eThesis - Kauppakorkeakoulun sähköiset gradut

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The main goal of this thesis was to determine what is a good index. Through a theoretical discussion, empirical analysis and consideration of practical aspects, the best index for a case study structured product, the US Residential Real Estate Capital Guaranteed Index-Linked Note, was chosen. The main motivation behind this study was that it is essential to understand how the construction and characteristics of an index affect the performance of the index, especially if one is creating or purchasing an instrument whose return depends on the index. A case study was chosen to give this paper a practical application, and the chosen case study was a capital guaranteed index-linked note because of their unique return possibilities. The research concentrates mainly on choosing the index, but also describes how the case study product is constructed.

The thesis included two research questions. The first research question was how is an index constructed. First, indices were examined from a theoretical point of view via studying index theories and index formulae. The material used was academic literature on index theory, as well as material published by financial institutions. The conclusion of this discussion was that there is no unified opinion upon which is the most accurate or suitable index formula for this case study. The research then took an empirical approach. The two candidates for the index-linked product were the Dow Jones U.S. Real Estate Index and the Philadelphia Housing Sector Index. The Dow Jones Index was more suitable from a practical point of view, as the existence of an exchange traded fund linked to this index makes the options market more liquid. On the other hand, the contents of the Philadelphia Housing Sector index suit the product better – the Philadelphia Index measures the performance of residential real estate sector while the Dow Jones index contains only commercial real estate.

The empirical study utilised time series data acquired from the Bloomberg database. Because of the better availability of options for the Dow Jones Index, it was chosen for closer statistical testing. A regression was run using EViews comparing the monthly returns of the Dow Jones Index and the S&P/Case-Shiller Home Price Composite-20 Index, which was chosen to represent the return development of the housing market. The Dow Jones Index did in fact have a strong positive correlation with the S&P/Case-Shiller Composite index, and thus it was selected as the best index for the case study product. The empirical study, nonetheless, requires further statistical testing to solidify the results.

The second research question was how is a capital guaranteed index-linked note constructed. To answer this question, pricing aspects, different types of structured products and investor and issuer goals were discussed. The study utilised some academic references, marketing materials from financial institutions and an interview from a structured product professional. The construction of the case study was kept to a basic form, consisting of a zero coupon bond and a long position in American call options on the underlying, the iShares Dow Jones U.S. Real Estate Index Exchange Traded Fund. The final conclusions were that even though the projected returns seem promising, the current low interest rate, high volatility, low confidence in financial institutions environment makes the timing poor for issuing the case study product.