral risk.

Collateral risk refers to the risk that the value of collateral may not be
sufficient when collateral is exercised to cover the loss. This could
happen for two reasons. Firstly, the exposure may not have been fully
collateralised in the first place. Secondly, the value of collateral could
have deteriorated since it was pledged. Either way, having collaterals
does not fully eliminate the risk exposure.

The way to manage collateral risk is to set adequate level of collateral

required, and to require additional collateral when its value has
depreciated. Since most structured products are OTC non-standard
contracts, the level of collateral is subject to private negotiations.

6. OTHER RISKS

6.1 Legal And Regulatory

Legal risk refers to the potential loss arising from the uncertainty of legal
proceedings, such as bankruptcy, and potential legal proceedings. One
close to home example is the Lehman Brothers Minibonds, where
investors were exposed to uncertainties resulting from Lehman’s
bankruptcy.

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 2. Risk Considerations Of Structured Products

Another source of legal risk is the regulatory risk, i.e., that legislation or
regulations may change during the life of the financial contract. The
regulatory regime for selling structured products is an example.

6.2 Correlation

Correlation is a statistical measurement of how the prices of two

securities move in relation to each other. Correlation is represented by a
correlation coefficient, which ranges from –1 to +1. A coefficient of
+1 indicates that the two securities are perfectly correlated. That is,
when the price of one security moves up or down, the price of the other
security moves in the same direction, by the same percentage.

A coefficient of –1 indicates that the two securities are perfectly

negatively correlated. When the price of one security moves up or
down, the price of the other security moves in the opposite direction, by
the same percentage.

If the correlation is 0, the movements of the securities have no

correlation; they are completely random.

In real life, perfectly correlated securities are rare. Even within the same
industry, prices of individual securities are correlated in some degree, as
they are subject to similar business risk factors, but they do not move
up and down in perfect harmony.

Negatively correlated securities may enhance portfolio diversification, as

the price movements go to the opposite directions, offsetting the
downside risk with the upside price movements.

6.3 Modelling

Advent of technology has led to the emergence of automated trading,

also known as algorithmic trading, or algo trading. It is the use of pre-
programmed algorithm to decide on the timing, price, or quantity of the
trade orders. In many cases, the computer initiates the order without
human intervention.

The same technology has enabled fund managers to implement their

quantitative strategies through computer-aided analysis in identifying
profit opportunities arising from subtle anomalies, affecting the prices of
various securities. These fund managers use computer models (either
built in-house or bought from third parties) to optimise their investment
portfolios, based on system-identified profit opportunities, risk factors,
and associated transaction costs.

While the computer modelling approach to quantitative strategy greatly

improves the speed and efficiency of portfolio management, it is not
without perils. The automated programmed trading was one of the

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factors causing the Flash Crash2 in the US on 6 May 2010. There is also
the risk that the models may not be robust enough to cater to evolving
market conditions. Technology does not fully displace the need for fund
managers to conduct research, analyse market trends and exercise
judgement calls on their own. Fund managers who use modelling need
to have the skills to construct the “right” models.

6.4 Early Redemption

Most structured products have fixed maturity dates. However,

redemption before maturity is possible under certain circumstances.

Early redemption may be initiated by investors who wish to cash out

early to meet unplanned financial needs. Investor-initiated early
redemption may not be allowed according to the contract terms. Or, if
allowed, it is subject to the market value adjustment. Depending on the
market conditions, investors may suffer substantial losses upon early
redemption.

Early redemption may also be triggered by the issuer or due to the

design of the underlying assets. For example, some structured products
are invested in securities that contain early termination features, such as
callable bonds, or kick-in, knock-out options. Such products may be
redeemed when the bonds are called, or when the kick-in / knock-out
levels are breached. Or, some structured products contain covenants
that allow for early termination should the size of the structured
products becomes too small. Upon early termination of the underlying
assets, the structured product may suffer losses.

6.5 Examples Of Redemption Amount

Redemption amounts may be adversely affected when certain key

risks are triggered, as illustrated by Table 2.3. Do keep in mind that
the table is not an exhaustive list of risks, and that there may be
transaction or unwinding costs associated with early or mandatory
redemption, which may further exacerbate the adversely impact the
redemption amount. In the examples in Table 2.3, the underlying
funds are structured notes.

2
On 6 May 2010, the Dow Jones Industrial Averaged plunged 900 points within a few minutes. US
regulators SEC and CFTC issued a joint investigative report on the incidence in September 2010.
The joint report detailed how a large mutual fund firm selling an unusually large number of E-
Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders
started aggressively selling, accelerating the effect of the mutual fund's selling, and contributing to
the sharp price declines that day.

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 2. Risk Considerations Of Structured Products

Table 2.3: Examples Of Key Risk That Affect Redemption Amount

Key Risk What This Means What Redemption

Happens Amount
Credit risk of The issuer’s inability to This The investor
the issuer meet a payment due triggers an may lose all
will constitute an event early (or or a
of default. mandatory) substantial
redemption part of his
of the original
notes. investment
amount.
Derivative Derivative counterparty This The investor
counterparty becomes unable to triggers an may lose all
defaulting make payments due early (or or a
under the derivative mandatory) substantial
transaction (which may redemption part of his
be a swap or an of the original
option), e.g. if it is notes. investment
insolvent or becomes amount.
bankrupt.
If the derivative
counterparty defaults,
the issuer will not
receive any payments
under the derivative
transaction and may
not be able to meet its
payment obligations
under the notes.
Certain The assets constituting This The investor
events the collateral may triggers an may lose all
adversely suffer a loss in market early (or or a
affecting the value, thereby leading mandatory) substantial
value or to a loss in the market redemption part of his
performance value of the collateral of the original
of the as a whole. notes. investment
collateral amount.
The issuer of the
collateral (e.g. bonds)
becomes insolvent or
defaults on any of its
payment obligations.

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Chapter
3 UNDERSTANDING DERIVATIVES

CHAPTER OUTLINE
1. What Are Derivatives?
2. Futures And Forwards
3. Options And Warrants
4. Swaps
5. Contract For Differences (CFD)

KEY LEARNING POINTS

After reading this chapter, you should be able to:
 know what derivatives are
 understand and explain the following derivatives:
- futures and forwards
- options and warrants
- swaps
- Contract For Differences (CFD)

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1. WHAT ARE DERIVATIVES?

A derivative contract is a delayed delivery agreement in which its value is

dependent upon or derived from other underlying assets. The holder of a
derivative contract does not own the underlying assets. Using home purchase
as an analogy, an option to buy a flat is a derivative contract. You pay a
fraction of the price of the flat for the right to buy that flat. However, you do
not own the flat until years later when you pay the balance of the purchase
price.

The underlying assets (simply called “underlying” sometimes) of a derivative

contract can be anything:
 weather (such as the number of days in a month that temperature is above
or below a certain level);
 farm and agricultural outputs (such as soy bean, corn, pork belly);
 metals (such as gold, aluminium, palladium);
 energy (such as oil and gas); and
 financials - both physical (such as equity, bond, currency) and intangible
(such as equity index, bond index, interest rates).

Derivatives are useful hedging tools for commodities producers and consumers.
For example, oil producers and airlines (aircraft consumes jet fuel) may use
futures and forward contracts to ensure stability of their revenue and expenses,
respectively.

For speculators, derivative contracts are often used as directional bets of the
price movement of the underlying. For example, if an investor anticipates the
price of a particular stock to go up within a certain time frame, instead of direct
investment in that stock, he can purchase an option on that stock. Since the
price of the option is just a fraction of the cost of the stock, the potential gain
from the option is multiple times than that from the direct investment, if his
“bet” is proven right.

Derivatives can be used as risk management tools. For example, a corporation

that is planning to issue bonds can use interest rate futures to control its
exposure to the interest rate risk, before the bonds are issued.

Similarly, a pension fund with a diversified holding in the stock market faces
considerable risk from general fluctuation of the stock prices. The fund
manager can use options on a stock index to reduce or virtually eliminate the
risk exposure.

Derivative contracts are integral parts of structured products. An understanding

of derivatives – different types, how they work and the associated risks – will
be an important foundation to understanding structured products.

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1.1 Practical Example Of Derivative

Stocks and bonds are financial assets. When you invest in a financial
asset, such as a stock in XYZ Company that is currently priced at S$10,
you receive a certificate stating that you have a legal claim on the
earnings (in the form of dividends) and assets (upon liquidation) of XYZ,
the issuer. If the company does well, and its share price rises to S$15,
you can sell your share in the open market for a capital gain of S$5.

In contrast, a financial derivative asset (or just derivative) is a financial

asset in that you receive a contract stating a legal claim, except that the
value of the derivative is based on the performance of an underlying
financial asset that you do not own yet.

Example

Imagine that you dream to own a share of Warren Buffet’s Berkshire

Hathaway Inc priced at US$108,850. If you are fortunate enough to
have this large amount of money, you can pay up right away and own a
share. Suppose you do not have this amount of money, and your
roommate is willing to sell you the right to buy the share at US$75,000.
For this right, your roommate charges you a fee of US$37,500, and this
right lasts three months. In effect, your roommate has sold you a
derivative contract in the form of an option.

If you buy the option, the value of your investment now depends on the
underlying asset – the share price of Berkshire Hathaway, even though
you do not own any Berkshire Hathaway shares. If the price of Berkshire
Hathaway goes up, so does the value your option. The reverse is true as
well. If the price of Berkshire Hathaway goes down, your option falls in
value as well.

At the end of three months, if the Berkshire share price falls below
US$75,000, you are unlikely to exercise your right to buy it from your
roommate, because you can buy it cheaper in the market. In this case,
your loss is the US$37,500 which you have paid for the option, a
100% loss.

However, suppose that the Berkshire share price has risen to

US$120,000 at the end of three months, you will be wise to exercise
your option. Your roommate will be obligated to sell the share to you at
US$75,000, regardless of the prevailing market price. If he des not own
a Berkshire share, he must buy it from the open market and then sell it
to you at the agreed price. The total price that you pay to own the
Berkshire share is US$112,500 (US$37,500 option fee plus US$75,000
exercise price) for the share that is worth US$120,000.

If you exercise the option and then sell the share, you make a profit of
US$7,500 (before transaction cost) on the US$37,500 investment that
you made, a 20% return. In contrast, your profit would have been
US$11,150 had you invested US$108,850 directly in the Berkshire

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 3. Understanding Derivatives

share, a 10.24% return. The reason for the higher rate of return by
taking up the option from your roommate is due to the leverage effect
typically inherent in derivative instruments.

This simple arrangement between you and your roommate is just one of
the many ways that derivatives can be constructed. There are two
particularly important types of derivatives, options and futures. Many
other types exist, but they can usually be created from these two basic
building blocks, possibly by combining them with all sorts of other
investment assets including stocks and bonds, stock indices, gold and
commodities such as wheat and corn.

In this chapter, we will discuss four types of derivatives contracts,

namely:
 Futures and Forwards;
 Options and Warrants;
 Swaps; and
 Contract for Differences.

2. FUTURES AND FORWARDS

Futures and forwards are contracts giving the obligation to buy (a “call”
contract) or sell (a “put“ contract) the underlying assets:
 in specified quantity;
 at a specified price (the “delivery price” or “future price”); and
 on a specified future date (the “delivery date” or “settlement date”).

The contract specifies one or both of two ways to fulfil the contractual
obligations. If both delivery options are provided in the contract, the buyer
gives the final instructions on the desired delivery option immediately before
the delivery date:
(a) Physical delivery – The underlying assets are delivered by the seller to the
specified delivery ___location as specified in the contract.
(b) Cash settlement – Cash is exchanged to settle the profits and losses
related to the contract. This is the only settlement method available when
the underlying is intangible, such as interest rate or stock index, where
physical delivery is not possible.

Only 2% to 5% of the contracts are settled through physical delivery. Most

contracts are settled either in cash, or by entering into offsetting contracts.

Futures and forwards operate in the same way, but have main differences as
shown in Table 3.1.

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Table 3.1: Main Differences Between Futures And Forwards

Futures Forwards
 Standardised contracts traded  Non-standardised contracts traded
on exchanges. over the counter (OTC) between two
parties.
 Subject to margin requirements  Not subject to margin requirements.
(See section below).
 There are partial settlements of  Settlement of gains / losses only
emerging gains / losses through occurs on delivery date.
daily mark-to-market1 process.
However, since forward contracts are
non-standard, features such as mark-to-
market and daily margining may be
negotiated into specific contracts.

2.1 Pricing Of Forward Contracts

In principle, the forward price for a contract is determined by taking the

spot or cash price at the time of the transaction and adding to it a “cost
of carry”.

Depending on the underlying asset, the cost of carry takes into account
payments and receipts for matters such as storage, insurance, transport
costs, interest payments, dividend receipts, etc.

forward price = spot or cash price + cost of carry

The difference between the spot and the forward price is often referred to
as the premium or discount. That is, the cost of carry is referred to as a
premium when it is positive; is referred to as a discount when it is
negative.

Example

Suppose John owns a house that is valued at S$100,000, and that

Mary enters into a forward contract to buy the house one year from
today. However, since John knows that he can get the S$100,000 only
in a years’ time, he wants to be compensated for the delayed sale.
Suppose that the risk free rate of return R (the bank rate) for one year is
2%. So, if John sells the house now for S$100,000 and puts the
money in the bank, he will get S$102,000. So John will want at least
S$102,000 one year from now for the contract to be worthwhile for
him. However, Mary knows that the house will fetch S$6,000 a year if
it is rented out, and that John has currently rented the property out. So

1
Mark–to–market is the daily process of revaluing outstanding positions to the daily settlement price at
the end of each trading day. The resulting amount of profit and loss will be added to or subtracted
from the margin account.

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Mary wants to be compensated for the rental income, and she is willing
to pay S$102,000 - S$6,000 = S$96,000. This will be the forward
price for the house today.

2.2 Practical Examples Of Forward Contracts

We look at two practical examples of forward transactions in the energy

and commodity markets.

(a) Energy
In the energy markets, forward markets have developed around
benchmark crude oils, such as North Sea Brent Blend (15-day Brent)
and West Texas Intermediate (WTI). In many of these forward
contracts, cash settlement is preferred rather than physical delivery.

The Brent 15-day market is the largest and most important crude oil
forward market in the world. The Brent forward contract gives 15
days notice to the buyer to take delivery of a cargo at Sullom Voe
during a notional three-day loading period. The terms are either
accepted or passed to another buyer who can repeat the process
forming a “chain”. This whole process is known as a book-out.

The majority of trades use a book-out process which means that the
contracts are cleared by the buyers and sellers in a series of trades to
cancel mutual contracts by cash settlement.

(b) Commodities
Forward contracts for commodities, such as wheat, corn and
soybeans are similar in principle with energy and metals, although the
details may differ. Commodity terms usually include terms CIF and
FOB. These terms indicate the types of delivery for different
contracts.

The term CIF means Cost-Insurance-Freight. A CIF contract means

that the total cost of the contract including delivery is known. FOB
means Free-On-Board, where the buyer has to arrange and pay for
transportation costs which must, therefore, be added to the quote
price.

2.3 Summary Of Forward Contracts

The major advantage of a forward contract is that it fixes prices for a

future date. The major disadvantage of a forward contract is that if spot
prices move one way or the other at the settlement date, then there is no
way out of the agreement for the counterparties. Both sides are subject
to the potential of gains or losses which are binding.

2.4 History Of Futures Contracts

Futures contracts address one of the key disadvantages of forward

contracts. With a futures contract, it is possible for market players to

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both fix the forward price of an asset and combine it with the opportunity
to take advantage of any future price volatility.

The disadvantages posed by early forward contracts led to the

introduction of futures contracts in the mid-1860s. In 1865, the Chicago
Board of Trade (CBOT) laid the foundation to all modern futures contracts
by introducing grain agreements which standardised the following:
 The quality of the grain;
 The quantity of grain for the contract; and
 The date and the ___location for the delivery of the grain.

In effect the only condition left for the contract was the price. This was
open to negotiation by both sides, but was carried out on the floor of the
exchange using open outcry. This meant that the prices agreed were
available and transparent to all traders.

