28. March 2018
KIDs for PRIIPs: Analysis and interpretation of performance scenarios
The KIDs (Key Investor Information Documents), which have been mandatory since the beginning of the year for PRIIPs (Packaged Retail and Insurance-based Investment Products), are another element in strengthening investor protection and increasing the transparency of financial instruments. The pre-contractual documents, governed by the PRIIPs Regulation1, are intended to enable retail clients (by MiFID classification) to understand and compare the basic features, opportunities and risks of the investment in question.
The goal of high comparability across different asset classes unfortunately leads to the fact that the methods and formats to be used are not always suitable for presenting each individual PRIIP in a comprehensible and consistent manner. This leads to a conflict with Article 6 (1), according to which a KID must be “accurate, fair and clear” and “not misleading”.
In practice, both objectives are difficult to reconcile, especially in the case of OTC derivatives for hedging purposes. The treatment of derivatives as an “investment” with investment amount and investment return, as well as the concrete results of the performance scenarios2 are hardly suitable to adequately reflect risks and opportunities.
Although the partially questionable results are fully in line with regulatory requirements and are not the responsibility of the issuers, this is regrettable, as the sometimes odd results damage the credibility and acceptance of KIDs among their target group retail investors. Meeting the original objective of increasing transparency and product understanding in favour of investor protection seems to be in danger.
This special issue of the Geistesblitz shows the main problems of performance scenarios and their interpretation using concrete examples. It should serve to contribute to a fundamental discussion and, in the best case, promote the acceptance of KIDs in your organization by clarifying the causes of odd results.
The following examples mark out four particularly obvious results in performance scenarios. Specifically, these are:
Calculation: Each of the four performance scenarios shows an absolute and a percentage return for each point in time. The percentage result is calculated as the average, annualized return.
Challenge: If particularly positive or negative results occur during interim holding periods, the annualization leads to the returns reaching levels that at first glance are incomprehensible and inaccurate.
Example: A customer buys a EUR-Call/USD-Put with strike 1,2350 USD/EUR (spot rate 1,2275 USD/EUR) with 1-month maturity at an option premium of 10.000 EUR (Notional 1.000.000 EUR).
Interpretation: In the favourable scenario, the customer almost triples his investment. In the other three scenarios a total loss occurs. The calculation of the annualized return of more than 18 million percent is formally correct. However, it is misleading because it suggests the customer an advantage that does not exist, as the following simplified assumption shows: If all four scenarios were equally probable, considering only these four scenarios (three times -100% and once + 200%) would result in a negative expected return. Thus, the indication of the annualized return is unsuitable for very short maturities.
Calculation: For products with a term of more than one year, an interim evaluation of the product must take place during the lifetime of the product, the so-called “Interim Holding Period” (IHP). The performance is determined from the cash flows up to that point and the residual value of the product at that time. Depending on the approach, the residual value is the sum of all outstanding cash flows. The time value of money is neglected.
Challenge: The approach of omitting the discounting leads to a systematic alteration of results, especially for the first point in time, given positive interest rates and long maturities. The effect is accentuated by increasing net cash flows over time. It is reinforced by the fact that where discounting takes place, it is carried out at the risk-free rate.
Example: A customer buys a 10-year EUR note with an interest rate of 2,00% p.a. (notional 10.000 EUR).
Interpretation: The note is priced so that the coupon of 2.00% p.a. compensates for the counterparty risk. In the performance calculation for the IHP after year 1 it is assumed that the residual value corresponds to the nominal value plus all undiscounted coupons. The benefit of the note to the customer is clearly exaggerated.3
Calculation: In the base case, which determines the “moderate scenario” and also forms the basis for the “favourable scenario” and the “unfavourable scenario”, no constant underlying is assumed but a trend in the underlying.4 This change is derived from the historical performance of the underlying over the last 5 years (historical drift).
Challenge: If the historical drift differs significantly from the forward premium / discount, the results are very one-sided. Positive or negative values predominate and make the strategy appear extremely favourable or unfavourable.
Example: For hedging purposes, a customer buys a 10-year interest cap on 3-month Euribor at 1,00% p.a. (notional 150.000 EUR). The cap premium is 10.000 EUR.
Interpretation: Since the 3-month Euribor has remained relatively stable in its relevant 5-year history, this development determines the (low) historical drift and is also assumed for the base case. Even the “favourable scenario” of rising interest rates assumes that there will be no fixing in the money. The purchase of the interest rate cap is therefore harmful in any performance scenario. In any case, a complete “loss” of the cap premium is expected.
Calculation: The methodology used for the stress scenarios differs from the other three performance scenarios. The stress scenario does not use a historic drift.
Challenge: If the product has a historic drift to the disadvantage of the client, that exceeds the forward premium considerably, it may lead to a better performance in the stress scenario than in one or more of the other three scenarios that incorporate the historic drift.
Example: To turn a fixed into a floating rate, a customer enters into a 5-year fixed rate swap where he pays the 6-month USD Libor (notional 1.000.000 USD).
Interpretation: The 6-month USD Libor has risen significantly since mid-2016. In the past 5 years, it has also developed very strongly in relative terms. It has sevenfold from below 0.30% p.a. to over 2.00% p.a. This historic development flows into the performance scenarios as a historical drift, with the exception of the stress scenario. The drift in the other scenarios is so pronounced that in the stress scenario – despite the highest volatility assumption – the lowest 6-month USD Libor rates are assumed. Although the interest rate swap is unfavourable in all scenarios from the customer’s point of view, the stress scenario shows the lowest loss. This is contrary to the intention of the stress scenario.
The special Geistesblitz “KIDs for PRIIPs: Analysis and Interpretation of Performance Scenarios” shows the conceptual weaknesses and possible criticisms of the calculation of performance scenarios in KIDs, as they have been used in accordance with the PRIIPs regulation since the beginning of the year. Through the exemplary presentation on the preceding pages, it offers the opportunity to actively engage critics outside and inside of your organization on the informative value of the KIDs in an open dialogue.
The primary focus for the providers of PRIIPs was the regulatory compliance of the KIDs at the reporting date. Now, the content of the performance scenarios is increasingly being examined. As noted in the two sections on discounting and historic drift, alternative approaches have already emerged in practice. The supervisory authorities are also involved in this process. It is speculated that the amendment of the PRIIPs regulation, already promised in Level 1, could be formulated and published much earlier than initially expected.
1 Regulation (EU) No 1286/2014
2 There are four different performance scenarios to cover a wide array of possible outcomes: A “moderate scenario”, assuming moderate returns (50th percentile of possible values), an „unfavourable scenario“ with a pessimistic development of returns (10th percentile of possible values), a „favourable scenario“ with an optimistic development of returns (90th percentile of possi-ble values) and a „stress scenario“.
3 Note: The coupon is independent of market risk. Thus, the return is identical in all four scenarios.
4 In addition to the “pure” approach presented here, a mixed form with adjustments of historic drift at specific points (e.g. IHP) and/or for certain products (e.g. swaps) are also used in practice.