Wealth management

Wealth Management

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Wealth Management

Private Banking, Investment Decisions

and Structured Financial Products

Dimitris N. Chorafas

AMSTERDAM • BOSTON • HEIDELBERG • LONDON

NEW YORK • OXFORD • PARIS • SAN DIEGO

SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO

Butterworth-Heinemann is an imprint of Elsevier

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Butterworth-Heinemann is an imprint of Elsevier

Linacre House, Jordan Hill, Oxford OX2 8DP

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First published 2006

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ISBN 13: 978-0-7506-6855-2

ISBN 10: 0-7506-6855-5

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Contents

Preface xi

Part 1: Private banking 1

1 Private banking defined 3

1.1 Introduction 3

1.2 Private banking clients 4

1.3 Organizational challenges in private banking 7

1.4 Security and secrecy requirements 10

1.5 A private banking roadmap 12

1.6 Household debt and private banking 15

1.7 The ownership society’s recycling pattern 18

1.8 Synergy of private banking and institutional investments 20

2 Know your customer and his or her profile 24

2.1 Introduction 24

2.2 The sense of ‘know your customer’ 25

2.3 A system approach to wealth management 28

2.4 Wealth management according to client profile 32

2.5 Why knowledge engineering can assist the investor 34

2.6 A financial advisory expert system for currency exchange 37

2.7 Caveat emptor and reputational risk 40

2.8 Who is accountable for failures in fund management? 43

3 Business opportunity: fees and commissions from private banking 46

3.1 Introduction 46

3.2 Trades, investments and private banking customers 48

3.3 Establishing a strategy for fees and commissions 51

3.4 Unbundling the management fee 54

3.5 Different companies have different private banking aims 57

3.6 Performance and remuneration of investment managers 59

3.7 Simulation of portfolio performance 62

3.8 The impact of business risk 65

4 Risk and return with investments 68

4.1 Introduction 68

4.2 Basic notions of risk assessment 69

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4.3 Mitigating the risk of losses 72