Originally, futures were traded only on commodities, in a market

dominated by the Chicago Mercantile Exchange (CME). However, after
their introduction in the 1970s, contracts on financial instruments
became hugely successful and quickly overtook commodities futures in
terms of trading volume and global accessibility to the markets. This led
to the introduction of many new futures exchanges across the world,
such as LIFFE, EUREX and TIFFE.

There are two basic types of assets for which futures contracts exist.
These are:
 Commodity futures contracts; and
 Financial futures contracts.

Table 3.2: Examples Of Commodity And Financial Futures

Commodity Futures Financial Futures

Metals – base, precious Interest rates
Grains and oilseeds – grain, livestock,
Bond prices
oilseeds, fibres
Softs – coffee, cocoa, sugar Currency exchange rates
Energy – crude oil, gas, oil products Equity stock indices

2.5 Pricing Of Futures Contracts

For most commodities, the futures price is usually higher than the current
spot price. This is because there are costs associated with storage,
freight and insurance, which will have to be covered for the futures
delivery. When the futures price is higher than the spot price, the
situation is known as contango.

If a chart is drawn of spot and futures prices, then, as the futures expiry
date approaches, the plots will converge. This is because the costs

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 3. Understanding Derivatives

diminish over time and become zero at the delivery date. Figure 3.1
shows a contango chart for a three-month futures contract.

Figure 3.1: The Convergence Of Futures And Spot Price

Futures
Futures
Price
price

Spot
Spot
price
Price

One-
One Two-
Two Three-
Three
month months months
Month Month Month
s s

When the futures price is lower than the spot price, the market is said to
be in backwardation. Backwardation occurs in times of temporary
shortage caused by strikes and under-capacity.

Another frequently used terminology in trading futures contracts is basis.

Basis is the difference between the spot price and the future price.

Example

Suppose the June futures price for corn is S$2.60 per bushel, and the
cash price in Farmerville USA is S$2.20. The basis is -S$0.40 (i.e.
S$2.20 - S$2.60). In market lingo, the basis is “40 cents under June”.
If the basis has been a positive 40 cents, then it is said to be “40 cents
over June”.

2.6 Margin (Futures Contracts)

Futures are traded on margin. The initial cash outlay (called “initial
margin”) is a fraction of the full value of the contract. The level of initial
margin is set by the exchange on which the contracts are traded, based
on the anticipated price volatility. The broker may add additional margin
requirement for specific clients, products or markets based on risk
analysis. The ability to trade at a fraction of the value of the contract
creates the leverage effect of futures trading.

A futures contract is marked to market on a daily basis. The broker issues

a “margin call” when the initial margin is eroded by losses. The additional
amount required to restore the account to the initial margin is called
“variation margin”.

To reduce the frequency of margin calls, brokers make margin calls only
when the account is below a “maintenance margin” level. Nonetheless,
the variation margin is always the amount required to restore the margin
account to the initial margin level.

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If the margin calls are not met, the broker has the right to liquidate
positions to raise the necessary amount.

Example: Gold Futures

Initial margin: S$2,500

Maintenance margin: S$2,000

An investor buying a gold contract will need to deposit S$2,500 as

initial margin with the broker.

If the value of the contract drops by S$1,000, the loss is offset against
the margin account, bringing it down to S$1,500 which is below the
maintenance margin.

The broker will issue a margin call, requesting a S$1,000 top-up to

restore the account balance to the initial margin level of S$2,500.

If the value of the contract drops by another S$300, the margin account
is reduced to S$2,200. Since this is above the maintenance margin
level, no margin call is made, even though it is below the initial margin.

2.7 Market Participants

There are two main types of market participants – hedgers and

speculators. We look briefly at what they do and why. The table below
summarises our discussion.

Table 3.3: Main Market Participants

Who Reason For Buying Reason For Selling

Hedgers To lock in a price and To lock in a price and
obtain protection from obtain protection from
rising prices. falling prices.
To profit from falling
Speculators To profit from rising prices.
prices.

(a) Hedgers
Hedgers are typically producers and consumers of the commodity.
Examples are: rubber plantations and tire companies that use rubber
to make tires; jet fuel refineries and airlines that use jet fuel; sugar
cane growers and cane sugar manufacturers.

The hedger buys or sells in the futures market today, to establish a

known price for something that they intend to buy or sell later in the
cash market. Buyers are thus able to protect themselves against
higher prices, and sellers are able to hedge against lower prices.
Whatever the hedging strategy, hedgers are willing to give up the
opportunity to benefit from favourable price changes, in order to
achieve protection against unfavourable price changes.

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Consider this example. A tyre manufacturer will need to buy

additional rubber from its supplier in six months, to produce tyres
that it is already offering in its catalogues at a known price today. An
increase in the cost of rubber can reduce or wipe out any profit
margin. To minimise this risk, the manufacturer buys futures
contracts for the delivery of rubber in six months at S$500 a tonne.

If, six months later, the cash market price of rubber has risen to
S$550. The manufacturer now has two choices. It may choose to
settle its rubber contract for a S$50 a tonne profit, and use that to
offset the S$550 that it has to pay to its supplier to acquire rubber.
Alternatively, it may choose to take physical delivery of rubber at
S$500 a tonne. In reality, most commodities futures are settled in
cash, although physical delivery is almost always an option under the
contract.

The hedge, in affect, provided protection against an increase in the

cost of rubber. It locked in a cost of S$500, regardless of what
happens in the cash market price. Had the price of rubber declined,
the hedger would have incurred a loss on the futures position, but
this would have been offset by the lower cost of acquiring rubber in
the cash market.

The number and variety of hedging possibilities is practically limitless.

A corporate treasurer who will need to borrow money at some future
date can hedge against the possibility of rising interest rates. An
investor can use stock index futures to hedge against an overall
increase in stock prices, if he anticipates buying stocks at some
future time. A coffee grower can hedge against lower coffee prices,
and a coffee retail store (like Starbucks or Coffee Bean) can hedge
against higher coffee prices.

(b) Speculators
Speculators are investors who buy to profit from a price increase or
sell to profit from a price decrease. Speculators put their money at
risk in the hope of profiting from an anticipated price change.

Speculators serve an important role of providing market liquidity.

Hedgers’ interest is to maintain price stability, while speculators seek
to benefit from price volatility and trade constantly to aim to buy-low
and sell-high. Without speculators, the market liquidity tends to be
low. A vibrant trading market requires the participation from both
hedgers and speculators.

2.8 Futures Trading Strategies

Futures contracts can be used for hedging or for speculation. In this

section, focus is on financial futures.

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(a) Speculating With Futures

In March, you expect the Taiwan stock market to rise strongly over
the next three months. You buy an MSCI Taiwan June futures
contract at 220 index points. Now suppose that your belief turns out
to be correct and, at contract maturity, the index has risen to 242.
Based on a multiplier of US$100 per index point, your payoff is
US$2,200:

Initial cash outlay = 220 x US$100 per point

= US$22,000
MSCI Taiwan Stock Index close = 242
MSCI Taiwan futures price = 220
Index points difference = 22 points
Payoff = 22 x US$100 per point
= US$2,200

Now if you got things wrong and the market went down instead to
200, your loss would be US$2,0002:

MSCI Taiwan Stock Index close = 200

MSCI Taiwan futures price = 220
Index points difference = -20 points
Payoff = -20 x US$100 per point
= -US$2,000

Speculating in futures can bring huge rewards, as well as losses.

While your upside is unlimited, neither is your downside. If the stock
index in our above example has dipped to 150, 100 or even 50, the
losses can be huge.

(b) Short Hedging With Futures

A short hedge means to go into a short position to protect an existing
portfolio of stocks. Consider a fund manager who manages and owns
a small diversified portfolio of Singapore stocks that closely tracks
the Straits Times Index (STI). He expects a near-term market decline,
but does not wish to liquidate his position. He can hedge his portfolio
by selling STI futures. In case the market falls, any losses on his
portfolio holdings will be partially offset by the gains from the short
futures position. If the market rises, he loses from the futures
position, but gains from the rise in the portfolio’s value. The gains
and losses hopefully will cancel out, and the fund manager‘s position
will not be adversely affected.

A fundamental problem exists in that there is no futures contract that

exactly matches his or any particular stock portfolio. By using a
futures contract to protect his portfolio, he is cross-hedging - the
underlying stock index is related, but not identical to his stock
position.

2
Recall that with stock index options, your loss is limited to the call premium and no more, but not
with futures. A long position in futures has very high downside risk, while a long call’s downside is
limited to the call premium paid.

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One other consideration is that the volatility of the portfolio may not
perfectly match that of the market index. This is a fundamental
problem because no market index can exactly match any stock
portfolio. For example, the market may fall 10%, but his portfolio
may fall by 15% or something else. The sensitivity of a portfolio’s
price movement to the market’s price movement can be summed up
in a number called the portfolio beta. For example, a portfolio beta of
1.2 means that that every 1% rise in the STI brought about a 1.2%
increase in his portfolio holdings. The reverse is also true if the STI
goes down.

Example

Suppose the fund manager’s Singapore portfolio is currently worth

S$1,000,000, and it has a portfolio beta of 1.2 to the STI. It is now
January and he is concerned about a market decline over the next
two months. The STI is currently at 1,850 and the March STI futures
contract is priced at 1,800. With a multiplier of S$10 per point, the
price coverage per contract (this represents the value of portfolio that
may be covered / compensated under each contract of the future
contract) of one March contract is:

Price coverage per contract = 1,800 x S$10

= S$18,000

To protect the portfolio against a market decline, the manager

calculates the hedge ratio, which is the number of futures contracts
to sell:

value of portfolio
Hedge ratio= x portfolio beta
price coverage per contract
S$1,000,000
= x 1.2
S$18,000
= 66.7 or 67 contracts

Contracts are not divisible, so our fund manager rounds up and sells
67 STI futures contracts.

By hedging, the fund manager has greatly reduced, or may even have
eliminated the possibility of a loss from a decline in the price of his
Singapore portfolio. However, he has also eliminated the possibility of
a gain from a price increase. This is an important point. If the STI
rises, he will have a loss on his short futures position, offsetting the
gain on his Singapore portfolio. Or if the STI falls, he will have a gain
on his short futures position, offsetting the loss on his Singapore
portfolio.

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(c) Long Hedging With Stock Index Futures

Imagine another fund manager who is starting up a new Singapore
fund. The fund does not own any stocks yet, but he will need to
acquire them in the future. He is bullish about the market and
expects the stocks to increase in value very soon. The problem is
that he does not have the cash to buy into the market right away.
With stock index futures, he can buy futures contracts at a much
lower cash outlay (due to leverage, which we discussed in Chapter
2), and lock in today’s prices to take advantage of the rise in prices if
it does occur.

3. OPTIONS AND WARRANTS3

Options and warrants are similar. Both give the right to buy (“call” contract) or
sell (“put” contract) the underlying security:
 in specified quantity;
 at a specified price (called the “exercise price”, or “strike price”); and
 on or before a specified date (called the “expiry date”).

Options and warrants grant the right, but not the obligation, to buy or sell the
underlying. The holder of the warrant or option may choose whether or not he
exercises the contractual rights. Indeed, many investors choose not to exercise
the rights when contracts are out-of-the-money, and simply let the contracts
expire. On the other hand, the holder of a futures / forward contract must fulfil
the contract terms on the settlement date.

A European style option / warrant is a contract that may only be exercised on

expiration. An American style option / warrant is a contract that may be
exercised on any trading day on or before the expiry date.

Both warrants and options may be traded on an exchange or a traded OTC.

Options are typically settled through physical delivery, except when the
underlying asset is intangible, such as an index. Exchange-traded warrants are
settled in cash.

Options and warrants have no value after the expiry date, because the right to
buy / sell no longer exists.

An option or warrant is said to be in-the-money, at-the-money, or out-of-the-

money, depending on the spot price of the underlying asset relative to the
strike price. A call option / warrant is in-the-money, when the strike price is

3
There are two types of warrants: structured warrants and company warrants. Only structured
warrants are used in structured products and, therefore, the discussion here confines to structured
warrants. For reader’s background information, company warrants are issued by a company in
conjunction with bond, rights issue, or loan stocks. Warrants issued in this way act as a sweetener
to make the bond, rights issue or loan stocks more attractive. Structured warrants (sometimes called
covered warrants) are issued by a third-party, usually an investment bank, unrelated to the issuer of
the underlying securities.

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 3. Understanding Derivatives

below the market price of the underlying. That is, the call option / warrant still
has intrinsic value as illustrated in the following:

Call Put
Intrinsic Value
(Right to Buy) (Right to Sell)
“in-the- Strike price is less Strike price is more
Positive value
money” than market price. than market price.
“at-the Strike price is equal Strike price is equal
No value
money” to market price. to market price.
“out-of-the Strike price is more Strike price is less
than market price. No value
money” than market price.

3.1 Risk Profile Of Option / Warrant

The shape of the risk-return profile of structured products comes from the
hockey-stick shape of the risk profiles of options and warrants.

A holder of a call option or warrant has a bullish view of the market. If

the market turns bearish instead, the value of the call option / warrant
starts to decline. When the option / warrant is at-the-money or out-of-the-
money (i.e. at or below the strike price for the call), the option / warrant
has no value, and the investor loses the entire premium paid to the
option.

Figure 3.2: Risk Profile Of A Call Option / Warrant

Profit

Strike Price

Maximum
Price of Underlying
Loss
Asset

Loss

A put option / warrant works the other way. As the price of the
underlying asset rises contrary to the investor’s bearish outlook, the value
of the put option or warrant starts to decline and reaches the maximum
loss level at the strike price.

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Figure 3.3: Risk Profile Of A Put Option / Warrant

Profit
Strike Price

Price of Underlying Asset

Maximum Loss

Loss

3.2 Plain Vanilla Versus Exotic Option

“Plain vanilla option” refers to option with predetermined underlying

assets, a stated strike price, a known expiry date, without special
conditions on any of the option parameters. The value of option is based
on a number of factors as follows:
 current spot price of the underlying asset;
 exercise price;
 time until expiry;
 interest rate;
 volatility of the underlying; and
 dividend rate on the underlying.

The value of option is determined by complex pricing models. However,

the market price of the option is influenced by the forces of market
supply and demand. The market price of option may deviate from its
intrinsic value from time to time.

“Exotic option”, by contrast, has conditions on any of its parameters. For

example, the payoff under an Asian option is based on the average price
of the underlying assets over a preset period. Needless to say, the exotic
options have an additional layer of complexity to their pricing.

Below is a list of more common exotic options.

 Asian option (or average price option): The payoff is determined by the
average price of the underlying assets over a preset period of time.
This is in contrast to the usual European option or American option,
where the payoff of the option depends on the price of the underlying
asset at maturity.
 Forward-start option: The option only comes into effect at a future
date. It is essentially a forward on an option, except that the premium
is paid today. It is often used in executive compensation.
 Compound option: This is an option on an option. As settlement is at
expiry, the option-holder receives another option.

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 Chooser option: Under this option, the investor chooses whether the
option will become a call or a put by a specified choice date.
 Barrier option: This is the option used in the barrier certificates. Under
this option, the option to exercise depends on the underlying assets
crossing or reaching a given barrier level. There are four combinations
of this type of options as follows:
– Up-and-out: Spot price starts below the barrier level and has to
move up and reaches the barrier level for the option to be knocked-
out (i.e., becomes null and void);
– Down-and-out: Spot price starts above the barrier level and has to
move down and reaches the barrier level for the option to be
knocked-out;
– Up-and-in: Spot price starts below the barrier level and has to move
up and reaches the barrier level for the option to become activated;
and
– Down-and-in: Spot price starts above the barrier level and has to
move down and reaches the barrier level for the option to become
activated.
 Binary option: This option pays off either nothing or a predetermined
amount. The cash-or-nothing binary option pays some fixed amount of
cash if the option expires in-the-money, while the asset-or-nothing
pays the value of the underlying asset.
 Rainbow option: There are two or more risky underlying assets
associated with this type of options. The name comes from the
analogy that the risky assets are like the colours in the rainbow. The
payoff of rainbow options depends on the best or the worst of the
risky assets. For example, best of x number of risky assets, or the
worst of, or the maximum of, or the minimum of.
 Swaption: This is an option giving the right to enter into an underlying
swap agreement. The term "swaption" typically refers to options on
interest rate swaps, although any type of swaps can be used.

