Trade of the month: Emerging markets underlyings

Emerging markets have always captured the imagination of investors and investment firms, so it is natural that they feature in structured product markets. Volatilities of emerging markets indexes and equities are usually significantly higher than those in developed markets, while interest rate levels in such countries are also often higher than in mainstream markets and stocks usually pay fewer (or no) dividends.

Most investors that want to gain exposure to emerging markets will want to have some long exposure to the market, and structured products are well positioned to offer downside protection. The ideal choice for many investors would be a fully capital-protected product with a participation in the underlying of as near to 100% as possible. However, in the current pricing environment, the likely participation rate would be very low.

The usual range of alternative product choices are possible - such as digital products, autocallables and leveraged products with only soft protection. Such product types are often substitute choices when a desired product type does not look attractive.

With emerging markets there are other ways to finesse the product structure. As well as the future equity prospects in the emerging market, a currency play can be introduced that ties the return of the product to the performance of the local currency. Because of the usual difference in interest rates between an established market (low) and emerging market (high), the currency will be pricing in a predicted depreciation of the higher yielding currency. This will increase the attractiveness of the structured product.

Whether to use the cross-currency effect is an important decision. Some investors might prefer the returns of the emerging market quoted in their own currency (that is, currency hedged or quanto), others prefer to take the currency risk in order to achieve better terms (composite).

The choice of underlying asset is critical with any structured product, but it is probably even more important for products that are linked to emerging markets.

The choice of market is very much a macro-economic and investment decision. It is certainly true that all emerging markets have experienced popularity at various times - Latin America and Asia being the most widely used in the past two decades. Of enduring popularity in the past five years or so are the so-called Bric (Brazil, Russia, India and China) countries. By featuring four major economies in different parts of the world, the idea is to offer a product linked to a basket of emerging markets and therefore achieve diversification. In theory, this should work very well, but in practice the pricing of correlation is usually quite high because although the countries' economies may not be directly linked, as investments they tend to be highly correlated because they fit in the same asset allocation bucket.

Many structured products linked to mainstream indexes will have a three- to five-year maturity, which is not a good match for emerging markets because sentiment can change dramatically over that time period. Various ways exist to counteract such a phenomenon - a product could include features such as lock-ins, averaging or early maturity to offer some protection against downturns.

Another solution is to keep the product term shorter - though this is only really feasible for a product of delta 1 or leveraged return construction, because capital-protected products will not work over this horizon. If the product has tight secondary pricing, then this will give investors further comfort that they can exit when it suits their market views.