Evaluation of interest rate-linked DLSs

Abstract

Derivative-linked securities (DLS) is a type of derivatives that offer an agreed return when the underlying asset price moves within a specified range by the maturity date. The underlying assets of DLS are diverse such as interest rates, exchange rates, crude oil, or gold. A German 10-year bond rate-linked DLS and a USD-GBP CMS rate-linked DLS have recently become a social issue in Korea due to a huge loss to investors. In this regard, this paper accounts for the payoff structure of these products and evaluates their prices and fair coupon rates as well as risk measures such as Value-at-Risk (VaR) and Tail-Value-at-Risk (TVaR). We would like to examine how risky these products were and whether or not their coupon rates were appropriate.

We use Hull-White Model as the stochastic model for the underlying assets and Monte Carlo (MC) methods to obtain numerical results.

The no-arbitrage prices of the German 10-year bond rate-linked DLS and the USD-GBP CMS rate-linked DLS at the center of the social issue turned out to be 0.9662\% and 0.9355\% of the original investment, respectively. Considering that Korea government bond rate for 2018 is about 2\%, these values are quite low. The fair coupon rates that make the prices of DLS equal to the original investment are computed as 4.76\% for the German 10-year bond rate-linked DLS and 7\% for the USD-GBP CMS rate-linked DLS. Their actual coupon rates were 1.4\% and 3.5\%. The 95\% VaR and TVaR of the loss for German 10-year bond rate-linked DLS are 37.30\% and 64.45\%, and those of the loss for USD-GBP CMS rate-linked DLS are 73.98\% and 87.43\% of the initial investment. Summing up the numerical results obtained, we could see that the DLS products of our interest were indeed quite unfavorable to individual investors.