3.3 Basic Option Trading Strategies

Options are appealing because they can be combined to offer investors a

wide variety of investment strategies. In fact, there is essentially no limit
to the number of different investment strategies available using options.
Fortunately, only a small number of basic option positions are available
and more complicated strategies are all built from these.

In this section, we learn how options work by looking at how to profit

and lose from them. To keep things simple, we assume each contract is
European style and lasts three months. We start by looking at basic call
and put positions followed by combining puts, calls, cash and shares of
stock.

Strategies can be categorised as bullish, bearish or neutral. We can

determine whether a strategy is bullish or bearish just by asking: “Is

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money made on the rise or fall of the stock price?” If money is made
when stock price rises, then it is a bullish position. If money is made
when stock price falls, it is a bearish position. If money is made when
stock prices rises, as well as when it falls, it is probably a neutral
strategy.

3.4 Bullish Option Strategies

We now discuss four basic bullish strategies as follows:

 Long calls;
 Covered calls;
 Protective puts; and
 Selling naked puts.

(a) Long Calls

Buying calls appeals to aggressive investors because of leverage.
Suppose Michael has a strong feeling that a particular stock is about
to move higher. If he purchases the stock, his cash outlay is S$1,000
for 100 shares, and his maximum loss possible is S$1,000. If he
buys a call, he pays S$100 (100 shares X S$1 per right), and his risk
is limited to S$100. Here we see leverage working - the call is only
10% of the S$1,000 needed to purchase the stock directly.

Cash Gain when Gain when

Outlay price=S$6 price=S$14
(S$) (S$) (%) (S$) (%)
Long Stock -1,000 -400 -40 +400 +40
Long Call -100 -100 -100 +300 +300

If the stock price falls to S$6, the long stock position loses S$400 as
compared to S$100 for the buy call. Leverage is magnified when the
stock price goes up. At S$14, the long stock’s S$400 gain is 40% of
the cash outlay of S$1,000 as compared to the long call’s profit of
300%. (Refer to Figure 3.2 for the profit / risk profile.)

When one considers the combination of leverage, limited downside

and unlimited upside potential, it is easy to see that buying call
options is an attractive strategy for bullish investors.

(b) Covered Calls

A covered call is a conservative strategy where one writes (i.e. sells)
call options on stock already owned (note that we are not newly
buying stock). Suppose Michael already owns 100 stocks of XYZ
purchased at S$10 per share. He subsequently sells a call option for
S$1 with an exercise price of S$10. What is the effect of these two
transactions?

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Cash Gain when Gain when

Outlay price=S$6 price=S$14
(S$) (S$) (%) (S$) (%)
Long Stock -1,000 -400 -40 +400 +40
Short Call +100 +100 +100 -300 -300
Covered Call -900 -300 -33 +100 +11

If XYZ falls to S$6, the option will expire worthless, and Michael
pockets the S$100 premium received. The S$100 helps to offset the
S$400 loss from his long position. Without selling the call option, his
loss is S$400 as compared to S$300 from the covered call position.

If the stock rises to S$14, the option will be exercised against

Michael, and he has to deliver the stock in exchange for S$10. Since
he already owns the stock, he is said to be “covered.” The net effect
of the strategy is to give up the possibility of higher profits in
exchange for the certain option premium of S$100. This decreases
the uncertainty surrounding returns and, therefore, decreases risk.

Look at Figure 3.4. Notice that the resulting profit pattern from a long
stock and sell call is a sell put. For instance, if the stock price runs up
to S$30 the loss from the sell call will always be offset by the long
stock position. The net result is a constant expected profit of S$100.

Figure 3.4: Profit / Risk Profile Of A Covered Call

Profit

Long Stock

0 Covered Call

Stock Price

Short Call

Why write a covered call when a covered call cancels out unlimited
upside potential and exposes the investor to unlimited downside risk?
Investors write covered calls because they are bullish on the stock
that they own and would like to keep the stock for returns in the long
term, but they feel that the potential of the stock going up is not
promising in the near term. Thus, they use options to generate some
additional income at very little risk in the short term. There is also the

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added advantage that the breakeven price is lowered, in our case to

S$9.

A covered call position can lower breakeven point:

Profit when stock price is (S$):

6 7 8 9 10 11 12 13 14
Long Stock
-4 -3 -2 -1 0 1 2 3 4
at S$10
Short Call 1 1 1 1 1 0 -1 -2 -3
Covered Call -3 -2 -1 0 1 1 1 1 1

(c) Protective Puts

A protective put strategy calls for buying a put on stock that one has
already owned. Suppose Michael already owns 100 stocks of XYZ
purchased at S$10 per share. He buys a put option for S$1 with an
exercise price of S$10. What is the effect of this transaction?

Cash Gain when Gain when

Outlay price=S$6 price=S$14
(S$) (S$) (%) (S$) (%)
Long Stock -1,000 -400 -40 +400 +40
Buy Put -100 +300 +300 -100 -100
Protective Put -1,100 -100 -9 +300 +27

If XYZ falls to S$6, Michael will exercise the put option and receive a
profit of S$300 (= -100 + 400). This S$300 offsets the S$400 loss
from his long position. Without buying the put option, his loss is
S$400 as compared to a loss of S$100 from the protective put
position.

If the stock rises to S$14, Michael will let the put option expire
worthless and lose the S$100 premium. The gain from his long stock
position of S$400 produces a net S$300 in profits.

Notice from Figure 3.5 the resulting profit pattern from a long stock
and buy put is a buy call. The net result is protection against
downside risk and exposure to an unlimited upside.

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 3. Understanding Derivatives

Figure 3.5: Profit / Risk Profile Of A Protective Put

Profit
Long Stock

Protective Put

0
Stock Price
Long Put

All in all, the protective put benefits investors who are mainly bullish
about the stock, but nevertheless want downside protection. Michael
uses S$1 to eliminate the downside risk. For this reason, a strategy
of buying a put option on a stock already owned is considered a
conservative strategy.

A protective put position increases breakeven point:

Profit when stock price is(S$):

6 7 8 9 10 11 12 13 14
Long Stock
-4 -3 -2 -1 0 1 2 3 4
at S$10
Buy Put 3 2 1 0 -1 -1 -1 -1 -1
Protective
-1 -1 -1 -1 -1 0 1 2 3
Put

(d) Selling Naked Puts

Selling a naked put seems unattractive at first. You get a limited
profit when the stock goes up and you are still exposed to great risk
when the stock price goes down. So why will anyone want to write
a naked put? The answer is that if you want to own the stock, selling
a naked put addresses your need and gives you a discount relative to
its current price.

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Figure 3.6: Profit / Risk Profile Of A Naked Put

Profit

Premium

0
Stock Price

To illustrate this, suppose Donald wishes to own XYZ, but feels its
current price of S$11 is still too expensive. He sells a put for S$1
with an exercise price of S$10. If XYZ drops to S$8, the put buyer
will exercise his right to sell to Donald at S$10. Donald receives the
stock by paying S$10. However, his net cost is really S$9 (-10 +1),
since Donald has receive S$1 for selling the put. In the end, Donald
has paid S$9 for XYZ (which is now worth S$8), as compared to its
initial price of S$11.

However, if XYZ rises to S$14, the put buyer will not sell XYZ to
Donald at S$10, since he can sell it in the open market for S$14. If
Donald still wants to own XYZ, he will need to buy it from the
market at S$14, offset by the S$1 that he has received on the put.
He ends up paying S$13 for the share, instead of S$11.

3.5 Bearish Option Strategies

We discuss two basic bearish strategies as follows:

 Long puts; and
 Naked calls.

(a) Long Puts

Now imagine that Michael has a strong feeling that a particular stock
is about to move lower. Yet he is fearful of selling a stock short
because of the potential for unlimited losses. Rather than subjecting
himself to unlimited downside risk, buying a long put is a safer
strategy.

If Michael shorts the stock, his cash inflow is S$1,000 for 100
shares. If he buys a put, he will pay S$100, and his maximum risk is
limited to S$100.

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 3. Understanding Derivatives

Cash Gain when Gain when

Outlay price=S$6 price=S$14
(S$) (S$) (%) (S$) (%)
Short Stock 1000 400 40 -400 -40
Long Put -100 300 300 -100 -100

If stock price falls to S$6, the short stock position earns S$400, but
above the breakeven price of S$10, losses can be unlimited. At S$6,
the long put earns S$300 in profits, S$100 less than the short stock
position earns because of the S$100 put premium. However, if the
stock runs a lot higher beyond S$10, the maximum loss is capped at
S$100. (See Figure 3.3 for the profit / risk profile of a put option.)

(b) Naked Calls

Unlike covered calls, where the call seller owns the underlying stock
and can make delivery at a known price, the naked call seller is
completely exposed to downside risk when the stock price goes up.

Cash Gain when Gain when

Outlay price=S$6 price=S$14
(S$) (S$) (%) (S$) (%)
Short Call 100 100 100 -300 -300

Selling naked calls is one of the riskiest strategies of all. Not only is
the downside unlimited, the upside is limited to the premium
received.

Figure 3.7: Profit / Risk Profile Of A Naked Call

Profit

Premium

0
Stock Price

3.6 Neutral Option Strategies

When you are neutral on a stock, it means you are undecided about
whether the price is going to go up or down. We look at one of the more
common strategies called a straddle.

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(a) Straddles
Suppose Steven expects a stock to have a big move, but he thinks
that the move can be in either direction. He simultaneously buys a
call and buys a put at the same strike price and expiration for S$1
each share. His total cash outlay is S$200 for a contract of 100
shares. This is called a bull straddle.

Cash Profit when Profit when

Profit when
Outlay price = price =
price = S$6
(S$) S$10 S$14
(S$) (%) (S$) (%) (S$) (%)
Long Call -100 -100 -100 -100 -100 300 300
Buy Put -100 300 300 -100 -100 -100 -100
Bull
-200 200 100 -200 -100 200 100
Straddle

If stock price falls to S$6 or it rises to S$14, the bull straddle earns
him S$200. In fact, the larger the price movement, either up or
down, the bigger will be the profits. The greatest risk in this case is
that the stock remains around S$10 where both options expire
worthless. His cost and maximum loss then will be S$200.

Figure 3.8: Profit / Risk Profile Of A Bull Straddle

Bull Straddle
15

-5 0 2 4 6 8 10 12 14 16 18 20

-15

In a bear straddle, you expect the opposite in that the market will not
move much in either direction. You simultaneously sell a call and sell
a put at the same strike and expiration for S$1 each share. Your total
cash receipt is S$200 for a contract of 100 shares.

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 3. Understanding Derivatives

Cash Profit when Profit when Profit when

Outlay price = S$6 price = S$10 price = S$14
(S$) (S$) (%) (S$) (%) (S$) (%)
Short Call 100 100 100 100 100 -300 -300
Short Put 100 -300 -300 100 100 100 100
Bear
200 -200 -100 200 100 -200 -100
Straddle

With a bull straddle, price volatility contributes positively to profits. It

is the opposite with a bear straddle – price volatility negatively
affects profits. If stock price falls to S$6 or it rises to S$14, the bear
straddle brings you a S$200 loss. The larger the price movement,
either up or down, the bigger will be the losses. The best situation is
for price to not move at all. The bear straddle brings you the largest
profits when the stock price is around S$10. The maximum profit is
S$200, which is the cash inflow from selling the two options.

Figure 3.9: Profit / Risk Profile Of A Bear Straddle

Bear Straddle
15

-5 0 2 4 6 8 10 12 14 16 18 20

-15

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3.7 Summary Of Options

The following table summarises options in terms of buyers / holders and

sellers / writers:

Buyer / Holder Seller / Writer

Buyer has the right to Seller has the obligation
Right or
buy or sell – no to buy or sell – no right
obligation
obligation to refuse
Obligation to sell / to go
Call Right to buy / to go long
short on exercise
Obligation to buy / to go
Put Right to sell / to go short
long on exercise
Premium Paid Received

Exercise Price Buyer’s decision Seller cannot influence

Max Potential
Cost of premium Unlimited
Loss
Max Potential
Unlimited Price of premium
Gain

4. SWAPS

A swap agreement is exactly what the name suggests, where two parties
agree to exchange cash flows at future dates. Nothing is bought or sold. If
the cash flows being exchanged are derived from financial instruments
owned by either party, there is no change in the ownership of these financial
instruments.

The genesis of the swap market can be traced back to the 1970s, when
foreign exchange controls made it difficult for companies in one country to
lend money to an overseas subsidiary. A parallel loan structure was
developed to circumvent the problem, whereby two companies domiciled in
different countries could lend equivalent amounts to the other’s subsidiary.

In the early days of the swap market, banks acted as brokers in return for a
fee. They identified counterparties with offsetting needs and put them
together. This was an arduous process as finding offsetting counterparties
was not straightforward. Each transaction had to be carefully customised,
and complex documentation had to be prepared to each party’s satisfaction.

As the market evolved, banks started to “warehouse” positions by taking on

one side of a transaction in the hope that an offsetting transaction may be
found later.

In this section, we discuss five types of swap instruments:

 Interest Rate Swaps
 Currency Swaps

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 3. Understanding Derivatives

 Credit Default Swap (CDS)

 Equity Swaps
 Commodity Swaps

4.1 Interest Rate Swaps

The most common type of swap is a plain vanilla interest rate swap. It
is the exchange of the interest payments on a fixed rate loan to the
payments on a floating rate loan. Since an interest rate swap operates
in the same currency, cash flows occurring on same dates can be and
are netted.

The reason for this exchange is to benefit from comparative advantage.

Company A may have greater comparative advantage in fixed rate
markets to raise funds, while Company B may have a comparative
advantage in floating rate markets. If each wishes to exploit its relative
advantage, A may end up borrowing fixed when it wants floating, and
B borrowing floating when it wants fixed. This is where a swap
agreement can offer a solution to achieve their desired outcomes. A
swap agreement between the two companies has the effect of
transforming A’s fixed rate loan into a floating rate loan and B’s floating
loan into a fixed loan.

Example

Company A wishes to raise S$10 million. A can borrow at 0.5% above

LIBOR 4 from a bank, or a 6% fixed rate loan. Company B wishes to
raise S$20 million. B can borrow at 2% above LIBOR from a bank, or at
6.75% fixed rate. In other words, A can borrow 1.5% cheaper than B
in the floating rate market, but only 0.75% cheaper than B in the fixed
rate market.

A prefers a fixed rate loan, but wishes to explore its comparative

advantage in floating rate loan market. On the other hand, B prefers a
floating rate loan, and wishes to bring down the borrowing cost. Both
A and B benefit from a swap agreement.

Three-step Transactions:
(1) Company A borrows a Floating Rate Loan pays LIBOR + 0.5%.
(2) Company B borrows a Fixed Rate Loan, pays 6.75% fixed.
(3) Company A and B enter into swap agreement, whereby Company
A pays 5.75% fixed interest to Company B, and receives in return
LIBOR +0.75% floating interest on a specific notional principal
amount agreeable by both parties.

4
LIBOR – London Inter-bank Offered Rate – is the interest rate at which banks can borrow funds, in
marketable size, from other banks in the London inter-bank market. The LIBOR is the world's most
widely used benchmark for short-term interest rates.

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With the swap agreement, the final cost to Company A is a fixed rate
5.5% (LIBOR + 0.5% to the bank, plus 5.75% to B, offset by the
LIBOR + 0.75% received from B), a savings of 0.5% as compared to
the 6% fixed rate that it would have incurred without the swap
agreement.

The final cost to Company B is a floating rate LIBOR + 1.75% (6.75%

paid on the bond, plus LIBOR + 0.75% to A, offset by 5.75% received
from A), a savings of 0.25% as compared to LIBOR + 2% that it
would have incurred without the swap agreement.

