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Such nuance creates complexity when it comes to analyzing portfolios and risk. Financial professionals may use proxies because these complicated instruments are hard to model properly. But this common modelling method may be too general to capture enough detail that understands the inherent risks, especially if there are many different types of investments working together inside a portfolio.
What could be a more effective way?
Building to see risk clearly
Proxies are an important tool but can only provide approximations. In some scenarios, they may not account for all the hidden risks within certain types of structured products.
This creates a challenge for advisors, who could miss the nature of what they’re trying to accomplish for their clients during the portfolio construction process, and in client conversations.
What’s enough detail for a decision?
Suppose you are browsing for a new home. A description on the number of bathrooms alone likely isn’t enough information to make a thoughtful decision –or to understand all the elements that may make a place right for your specific needs.
A proxy might not be either for structured products in a portfolio.
Beyond the window
There’s only so much a generic proxy can do. Advisors who can incorporate greater detail into their analyses can better serve their clients’ critical needs for deeper clarity.
One way that advisors can improve their experience is by getting more specific with a bottoms-up, full revaluation for scenario analysis that uses the full terms and conditions of each security, instead of risk parameters to proxy assuming normal distribution.
Modelling structured products based on daily terms and conditions enables advisors to see the potential impact of risk factors before they happen. Advisors can then boost risk/reward conversations with a more complete view of the payoff scenario than just a window of it.
Spotting the details
Let’s dig a bit deeper by looking at a scenario with a sample structured product.
We’ve selected an autocallable structured note that has coupon memory. It’s a complex structured product with many different drivers of risk.
In the chart below, we stress tested how the note would perform when European stocks go up, or down by 10%.
See how there are two very different analyses based on whether you used a proxy or full revaluation model.
How might these analyses shift client conversations?
For illustrative purposes only. 3 Year Tenor, Mono on Euro Stoxx, Quarterly Knockout at 100%, European Knockin at 70%, Quarterly Coupon at 8%, Memory Conditional Coupon at 80%.
As European markets fall (left), the structured product nears breaching its downside barrier. The full revaluation framework captures the increasing equity exposure while using a proxy significantly underestimates the resulting negative return.
When European markets are rising (right), falling volatility in the up-shock generates positive return in the proxy. But when using a full revaluation, the increased likelihood of knockout is captured, outweighing positive returns.
The proxy didn’t capture the full risk picture because of the inherent non-linearity of the structured product. It showed an equal gain or loss of 1.51%, in up or down markets. It didn’t effectively model the specific terms and features of the asset.
With the full revaluation comparison, advisors don’t have to rely solely on proxies.
Advisors can improve client conversations and build portfolios that are better tuned with risks that proxies might miss.
Constructing portfolios with Aladdin Wealth™
The Aladdin Wealth™ platform’s risk engine captures data on a broad array of structured products in the universe. Our teams model these products to keep up with mark-to-market sensitivities.
Our tools help advisors see more clearly into any asset type and how each asset impacts a full investment portfolio. With an enhanced risk picture, advisors can save valuable time to build relationships with clients and discuss financial goals.
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