Sapphire sales show buyers still want guaranteed capital

Derivatives dealers have been designing increasingly complex equity-linked structures for the European retail market-place. But it appears that there is limited demand for products that do not offer a capital guarantee. SG, the investment banking arm of Société Générale, appears to have found this out to its cost with Sapphire, part of its new ‘Gemstone’ range of products for 2002. Instead of a guarantee that investors will get 100% of their capital back if stock markets fall, Sapphire offers investors additional equity instead.

But Stanislas Debreu, SG’s global head of equity sales and derivatives marketing, says interest in Sapphire from distributors of retail products has been relatively slow to develop. “We’ve had a couple of hundred million euros out there but nothing as significant as what we have seen in the past with Everest, Altiplano or Kilimanjaro,” he admits. Not only has SG been reminded that the capital guarantee has become established as the key selling point for equity derivatives products among individual investors, but there has also been a marked decrease this year, following a post-September 11 fall in investor demand, in the volume of structured products being bought.

SG’s most successful products have been the ‘mountain range’, launched over the past four years and including the Everest, Himalaya, Kilimanjaro and Altiplano structures. These all came with a 100% capital guarantee and allowed investors to take different views on volatility and correlation depending on prevailing market conditions. Sapphire, which was first marketed by SG to retail distributors in May, was a bold departure. Sapphire is a five-year, 24-stock portfolio investment. If, at the end of each quarter, at least one of the stocks in the initial portfolio has gained in value or has remained unchanged relative to its starting price, the investor receives a 3% coupon at the end of that year and the best performing stock is removed from the portfolio. The investor could therefore receive a maximum coupon of 12% at the end of each year.

If, however, at the end of a quarter, none of the stocks in the initial portfolio has gained in value or remained unchanged then no coupon is paid and no stocks are removed from the basket. If this happens then the portfolio exposure at the end of five years goes up by 3%. So, at maturity, investors could receive anywhere from 100% to 160% leverage on the portfolio’s value at maturity. Investors that buy Sapphire are going short vega and long correlation, so they are betting on a future decrease – or at least not an increase – in implied volatility.

Sapphire’s key selling point is supposed to be that it comes with a natural hedge. Despite the lack of a specific guarantee, investors have downside protection. Sofiéne Haj-Taieb, a quantitative analyst and head of pricing and new products for SG, says if the basket goes down from 100 to 97, then the leverage goes from 100% to 103%, and that this “compensates” somewhat for the fall. “And if you then have a recovery in the equity market,” adds Debreu, “you have fantastic upside. Instead of saying, OK, you get a capital guarantee at the end, we say forget the capital guarantee and if markets go down we give you more and more equity.”

SG’s competitors are not surprised that Sapphire has not been a success. “What you end up carrying is a basket of poor-performing stocks,” claims Axel Kilian, London-based co-head of European equity derivatives investor marketing at JP Morgan Chase. “I don’t like the pick-and-drop concept if the basket selection is solely driven by the correlation of the underlying shares. If you buy a five-year product, you should pick stocks where performance is the goal.”

Kilian says JP Morgan Chase retains a strong preference for structuring capital-guaranteed products. For example, at the end of last year it released the Escalator, a three-year offering that on top of guaranteeing the principal pays a coupon, the value of which is linked to a combination of digital options that, at maturity, pay out according to the number of stocks with a final reference level – the average spot rate on six monthly observation dates prior to maturity – at or above the strike rate. Kilian claims the Escalator has been selling well since the spring but declines to give volume figures. “The Escalator is the defensive structure that investors need in the current market environment,” says Kilian.

SG has not given up on the 100% protection concept, however. Emerald, the other product in the Gemstone line, represents a natural progression from SG’s previous structured products because it comes with a full capital guarantee. It pays a coupon with a payout linked to the best performance of a portfolio of 12 stocks on any of six annual observation dates, the gains of the top two performing stocks being locked in at the end of each year. With Emerald, investors are going long vega and long correlation. Unlike with Sapphire, a rise in implied volatility will benefit Emerald investors, but they are taking a similar play on correlation, which they are buying. Debreu says he has sold between E1.5 billion and E2 billion of Emerald since its launch in March. He says: “All the past products were based on the worst-off concept and people were getting tired of it. There’s been a lot of products using Asian – or average – options. Here, we get rid of the average.” SG’s Himalaya, for example, was a six-year product that offered the average performance of a six-stock basket.

But the competition is also critical of Emerald, especially its lock-in feature. “This is a nice way to try to provide investors with some kind of best-of feature, but obviously you cut, quite early, the best-performing stocks, whereas you leave the worst-performing stocks running,” says Laurent Bouaziz, responsible for equities product development at BNP Paribas in Paris.

Traditional
BNP Paribas is also sticking to traditional capital-guaranteed structures. The bank’s latest offering is called the Mutant Ariane. It was launched last month and is being advertised on billboards around Paris. Mutant is an 18-month product that puts half the investor’s money in a cash deposit, the other half being invested in a portfolio of 12 equities. The payout on the equity side depends on the number of stocks settling at or below a barrier – a ‘worst-of’ structure. “If the worst-performing stock hits a barrier, you are not left with nothing,” says Bouaziz. “The size of the coupon payment depends on the number of stocks that do well.”