Figure 3.10: Interest Rate Swap

Company A Company B

B receives
5.75%

A receives LIBOR
+ 0.75%

A pays LIBOR B pays 6.75%

+ 0.5%

Floating Rate Loan Fixed Rate Loan

Note that a swap agreement is based on a “notional” principal amount,

used to calculate the amount of interest payment to exchange between
A and B. In this case, the notional principal can be an amount between
S$10 million to S$20 million, agreed upon by A and B.

4.2 Currency Swaps

With an interest rate swap, cash flows occurring on same dates are
netted, only the difference in cash flows changes hand. An interest rate
swap involves only the swapping of interest payments, and not the
principal amount.

With a cross-currency swap, both the principal and interest payments

are exchanged without any netting, because the cash flows are in
different currencies, rendering netting impossible. Both principal and

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 3. Understanding Derivatives

interest payments are exchanged between two counterparties, at a rate

agreed now, at a specified point in the future.

Currency swaps are often used by companies that have loans

denominated in one currency, while revenues are denominated in
another currency. Hence, it is exposed to currency risk.

(a) Contrast With Futures And Forwards

The simplest currency swap structure is to exchange the principal
only with the counterparty. Such an agreement is in fact equivalent
to a futures or forward contract. A swap is more expensive than a
futures or forwards for short-term contracts, so it is rarely used.
However, principal-only currency swaps are often used as a cost-
effective way to fix forward rates for longer-term futures where the
spreads are wider.

(b) Contrast With Currency Exchange

Currency swap is based on a rate agreed now, to be exchanged in
the future. The currency exchange is for an exchange of two
currencies to take place now.

4.3 Credit Default Swap (CDS)

A CDS transfers the credit risk of a credit instrument, namely bond,

note or loan, to another party, in exchange for a series of fee
payments. It is similar to insurance because it provides the CDS buyer,
who owns the underlying credit, with protection against default, a
credit rating downgrade, or other defined "credit events".

Suppose Bank A made a 5-year loan to a borrower. Bank A now wishes

to eliminate its exposure to the borrower’s credit risk. This can be due
to a variety of reasons: to reduce its regulatory capital requirements; to
reduce concentration of risk exposure to the same borrower; or to
reduce concentration of risk exposure to similar loan portfolios.

Thus, Bank A (the protection buyer) enters into a CDS with Bank B (the
protection seller) based on the 5-year loan, and makes periodic
premium payments to Bank B. If the borrower (the reference entity)
defaults or suffers any of the predefined credit events, Bank B pays
Bank A the par value of the loan.

It is important to note that the reference entity and the underlying

credit instrument are not parties to the CDS agreement. They are
merely used as a reference point. In fact, the CDS protection buyer
need not even own the underlying credit instrument.

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Figure 3.11: Credit Default Swap

Bank A Bank B

Buys protection with

periodic payments

Payment upon default

5-year Interest &

loan loan
repayment CDS: Bank A
need not own
the loan to
effect the CDS
with Bank B.

Reference Entity

4.4 Equity Swaps

As with all swap agreements, an equity swap is an exchange of cash

flows between two parties. What distinguishes it from other swaps is
that one set of cash flow is equity-based, such as from a stock or from
an equity index. The other set of cash flow is often fixed income-based
(either a fixed rate or floating rate such as LIBOR), but can also be
equity-based.

Equity swaps are used to substitute for a direct investment in stock

markets, in order to avoid transaction costs, to avoid local dividend tax,
to avoid limitations on leverage, or to get around rules governing the
particular type of investment that an institution or person can hold.

For example, let's say A wants to invest in stock X listed in Country C.

However, A is not allowed to invest in Country C due to capital control
regulations. He can, however, enter into a contract with B, who is a
resident of C, and ask B to buy the shares of company X and provide A
with the return on share X. In return, A agrees to pay B a fixed (or
floating) rate of return.

When effectively used, equity swaps can eliminate cross-border

investment barriers.

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4.5 Commodity Swaps

A commodity swap is an agreement in which one set of payments is

set by the price of a commodity or by the price of a commodity index.
The most common examples of commodity swaps involve plain vanilla
OTC agreements for a fixed-for-floating exchange of risk in which no
delivery of the physical commodity is involved.

Commodity swaps are used by many consumers and producers of

commodities to hedge price rises over a long-term period. For example,
bread makers hedge grain prices, while shipping companies hedge fuel
prices.

Example

Cost-Cutter Airlines (CCA) wishes to fix or set ticket prices for up to a

year forward being used to help to predict its future revenue. Suppose
fuel prices represent 30% of CCA’s operating costs, so any price
fluctuations can seriously affect its profits if ticket prices are fixed.
How can CCA eliminate or reduce this floating price risk besides
imposing fuel surcharges?

There are a number of derivatives that CCA can use to hedge its risk
such as futures and options. However, an energy swap is the most
likely instrument as it provides a flexible, long-term OTC contract.

Airlines often enter into swap contracts of two years’ maturity

involving payment periods every six months, where they either pay or
receive a cash amount as determined by the value of a specific Platts
index oil price. The swap contract relates to a specific amount of oil
which the airline is either contracted to take physical delivery of or is
bought on the spot market.

By entering into an energy swap agreement, the airline effectively locks

in the price of its fuel for the two-year period.

5. CONTRACT FOR DIFFERENCES (CFD)

CFD is a contract between an investor and a CFD provider, usually a broker,

that allows investors to speculate on the price movements of an underlying
security, typically a stock, on margin.

The CFD provider quotes bid and offer prices based on current market price
of the underlying stock. CFD trades like a stock. Upon opening a position,
the investor puts up margin with the broker, and pays a commission based
on the total value of the contract. A financing charge is applicable each day
that the position is open. Interest adjustments on a short position can appear
on the investor’s account either as a debit or a credit, because the financing
fee is subtracted from, rather than added to, the interbank offered rate when

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calculating interest adjustments. The profits and losses are settled when the
position is closed.

CFDs are similar to futures and options with one distinctive difference - CFDs
do not have expiry dates. A CFD is effectively renewed at the close of each
trading day and rolled forward if desired, providing that there is enough
margin in the account to support the position. The investor in a CFD can
close the contract at any time.

Similar to other derivative instruments, CFDs allow investors the flexibility to

trade on both the long and the short sides of the market. By taking a long
position, the investor receives dividends and pays interest; while by taking a
short position, the investor pays dividends and receives interest.

Compared to normal share trading, CFD is leveraged, and the loss can be
greater than the original margin amount.

Example

The share price of Apple Inc is US$194.38. An investor believes that the
share price will rise and decides to take a long CFD position. The CFD
provider is quoting US$194.34 bid and US$194.42 offer.

Step 1 Opening a position

Buy 100 Apple CFDs at offer price. This is

the notional amount against which 100 x US$194.42 =
commission, margin requirement, profit and US$19,442.00
loss is calculated.

Margin requirement is open position x margin

percentage. Typical margin for equities is
US$19,442.00 x 0.05 =
5%-15%, depending on the liquidity of the
US$972.10
underlying stock. In our example, assume
Apple CFDs require margin of 5%.

Commission is 0.15%. US$19,442.00 x 0.0015 =

US$29.16

Step 2 Overnight Financing

To hold this position, a financing charge is

made each night. This is normally based on a
benchmark rate per cent like (SIBOR + 0.0025+0.02
US$19,442.00 x
broker margin) / 365. For simplicity, we will 365
assume that the price of Apple shares will = US$1.20
stay the same until the market close and, so,
no P&L was generated on this day.

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 3. Understanding Derivatives

Step 3 Closing the position

The next day Apple share price has risen by

US$6.15, or 3.16%. The investor decides to
close the position and take profit.

CFD provider is quoting US$200.50 bid and

US$200.58 offer.

100 x US$200.50 =
Sell 100 Apple CFDs at bid price.
US$20,050.00

The position is now closed, and the margin

US$0.00
requirement is now zero.

The investor is charged commission of US$20,050.00 x 0.0015 =

0.15% on this transaction. US$30.08

Gross profit is difference between the US$20,050.00 – US$19,442.00

opening position and the closing position. = US$608

The costs are commissions and overnight US$29.16 + US$30.08 +

financing. US$1.20 = US$60.44

US$608.00 – US$60.44 =
Net profit after costs
US$547.56

In summary, the investor had put up US$972.10 to cover the margin on

this trade and made a 56% profit of US$547.56 on a 3% rise in the Apple
share price. If the price of Apple shares had dropped by US$6.15 instead,
he would have sustained a 70% loss of US$681.59 (i.e. a loss of
US$623 plus costs of US$58.59).

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Chapter

4 INTRODUCTION TO STRUCTURED ILPs

CHAPTER OUTLINE
1. What Is A Structured ILP?
2. Advantages And Disadvantages Of Structured ILPs
3. Who Would Invest In Structured ILPs?
4. When Are Structured ILPs Unsuitable?
5. Governance
6. Typical Types Of Documentation And Risks
7. After Sales
Appendix 4A: Sample Benefit Illustration 1
Appendix 4B: Sample Benefit Illustration 2

KEY LEARNING POINTS

After reading this chapter, you should be able to:
 know what a structured ILP is
 explain advantages and disadvantages of investing in a structured ILP
 identify the investors who are and who are not suitable for investing in
structured ILPs
 understand the governance structure of structured ILPs
 list the documentation, risks and after sales actions associated when investing in
structured ILPs

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 4. Introduction To Structured ILPs

1. WHAT IS A STRUCTURED ILP?

As mentioned in an earlier chapter, life insurance is one of the possible

wrappers for structured products.

A typical life insurance policy has a protection element and a savings /

investment element. Part of the insurance premium is used to provide
protection against death or other misfortunes, such as disability or terminal
illnesses. The balance of the premium is invested, to be paid out upon policy
maturity, early termination of policy, or other occasions according to policy
terms and conditions.

Traditionally, the life insurer invests the premiums collected from all policies
in common funds 1 . The investment of insurance funds is at the insurer’s
discretion, subject to stated investment objectives, and regulatory solvency
requirements. Unlike unit trusts, there are no units allocated to each policy
based on premiums received. To maintain equity among policy owners, the
insurer may earmark portions of the fund to support particular blocks of
policies, and credit investment returns accordingly.

Participating or par life insurance policies provide both guaranteed and non-
guaranteed benefits. While the guaranteed benefits are based on the
contractual terms, regardless of the experience of the common par fund,
non-guaranteed benefits may change from year to year depending on the
performance 2 of the par fund. Insurers typically “smooth” the investment
experience of the common fund to avoid wide year-on-year fluctuation in the
non-guaranteed benefits. That is, insurers do not credit the full extent of
investment gains in good years, saving some of the gains to make up for the
losses in bad years, so that policy owners still enjoy some returns in the
years of poor investment experience. While this smoothing process maintain
certain degree of stability in the non-guaranteed benefits, it means that
policy owners may not receive the full upside (or downside) of the
investment returns on his money, depending partly on the timing of his exit
from the policy.

ILPs were introduced in Singapore in early 1990s, which adopted a different

approach to investment as compared to traditional par life policies. An ILP
allows the policy owner to direct how his premiums are invested by choosing
to invest in a number of investment funds, called the ILP sub-funds. ILP
policy owners buy and sell units in these sub-funds just as they would for
unit trusts.

An ILP essentially combines a term insurance and unit trust investments in

one product. The most significant difference between an ILP and a traditional

1
Separate funds are maintained based on the nature of policies issued. An insurer must maintain
separate funds for participating (par) policies, non-participating (non-par) policies, and Investment-
linked Life policies (ILPs).
2
Performance of the fund refers to the actual experience of the fund relative to the pricing
assumptions, in the areas of investment, mortality rate and expenses. Although investment
experience forms the bulk of the performance, it is not the only factor affecting the fund’s
performance.

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life insurance is that the ILP policy owner bears the full investment gains and
losses. There is no smoothing of returns. If the investment experience is bad,
an ILP policy owner may even lose part or all of his principal.

Figure 4.1: Working Of ILP

Insurance Premium

Part of the premiums

is used to buy term
insurance to provide
protection.

Balance of the premiums

is invested into ILP sub-
funds as selected by the
policy owners. Term Insurance

+
ILP sub-funds

Unit Trust

A “structured ILP” is typically a single premium3 ILP where the sub-funds are
invested in structured products or other structured funds. In this context,
structured products are products tailor-made for an ILP sub-fund, such that
the issuer(s) of the securities and / or instruments, or an entity other than the
issuer(s), will stand ready to unwind the products at prevailing market prices,
so as to enable the ILP sub-fund to meet redemption on each dealing day4. A
structured ILP shares the common characteristics as other structured
products: it is purchased with a single payment; has a fixed policy term or
maturity date; usually has complex structures; and is exposed to
counterparty, credit default, market, foreign currency, liquidity, and other
risks.

ILPs are investment products, subject to similar rules as applied to unit

trusts. Nonetheless, because they are life insurance policies, only a life
insurer may issue ILPs, and the terminology follows that for insurance
products. The investments are called premiums; the investment contract is
called a policy; and the redemption value available under the policy is called
cash value.

3
In theory, a structured ILP can be issued as either a single premium or a regular premium policy.
However, in practice, structured ILPs are more likely to be single premium products, with the
primary goal to maximise investment returns. This is because the cost structure of single premium
products is more conducive to that goal.
4
Defined in Notice No: MAS 307.

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1.1 Payout Under A Structured ILP

There are several ways for payments to be made under a structured ILP
to the policy owner:

(a) Death Benefits: Should the policy owner die while the policy is still
inforce, the higher of:
 the sum assured from the term insurance; or
 the cash value of the policy;
is paid to the designated beneficiary. Once the death benefit is
paid, the policy is terminated, and no further payment will be made.

(b) Maturity / Survival Benefits: Should the policy owner survive to

maturity date, the term insurance expires and the maturity value of
the policy is paid to the policy owner.

There are products designed to provide regular payments

throughout the term of the policy, similar to coupon payments on
bonds. The amount of payment may fluctuate based on market
conditions.

(c) Other structures are possible, depending on the design of the

products.

Structured ILPs are designed as investment products. As such, the

protection element is typically very low, so that more premiums are
channelled into investments. The death benefit under a structured ILP
could be as low as 101% of single premium. That is, should the policy
owner die during the term of the policy, the designated beneficiary
would receive S$101,000 for a policy with a single premium of
S$100,000, or the cash value of the policy if it is higher than
S$101,000. It is rare for the death benefit to exceed 125% of single
premium.

Depending on the practice of the insurer, the cost of term insurance

may be charged in one lump sum at the inception of the policy, or
charged periodically together with other investment and administrative
expenses.

1.2 Common Terminology

The common terms used in the life insurance industry include:

Single premium The one-time upfront payment which the policy

owner pays for the policy. It represents his
principal sum of investment in the policy.

Regular premium Periodic premium payments (monthly, quarterly,

half-yearly or yearly).

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Policy owner Owner of the policy who is also the investor.

Sum assured The guaranteed amount of death benefit payable.

Cash value Amount which the policy owner receives if he

terminates the policy. Also called surrender value.
It is the market value of units in ILP sub-funds.

Benefit illustration A year-by-year illustration of the benefits and

values of the insurance policy, both guaranteed
and non-guaranteed, and the costs and charges
associated with the policy, including distribution
costs, and the charges for insurance coverage.

Subscription The purchase of units in ILP sub-funds.

Redemption The return of units in ILP sub-funds for cash.

Bid price Price at which units are redeemed.

Offer price Price at which units are subscribed.

Bid / offer spread Difference between the bid and offer prices,
usually in the range of 3% to 5%. This is the
insurer’s fees for operating the sub-funds. This is
separate from the investment management fees
which are charged directly to the sub-funds
monthly or quarterly, based on the assets under
management (AUM) by the investment managers.
The insurer may manage the sub-funds in-house,
or outsource the investment management to
third-party managers.

Forward pricing Subscription and redemption of units are based

on bid and offer prices as determined on the next
asset valuation date. This is in contrast with
historic pricing, which uses bid and offer prices
determined on the last asset valuation date.

Net asset value Total value of fund assets, less total liabilities
(NAV) (excluding policy owners’ interest if this is
classified as a liability).

