This six-year capital-protected capped call product provides 1 for 1 upside in the averaged FTSE100 performance up to a maximum payout of 152%.

This is a six-year growth product linked to the FTSE100 whose historical values are shown in Figure 1. At maturity, the product offers a minimum capital return of 100%, plus 100% of the rise in the index over the investment period, subject to an overall maximum capital return of 152%.

The final index level is calculated as the average of daily readings taken over the last year of investment. There is an initial charge of 7.81%. See the table for further product information.

Figure 1: Historic FTSE 100 Levels

 

Table: Product Termsheet

Product Name Capital Protected Fund 20
Provider Scottish Widows
Provider Group Lloyds Banking
Contact Details www.scottishwidows.co.uk/ifa
Offer Open Date 24/08/2011
Offer Close Date 27/01/2012
Initial Strike Date 10/02/2012
Final Index Date 26/01/2018
Maturity Date 29/01/2018
Term 6 years
Product Type Growth
Wrapper Type Isa, open-ended investment company
Underlying Market FTSE100
Payoff Type Capped call
Minimum Return 100%
Distribution Channel Financial advisers, salesforce

 

Product pricing
Our analysis is performed assuming the payout date is exactly six years from the strike date and we analyse the price of the structure as at the strike date. Initially we shall use the standard Black Scholes assumptions in our analysis and in particular assume that returns on the index follow a normally distributed process with constant drift and volatility.

The product can be broken down into the following structures:

  • Buying a zero coupon bond to generate a 100% capital return.
  • Buying a call with a strike of 100% and participation 100%.
  • Selling a call with a strike of 152% and participation 100%.

Ignoring both skew and averaging and assuming the following parameters (all to 1dp) GBP interest rate 1.7%, index volatility 24.8% and index dividend yield 3.1%, the price of the bond returning 100% capital at maturity is 90.6%, the price of the long call position is 17.1% and the price of the short call position is 7.1% giving an overall price of 100.6%. Note that this price also excludes credit spreads.

For pricing in the presence of averaging and skew we shall use the pricing tool on the www.StructuredRetailProducts.com website. The pricing tool allows users to structure a range of typical structured retail products e.g. capped/uncapped calls, reverse convertibles and digitals by selecting the type of product (growth/income), the term, index, level of capital protection and income.  The pricing tool uses a large set of so called 'system rates', which are mid market rates compiled by www.StructuredRetailProducts.com from investment banks rates and can be used to price the user defined structure. These system rates comprise dividend yield and volatility information for the FTSE 100, S&P 500, Eurostoxx 50 and Nikkei 225 indices and interest rate data for GBP, USD, EUR and JPY for maturities up to 10 years, and, for the volatility surfaces, over strike levels 80% to 120%.

We can firstly analyse the effect of averaging on the price of the structure. We load the rates for the 13th January 2012 and adjust the implied volatility matrix to make it flat at our assumed implied volatility of 24.8% (see the figure below). We also flatten the term structure of interest rates and dividend yields at the assumed rates and save the rates.

 

Now clicking on the 'Pricing' tab we enter the inputs shown in the figure below noting that we set the difference between the strike date and final index date to be the term of the product (6 years), and set the minimum return to be 100% (capital protected), the participation in the upside of the underlying to be 100% (1 for 1 participation), the strike to be 100% (of the initial index level) since this is the level above which the investor shares in the participation and finally the cap level to be 152% which is the maximum payoff achievable for this structure. Finally the averaging is 12 month daily which is selected in the last dropdown box.

Clicking on calculate gives the following results page:

This shows that the price of the structure (denoted 'Asset Price' in the figure above) when averaging is included (100.3%) is only marginally less (about 0.3%) from that without averaging (100.6%). This is mainly due to the length of time between the strike date and the start of the averaging period. The above figure also shows how the price is broken down into the price of the derivative, 10.0% (denoted 'Options' in the figure above) and the price of the bond, 90.3% (denoted 'Cashflows' in the figure above).

To include both skew and averaging we go back to the market rates page and click on the checkbox 'Use Latest System Rates' which loads the most recently uploaded market rates. Returning to the pricing tab and clicking calculate gives the price of the structure as 103.7% broken down into the price of the derivative (13.1%) and the price of the bond (90.6%). The price is now 3.4% higher than when we ignored skew but included averaging (100.3%). This is mainly due to the lower volatility parameter used to price the higher strike call due to volatility skew (shown in Figure 2). This reduces the price of this particular call option which is deducted from the price of the structure since it is sold within the structure. Therefore the overall structure price is higher when including skew.

Figure 2: Implied volatility surface for FTSE 100 (at 13/01/2012)

We illustrate the effect of including a credit spread in the structure by increasing the discount rate used to price the bond by an arbitrary amount. If we apply a credit spread of 200bps in this manner then the price of the structure is approximately 93.4% broken down into the price of the derivative (13.1%) and the price of the bond (80.3%). We note that this is now much closer to the structure price when calculating it simply as 100% minus the initial charge specified in the brochure of 7.81%.