A Study On Koda As A New Kind Of Structured Product

Investment and wealth management has during the recent 20 years become the mainstream of development in the international the capital market. Under the name of financial innovation, the structured financial notes—a new type of financing products have attracted extreme attention and undergone a constant increase in terms of issued amount and issued scale. With an exploring growth after the year 2005, the structured notes had had by June 2008 an accumulative issued amount of 316,000 rounds and an accumulative issued scale of Euro 4.4 trillion. Structured financial notes have various forms and various types, with many complicated financial notes derived from basic structured financial notes. KODA is one of them.KODA stands for the Knock Out Discount Accumulator which allows investors to buy leveraged contracts of underlying assets at the discounted price and is generally granted by private banks to clients with high assets. The issuer will design a contract based on the stock price, exchange rate or commodities which enables the investors to buy securities, foreign currency or commodities at a fixed time interval at a discounted price based on the spot price. However, the contract will automatically become invalid when the market price exceeds the spot price to a certain extent while the investors have to buy double or even more of the stocks/foreign currency/commodities at the discounted price when the market price is lower than the discounted price. KODA is generally, included in the over-the-counter trade and can be classified into stock KODA, foreign currency KODA and commodity KODA according to specific underlying assets-linked.KODA product generally has the following four features:1) the strike price for buying the underlying assets is often 10-20% lower than the spot price; 2) the contract will automatically terminate when the price of the underlying assets is 3-5% higher than the spot price; 3) when the price of the underlying assets falls below the strike price, the investors must buy stocks two or more times of the original amount (up to five times); and 4) the contract will have a fixed term of validity, mostly one year. KODA product is composed of a series of agreements, with one combined up-and-out barrier option agreement in each observing day during the term of the contract. Therefore, the KODA product is in essence the aggregate of a series of combined up-and-out barrier option agreements in terms of structure.KODA emerges as a commercial product in Europe at the beginning of the 21 century in response to the demand of some companies who want to buy more stocks of other companies and avoid the significant stock price increase of the target companies and was later used in agricultural production gradually. Due to the high leverage, KODA sales are forbidden in many European countries and in the USA. However, along with the upturn of Asian financial market since year 2005, the KODA has gradually become the hot product in Asian regions and countries, Hong Kong in particular. With a high threshold, the KODA is considered by many investors as a preferential financing product provided by banks to their clients with high assets. At present, Hong Kong is the largest market of this product, with a value of about HKD 180 billion in the market by the beginning of year 2009.In a bull market KODA is like something falling into investors'laps. Investors can obtain great benefits from such contracts as they automatically become invalid within several days or even one day after signing when the price thereof reaches the knock-out price. Investors having shared the fruits will increase their investment as the strike price rises along with the rising of the market, underestimating the risk of market downturn and constant sharp fall thereafter.The financial tsunami arising from the subprime lending crisis of the US spread over the world in 2008 and caused the sharp fluctuation of international foreign currency market, commodity market and stock markets of various countries. The high leverage of KODA was fully revealed under such background, with huge losses of investors and bringing the boom of lawsuits. Atypical example of this is CITIC PACIFIC which bough lots of foreign currency KODA contracts and lost HKD 15.5 billion. CITIC PACIFIC issued an announcement on October 20,2008 claiming that the 24 leveraged currency option contracts signed thereby with 13 banks to mitigate foreign currency risks for the Magnetite Project in Australia were heavily impacted with a loss of HKD 15.5 billion. The stock price of the company fell remarkably later and the senior managers were investigated.KODA is a new and complicated structured financial derivative. Due to the feature of over-the-counter trade and the high leverage which leads to the prohibition of its sales in the USA and European countries, there are very few studies on KODA products both home and abroad, which mainly focus on product features. However, a systematic study on the definition, features, structure and pricing model of KODA as well as an analysis on the reason of huge losses in 2008 would be of great significance for the issuers, investors and financial regulation institutions.It is based on this concept that this paper develops a basic analysis framework. The paper starts from the basic definition and evolution of KODA contracts to analyze the features and structural design of the product; then it presents a specific discussion on the pricing principles, pricing methods and value determination process of KODA contracts based on the above basic features and giving consideration to basic pricing principles of structured financial notes; later the paper will analyze the KODA in two steps using CITIC PACIFIC as the example. First, the background, consequences and treatment of the loss event will be systematically presented to provide information for later discussion on the reasons of and lessons from the loss event. Second, the pricing study will be conducted on the value of an AUD/USD accumulated target knock-out forward contract signed by CITIC PACIFIC and the results will be analyzed. Finally, the paper will conclude the reasons of huge loss from four aspects:the contract, the bank, the investor and the financial regulation institution and analyze the lessons each party shall learn.