We will take the example of a FTSE-linked product offering a guaranteed coupon of 7% p.a., with a capital return of 100% if the final index is the same or has risen over the investment period, or a capital return reduced by 1% for every 1% in the fall of the index otherwise.
With interest rates around 5%, the cost of offering a 7% per annum coupon comes up to £29.9 out of each £100 placed by the investor into the product, while the value of offering a capital return of 100% at maturity is £75.9 out of each £100.
The total cost comes up to £105.8, which is more than the product provider has received from the investor for the product. To make the structure possible therefore, the product provider sells an at-the-money put option, for which it receives £8 for each £100 placed into the product. Therefore, the overall cost of the structure is decreased from £105.8 to £97.8, allowing for £2.2 to be left over for the provider’s margin and administrative costs.
At maturity, if the index has fallen however the capital return will be reduced by 1% for every 1% fall in the index.