4.4 Prerequisites for rigorous risk control 75

4.5 Fine-tuning the philosophy of investments 78

4.6 Risk and return with implied volatility 81

4.7 Risk-adjusted pricing: an example with credit risk 84

4.8 An introduction to stress testing 86

Part 2: Asset management 91

5 Asset management defined 93

5.1 Introduction 93

5.2 Asset management and capital mobility 95

5.3 Asset allocation strategies 97

5.4 Asset allocation and the shift in economic activity 101

5.5 Real estate property derivatives: a case study 103

5.6 Passive and active investment strategies 106

5.7 A critical view of alternative solutions 110

5.8 The portfolio’s intrinsic value 112

6 Business models for asset management 116

6.1 Introduction 116

6.2 Choosing the investment manager 118

6.3 Don’t kill the goose that lays the golden egg 120

6.4 The contribution to asset management by contrarians 123

6.5 Asset management as an enterprise 126

6.6 Hedging strategies followed by portfolio managers 129

6.7 Deliverables and performance in administration of assets 132

6.8 Past performance is no prognosticator of future results 134

7 Outsourcing and insourcing wealth management 138

7.1 Introduction 138

7.2 Risk and return with outsourcing 140

7.3 Internal control and security are not negotiable 142

7.4 Custody only, mid-way solutions and discretionary powers 144

7.5 Building up the investor’s portfolio 148

7.6 The option model of investing 152

7.7 Efficiency in private banking and asset management 154

7.8 The private banking profit centre 158

8 Trust duties and legal risk 163

8.1 Introduction 163

8.2 Trusts and trustee responsibilities 164

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Contents vii

8.3 Legal risk and the case of tort 167

8.4 Reasons behind legal risk and cost of litigation 170

8.5 Legal risk and management risk correlate 172

8.6 Mishandling the client: small cases that can lead to legal risk 176

8.7 Big cases of legal risk: high-tech crime and identity theft 178

8.8 Merck and Co.: legal risk with Vioxx 180

Part 3: Derivative financial instruments, structured products and

risk control 183

9 Derivative financial instruments defined 185

9.1 Introduction 185

9.2 Derivatives and hedging 186

9.3 Underlying and notional principal amount 189

9.4 From notional principal to financial toxic waste 193

9.5 Derivatives that became institutionalized 197

9.6 Private banking derivatives and the paper money trauma 199

9.7 Dr Alan Greenspan on derivatives and the case of

hedge funds 202

9.8 George Soros on derivatives 206

10 Structured financial products 209

10.1 Introduction 209

10.2 Structured products and capital protection 210

10.3 Structured versus synthetic products 213

10.4 The role of strategists, traders and modelling controllers 216

10.5 Aftermath of design factors on risk profile 219

10.6 Structured investments are not liquid 222

10.7 A secondary market for structured instruments 225

10.8 Dynamic threshold mechanism 227

11 Controlling the risk taken with structured products 229

11.1 Introduction 229

11.2 Credit risk and exposure at default 231

11.3 Credit risk transfer and hazard rate models 234

11.4 Credit risk volatility and bond spreads 237

11.5 A case study on General Motors 241

11.6 Liquidity risk in an ownership society 243

11.7 General and specific market risk 245

11.8 Stockmarket bubbles and damage control 248

11.9 Risk management and the ‘Greeks’ 250

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viii Contents

Part 4: Case studies with the three main classes of structured products 253

12 Fixed income structured products 255

12.1 Introduction 255

12.2 Fixed interest structured products defined 258

12.3 Constant proportion portfolio insurance 261

12.4 FISP versus CPPI: a comparative study 264

12.5 Borrowing through issuance of derivatives 266

12.6 Capital protection notes and bondholders’ risk 270

12.7 Structured instruments with underlying credit risk 273

12.8 Embedded derivatives for the ownership society 276

13 Practical examples with fixed income derivatives 279

13.1 Introduction 279

13.2 Money rates, money markets and financial instruments 281

13.3 Inflation-linked notes 284

13.4 Stairway notes (step-ups) 288

13.5 Callable reverse floaters 290

13.6 Accrual notes 293

13.7 Fixed and variable rate notes 296

13.8 Bull notes 297

14 Equity-type structured products 300

14.1 Introduction 300

14.2 Headline risk and the nifty-fifty 303

14.3 Equity derivatives defined 306

14.4 Players in equity derivatives 309

14.5 Risks taken with analytics 311

14.6 Criteria used for dynamic rotation 315

14.7 Equity derivatives swaps 316

14.8 The use of embedded barrier options 318

15 Practical examples with equity-type derivatives 322

15.1 Introduction 322

15.2 Equity index and basket structured notes 324

15.3 Absorber certificates 326

15.4 Early repayment certificates 328

15.5 Enhanced yield certificates 330

15.6 Reverse exchangeable certificates 331

15.7 Potential share acquisition certificates 332

15.8 EUR complete participation securities 334

15.9 US dollar non-interest-bearing note linked to equity 336

15.10 The strategy of pruning the basket and reallocating securities 336

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Contents ix

16 Currency exchange structured products 338

16.1 Introduction 338

16.2 Currency transactions and economic exposure 340

16.3 Exchange rate volatility and risk control 343

16.4 Mismatch risk and carry trades 346

16.5 Forex rates and structured instruments 349

16.6 Dual currency structured products 352

16.7 A US dollar/Asian currency basket and a forex benchmark fund 354

16.8 Conclusion 357

Appendix Derivatives as a tax haven 359

A.1 Introduction 359

A.2 Wealth tax 359

A.3 Derivatives, offshores and private individuals 361

A.4 Companies have been masters in using derivatives and offshores 362

A.5 Shifting the risk with no return to the household sector 364

A.6 Cynics look at the private banking client as a cash cow 366

Index 369

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Preface

An investment is a voyage with a purpose, and therefore investors must navigate in

charted waters. Whether a person or a legal entity, an investor who starts nowhere

generally gets there. Few people truly appreciate that wealth management is a process

that never succeeds if it has not been calculated and planned in advance.

What’s more, while the management of wealth seems to be a process simple enough

in its conception, in the general case this is not true. In addition, even if a certain

investment seems to be rather simple, chances are that it will be fairly complicated in

its execution and in its monitoring, particularly when:

The market is nervous,

Volatility is rather high, and

The investor cannot see clearly the aftermath of his or her moves and commitments.

