Capital protected products – swapping coupons for upside
At the inception of the structured product market, capital protected notes were the most popular product type. They were attractive because of the simple concept and were made possible by higher interest rates than are seen today.
Capital protected products offer at maturity a minimum return of the initial capital invested, plus a potential upside linked to an equity market. The two basic pricing alternatives are:
- a zero coupon bond + option combination; or
- an interest rate swap + rolling short-term deposits + option combination
We will take the example of a product offering after five years a minimum capital return of 100% plus 100% of any rise in the Eurostoxx 50 over the investment period. The traditional way to build a guaranteed equity product would be to split the money received from the investor into two main building blocks:
- An upfront deposit also known as a zero coupon deposit or zero coupon bond, which is guaranteed (as long as the deposit taker or bond provider do not default on their obligations) to grow to 100% at the maturity date.
- An option premium used to purchase at-the-money call options on the Eurostoxx 50, offering upside exposure. For example, if the Eurostoxx 50 was at a level of 2,500 at the start of the investment and rises to 3,500 after five years, the option will pay out the difference between the strike price (the initial index level of 2,500) and the final index level, resulting in a gain of 1,000 points (3,500 minus 2,500), i.e. the rise in the index over the investment period. Otherwise, if the index falls, the option expires worthless.
Key factors that influence pricing:
They impact the price of structured products in different ways as this is what defines the bond or deposit. This is the most important factor for capital protected products: this is the part of the product which allows the full capital to be returned either at maturity, or if the conditions of the product are met and the plan matures early. A higher interest rate means less needs to be set aside to ensure a full return of capital and leaves more to spend on the options, generally making the investment return more favourable.
This is a statistical measure of dispersion of potential returns around the current market price and is measured via the standard deviation of the underlying asset or market index. Generally, the higher the volatility, the riskier the asset and the more price variance there is likely to be. The volatility of the underlying asset is clearly important in assessing the likelihood of the option being exercised. It is also the one factor that cannot be directly observed. In summary, low volatility makes options cheaper, while high volatility makes them more expensive.
Equity holders, as owners of the company, are generally entitled to a share of the profits, which may be paid to them in the form of dividends. On structured products, the investor is not entitled to receive the dividends that the stock pays. However, the dividend is discounted from the option premium, allowing the option to become cheaper, hence increasing participation or capital protection.
This is the level at which the structured product payoff starts to provide a positive return. Usually, if the strike price is above the underlying price, the option cost decreases as the likelihood of a positive return is lower compared with a strike price below the underlying spot price.
This is the period between the initial date and the maturity date. Usually, the cost of an option increases with the term. Nevertheless, the annualised cost decreases. This is why when interest rates are low, the term of structured products increases to offer the same participation or capital protection.