PRIIPS stress testing solution available now from Cube and Investment Product ResearchApril 19, 2016 - 07:56
Cube Investing's research partner, Investment Product Research (IPR) has been offering analysis of structured products since the UK regulator, the FSA (as was), first raised the requirement for structured products to be stress-tested in 2012. The Financial Conduct Authority (FCA) reiterated the requirements for stress testing of structured products in the 2015 Thematic Review, but has never been specific about how this should be done.
The European regulator has gone further, and has published a paper describing the process that they want providers and manufacturers to follow when calculating risk and return for the new Key Information Document (KIID), which will be required to accompany all investment products under the packaged retail investment and insurance-based investment products (PRIIPs) directive. The new regulations will come into force from January 2017. IPR can now offer a stress test that is consistent with the new European PRIIPS Regulatory Technical Standard.
NEW STRESS TEST STANDARD
The new Regulatory Technical Standards (RTS) are very similar to the process that IPR has been using for the last four years, which is no surprise given that IPR was a key contributor to the regulator's consultation on the best methodology to calculate risk and return in structured products. The way that the inputs to the stress testing process are generated, and the way that the results are converted into risk and return, are both broadly in line with the existing IPR process. This means that IPR is able to offer a PRIIPS stress test now.
GOOD PRACTICE AND REGULATORY REQUIREMENT
Stress testing a product is now recognised as good practice globally. Investors demand reliable information about the risks that they face and the returns that they may receive. Portfolio managers require detailed analysis to support their decision making process. Advisers have to have this information if they are going to be able to match a product against a client’s attitude to risk and capacity for loss. Now stress-testing is going to be mandatory across Europe from 2017, and is already a requirement in the UK as a result of the FCA thematic review in 2015.
STRESS TESTING WILL BOOST THE APPEAL OF STRUCTURED PRODUCTS
It is tempting to see this as a regulatory chore, but the reality could be very different. Stress testing will be the catalyst that transforms the use of structured products across all investor groups. Stress testing means that products can be compared with each other, and also with benchmark assets like equities and bonds. Stress testing will show where structured products can expand the efficient frontier, and how investors can achieve a better risk/return profile from structured products than through conventional assets.
The chart below shows the current crop of retail structured products in the UK as of 15th April versus an efficient frontier connecting swaps to a FTSE tracker fund.
Source: Investment Product Research 15 April 2016
Stress testing will also expose the products that rely on optical arbitrage. Those that seem to offer the promise of high returns with little risk, but in reality offer a much worse combination.
IPR offers independent analysis that not only meets the regulatory requirements, but exceeds them. Investment Product Research is a service aimed at users that want to know what returns a product may offer and what risks investors face. Users of IPR include:
- Issuing banks
- Product manufacturers and promoters
- Investment managers and investors
IPR offers seven default scenarios, and allows users to define their own parameters:
- The standard IPR market risk scenario, and market and issuer risk scenario
- The new European PRIIPS scenario
- A historic back test
- The three UK SPA scenarios
IPR is able to generate bespoke scenarios where users can stipulate the parameters to be used in the stress test. This may be a simple volatility and drift assumption, or a complete set of surfaces and correlation grids.
Users can upload most products easily themselves, and get instant results across all seven scenarios. A PDF of the analysis is available immediately. Products are stored so that they are visible to the user.
The analysis is updated weekly as a minimum. Each product is re-tested under each of the scenarios every week. For post strike products the stress test uses the closing levels of the underlying and the closing price of the product at the end of the week.
If you would like to know more about the research that IPR offers, please get in touch.