Just as an airline pilot readies himself to act with cool precision in an emergency,

by continually posing to himself problems that could arise at any moment, the

investor should get ready for different market scenarios, including panic. He or she

can do so by examining several alternative courses of action even if one knows in

advance that they have a low probability of materializing. A thorough examination

of alternative plans and market scenarios helps in:

Seeing more clearly, and

Getting ready to act.

Plans made for wealth management must be factual and documented, which is not

always the case. Because of wanting analysis, many investment plans are substandard,

distinguished for nothing else than their confusion. ‘Everything that can be thought

at all, can be thought clearly. Everything that can be said, can be said clearly’, said

Dr Ludwig Wittgenstein. This is precisely the attitude that should characterize the

investor.

Addressed to private investors, a growing breed, as well as institutional investors,

this book has two themes: Private banking and investment decisions regarding

Structured financial products. In meeting this second goal, the text examines in a rig￾orous way whether structured financial products are advisable investments for retail

and institutional investors and, if yes, which risks they entail.

The link between private banking and structured products is strong because, since

the early twenty-first century, banks have offered a whole array of structured finan￾cial instruments to clients whose wealth they manage,. Then, time and again, they

come back to their clients with new structured products that involve many

unknowns.

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xii Preface

During the past few years, private bankers have made plenty of effort to convince

investors that their portfolio should feature a whole array of structured products, up to

5, 10 or 20 per cent of its worth. There is nothing rational about this and, in fact, the

exact percentage depends on the bank’s strategy. The large majority of these clients do not

know enough about derivative instruments to evaluate risk and return. The present book

provides such knowledge, and that is why it is so important to put in the same cover:

Structured products, and

Private banking.

The chapters pertaining to Private Banking have been written mainly, but not

exclusively, for high net worth individuals and people on their way to becoming

financially independent. In the background lies the fact that the wealth characteris￾tics of our society are changing. Just after World War II the Probate Court Records

in New York showed that 85 per cent of people left nothing at all after death; and

only 3.3 per cent left over $40 000.

Happily we are no longer there. Astute individuals realize that on a rainy day they

can depend only on themselves and, therefore, they have to be wealth managers. This

is a fast growing population. In June 2005, the Merrill Lynch/Cap Gemini world wealth

report said that 8.3 million people around the globe have more than $1 million each.

On the institutional side, the typical audience of this book comprises practitioners

and professionals, from treasurers to operations executives, investment officers, risk

management officers and their staff, as well as auditors and financial analysts. On the

retail side, the readership is the educated person in the street, who has become an

investor and cares about his or her nest-egg.

Other populations of readership include investment consultancies, accountancies,

auditing firms, independent rating agencies and, evidently, central bankers, as well as

college and university students. The text has been designed to lead the reader through

ways and means permitting them to capitalize from experience that has been so far

acquired in:

Institutional investment projects, and

Individual investment practices.

As our society becomes increasingly affluent, and state-supported pension and

health-care schemes find it difficult to survive, a growing number of individuals and

families have become retail or private investors. In so doing, they are looking for

ways and means to optimize the management of their wealth. Private banking and

asset management are the main issues addressed by Parts 1 and 2.

The approach that has been chosen deliberately confronts both institutional

investor and private investor requirements. This has been done for three reasons.

First, in many cases, it is difficult to state the difference between an institutional

investor and a high net worth individual, because the latter sets up a company to

manage his or her wealth.

Second, all organizations are made of people. The institutional investors, who are

pension funds, mutual funds and insurance companies, have very similar wealth man￾agement goals to those of private individuals. What both populations are after is to

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Preface xiii

safeguard their capital and gain a decent return, or a much larger return by assum￾ing, unwisely but quite often, an inordinate amount of risk.

The third reason for the synergy existing between the aforementioned two popula￾tions is that both institutional and retail investors are being offered structured finan￾cial products by the banks managing their account. Typically, these are securities that

provide them with a redemption amount, featuring either full or partial capital pro￾tection and some sort of usually unsecured return. Parts 3 and 4 address structured

financial products,

Their polyvalent nature, and

Risk and return that could be expected from them.

