Payoff Policy
Payoff Policy is a direct subtype of Financial
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TYPE INCLUSION RELATIONSHIPS
AVAILABLE FUNCTIONS
AVAILABLE CREATE FUNCTION KEYS
TYPICAL OBJECTS OF TYPE Payoff Policy
This type represents the rules that define the payoff associated with a Structured Product.
It contains no financial information and no links to the underlyings referenced by the Structured Product.
Below is a schematic diagram of the structure of a Payoff Policy.
It primarily consists of a set of u Contingent Claims - denoted symbolically as - C₁ , C₂ , ... , Cᵤ - specified through the key Contingent Claims.
Each Contingent ClaimCᵢ specifies a condition to be valuated - expressed as a predicate function𝘨 and two payoff functionsƒON and ƒOFF as described in Contingent Claims, but crucially it leaves the following questions open:
Question 1
When must the condition 𝘨 be valuated, i.e. what are the observation times t₁ , t₂ , ... , tᵣ corresponding to that condition?
Question 2
If more than one Contingent Claims are observed at the same observation timetᵢ, what is the priority order by which these Contingent Claims are processed at that time tᵢ?
Question 3
Given a specific observation time tᵢ, should the condition indeed be valuated or rather skipped due to prior events?
Question 4
Given an amount amt already calculated by the payoff function ƒON, should that amount indeed be paid at the specified payment time or rather cancelled due to prior events?
Question 5
Given an amount amt already calculated by the payoff function ƒOFF, should that amount indeed be paid at the specified payment time or rather cancelled due to prior events?
The Payoff Policy answers all these questions, as follows:
Answer to 1
The Payoff Policy defines a time plan through the key Time Plan that lists all relevant Contingent Claims together with their respective observation times.
This time plan therefore associates every time in a sequence of observation times t₁ , t₂ , ... , tᵣ with at least one Contingent ClaimCᵢ.
This by itself does not mean that the Cᵢ will indeed be processed at tᵢ, as exceptions may arise due to the occurrence of prior events, as it will be explained below.
But it does specify the times when the Cᵢ is at least allowed to be processed.
Answer to 2
It may happen that the observation times of two or more of the C₁ , C₂ , ... , Cᵤ overlap.
In that case, on the overlapping observation times two or more Contingent Claims will apply.
Then the rule is that the relevant Contingent Claims will be processed in the order - from top to bottom - in which they are entered in the time plan table.
Answer to 3
The default rule is the Knock-Out rule according to which if any Contingent ClaimCᵢ is processed at some observation timetᵢ with its predicate function𝘨 valuating to TRUE, then all other Contingent Claims immediately cease to exist and any amounts already calculated but not yet paid are immediately cancelled and never paid.
But an exception can be defined through the key Alive Triggers, where for each claim Cᵢ, a list of claims may be listed, of which the predicate functions are meant to survive an event associated with that claim Cᵢ.
According therefore to the default Knock-Out rule and the mentioned exception, the evaluation of a condition defined in a claim Cᵢ observed at a time tᵢ will be handled as follows:
a) If no other event has happened so far - i.e. no other prior condition has been evaluated to TRUE - the condition of the claim Cᵢ will be always evaluated.
b) If at least one other event associated with a claim Cₐ (note Cₐ may equal Cᵢ) has occurred previously, the claim's Cᵢ condition will be evaluated only if Cᵢ belongs in the Alive Triggers list of the claim Cₐ.
Note the word "previously" applies also to the case when the event associated with the claim Cₐ occurred at the same time tᵢ, but recorded prior to processing the claim Cᵢ.
Answer to 4
When an event associated with a claim Cᵢ occurs - i.e. when that claim's predicate function valuates to TRUE - at some observation time tᵢ, the payoff function ƒON associated with Cᵢ is valuated and the resulting number amt represents an amount payable at some specified payment time T, with T ≥ tᵢ.
This does not mean that the amount amt will be actually paid at T.
According to the default Knock-Out rule mentioned above, the payment will not take place if a prior event has been registered at or before T.
But an exception can be defined through the key Alive On Payoffs, where for each claim Cᵢ, a list of claims may be listed, of which all ƒON-related amounts that have been calculated prior to that claim's event will be deemed payable and therefore not affected by that claim's event.
According therefore to the default rule and the mentioned exception, the amount amt calculated by the payoff function ƒON and payable at T resulting from an event associated with a claim Cᵢ observed at a time tᵢ will be handled as follows:
a) If no other event has happened before or at T, the amount amt will be always paid at T.
b) If at least one other event associated with a claim Cₐ (note Cₐ may equal Cᵢ) has occurred previously, the amount amt will be paid only if Cᵢ belongs in the Alive On Payoffs list of the claim Cₐ.
Answer to 5
The answer here is the same as that above but replacing the Alive On Payoffs with Alive Off Payoffs.
Concretely, the amount amt calculated by the payoff function ƒOFF and payable at T resulting from an event associated with a claim Cᵢ observed at a time tᵢ will be handled as follows:
a) If no other event has happened before or at T, the amount amt will be always paid at T.
b) If at least one other event associated with a claim Cₐ (note Cₐ may equal Cᵢ) has occurred previously, the amount amt will be paid only if Cᵢ belongs in the Alive Off Payoffs list of the claim Cₐ.