In Choudry, Explain the decline in demand in the new-issue securitized finance products market following the 2007 financial crisis, it's written that structured products provide inherent leverage. Is this just because the originators of structured products themselves would take out loans to purchase the underlying assets? I thought that due to overcollateralization, the value of assets would be less than liabilities and therefore the leverage would be lower
Question on Choudry's Inherent Leverage
- Thread starter kchristo
- Start date
Lu Shu Kai FRM
Well-Known Member
Hi @kchristo ,
Thanks for your question.
My understanding is that they are different things (1. The inherent leverage in structured products vs 2. Loans taken out by the originators of the structured products).
1. The inherent leverage of structured products come from the layering of derivatives along with a traditional asset. One example would be structured products in the form of notes - take a zero coupon bond with a face value of 100 and an European call option with strike K = 100. Both of the instruments also have the same time to maturity. When both instruments expire, you profit from positive movements in the price of whatever is underlying the European call option. If you are not familiar with the leverage in options, say you have the same option above with stock price 100. If the stock ends up at 120, you gain a profit of max(120 - 100,0) = 20. The leverage comes in as you only need to pay a fraction of the stock price, the premium, to be exposed to favourable movements in the stock price.
2. I think the point on leverage with regards to overcollateralisation is particularly interesting. From Wikipedia, leverage takes place when you take on debt in the purchase of an asset with an expectation that the after-tax profit profit will exceed the financing cost. I don't quite agree that due to overcollateralisation, the leverage (ratio, in this case) would be lower as the cash from the loan must be used for a bet (whether its with stocks, derivatives or business ventures) - this is more of a definition issue for me.
Hope this is helpful!
Thanks for your question.
My understanding is that they are different things (1. The inherent leverage in structured products vs 2. Loans taken out by the originators of the structured products).
1. The inherent leverage of structured products come from the layering of derivatives along with a traditional asset. One example would be structured products in the form of notes - take a zero coupon bond with a face value of 100 and an European call option with strike K = 100. Both of the instruments also have the same time to maturity. When both instruments expire, you profit from positive movements in the price of whatever is underlying the European call option. If you are not familiar with the leverage in options, say you have the same option above with stock price 100. If the stock ends up at 120, you gain a profit of max(120 - 100,0) = 20. The leverage comes in as you only need to pay a fraction of the stock price, the premium, to be exposed to favourable movements in the stock price.
2. I think the point on leverage with regards to overcollateralisation is particularly interesting. From Wikipedia, leverage takes place when you take on debt in the purchase of an asset with an expectation that the after-tax profit profit will exceed the financing cost. I don't quite agree that due to overcollateralisation, the leverage (ratio, in this case) would be lower as the cash from the loan must be used for a bet (whether its with stocks, derivatives or business ventures) - this is more of a definition issue for me.
Hope this is helpful!
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