Return on structured instruments, which are essentially derivatives, is paid in func￾tion of a specific investment strategy on selected underlying asset(s). This practically

means that a great deal depends on the performance of underlyings. There is no assur￾ance that expected performance will be obtained. This is one of the risks.

Down to basics, with all structured products, risk and return to be expected from

structured products are related to the volatility of future value of an underlying, there￾fore of an a priori investment or trade. Results are based a great deal on market

changes, largely conditioned by the unpredictability of future events. The keywords are:

Volatility

Uncertainty

Exposure.

There are many reasons behind these three keywords and the forces propelling

them; for instance, general and specific leverage. Both general market leverage and

the specific gearing of the structured product magnify the risk(s) confronting the

investor. Other reasons are market psychology and possible market illiquidity. Both

can lead to conditions of growing exposure. Moreover, all financial instruments have

embedded in them the credit risk of their issuer.

Because this book has been written for investors and not for speculators, another

deliberate decision has been to focus on the more common structured instruments

sold as packaged products. In this sense, the more basic characteristics of credit

default swaps, collateralized debt obligations, credit-linked notes and mortgage￾backed securities have not been included in this text. They will be the subject of

another volume.

Examples of structured instruments that are covered are interest rate notes, such as

step-ups and products following different interest rate scenarios, and equity-type

structured instruments linked to a basket of stocks or an equity index. The latter offer

exposure to equity markets, and usually feature different maturities, currencies and

participation levels.

Still other case studies focus on foreign exchange structured products, which often

come in currency pairs and are usually characterized by a strategy that can act on

both the downside and upside of an underlying. Structured notes in connection to

commodities such as currencies, equities and debt are conceived to generate oppor￾tunistic returns according to prevailing macroeconomic or other conditions.

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xiv Preface

Some banks offer their clients structured products linked to selected hedge funds,

which typically feature highly risky mechanisms in order to yield theoretically

attractive returns of the underlying funds. With the exception of the occasional

reference, hedge funds and funds of funds are not part of this text.

Instead of spreading itself too thin on the myriad of market players, the book pays

significant attention to risk management and damage control. Every type of invest￾ment is subject to market forces, and the more leveraged a portfolio, the greater the

risk assumed in expectation of reward. The fact that structured financial products

appeal, or at least are being marketed, to both retail investors and institutional

investors, calls for a dual approach to risk control.

In a nutshell, the best advice that can be given to individual investors, personal

bankers and institutional assets managers on risk control is the way in which Andrew

Carnegie, the great Scottish American industrialist, instructed the directors of his fac￾tories: ‘You have only to rise to the occasion, but no half-way measures. If you are

not going to cross the stream, do not enter at all and be content to dwindle into sec￾ond place.’1

In conclusion, the key elements of both institutional and private investments are

linked to the role of the banking industry in our modern economic and social fabric.

Investing for the future is a necessary precondition for better living, as well as for

many other activities that could not take place without the availability of capital in

the name of private individuals.

At a fundamental level, investing is a peculiar business where the saver pays, often

during many years and well in advance of a potential event, for the coverage of later

years in his or her life. This coverage may then help him to bear the consequences of

adversity. In this sense, investing is an insurance and a trust requiring good governance.

If the trust is shattered even by a small group of individuals or entities in the invest￾ment business, and regardless of whether these individuals violated express company

policy or not, such breach of confidence has repercussions for the banking industry as

a whole, as well as for its clients. This is why wealth management should be treated

boldly as a whole, going to the root of problems and setting it upon sound foundations.

My thanks go to a long list of knowledgeable people and their organizations, who

contributed to the research that led to this text. Without their contributions this book

would not have been possible. I am also indebted to several senior executives of finan￾cial institutions and securities experts for constructive criticism during the prepara￾tion of the manuscript.

Let me take this opportunity to thank Karen Maloney for suggesting this project,

Fran Ford for her hand-holding, Melissa Read for seeing it all the way to publication,

Charlotte Pover and Anne Powell for the editorial work, and Eva-Maria Binder for

compiling the research results, typing the text, and preparing the camera-ready artwork

and index.

Valmer and Vitznau Dimitris N. Chorafas

May 2005

Note

1 P. Krass, Carnegie, Wiley, New York, 2002.

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