Beyond Payoff Diagrams: How to Present Risk and Return Characteristics of Structured Products

Abstract

The market for structured products in Germany and Switzerland experienced a decade of rapid growth before the financial crisis. When Lehman Brothers went bankrupt, however, it became apparent that many private investors had not been aware of the risks involved in these certificates. There is evidence that the success of some of the most popular products was due to behavioral biases of investors. There is also concern that the complexity and diversity of the products was accompanied by low transparency. In practice, the information provided to investors is still often focused on payoff diagrams. For the future development of the market, it is important to improve investors’ information and understanding. To this end, this paper analyzes the information requirements and proposes a risk and return survey to provide relevant and comprehensive information on market risk. Specifically, we propose to illustrate the return probability distribution in three different ways, in particular a rolling dice analogy, apply the Leland model to specify the risk and return tradeoff, and include a specific measure of active risk. We illustrate these measures and information tools for a sample of stylized products.

Keywords: structured products, retail derivatives, risk measurement, risk-return tradeoff, investment decisions, information tools

JEL Classification: G11, G14, G24