Monte Carlo Simulations of Portfolios Allocated with Structured Products : A method to see the effect on risk and return for long time horizons

Sammanfattning: Structured products are complex non-linear financial instruments that make it difficult to calculate their future risk and return. Two categories of structured products are Capital Protected and Participation notes, which are built by bonds and options. Since the structured products are non-linear, it is difficult to asses their long-term risk today. This study, conducted at Nordea Markets, focuses on the risk of structured products and how the risk and return in a portfolio changes when we include structured products into it. Nordea can only calculate the one-year risk with their current risk advisory tool, which makes long time predictions difficult. To solve this problem, we have simulated portfolios and structured products over a five-year time horizon with the Monte Carlo method. To investigate how the structured product allocations behave in different conditions, we have developed three test methods and a ranking program. The first test method measures how different underlying assets changes the risk and return in the portfolio allocations. The second test method varies the drift, volatility, and correlation for both the underlying asset and the portfolio to see how these parameters changes the risk and return. The third test method simulates a crisis market with high correlations and low drift. All these tests go through the ranking program, the most important part, where the different allocations are compared against the original portfolio to decide when the allocations perform better. The ranking is based on multiple risk measures, but the focus in this study is at using Expected Shortfall for risk while the expected return is used for ranking the return. We used five different reference portfolios and six different structured products with specific parameters in an example run where the ranking program and all three test methods are used. We found that the properties of the reference portfolio and the structured product’s underlying are significant and affect the performance the most. In the example run it was possible to find preferable cases for all structured products but some performed better than others. The test methods revealed many aspects of portfolio allocation with structured products, such as the decrease in portfolio risk for Capital Protected notes and increase in portfolio return for Participation notes. Our ranking program proved to be useful in the sense that it simplifies the result interpretations.