Both assets and liabilities are valued in

accordance with the insurance regulations and
other applicable regulatory requirements.

Switching of funds The transfer of units in one sub-fund to another.

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Expense ratio The ratio of the sub-fund's operating expenses to

the daily average NAV. For Singapore domiciled
funds, the calculation of expense ratio should
follow guidelines as issued by the Investment
Management Association of Singapore (IMAS).

Operating expenses include investment

management fees, trustee’s fees, administrative
and custodial expenses, taxes, legal fees, and
auditing fees. Trading expenses related to the
buying and selling of fund assets are not included
in the calculation of expense ratio.

Initial sales charges and redemption fees, if any,

are paid directly by investors and, therefore, not
included in expense ratio.

Turnover ratio The number of times that a dollar of assets is

reinvested in a given year. It is calculated based
on the lesser of purchases or sales of underlying
investments of a fund expressed as a percentage
of daily average NAV.

Trading incurs transaction costs. Therefore, the

higher the turnover, the higher will be the
transaction cost, which reduces the fund returns.

For example, a stock index fund typically has a

low turnover ratio, but an equity fund typically
has high turnover, because active trading is an
inherent nature of equity investments. An
aggressive small-cap growth stock fund will
generally experience higher turnover than a large-
cap value stock fund.

Soft dollar This refers to arrangements under which

products or services, other than the execution of
securities transactions, are obtained from or
through a broker in exchange for the direction by
the manager of transactions to the broker. Soft
dollars include research and advisory services,
economic and political analyses, portfolio
analyses, market analyses, data and quotation
services, and computer hardware and software
used for and / or in support of the investment
process of managers.

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2. ADVANTAGES AND DISADVANTAGES OF STRUCTURED ILPs

2.1 Advantages Of Investing In Structured ILPs

Individual investors typically do not have the knowledge, resources or

time to perform adequate analysis of investment opportunities. Nor do
they typically have large amount of funds to implement sufficient
portfolio risk diversification. Thus, a pooled-investment vehicle such as
ILP offers the average investors the advantages as mentioned below.

 Professional Management
Individual investors typically do not have the necessary knowledge
and experience to invest in sophisticated instruments, such as
derivatives or structured products based on derivatives. By investing
in a structured ILP, the individual gains access to products designed
and managed by investment professionals, with specified risk /
return characteristics. The individual does not need to understand
the mechanics behind the actual execution of the investment to
enjoy the investment outcome. However, he needs to fully
understand and appreciate the levels of risk and returns of the
product, particularly the maximum loss under the worst case
scenarios.

 Portfolio Diversification
Diversification means investing in different assets within an asset
class, and also in different asset classes. Simply put, diversification
means “don’t put all your eggs in one basket”.

Because asset prices do not move in synchrony, the downward

movement in one asset may be offset by the upward movement in
another. Hence, a diversified portfolio is less risky and less volatile.
However, it requires a large portfolio to achieve effective
diversification, often beyond the means of individual investors. An
ILP sub-fund allows individuals the means to diversify through the
pooled investment mechanism.

It should be noted that not all ILP sub-funds are diversified. There are
special purpose sub-funds that are highly concentrated in one asset
class or a few entities.

 Access To Bulky Investments

Some investments are issued in large sizes. For example, corporate
bonds are issued in millions of dollars. Individually, investors will not
have the financial means to tap such bulky investments. Collectively
through an ILP, they can access these opportunities on par with
other institutional investors.

 Economies Of Scale
Transaction costs are typically scaled: the larger the size of the
transaction, the lower will be the per-unit cost. An ILP sub-fund may

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take advantage of its buying and selling size, and thereby reduce
transaction costs for its investors.

2.2 Disadvantages Of Investing In Structured ILPs

Structured ILPs share some common drawbacks with conventional

ILPs, as highlighted below.

(a) Fees And Charges

An ILP has several layers of expenses.
 Front-end sales charge, typically 5% for single premium, and can
be as high as 50% to 80% of first year premium for regular
premium policies.

 Annual fund management fee, based on the size of the fund and
asset types, typically 1% to 3% for equities, and 0.5% to 1.5%
for fixed incomes. A general rule is that the asset classes
requiring greater fund manager’s attention command a higher
level of fees.

 Bid / offer spread or redemption / surrender charge is in the

range of 3% to 5%. An ILP sub-fund may adopt either single or
dual pricing. In a dual pricing structure, the policy owner
purchases units in the fund at the “offer price” when he makes
an investment in the fund. He sells units in the fund at the “bid
price” when he liquidates all or part of his investments. The
spread between the bid and offer price is the margin to cover
the insurer’s cost and profits. In a single pricing structure, the
bid and offer prices are the same. To cover its costs, the insurer
may charge a specific redemption (or surrender) charge.

 Cost of death benefit, and other charges for administering the

fund, such as audit fees, custodian fees, cost of preparing
reports, administering fund switching, etc.

Compared to unit trusts, the ILP has the added cost of death
benefit, which affects investment performance. Increasingly,
structured ILPs are designed with very little death benefit, to
maximise the investment content of these policies.

An insurer may choose to invest ILP sub-funds in other unit trusts,

particularly for specialty investment areas, where the insurer does
not have the expertise. This results in an extra layer of fees and
expenses for policy owners, as compared to a direct investment in
these unit trusts by the policy owners. Offsetting somewhat the
added cost is the insurer’s ability to negotiate lower upfront
distribution charges levied by the external unit trusts due to its
larger buying power.

It takes time for the ILP sub-fund’s investment experience to

compensate the expenses charged. For example, total expenses for

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the first year can be as high as 8% of single premium, not counting

surrender charges. The ILP sub-fund needs to earn 8% in the first
year just to break even for the policy owner. Regular premium
policies may not have any surrender value in the first three years
because of high front-end costs. For this reason, an ILP is not a
suitable short-term investment instrument. An investor needs to
have a medium to long-term time horizon when considering
investing in an ILP, to allow investment performance to make up
for expenses.

(b) Loss Of Investment Control

The flip side of enjoying professional management expertise is the
loss of investment decisions by individual policy owners. So long as
the fund manager invests in accordance to the investment
mandate, there is little that a policy owner can do if he disagrees
with the investment decisions, except to divest from the fund
which, if allowed at all, may be costly depending on market
conditions and policy terms. While some funds provide up to one
free fund-switch per year, frequent fund-switching may
compromise investment objectives and time horizon and, therefore,
is not advisable. Moreover, frequent fund-switching may result in
fund managers imposing switching fees.

Keep in mind that fund managers are investment professionals.

They are more likely to make the right investment decision than
individual investors. Nonetheless, an ILP is not the right investment
vehicle for investors who prefer to make investment decisions
themselves.

(c) Opportunity Cost

Opportunity cost means that, by putting money into an ILP, an
investor loses the opportunity to invest it elsewhere. Of course,
there is no guarantee that putting money elsewhere will yield better
returns.

Another source of opportunity cost is from the diversification of the

fund. The very nature of diversification (offsetting gains and losses
to reduce risk) means that the good performance of a single
security or a single asset class is dragged down by others in the
same portfolio.

2.3 Risk Considerations For Structured ILPs

In addition to the advantages and disadvantages of investing in ILPs in

general, an investor considering structured ILPs should also consider
the risks of investing in structured products, in particular:

(a) Counterparty Risk

Investors in a structured ILP are typically exposed to credit risk
associated with the counterparty issuing the derivative contracts.
A structured ILP would suffer significant losses should the

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counterparty be unable to fulfil the terms of the contracts, which

could be payment of cash, or delivery of securities, or providing a
guarantee.

A counterparty may experience adverse changes in its financial

condition which may not yet affect its ability to fulfil its terms of
contracts. However, any resulting downgrade in its credit rating
may in turn lead to greater volatility in the price of the security that
it underwrites and, in turn, the net asset value of the ILP sub-fund.

Furthermore, the international investment banking community has

become highly inter-related. If one counterparty that issues a
derivative contract defaults, it may have a domino effect on other
counterparties. Hence, investors in a structured ILP may suffer a
greater loss than they expect from the default of a single
counterparty, if other counterparties become embroiled in the credit
crunch.

(b) Liquidity Risk

Derivative contracts are difficult to price and affix a market value
to. Therefore, typically, structured ILP sub-funds are valued less
frequently (such as weekly or monthly) as compared to other ILP
sub-funds, which are valued daily. An investor in a structured ILP
may not be able to immediately redeem his units, when he wishes
to do so. However, insurers are obliged to disclose the frequency
of redemption, and the period within which redemption proceeds
shall be paid to investors.

Furthermore, the size of a structured ILP sub-fund is usually

smaller. Therefore, redemptions represent a higher proportion of a
structured ILP fund than they do in a traditional ILP fund. For
example, a total pending redemption of S$1 million is 10% of a
S$10 million fund, but is only 1% of a S$100 million fund. While
the S$100 million fund may have no difficulty in meeting the
redemption requests, the S$10 million fund may find it necessary
to limit the size of redemption to protect the fund, and the
remaining investors. As a result, it is common for a fund to cap the
size of unit redemption on a single day (such as 10% of total units
outstanding), restricting investor’s liquidity. When the redemption
limit is reached for a particular day, investors wishing to redeem on
that day can only redeem a pro-rated number of units. Also, early
redemption may lead to a loss of certain protection features, such
as those for capital guaranteed funds.

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2.4 Examples Of Structured ILPs

A great variety of structured ILPs can be designed to suit investor

needs. Some examples are mentioned below.

(a) A Product Providing Regular Payments

This is designed to provide regular payouts (such as quarterly or
yearly), and a repayment of capital upon maturity. A small amount
of life insurance is added to complete the wrapper.

However, neither the regular payments nor the principal

repayments are guaranteed. The underlying assets (derivatives or a
combination of fixed income and derivative instruments) aim to
provide a cash flow to match the intended payments. The actual
delivery of the targeted cash flow depends on the underlying
assets’ performance. The insurer is not obligated to step in and
make good the intended payments should the underlying assets fail
to deliver.

An example:

The Fund objective is to seek to provide policy owners with:

(i) Annual payouts of 3.50% of the Initial Unit Price per
unit held by each policy owner as at each policy
anniversary; and
(ii) 100% capital protection on maturity.

The description may be similar to that of an ordinary bond, but the

risk profile is completely different. For an ordinary bond, the bond-
issuer has an obligation to pay the stated coupons and the principal
on maturity. Failing to do so is considered a default on financial
obligation. In contrast for a structured ILP, the insurer need not pay
the regular payments at the stated level, nor the principal
repayments at maturity, if the investment experience cannot
support such payments. The product is merely structured to “seek
to provide” the targeted level of returns. There is no obligation for
the insurer to make good on the intention if performance does not
support it.

(b) A Product Linked To Index Return

This product uses derivatives to track the performance of a
selected index, and fixed income instruments may be used to
provide full or partial protection of downside. The index may be a
widely used market index (such as STI or S&P500), or a
customised basket of stocks (e.g. selected blue chips to inspire
investor confidence). The tracking of the index may be in the same
or the opposite direction of the movements of the index, and may
be in multiple times of the index movements.

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An example:

The fund seeks daily investment results, before fees and

expenses, that correspond to twice the inverse of the
daily performance of the NASDAQ-100 index.

This fund uses short-selling and derivatives to track the opposite

(i.e. inverse) performance of the NASDAQ-100 index. This fund
also uses leveraging techniques to achieve multiples (two times in
this case) of the movement of the underlying index. If the
NASDAQ-100 index declines by 2%, the fund is designed to go up
by 4%. Keep in mind that such a leveraged fund creates multiple
negative returns as well, when the underlying index moves in the
opposite direction than anticipated.

A leveraged fund, such as this example, is designed to create the

leveraged effect on a daily basis, which may differ on a cumulative
basis, as illustrated below.

Underlying Index The 2x Inverse Fund

Index Daily % Fund Price Daily %
Level Movement (S$) Movement
Day 1 100 -- 100.0 --
Day 2 98 -2.00% 104.0 +4.00%
Day 3 102 +4.08% 95.51 -8.16%

When the index falls 2% (from 100 to 98) on day two, the 2x
inverse fund rises 4% (from 100 to 104). When the index rises
4.08% (from 98 to 102) on day 3, the leveraged inverse fund
correspondingly falls 8.16% (from 104 to 95.5). This is the way a
leveraged fund is designed: to track the daily movement of the
underlying index.

After two days, the underlying index has a cumulative return of 2%

(from 100 to 102), but the leveraged inverse fund has a cumulative
loss 4.49% (from 100 to 95.51), not 4%. Hence, this illustrates
that the accumulation of daily movements (regardless of direction
or multiples) over a time period is not the same as the cumulative
movements over the same period. The higher the multiples, the
higher will be the “distortion”.

(c) A Product With Capital Appreciation Potential

This structured ILPs’ aim is to maximise capital appreciation
potential, with less focus on the safety of principal. One such
product has the following stated investment objective:

“The Fund aims to provide long-term capital appreciation

and to achieve the best possible result.

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The Fund was invested as of 30 April 2010 in:

 Synthetic zero coupon bond, 85%, and
 International Derivatives Fund, 15%.”

Unlike the regular payment or indexed return products, these

products are not designed to protect capital, or measured against
any performance benchmark. In this particular example, while the
use of synthetic zero coupon bonds offer a certain degree of
protection, synthetic bonds are riskier than traditional bonds. Its
use does not detract from the fund’s main objective to maximise
capital appreciation.

3. WHO WOULD INVEST IN STRUCTURED ILPs?

Structured ILPs are useful to investors who are seeking capital appreciation
with a medium to high tolerance for loss of capital. They are also suitable for
investors who are interested in specialty investment areas (such as hedge
funds and private equity), but do not have sufficient experience, knowledge
or resources, to invest in such niche areas on their own. In deciding whether
structured ILPs are suitable, the investors should weigh the additional costs
and risks against the benefits.

An ILP has similar characteristics to a CIS. The decision to buy a structured

ILP or a structured fund, or any other CIS with similar investment strategy is
often influenced by non-investment factors, such as the relationship with the
sales representative, and the perceived difference in customer service.

4. WHEN ARE STRUCTURED ILPs UNSUITABLE?

Structured products are more complex than the traditional investment

instruments, such as stocks and bonds. The more complex the product, the
more difficult it is for the investor to understand how the product behaves
under different market conditions. An investor who does not understand the
features of a structured ILP, including the maximum possible loss, should
either not invest in it, or invest in a smaller amount to minimise his exposure.

An investor with a low risk tolerance should consider carefully before

investing in a structured ILP, as it often carry a higher degree of risk as
compared to the traditional investments. There are structured products
designed to resemble bonds, with regular “coupon” payments and repayment
of “par” value at maturity, or to resemble equity investments with return
pegged to market indexes. However, the risk profiles may be substantially
different from that of bonds and shares, as described in previous chapters.
Structured ILPs may not be suitable for investors who do not understand the
features of the product, in particular those who do not fully understand the
“risk and return” trade-off of the product.

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5. GOVERNANCE

An insurer marketing structured ILPs must comply with requirements in the

Financial Advisers Act (Cap. 110), the Insurance Act (Cap. 142), related
regulations and relevant notices and guidelines issued by the MAS. They
must also observe the relevant sections of the Code on CIS (the “Code”)5.

In particular, Notice No: MAS 307 on ILP sets out the requirements for
valuation, audit, disclosure, payments and others.

5.1 Legal Structure Of ILP

Assets of an ILP are held under the investment-linked sub-fund. An

investment-linked sub-fund is not a trust. Unlike a trustee (in the case
of a unit trust) who holds the fund assets on behalf of unit-holders, the
insurer is the legal owner of assets in the ILP fund. However, the ILP
fund and its associated sub-funds have quasi-trust status in Singapore,
because the Insurance Act (Cap. 142) gives the policy owners priority
claims over the general creditors in the event of liquidation.

5.2 Investment Guidelines For Retail Funds

The Code was first issued in 2002. Since then, it has been amended
several times, most recently in August 2014, to cater to market
developments and feedback from the fund management industry. It
contains core investment guidelines for all funds (including structured
funds), and special guidelines for money market funds, hedge funds,
capital guaranteed funds, index funds and property funds.

