Market Pricing of Credit Linked Notes: The Case of Retail Structured Products in Germany

After Lehman's bankruptcy, we observed that the related CLN in Germany, Singapore and Hong Kong became almost worthless. This raises investors by nature the question, if the issue prices of these instruments were fair and adequate to the related risk. There are several studies on the pricing of equity linked notes or rather certificates especially in the European Markets. For Credit Linked Notes there is no comparable study of overpricing. In our opinion the results of such a study will be of special concern because it will shed more light on the reasons for the overpricing. These products are similar to bonds as well as to reverse convertibles and make the retail investors believe, that they are straight bonds. Furthermore, the replicability for the private investor is in opposite to the institutional investor not practicable and the valuation is depending on the individual characteristics scaleable complex. Therefore, we can measure the complexity on an ordered scale, because complexity strictly increases with the number of reference entities and payments days. In this paper we analyzed the pricing of the 136 outstanding CLN of the four major issuers in the German market. To this end we applied a market based valuation model for CLN, which is based on the reduced model of Jarrow/Turnbull and extended by the single factor Merton model to estimate the joint default probabilities out of assets correlations. The model was calibrated by CDS-spreads and correlations of stock returns for the underlying reference entities. We found out that the observed CLN are generally overpriced in the primary market: Thereby the result is robust to changes of recovery rates or correlation coefficients. As market maker, issuers of structured financial products participate in almost every transaction and they have the incentive to overprice. The more complex the product and the less transparent the market is, the larger overpricing there tends to be. This consideration is confirmed by the results regarding our major hypothesis of overpricing and the extent of overpricing is positively correlated with the number of underlying reference entities, the coupon rates and the maturity of the contract. ii CONTENTS