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Implicit Hedging and Liquidity Costs of Structured Products

Author

Listed:
  • Kujtim Avdiu

    (Department of Statstics, Oesterreichische Nationalbank (OeNB), Otto-Wagner-Platz 3, 1090 Vienna, Austria)

  • Stephan Unger

    (Department of Economics & Business, Saint Anselm College, Goffstown, NH 03102, USA)

Abstract

This article analyzes the implicit hedging and liquidity costs of structured equity products offered by various financial institutions. We replicate several payoffs of structured products, compare the calculated fair values based on the Heston model as well as geometric Brownian motion, using various optimization techniques, and compare their fair values with the historic prices traded in the market. We find that implicit hedging costs range between 0.9% and 2.9% markup on the fair value, where we find the underlying market volatility to be the relevant driver of this range for complex structures, while market liquidity can be extracted as the only driver of markups for simple structures with no hedging requirements.

Suggested Citation

  • Kujtim Avdiu & Stephan Unger, 2023. "Implicit Hedging and Liquidity Costs of Structured Products," JRFM, MDPI, vol. 16(9), pages 1-14, September.
    • Handle: RePEc:gam:jjrfmx:v:16:y:2023:i:9:p:401-:d:1235061
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    References listed on IDEAS

    as
    1. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    2. Henderson, Brian J. & Pearson, Neil D., 2011. "The dark side of financial innovation: A case study of the pricing of a retail financial product," Journal of Financial Economics, Elsevier, vol. 100(2), pages 227-247, May.
    3. Ammann, Manuel & Arnold, Marc & Straumann, Simon, 2023. "Pricing, issuance volume, and design of innovative securities: The role of investor information," Journal of Financial Intermediation, Elsevier, vol. 55(C).
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