The purpose of the Code is to foster retail investors’ confidence in

Singapore retail funds, by clearly specifying the duties of the trustee and
the manager, and how the funds should be managed and valued. The
Code strives to balance the investor’s interest with industry
developments, recognising that overly restrictive investment guidelines
are not necessarily to the investor’s advantage.

Do note that the investment guidelines in the Code are complex and
detailed. The purpose of this section is to highlight the general investment
restrictions that exist for retail funds in Singapore. It is not meant to
capture or reproduce the Code. As a result, some details on the
conditions, qualifications or exemptions associated with the restrictions
are omitted. The readers should not assume that the restrictions listed
below are complete.

5
Paragraph 51 of Notice No: MAS 307 stipulates that an insurer should ensure that an ILP sub-
fund complies with the requirements as contained in the relevant appendices of the CIS Code, as
if the ILP sub-fund were a “fund”, “scheme” or “collective investment scheme” and product
summary were a “prospectus”.

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The investment restrictions imposed by the Code are meant to address

the risk factors as mentioned below.

(a) Liquidity Risk

Only liquid investments and those subject to reliable and verifiable
valuation on a daily basis are permitted under a retail CIS. This
includes shares, bonds, deposits, money market instruments, and
financial derivatives. A retail CIS is not allowed to invest in another
hedge fund or a fund of hedge funds.

(b) Concentration Risk

Concentration is the “putting most of your eggs in one basket”
syndrome. It not only overexposes the fund to the issuer’s credit risk,
but also affects the fund’s liquidity, because it takes time to unwind
a large position without disrupting the market. A retail CIS is subject
to the following concentration limits:
 Single issue of securities - No more than 10% of the fund’s NAV
may be invested in a single issue of securities.
 Single entity limit - The exposure to a single entity is capped at
10% of the fund’s NAV. In calculating the limits, risk exposure to
the underlying financial derivatives, investments in securities
issued by and deposits placed with the entity are to be included.
The limit is reduced to 5% for unrated for non-investment grade
corporate debt securities. The limit is raised to 35%, if the issuing
entity or the issue is guaranteed by government or quasi-
government agencies with minimum credit rating.
 Single group limit - The exposure to a single group of entities
(including the entity, its holding company, its subsidiaries and
related special purpose vehicles) is capped at 20% of the fund’s
NAV. The limit is raised to 35%, if the issuer or issue is
guaranteed by government or quasi-government agencies with
minimum credit rating.

(c) Credit Risk

 Securities lending - Securities lending is an arrangement under
which the lender transfers securities to the borrower by way of
sale, and the borrower agrees to transfer those securities, or
securities of the same type and amount, back to the lender at a
later date via a repurchase. There must be a separate transaction
which transfers collateral to the lender to cover the risk that the
future resale / repurchase of the securities cannot be satisfactorily
completed. All benefits of ownership, except proxy voting, are
transferred back to the lender under contractual arrangements.

Securities lending by a retail CIS is permitted for the sole purpose

of effective portfolio management, with proper collaterals. The
counterparty to a securities lending agreement should be a
financial institution of minimum credit rating, and subject to
prudential supervision by a financial supervisory authority in its
home jurisdiction. The fund manager should address risks

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associated with securities lending, including borrower credit risk,

collateral deficiency risk, settlement risk, investment of cash
collateral risk and fund liquidity risk.
 Capital guaranteed funds - A guarantee is only as good as the
credit standing of the guarantor. Therefore, guarantors of capital
guaranteed funds must have a minimum long-term credit rating.
The long-term credit rating is a forward-looking opinion about an
obligor’s overall ability to meet its financial obligations that have a
maturity of more than one year.

(d) Counterparty Risk

Managers may only enter into OTC financial derivative transactions
with a counterparty which is a financial institution, subject to
prudential supervision by a financial regulator in its home jurisdiction.
If the financial derivative transaction takes place on an exchange,
where the clearing house acts as a central counterparty, the
counterparty risk is taken as zero.

The counterparty exposure is capped at 10% of the fund's NAV for

financial institutions that meet a minimum long-term credit rating. For
other financial institutions, the counterparty exposure is capped at
5%. The exposure to a counterparty may be considered to be lower if
it is backed by suitable collateral.

(e) Financial Derivatives

To mitigate the risks arising from the use of financial derivatives, the
exposure of a fund to the underlying assets of financial derivatives
should be sufficiently diversified on a portfolio basis. In addition,
financial derivatives must be:
(i) liquid;
(ii) subject to reliable and verifiable valuation on a daily basis; and
(iii) able to be sold, liquidated or closed by an offsetting transaction
at any time at their fair value.

In the case of financial derivatives on commodities, the transactions

must be cash settled, and the fund’s investments are sufficiently
diversified across different types of commodities.

(f) Other Restrictions

With the exception of property funds, funds should not invest in
infrastructure and real estate.

Funds should not engage in lending of moneys or granting

guarantees, underwriting, and short selling, except arising from
derivatives transactions.

Fund name should be clear and not misleading. The fund name is to
reflect its geographic focus, asset type and sector focus.

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6. TYPICAL TYPES OF DOCUMENTATION AND RISKS

An investor should have sufficient information before he makes an investment

decision, and be kept up to date on the performance of his investments.
Communication with customers is continuous, separated in three stages of the
product life cycle:
 disclosure at the point of sale;
 disclosure at policy inception; and
 ongoing disclosure after policy inception.

6.1 Point-of-sale Disclosure 6 : Product Summary, Benefit Illustration And

Product Highlights Sheet

(a) Product Summary

The MAS requires a product summary be provided during the ILP
sales process. All sales materials must contain information no older
than 12 months before any such marketing. The information that
must be disclosed in the product summary includes the following:

(i) General Information Of The Policy

 A general description, in non-technical terms, of the principal
features of the ILP, including a description of the manner in
which the benefits reflects the investment performance of
each ILP sub-fund and factors affecting the policy benefits;
 A list of the ILP sub-funds available for investment, their
investment managers and sub-managers, and the funds’
auditors;
 Information on the fund manager; and
 The structure, investment objectives, focus and approach of
each available ILP sub-fund. If the sub-fund is included under
the CPF Investment Scheme, state so and indicate its risk
classification.

(ii) Fees And Charges

Disclosure of all fees and charges for the ILP and ILP sub-fund,
whether through deduction from premium, cancellation of
units, or deduction from asset value of the fund. Where there is
a provision for a maximum fee or charge payable, highlight that
fact and state that maximum.

(iii) Risk Information

 Warning statements on the general risks of investing in the
ILP and each ILP sub-fund.
 Description and explanation of major risks peculiar to the ILP
sub-fund, including any risk arising from the markets,
countries or sectors in which the ILP sub-fund invests; the

6
Refer to Notice No: MAS 307 for complete description of the requirements.

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 4. Introduction To Structured ILPs

foreign currency exposure and any hedging policy adopted;

and over-concentration risk, if any.

(iv) Fund Performance

 A statement of the return on the ILP sub-fund over the last
one, three, five, ten years and since inception of the ILP
sub-fund, where applicable.
 A warning that any past performance of the ILP sub-fund is
not necessarily indicative of the future performance of the
ILP sub-fund.
 The insurer SHALL NOT include in the product summary, or
in any of the documents provided to the policy owners, any
information on past performance based on the simulated
results of a hypothetical fund.
 The insurer SHALL NOT include in a product summary any
comparison of the past performance of the ILP sub-fund
with that of another form of investment, or another CIS or
ILP sub-fund, unless:
(1) they share similar risk profile, investment objectives and
investment focus; and
(2) the past performance is calculated net of fees and
charges and the basis of calculation is stated.

(v) Other Miscellaneous Items

The product summary should also include description and / or
explanation of subscription and redemption of units (if the ILP
sub-fund is structured as a unit trust), expense ratio, turnover
ratio, soft dollar commissions, conflict of interest, financial
year-end, and any other material information.

(b) Benefit Illustration

The purpose of a benefit illustration is to show the potential policy
owner how the policy value accumulates under reasonable
investment expectation. One important feature of the benefit
illustration is to distinguish the guaranteed benefits from the non-
guaranteed benefits under the policy. The Life Insurance
Association, Singapore is responsible for issuing guidelines on
benefit illustrations. The guidelines are binding on all its members.

For ILP products, two hypothetical rates of returns must be used,

to demonstrate the uncertainty of the potential return. In choosing
the two illustration rates, the insurer should take into account what
could be realistically expected to earn under the adopted
investment strategy. Do refer to Appendix 4A and 4B for examples
of how policy benefits are illustrated, one for a short-term plan,
while the other for a long-term plan.

(Note that the examples shown are only the numeric portions of
benefit illustrations. A complete benefit illustration includes

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explanation of terms used, and client’s signature acknowledging

receipt of the benefit illustration.)

(c) Product Highlights Sheet (PHS)

The purpose of providing a PHS is to highlight key features and risks
inherent in the ILP sub-fund under consideration. The prospective
policy owner should read the product summary first, to gain a basic
understanding of the product features, and then read the PHS which
is prepared in a question-and-answer format, to address any
questions that he may have. The PHS should not contain any
information that is not in the product summary.

There is a prescribed format of how the PHS should be prepared7,

giving answers and explanations to the following questions, at a
minimum:
 Who is the sub-fund suitable for?
 What are you investing in?
 Who are you investing with?
 What are the key risks of this investment?
 What are the fees and charges of this investment?
 How often are valuations available?
 How can you exit from this investment, and what are the risks and
costs in doing so?
 How do you contact the insurer?

The answers and explanations provided in the PHS should be clear

and use simple language for ease of understanding. To this end,
the insurer should observe the following requirements:
 the use of diagrams (graphs, charts, flowcharts, tables) and
numerical examples to explain structures and payoffs of the
product aids investor’s understanding, and is encouraged;
 technical jargons should be avoided. When technical terms are
unavoidable, a glossary should be attached to the PHS to explain
these technical terms;
 the PHS should not be longer than four pages, not counting
diagrams and glossary. The PHS, including diagrams and glossary,
should not exceed eight pages;
 text, including footnotes and references, should be in a font size
of at least 10-point Times New Roman; and
 an insurer shall refrain from including disclaimers in a PHS.

6.2 Disclosure At Policy Inception: Policy Document

A policy document is issued after the investor has purchased a

structured ILP. The policy owner is given 14 days to review the policy

7
Refer to Notice No: MAS 307, Annex Ha for the prescribed template.

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 4. Introduction To Structured ILPs

document and to decide if he wants to keep the policy or cancel it.

Upon cancellation, the policy owner receives a full refund of the
premium paid, adjusted for any downward market price movements in
the Net asset value (per unit) of the ILP during the period.

The policy document is the evidence of the insurance contract between

the insured and the insurer. It contains all the information found in the
product summary, as well as those described below.

(a) Fees And Charges

There are two ways to pay fees and charges under an ILP. One
way is through deduction of premium or cancellation of units. For
example, the upfront sales commission is deducted from the single
premium before the balance is invested in the underlying ILP sub-
funds. Ongoing mortality and administrative charges, if any, are
payable by deducting units from the investor’s account monthly,
quarterly or annually. The other way is through payment directly
from the assets of the ILP sub-fund. For example, fund
management charges and auditor’s fees are deducted from the
fund’s net asset value, before the unit price is determined.
However, marketing and promotional expenses are NOT allowed to
be paid from the sub-fund.

All fees and charges payable under the policy, however they are
paid, must be specified in the policy document. Fees need not be
fixed for the term of the policy. Where the insurer has the right to
make changes to the fee schedules, the insurer must highlight that
fact, and state the maximum if there is a provision for a maximum
fee or change payment. The policy document must also state how
future changes will be communicated to the policy owner.

(b) Subscription And Redemption Of Units

Most ILP sub-funds are set up as unitised funds. The policy
document should specify how units are subscribed and redeemed,
such as:
 the pricing basis (i.e. whether done on a forward or historical
basis, whether done on a bid-offer or single pricing basis);
 dealing deadline;
 the minimum holding amount and minimum redemption amount;
and
 stating the circumstances in which the insurer or manager for the
ILP sub-fund, or any other person may be required to purchase
from the policy owner any unit subscribed for or acquired by the
policy owner, and the method of determining the price at which
the unit is to be purchased.

(c) Switching Of Sub-funds

Some policies allow switching between ILP sub-funds. There may
be a restriction on how many times switching may be done in a
year. There is a cost involving in switching funds, as the switching

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is done on a bid-offer basis. However, some policies allow one

switching per year free of charge, i.e. done on a bid-to-bid or offer-
to-offer basis. If switching is allowed under the policy, the policy
document should specify the procedures involved. For structured
ILP, it is common to have only one fund available, and switching is
not allowed.

(d) Suspension Of Dealings

Under certain market conditions, the insurer may decide to suspend
some or all of the activities for ILP policies. For example, when a
large number of policy owners wanting to redeem their units under
their policies, the insurer may need to sell off a large portion of the
portfolio to meet the amount of cash required. If the underlying
investments are illiquid, there may not be a ready market, and the
sale may artificially depress the market value. Under such
circumstances, for the protection of the remaining policy owners,
the insurer may decide to suspend the unit redemption.

Where the insurer reserves the right to suspend dealings, the policy
document should describe the exceptional circumstances under
which the insurer would do so.

6.3 After Sales Disclosure: Policy Statements And Fund Reports

At least once a year, the insurance company must send to all policy
owners a statement on the performance and status of their policies,
called the “Statement to Policy Owners”, within 30 days after each
policy anniversary. For ease of administration, the insurer may choose a
common date in the calendar year to issue the Statement to all policy
owners.

The Statement is to show the transactions occurred during the

statement period, and the current values under the policy on the
statement date. It should contain the following information:
(a) number and value of units held at the end of the previous
statement period;
(b) number and value of units (at point of subscription) bought during
the statement period including the average unit price8;
(c) number and value of units (at point of redemption or deduction)
sold or deducted during the statement period including the average
unit price;
(d) number and value of units held at end of current statement period;
(e) fees and charges payable through deduction of premium or
deduction of units, identifying each by the purpose for which the
fees and charges relate, such as initial charge, charge for insurance
coverage or switching fee;
(f) premiums received during the statement period;

8
“Average unit price” is calculated as the value of units divided by number of units.

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 4. Introduction To Structured ILPs

(g) current death benefit at the end of the current statement period;
(h) net cash surrender value at the end of the current statement
period; and
(i) amount of outstanding loans, if any, at the end of the current
statement period.

In addition, the insurer must provide a “Semi-Annual Report” and the

“Relevant Audit Report” on each of the ILP sub-funds, within two
months and three months, respectively, from the last date of the period
to which the report relates. These two fund reports need not be
provided for a newly launched fund, or a fund to be terminated or reach
maturity date soon9.

Among other things, the Semi-Annual Report should include (a) the
market value of investments; (b) top 10 holdings at market value; and
(c) market value of exposure to derivatives. All values must be shown
in both dollar amounts and as percentage of net asset value (NAV).

The insurer may send these statements and reports by electronic means
if the policy owner has given written consent to receive them in such a
manner.

6.4 Risk Considerations

Chapter 2 has identified various risk factors for structured products:

market risk; counterparty credit risk; liquidity risk; foreign exchange
risk; risks inherent in product structure; and others. It is not possible to
completely eliminate investment risks. Even the safest investments, the
investment grade sovereign securities, carry some level of risk that the
country may default. A more appropriate response is to manage risk
according to risk tolerance.

There are various risk management techniques that an investor may

adopt to mitigate or manage the investment risks.

A common method to reduce market risks is diversification of

investments across asset classes and geographic locations, and by
using negatively correlated securities. By holding investments in a
broad spectrum of asset classes and geographic locations, the market
downturn in one asset class or market is offset by the upturns in other
asset classes and markets. Likewise, the loss from one security is
cushioned by the gain from another negatively correlated security.

Credit and FX risks can be shared or transferred to another party

through the use of swaps and credit derivatives. However, keep in

9
The Semi-Annual Report and Relevant Audit Report need not be provided if the reports cover a
period of less than three months from the launch of the ILP sub-fund, or the termination or
maturity date of the ILP sub-fund is within one month from the date of the report that is due to
be sent to the policy owners.

