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    ABC's of Structured Notes

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    ABC's of Structured Notes

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    22 views5 pages

    ABCs of Structures

    Uploaded by

    miroslav.visic8307
    ABC's of Structured Notes

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
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    FEATURE The ABCs of Structured Notes By Kelth Styreula and Ari Brand F Inancl institutions provide a large menu of structured notes from which investment advi= sors can satey the specific risk and economic exposure appetites of each lent. This article will describe the four general types of structures principal protected notes, modest leverage notes, ‘Income generating notes, and special access notes—and the types of clients ‘each notes most suitable for. Inillustating each type of note, this tile wil present multiple examples ‘The ollowing assumptions will be made {er each structured note example in ‘order to permit easy comparison of the examples 1. The undesying ofeach notes the SEP 500 Index. 2. Each note has aterm of two years. 3. Each noteis issued by a highly rated financial institution. Please note that the assumptions, az well asthe specific numbers used to Ilustrate the return profile of ech of, the notes presented, do notcharacter- ine the ul variety of notes issued inthe marketplace. For example, prevailing ‘market conditions may provde return profs that are more favorable than the examples inthis article and, importantly, financial institutions tend to always offer structured note that range from terms of just few months to many decades. Types of Structured Notes Principal protected notes (deal for Investors secking wealth preserva- ton. Principal protected notes pro- vide investors with complete principal protection. These types of structured notes ae ideal for investors viewing, ‘wealth preservation as ofthe utmost Importance but also desiring some growth of capital leva sesinio vias Figure illustrates the payoff structure of one type of principal protected structured note. The return ‘onthe note is represented by the red line and, for comparison, the retuen on ‘a dite investment in the under}ying Is represented by the doted blue line (dividends aside). The note’ return can be broken down a follows + Ifthe return onthe undertying (the ‘S&P 500 Index) is postive at mat tity the return onthe note equal the lesser of 1) the eturn onthe S&P 500 Index plus some percentage ofthe Principal ofthe note (for example, 4 percent) and 2) the maximum return ‘onthe note (fr example, 10 percent); + Otherwise, the return on the note ‘equals some predetermined rate for ‘example, 4 percent) Hence, under the terms ofthis note, the investor receives atleast a4-percent return regardless of how the S&P 500 Index performs, In contrast toa short term, highly-rated debt instrument that ‘may provide this type of guaranteed return, this structured note gives the lent both some guaranteed return and the ability to enjoy some ofthe S&P 500 Index upside ifthe S&P 500 Index appreciates. However, in contrast to ‘owning the undetlying components of the S&P 500 Index directly, the owner ‘ofthis note would not receive the divi- ‘dends paid out by the members of the ‘S&P 500 Index. ‘Modest leverage notes i Investors seeking high portfolio growth). Modest leverage notes are ‘deal for investor ling to have some (but not complete) downside risk forthe possiblity of greater upside potential, Before explaining these types of structured notes, one term— “participation rate"~must be defined for ‘The participation rte indicates the note’ level of exposure to changes in the price ofthe underying and repre- sents, n essence, how leveraged the return on the notes. Hence, 8 200-per- ‘ent participation rate indicates thatthe structured note benefits from two times (double the price change inthe unde lying tis important to remember, though, that in many structured notes, asin the note in figure 2, the patcipa- tion rate determines the note’ return Inonly some potential future states of the word ‘With this definition in min, ‘consider the note in figure 2. This type of note often is refered to as bullish buffered note bullish” because the client’ return increases asthe return on the S&P 500 Index increases and “fered” because the client enjoys some level of downside protection). ‘The note’ return can be broken down, ss follows: + If the return on the S&P 500 Index Is postive at maturity, the return on the note equals the lesser of January/February 2010 EZ] 37 FEATURE 1) the return onthe S&P 500 index rtipied bya participation rate (Gr example, 200 percent) and2} he maximum return ono he“eap of the note (fr example 30 percent + the return onthe S&P 500 Index Isbetween zero and ~10 percent (inclusive), the etn on the note equals 20 + Otherwise, the return on the note equals the return on the S&P 500 Index pls the bur amount (or ‘example, 10 percent Dividends aside as gure is trates, ifthe S&P 500 Index ether decins over the term of the note co ises 30 percent oles, the client ‘woul end up with more money or the same amount of money) after two ear ifshe old exposure othe S&P 500 index hough a stuctured note rather than through det ownership othe components