1 Consider the structured security disregarding the Upside Payment, Trigger component and any credit risk. This is equivalent to assuming that the Upside payment and the Trigger level are both zero. Decompose the payoff into simpler securities, and compute the market value of each security as of the pricing date. (Make sure not to use any information that was not available on that date, though you are free to make plausible assumptions where necessary. See notes below for tips / allowed simplifying assumptions). (a) Is the value you obtain the same as the issue price, i.e. is the security sold at par? (b) Are there volatility levels that make the value of the security equal to the issue price? Explain your findings and the intuition. 2 Given your calculations in question 1 (i.e. for the simplified security): (a) Is this security a good deal for investors? (b) How do these securities compare with a $10 riskless bond investment? (c) As the issuer, how would you Delta hedge each Dual Directional Trigger Jump security you sell to your clients? Be specific about each position you would take. (d) Suppose you are also worried about the convexity of the product. How would you Delta-Gamma hedge each Dual Directional Trigger Jump security you sell to your clients? Again, be specific about each position you would take. (e) What are the advantages of Delta-Gamma hedging over Delta hedging? Are there any disadvantages? 3 Consider now the Jump components due to upside payment and the trigger level of the security. Intuitively, how do these Jumps change the value of the security? (A payoff diagram could help). 4 Compute the value of the security using Monte Carlo simulation, this time fully taking into account any Jump components (upside payment and trigger level are not zero). Prepare a sales pitch for potential investors based on your best estimate of the value of the security taking into account the Jump components. Make sure to submit a spreadsheet or a computer program showing your simulations as supporting material. (a) Is your price consistent with the one obtained in question 1? (Of course, we do not expect the same value, but they should not be too far apart). Is the value now closer to the asking price of $10? (b) Is there a term of the deal Morgan Stanley can change to make the value exactly $10? 5 Credit Risk: Clearly, Morgan Stanley can go bankrupt before the time of payoff. In this last part, we revisit question 1, under the same assumptions (no jumps), but now con- sider the possibility of default. We use the Merton Model, under the assumption that all of Morgan Stanley's debt (total liabilities) including deposits is senior short-term debt in the form of a zero coupon bond (of course it is not true) maturing in about 1 year.
Proceed as follows (a) Compute the KVM approximation to the face value of MS debt (the default point F) using the 2016Q3 balance sheet information provided for MS. Let T0 = 1 denote the maturity of the short-term zero coupon bond. (b) Use this information together with the market value of equity to compute the value of assets and its volatility. (c) Compute the risk neutral probability that default occurs at T0, when the equivalent short-term zero coupon bond matures (see point 5.a). (d) Assume that if MS does not default at T0, it will certainly pay off the Jump securities, while if it defaults at T0, the Jump investors will receive 0. What is the value of the securities after you adjust for the probability of default? Do your conclusions from question 4.a survive? Discuss.
Where is the economic value, if any, in the issuance of this structured product coming from? 1 Are there any ethical issues in their issuance?