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mind that, while the use of derivatives may mitigate one type of risk, it
introduces another - the counterparty risk.

7. AFTER SALES

7.1 Valuation

The value of an ILP sub-fund is based on the NAV of the sub-fund. The
only exception is a capital guaranteed fund, whose value upon maturity
is the higher of the NAV and the guaranteed amount.

Notice No: MAS 307 requires that the value of quoted investments of
an ILP sub-fund should be based on:

(a) the official closing price or the last known transacted price on the
organised market on which the investment is quoted; or
(b) the transacted price on the organised market on which the
investment is quoted at a cut-off time specified in the product
summary and applied consistently by the manager;

unless such price is not representative or not available to participants of

the organised over-the-counter market. The manager of an ILP sub-fund
should be responsible for determining, with due care and in good faith,
whether the price should be considered representative.

Nonetheless, if the manager of the ILP sub-fund believes that the

transacted price is not representative or not available to the market, the
NAV should then be based on “fair value” of the assets, which is the
same valuation basis that applies to unquoted investments of a fund.

Fair value is the price that the fund can reasonably expect to receive
upon the current sale of the asset, determined with due care and in
good faith. The basis for determining the fair value of the asset should
be documented.

When the fair value of a material portion of the fund cannot be

determined, the manager of the ILP sub-fund should suspend valuation
and trading of units.

A structured ILP sub-fund should be valued at least once a month.

7.2 Pricing Information

Unit prices of ILPs are published in newspapers, as well as on the

insurer’s website.

As part of the ongoing disclosure requirements, semi-annual fund

reports are prepared for each ILP sub-fund. Among other things, the
report contains the following information on fund values and
performance:

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 4. Introduction To Structured ILPs

(a) investments at market value and as a percentage of NAV as at the

end of the period under review; and
(b) the performance of the ILP sub-fund and where applicable, the
performance of the benchmark, in a consistent format, covering the
periods of three months, six months, one year, three years, five
years, ten years, and since inception of the ILP sub-fund.

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Module 9A: Life Insurance And Investment-Linked Policies II

Appendix 4A
For Information Only
Sample Benefit Illustration 1
Prepared For: Mr John Smith Payout Frequency: Yearly
Age Next Birthday: 50 Years, Policy Term: 5 Years
Male Non-smoker
Occupation: Account Executive Sum Assured: S$10,500
Single Premium: S$10,000

Benefit Illustration Per S$10,000 Single Premium:

CASH VALUE (S$) DEATH BENEFIT (S$) INCOME PAYOUT

(S$)

End of Total Non-Guaranteed Total Total Non-Guaranteed Total Non-

Policy Projected at investment Guaranteed Projected at investment Guaranteed
Year return of return of Projected at
investment return of

4.3% 5.3% n/a 4.3% 5.3% 4.3% 5.3%

1 7,620 9,520 10,500 10,500 10,500 304 380

2 7,710 9,640 10,500 10,500 10,500 304 380

3 7,810 9,760 10,500 10,500 10,500 304 380

4 7,900 9,880 10,500 10,500 10,500 304 380

5 8,000 10,000 10,500 10,500 10,500 304 380

MATURITY BENEFIT (S$) TOTAL VALUE INCL INCOME PAYOUTS (S$)

Total Non-Guaranteed Projected at Total Non-Guaranteed Projected at investment

End of Policy investment return of return of
Year
4.3% 5.3% 4.3% 5.3%

5 8,000 10,000 9,520 11,900

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 4. Introduction To Structured ILPs

Appendix 4B
For Information Only
Sample Benefit Illustration 2
Prepared For: Mr Prospect Policy Term: To age 99
Age Next Birthday: 33 Years, Sum Assured: S$625,500
Male Non-smoker
Occupation: Account Executive Single Premium: S$500,000

 Global Equity Fund…………....10%

 Global Fixed Income Fund……10%
 Capital growth Fund.………….80%

Capital Growth Fund matures in 10 years. For the purpose of this benefit
illustration only, it is assumed that all units in this fund upon maturity will be
switched into another fund with comparable charges.

Total Total
End of Surrender Value Death / Terminal Illness / TPD Benefit Effect of
Premium Dist’n
Policy Non-guaranteed (S$) (S$) Deduction
Paid Cost
Year
(S$) (S$) 5% 9% Guaranteed 5% 9% (S$)
1 500,000 13,750 504,552 523,774 625,000 625,000 625,000 21,226
2 500,000 13,750 522,201 562,746 625,000 625,000 625,000 31,304
3 500,000 13,750 540,468 604,618 625,000 625,000 625,000 42,896
4 500,000 13,750 559,373 649,606 625,000 625,000 649,606 56,185
5 500,000 13,750 578,939 697,942 625,000 625,000 697,942 71,370
6 500,000 13,750 599,190 749,874 625,000 625,000 749,874 88,677
7 500,000 13,750 620,150 805,670 625,000 625,000 805,670 108,350
8 500,000 13,750 641,842 865,617 625,000 641,842 865,617 130,664
9 500,000 13,750 664,293 930,025 625,000 664,293 930,025 155,921
10 500,000 13,750 687,530 999,226 625,000 687,530 999,226 184,456
15 500,000 13,750 816,489 1,430,567 625,000 816,489 1,430,567 390,674
20 500,000 13,750 969,636 2,048,107 625,000 969,636 2,048,107 754,098
25 500,000 13,750 1,151,509 2,932,224 625,000 1,151,509 2,932,224 1,379,316
30 500,000 13,750 1,367,495 4,197,993 625,000 1,367,495 4,197,993 2,435,846
35 500,000 13,750 1,623,993 6,010,162 625,000 1,623,993 6,010,162 4,196,822
40 500,000 13,750 1,928,603 8,604,600 625,000 1,928,603 8,604,600 7,100,110
Age 55 500,000 13,750 1,074,988 2,540,150 625,000 1,074,988 2,540,150 1,088,787
Age 65 500,000 13,750 1,276,622 3,636,670 625,000 1,276,622 3,636,670 1,946,900

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Module 9A: Life Insurance And Investment-Linked Policies II

Benefit Illustration
End of Total DEATH BENEFIT
Policy Premiums Guaranteed Projected at Projected at
Year / Paid To (S$) [X%] investment return [Y%] investment return
Age Date Non-guaranteed Total (S$) Non-guaranteed Total (S$)
(S$) (S$) (S$)
1 / 36 500,000 625,000 0 625,000 0 625,000
2 / 37 500,000 625,000 0 625,000 0 625,000
3 / 38 500,000 625,000 0 625,000 0 625,000
4 / 39 500,000 625,000 0 625,000 24,606 649,606
5 / 40 500,000 625,000 0 625,000 72,942 697,942
6 / 41 500,000 625,000 0 625,000 124,874 749,874
7 / 42 500,000 625,000 0 625,000 180,670 805,670
8 / 43 500,000 625,000 16,842 641,842 240,617 865,617
9 / 44 500,000 625,000 39,293 664,293 305,025 930,025
10 / 45 500,000 625,000 62,530 687,530 374,226 999,226
15 / 50 500,000 625,000 191,489 816,489 805,567 1,430,567
20 / 55 500,000 625,000 344,636 969,636 1,423,107 2,048,107
25 / 60 500,000 625,000 526,509 1,151,509 2,307,224 2,932,224
30 / 65 500,000 625,000 742,495 1,367,495 3,572,993 4,197,993

End of Total SURRENDER VALUE

Policy Premiums Guaranteed Projected at Projected at
Year / Paid To (S$) [X%] investment return [Y%] investment return
Age Date Non-guaranteed Total (S$) Non-guaranteed Total (S$)
(S$) (S$) (S$)
1 / 36 500,000 0 504,552 504,552 523,774 523,774
2 / 37 500,000 0 522,201 522,201 562,746 562,746
3 / 38 500,000 0 540,468 540,468 604,618 604,618
4 / 39 500,000 0 559,373 559,373 649,606 649,606
5 / 40 500,000 0 578,939 578,939 697,942 697,942
6 / 41 500,000 0 599,190 599,190 749,874 749,874
7 / 42 500,000 0 620,150 620,150 805,670 805,670
8 / 43 500,000 0 641,842 641,842 865,617 865,617
9 / 44 500,000 0 664,293 664,293 930,025 930,025
10 / 45 500,000 0 687,530 687,530 999,226 999,226
15 / 50 500,000 0 816,489 816,489 1,430,567 1,430,567
20 / 55 500,000 0 969,636 969,636 2,048,107 2,048,107
25 / 60 500,000 0 1,151,509 1,151,509 2,932,224 2,932,224
30 / 65 500,000 0 1,367,495 1,367,495 4,197,993 4,197,993

Table Of Deductions
End of Total DEDUCTIONS
Policy Premiums Projected at X% investment return Projected at Y% investment return
Year / Paid To- Value of Effect of Non Value of Effect of Non
Age date Premiums Deductions Guaranteed Premiums Deductions Guaranteed
(S$) Paid To Date To Date Cash Value Paid To Date To Date Cash Value
(S$) (S$) (S$) (S$) (S$) (S$)
1 / 36 500,000 525,000 20,448 504,552 545,000 21,226 523,774
2 / 37 500,000 551,250 29,049 522,201 594,050 31,304 562,746
3 / 38 500,000 578,813 38,345 540,468 647,515 42,897 604,618
4 / 39 500,000 607,753 48,380 559,373 705,791 56,185 649,606
5 / 40 500,000 638,141 59,202 578,939 769,312 71,370 697,942
6 / 41 500,000 670,048 70,858 599,190 838,550 88,676 749,874
7 / 42 500,000 703,550 83,400 620,150 914,020 108,350 805,670
8 /43 500,000 738,728 96,886 641,842 996,281 130,664 865,617
9 / 44 500,000 775,664 111,371 664,293 1,085,947 155,922 930,025
10 / 45 500,000 814,447 126,917 687,530 1,183,682 184,456 999,226
15 / 50 500,000 1,039,464 222,975 816,489 1,821,241 390,674 1,430,567
20 / 55 500,000 1,326,649 357,013 969,636 2,802,205 754,098 2,048,107

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 5. Portfolio Of Investments With An Insurance Element

Chapter
5 PORTFOLIO OF INVESTMENTS
WITH AN INSURANCE ELEMENT

CHAPTER OUTLINE
1. What Is A Portfolio Of Investments With An Insurance Element?
2. Advantages And Disadvantages Of Portfolio Of Investments With An Insurance
Element
3. Who Would Invest In Portfolio Of Investments With An Insurance Element?
4. When Are Portfolio Of Investments With An Insurance Element Unsuitable?
5. Governance And Typical Documentation

KEY LEARNING POINTS

After reading this chapter, you should be able to:
 describe the portfolio of investments with an insurance element
 understand the advantages and disadvantages of investing in the portfolio of
investments with an insurance element
 explain who would or should not invest in the portfolio of investments with an
insurance element
 describe the governance and typical documentation of portfolio of investments
with an insurance element

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1. WHAT IS A PORTFOLIO OF INVESTMENTS WITH AN INSURANCE

ELEMENT?

A portfolio of investments with an insurance element is generally

understood as an insurance wrapper product that provides the flexibility of a
wide range of investment choices. This product may be referred to as a
“portfolio bond” or “insurance wrapper”. It falls within the definition of an
ILP.

Compared to traditional life policies, ILPs provide much greater flexibility (and
responsibility) to investors over how their moneys are invested. However, an
ILP policy owner’s investment choices are limited to what the insurer offers,
and he has no say in the selection of fund managers. “Portfolio bonds” go a
step further by allowing policy owners to appoint managers of their
portfolios, within the insurer’s platform.

“Portfolio bonds” offer a wide range of investment choices. It is possible to

invest in cash and deposits, equities, bonds, derivatives and collective
investment schemes. Where CIS are wrapped under the portfolio, the
requirements under the SFA will apply.

“Portfolio bonds” are popular in countries where insurance policies enjoy tax
benefits. Policy owners enjoy tax advantage by using the insurance platform
to manage their investment portfolios. Although they are called “portfolio
bonds”, they are NOT conventional bonds. The value of portfolio bonds
moves up and down according to the value of their underlying investments
(as opposed to interest rates, in the case of conventional bonds).
Furthermore, there is no guarantee or protection of the principals invested
(as opposed to the repayment of par value, in the case of conventional
bonds).

Like other single premium ILPs, there is usually a small amount of death
benefit included to facilitate the insurance wrapper.

1.1 An Example Of Portfolio Bond Marketed In The United Kingdom (UK)

(a) Product Features1

The International Portfolio Bond is a single premium investment
bond available to UK residents, designed for medium to long-term
investments of at least five to ten years or longer. The minimum
investment is £15,000 (or currency equivalent) for the Family or
Select funds, or £50,000 if invested in External funds or Cash
deposits.

To increase flexibility, the Bond will be made up of a series of 12

identical policies, called segments. It is unit linked, which means
that the investment is used to purchase units in the chosen fund(s),
thereby pooling this investment with those of investors with similar
objectives. This has the benefit of spreading the investment and

1
Source:
https://www.axa-international.com/dotnet/ePublic/basic.aspx?id=AdvProd&almi=EPSQWEB

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 5. Portfolio Of Investments With An Insurance Element

administration costs. Funds are available with a variety of risk

profiles.

The International Portfolio Bond is about choice and flexibility. It

provides a tax efficient product “wrapper” in which your
investment can be managed in one place and in a form that is able
to evolve as your financial requirements change.

It can be used to provide an “income” through regular withdrawals

of capital which may be useful for a range of needs, for instance,
tax efficient school fees planning, or supplementing your income in
retirement. It can be used purely for capital growth which can be
realised at a time to suit you, perhaps waiting until you are in a
more favourable tax bracket. Depending on your investment
choices, you also have the option of adding either Drip-Feeding or
Portfolio Rebalancing to your bond, without further charge.

 What Is Drip-Feeding?
Simply put, drip-feeding is fund-switching implemented in small
doses. Drip-feeding has the benefit of avoiding potential market
disruption when switching funds in large quantities.

 What Is Portfolio Rebalancing?

A portfolio invested 50% / 50% in two funds may become 63%
/ 37% after a few years due to investment experience. To
maintain the original level of risk exposure, a rebalancing by
moving units from one fund to the other is necessary. Portfolio
Rebalancing is an automatic rebalancing on a monthly, quarterly,
half-yearly or annual basis.

In Chapter 4, we have discussed the relationship between

opportunity cost and risk diversification. The same applies to
portfolio rebalancing. Rebalancing means moving units from a
fund that is outperforming other funds into funds that are
performing less well. This means that, while the desired level of
risk is maintained, performance is adversely affected in the short
run.

(b) Fees And Charges

(i) Product Charges
The product charges cover the cost of setting up the bond and
its ongoing administration, including commission paid to the
financial adviser.
(ii) Fund Charges And Other Investment Transaction Costs
Charges are made by the fund manager for running the fund,
including the cost of buying and selling the assets of the fund.
Depending on the funds chosen, there may be an initial charge
and an ongoing fund charge.

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Module 9A: Life Insurance And Investment-Linked Policies II

(iii) Early Withdrawal Charge

There may be a charge imposed by the deposit taker or fund
manager for early withdrawals, e.g. when the investor breaks a
fixed deposit early, or does not provide the required notice
period.
(iv) Surrender Charge
A charge may be payable if the bond, or any policy segment
within the bond, is surrendered. The surrender charge ensures
that the insurer has recovered the costs of setting up the bond,
including any commission paid to the financial adviser, at the
point that the contract is terminated.
(v) Valuation Charge
A yearly statement is provided on each policy anniversary. A
soft copy is available on the insurer’s website at any time, free
of charge. A charge will be imposed for sending paper
valuation statement.
(vi) Payment Charge
Certain methods of payment, such as telegraphic transfers,
result in additional service fees or provider charges.
(vii) Dealing Account – Debit Interest
A Dealing Account is set up when investor elects to invest in
External funds or a combination of External and Family funds or
cash deposits. This is because “funds” are securities. Buying
and selling units in funds are considered dealing in securities. It
is possible for a Dealing Account to hold a negative balance,
for instance, when the charges are applied. In such
circumstances, debit interest will accrue.

2. ADVANTAGES AND DISADVANTAGES OF PORTFOLIO OF INVESTMENTS

WITH AN INSURANCE ELEMENT

Portfolio of investments with an insurance element is often marketed as a

“lifestyle” policy, to satisfy an individual’s changing investment objective
during his lifetime. In his 30’s and 40’s, his main objective is capital
appreciation. In his 50’s and 60’s, his main objective is safety of principal in
anticipation of retirement. After retirement, his main objective is stability of
income and safety of principal. These products offer policy owners the
convenience of buying one policy, and being able to change asset allocation,
fund selection, and make regular withdrawals, as his primary investment
objectives and financial needs change over time.

Another advantage is the convenience of having a consolidated view of

investments in a single statement from the insurer, instead of multiple
statements from various fund managers. On the other hand, the convenience
of consolidation may be accompanied by high charges levied, as insurers will
have to invest considerably in IT systems to integrate with various fund
managers’ reporting systems.

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 5. Portfolio Of Investments With An Insurance Element

3. WHO WOULD INVEST IN PORTFOLIO OF INVESTMENTS WITH AN

INSURANCE ELEMENT?

Since the main advantages are convenience and flexibility, investors who
look to invest in a portfolio of different funds may find this product
attractive. Such a product may also be used for tax planning.

Investors in high tax brackets may benefit from the favourable tax treatment
for insurance products.

4. WHEN ARE PORTFOLIO OF INVESTMENTS WITH AN INSURANCE ELEMENT

UNSUITABLE?

Portfolio bonds are investment products, designed with low level of

protection against death. As such, they are not suitable for individuals
seeking insurance protection.

The investment horizon for portfolio bonds tends to be longer as compared to

other single premium investment products, owing to the longer time period
needed to cover the higher front-end and ongoing fees and charges. This is
partly the reason why they are typically marketed as lifestyle policies,
covering different stages of the lives of the policy owners. Investors with a
three to five-year time horizon may not find the cost-benefit attractive.

Investors who do not need the flexibility offered by such products, may be
unsuitable for this product. For example, an investor who invests in one or
two funds may not benefit from the bells-and-whistles attached to the
product.

Keep in mind that portfolio bonds are not bonds. While it is possible to elect
to receive regular income from the “bond”, the source of payments is
redemption of units, i.e. sale of investments.

5. GOVERNANCE AND TYPICAL DOCUMENTATION

The requirements on sale and documentation will be similar to those of the

typical ILP.

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Module 9A: Life Insurance And Investment-Linked Policies II

Chapter

6
CHAPTER OUTLINE
CASE STUDIES

1. Case Study 1 – Annual Payout Plan

2. Case Study 2 – Lifestyle Plan

KEY LEARNING POINT

After reading this chapter, you should be able to:
 understand structured ILPs through in-depth analysis of two case studies

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 6. Case Studies

1. CASE STUDY 1 – ANNUAL PAYOUT PLAN

1.1 Product Features

ABC Insurance Company issues a Superior Income Plan (SIP), a single

premium five-year investment-linked plan.

(a) Annual Payouts

SIP provides an annual payout, at the end of each policy year, of
the higher of:
(i) a guaranteed payment of 1% of the single premium; or
(ii) a non-guaranteed payment based on the performance of a
basket of six stocks, determined as:

n
5% ×
N

where: n is the number of trading days in which all six

stocks were equal or above 92% of their initial
stock prices (prices at the inception of the policy);
and
N is the total number of trading days in the policy
year.

(b) Maturity Value

Single premium will be re-paid together with the last annual payout.

(c) Death / Accidental Death

101% of the NAV will be paid. In the event of accidental death,
106% of the NAV will be paid.

(d) Surrender / Early Termination By Policy owner

100% of the NAV will be paid.

The guarantee of the minimum 1% annual payout and the re-

payment of single premium upon maturity and early redemption are
provided by XYZ Bank, a non-related entity of ABC. The guarantee
is terminated if XYZ goes into liquidation.

(e) Early Redemption By ABC

After the third month, if all six stocks are equal or above 108% of
their initial stock prices, the single premium will be returned,
together with the pro-rata annual payout. The policy terminates
after the payment is made.

(f) Fees
There is an initial fee of 5% of the single premium, payable through
deduction from the NAV of the sub-fund immediately upon
investment. In addition, there is an annual fund management fee of
1.5% of the sub-fund value, deducted from the fund before the
NAV is determined.

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1.2 Selling Points

SIP combines the advantages of the:

(a) annual payment feature of a bond;
(b) capital appreciation potential of stocks; and
(c) capital guarantee feature of a fixed deposit.

The guaranteed annual payout of 1%, while not high, is competitive as

compared to the prevailing fixed deposit rate, with the added upside
potential if the six stocks perform well.

1.3 Risk Analysis

(a) Guarantee
In all financial products, guarantees come with a price. ABC must
use part of the premiums collected to pay XYZ to provide the
guarantee, which is why the SIP cannot provide the full upside
potential of the six stocks. There is a trade off between safety and
return.

However, guarantees are only as good as the financial strength of

the guarantors. In this case study, the policy document states that
the guarantee is terminated if and when XYZ goes into liquidation.
Without this explicit statement, ABC as the primary party to the
insurance contract must honour the guarantee even if XYZ fails to
do so.

(b) Market Risk

The NAV of the ILP sub-fund is subject to market fluctuation.
Therefore, the amount of the death benefit and the cash value
upon early termination of the policy may be lower than the original
investment. Moreover, because of the initial fees, the fund must
earn at least 5% just to breakeven. It should be noted that the
underlying investments are NOT in the six stocks. The six stocks
are only used as a reference benchmark to determine the level of
annual payout and the occurrence of early redemption.

(c) Early Redemption Risk

The policy is redeemed and terminated when all six stocks are at or
above 108% of their stock prices. The maximum return under the
policy is 5% on an annualised basis. Do not be confused by the
108% reference and think that the maximum return is 8%. The
108% is used as a reference point to determine the occurrence of
early redemption. It has nothing to do with the level of payment to
policy owners. For example, if the price of all six stocks is above
108% of the initial price every trading day after policy inception,
the policy is redeemed and terminated after three months. The
policy owner receives the originally invested single premium, plus
5% return prorated for three months out of the year, or 1.2%. See
Scenario 1 below.

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 6. Case Studies

The early redemption risk is a form of re-investment risk, as the

policy owner faces the risk of re-investing in a rising market. There
is also an element of market risk, as the policy owner loses the
opportunity to enjoy the investment return from a rising market.

(d) Opportunity Cost

The maximum return under the policy is 5%, and there is no
downside risk, other than in the case of early termination by the
policy owner, or when bank XYZ fails to re-pay the capital. In other
words, the policy owner forgoes the full upside potential of these
six stocks in exchange for the capital guarantee. The policy owner
should form his own judgement whether the forgone potential is
commensurate with the guarantee offered.

1.4 Performance Under Different Market Conditions

An investor took up a S$10,000 policy. A few scenarios are

considered, with different level of performance on the six stocks.

Scenario 1: Best Possible Market Performance

(a) Investment Experience

The prices of all six stocks gradually rise to 108%, three months
after the policy inception. None of the stock prices falls below 92%
during the 3-month period. Early redemption is triggered.

(b) Annual Payout

This will be the higher of: (a) guaranteed 1%; or (b) non-guaranteed
5% per annum, pro-rated by number of trading days. Assuming
there are 250 trading days in the policy year, and 60 trading days
in the 3-month period, then the annual payout is the higher of 1%
or 1.2% (i.e. 5% x 60 / 250), which is 1.2%. Hence, there is only
one payout of S$120 (i.e. S$10,000 x 1.2%).

(c) Early Redemption Payment

This will be the initial single premium of S$10,000 plus a single
payout of S$120.

Under this scenario, the policy is terminated after three months,

and the policy owner receives S$120 for the initial S$10,000
investment. The best market performance for the basket of six
stocks is not necessarily the best investment scenario for the policy
owner, as the policy owner’s return is capped at 5% per annum,
and the policy owner now needs to re-invest the proceeds of
S$10,120.

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Scenario 2: Worst Possible Market Performance

(a) Investment Experience

The prices of all six stocks are consistently below 92% of the initial
stock price throughout the five-year period.

(b) Annual Payout

This will be the higher of: (a) guaranteed 1%; or (b) non-guaranteed
5% x n / N. Since the number of trading days in which all six
stocks were equal or above 92% of their initial stock prices
(denoted by n) is 0, the non-guaranteed return is 0, and the
guaranteed 1% applies. For each S$10,000 of initial single
premium, the annual payout is S$100.

(c) Maturity Payout

This will be the initial single premium of S$10,000 plus the final
annual payout of S$100.

Under this scenario, the return under the policy is 1% per year. The
policy owner is protected from the fall in the six stock prices, while
receiving a modest return.

Under this scenario, the policy owner receives a total of S$10,500

over the five years.

Scenario 3: Moderate Market Performance

(a) Investment Experience

The prices of all six stocks trade consistently between 92% to
108% of their initial stock prices throughout the five years.

(b) Annual Payout

This will be the higher of: (a) guaranteed 1% or (b) non-guaranteed
5% x n / N. Since n = N in this scenario, the non-guaranteed
return of 5% is the higher of the two. For each S$10,000 of initial
single premium, the annual payout is S$500.

(c) Maturity Payout

This will be the initial single premium of S$10,000 plus the final
annual payout of S$500.

Under this scenario, the return under the policy is 5% per year, the
best possible return for the policy owner (a total of S$12,500 over
the five-year period). The policy owner forgoes some of the upside
potential of these six stocks, in exchange for the downside
protection.

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 6. Case Studies

Scenario 4: Mixed Market Performance

(a) Investment Experience

The prices of the six stocks fluctuate, but during any trading day,
at least one of the stock prices falls below 92% of its initial stock
price.

(b) Annual Payout

The non-guaranteed portion of the payment is 0, since n = 0. The
annual payout is the guaranteed amount of 1%, or S$100 per
S$10,000 investment.

(c) Maturity Payout

This will be the initial single premium of S$10,000 plus the final
annual payout of S$100.

This scenario is probably the most realistic, as the performance of

the stocks in the basket is more likely to fluctuate based on general
market conditions, industry sector, and the company’s own
situations. It is important to note that the non-guaranteed portion
of the annual payout is determined by the WORST performing
stock in the basket on any given trading day. The likelihood that
the annual payout is better than the guaranteed 1% is substantially
lower, when it is based on six stocks, than if it is to be based just
on any single stock in the basket.

2. CASE STUDY 2 – LIFESTYLE PLAN

2.1 Product Features

Acme Insurance has introduced a flexible Whole Life ILP product that
invests into a variety of funds, including a structured fund called Choice
Fund.

The policy is a recurrent single premium plan, where the policy owner
has full control over the timing of payment to this plan. He may use
this plan as a regular savings plan, or a single premium plan with an
option to top up periodically. He also enjoys the choice of investments
offered by the Acme stable of funds to suit his changing investment
objectives over the term of the policy, with unlimited free switches (if
permitted) between funds.

(a) Death / Total & Permanent Disability Benefit

A guaranteed benefit is provided at 125% of premiums paid upon
death or total and permanent disability of the life insured. Mortality
charges for the death and disability benefit are deducted from the
policy value on an annual basis.

(b) Surrender / Early Termination

100% of the NAV will be paid.

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(c) Fees
There is a front-end sales charge of 5% of each recurrent single
premium paid. Annual fund management fee ranging from 1% to
2% is levied at each sub-fund level.

For the remainder of this case study, we will assume that the
policy owner has chosen to invest in the structured fund, the
Choice Fund.

2.2 Choice Fund – Fund Details

The Choice Fund is a closed-ended fund with a fixed maturity date. The
maturity value is at least equal to the Secure Price. (The Secure Price is
set at the end of each year at the discretion of Acme.)

(a) Investment Objective

The Fund aims to provide long-term capital appreciation and to
achieve the best possible result, so that the payout on each unit on
the Maturity Date is at least equal to the Secure Price.

(b) Performance Benchmark

This is not applicable, because the Fund does not any specific
investment allocation targets.

(c) Fund Information As At 31 March 2011

NAV: S$0.9293
Fund Size: S$6.82 million
Inception Date: 1 April 2008
Management Fee: 1.40% p.a.
Bid / offer Spread: None, as pricing being done on a single pricing
basis
Dealing: Daily
Maturity Date: 1 April 2023
Secure Price: S$1.00455

(d) Fund Performance

3 6 3 Since
1 Month 1 Year
Months Months Years* Inception*
0.58% 1.39% -3.93% -1.82% -2.47% -2.47%
* Annual compounded return.

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 6. Case Studies

(e) Investment Holdings

Description Market Value (S$) % of NAV

OTC Zero-coupon Bonds 6,315,634 92.6
Golden Derivative Fund 170,508 2.5
Cash & Cash Equivalents 334,197 4.9
Total 6,820,339 100.0

2.3 Selling Points

The ILP product combines flexibility of savings with flexibility of

investments with changing life cycles of customers. A young policy
owner may start the plan with small monthly premiums, for example,
and gradually increase the regular premiums, as he becomes more
financially secure. He can also top-up his savings when he receives
lump sum payments, such as year-end bonuses.

Withdrawals can be made at any time to meet his financial needs. The
single unit pricing basis enables customers to make withdrawals,
without suffering an early withdrawal penalty.

When the investment horizon is long initially, the policy owner can
afford to take greater risks, by investing in equity funds with higher
return potential. As time progresses and his investment horizon
shortens, he can make use of the free switching feature to re-allocate
his investments to less risky funds. In this example, the policy owner
has chosen to invest in a structured fund with a fixed maturity date.
When the fund matures, he may choose to invest in other funds,
depending on his financial requirements at that time.

In addition, there is a guaranteed death benefit of 125% of premiums

paid.

This ILP product may be the only investment policy that the customer
needs over his lifetime.

2.4 Risk Analysis (Based On The Choice Fund)

(a) Non-guarantee
This is not a guaranteed product. The Secure Price is not a
guaranteed minimum return upon maturity. It is merely an
investment target that the fund manager strives to achieve. If the
per unit NAV is lower than the Secure Price at maturity, the payout
is based on the unit price, not the Secure Price.

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(b) Market Risk

As is the case with all investment products, the NAV is subject to
market fluctuation. After three years of operation (from 1 April
2008 to 31 March 2011), the unit price is S$0.9293, which means
that a customer invested in the Fund since inception has lost 7% of
his investment.

The Choice Fund does not have any fixed asset allocation strategy,
nor a performance benchmark. This makes it challenging for a client
to assess the market risk inherent in the Fund, because the
manager has the full discretion to invest in any asset class, as he
sees fit. While the investment holdings are predominantly in fixed
income instruments currently, the manager may change the asset
mix drastically in a short period of time if he so chooses. The
investment objective is ambiguous without knowledge of how the
Secure Price is determined. It is important that the policy owners
fully understand and appreciate the risk and return balance of this
fund.

(c) Liquidity Risk

The Fund size is relatively small at S$6.8 million, and is heavily
invested in OTC fixed income instruments. It may temporarily be
unable to liquidate its investment holdings to meet high demand of
withdrawals. When that happens, a policy owner may receive only
part of the cash withdrawal that he needs.

(d) Derivatives Risk

The Fund depends on the exposure to an externally managed
derivative fund, to provide an upside investment potential above
the return from the zero coupon bonds. The policy owners should
review the fund fact sheet and prospectus of the Golden
Derivatives Fund to understand its investment objective and the
associated structural risks.

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 6. Case Studies

ACCESS TO ONLINE E-MOCK EXAMINATION [CLICK HERE]

You can also access the e-Mock examination via an active link
labeled as “E-MOCK EXAMINATION” in the Table of Contents
of the e-book Study Guide (PDF or PC version).

The e-Mock examination can only be accessed from devices with

an internet connection, and which are installed with
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