ofthe S&P 500 Index: However. ifthe S&P 500 Index Increases by more than 30 percent, the lent woud een more holding the components ofthe S&P 500 Index Instead ofa structured note referencing the S&P 500 Indes. As tis example lasts, this structured note gives dents sme downside protection and the ability to ‘enjoy good portion ofthe S&P 500 Index upside simply by ving up the possbily ofa very large ite inthe ‘SRP 500 Inde. In terms of counseling clients on which choice—the strue- tured note ora direct equity inves rment—is preferable observe that 8 lens maximum gin hong the note would be 30 percent over two yeas, which epreents a compound annual growth ate of more than 14 percent per year Such a growth rate would significant beat the long-term returns fal msjr domestic equity indexes (such asthe SEP 500 Inde). While clients purchasing the structured note inthis example would not prof fom allof the upside of very large spike in the S&P 500 ndex and wil not receive the dividends paid ou by the member 38 FB tnvesements Wealth noreron levator 28 ‘companies ofthe S&P 50D Index, the ‘downside buffer that this note pro- vides in addition tothe possibility of & retuen—more than 16 percent—that ‘would beat the long-term returns of the major domestic equity indexes may provide an enticing invetiment oppor- tunity for many clients Income generating notes (deat for investors seeking tobalance cut- rent income with growth of capital ‘or secking high currentincome ‘with a specified rsk of capital loss). Income generating nots give investors both current income and the possibility for capital appreciation. Figure 3 ilus- trates the payoff structure of one type of income generating note. he return on this note comprises two separate pats First, a coupon of2 percent per year is paid each year forthe two-year term. “Thus, the investor's etura upon the ‘notes maturity willbe at hast the sum ofthe coupons receved oer the if ofthe note (regardless of whether the investor receives more than her princ- pal back at maturity. At maturity, what the investor wil receive on the note can be broken down, asfollows: + Ifthe return on the S&? 500 index stocks postive, the investor receives the lesser of 1 the retun onthe SRP 500 index multiplied bya partcipa- tion rate (for example 200 percent) ‘and 2) the maximum rtuen onthe note (for example, 10 pircen). + Otherwise, the investor receives her rincpal back Just ike with egard to principal protected structured nots (discusted above), a short-term highly-rated debt Instrument also may be able to provide coupon income like this note. However, this structured note gives the client both some guaranteed upside (i the form of ‘coupons) with the ability tenjoy some ‘ofthe upside of the underlying (even ‘non-diviend-paying undalying equl- ties) ifthe undesying appreciates. ‘Another example of anincome gen- erating note is clled a reverse convert- Kas Rau'on re urceying ble. The reverse convertible iustrated In figures 4a and 46 follows all ofthe assumptions indicated atthe begining ofthis section except that the tem ofthe reverse convertible is one year rather than two years (wich reflects the fact that most reverse convertibles have terms of approximately one yea) reverse convertible provides avery high coupon—for example, 10 percent per year—and provides forthe return of the client’ principal unless two events ‘occur ding the if of the note (both events are required): the underlying (the S&P 500 Index) declines by more than some percentage (for example, - ‘frases Retumon to structures noo 30 percent) as compared to the level ‘ofthe S&P 500 Index when the note was issued and the level of the S&P S00 Index when the note matures is ess than the level ofthe S&P $00 Index when the note was issued If both of these events occur the return ofthe note sas illustrated in igure 4 Figure 42 shoves that, regardless of the level ofthe S&P 500 Index, the client has received a 10-percent coupon over the term ofthe note. However, at mati tity ifthe level ofthe S&P 500 Index is below the level ofthe SEP 500 Index ‘when the note was isued (andi the SP 500 Index has declined by more than 30 percent at some point during the fe ofthe note), the investor's return {sas the investor invested in the com- ‘ponents of the S&P 500 Index directly. In many cases, ifthe investor doesnot receive her entire principal back, she may eect to receive the value she fs nttled to in the form of actual shares ofthe underlying. both of the downside conditions do not occu, the return ofthe strue- tured note is as illustrated in figure 4, ‘As figure Ab ilustrates, the cient would receive her principal back st maturity, having also received a 10-percentcou- ‘pon during the term ofthe note. Reverse convertibles may be pat= ticularly appealing to investors who ate long-term bullish on the underly- Ing because, ithe stock happens to decline during the term of the reverse convertible, leaving the investor with ‘some amount of stock ofa valu less than the investor's principal versus her principal returned, the investor sil may be able to profit inthe long-term from ‘capital appreciation (which the investor believes will occur based on her view ofthe stock). Further revere convert: bles may be suitable for investors who believe thatthe volatility of the underly ing index will decrease over the term ofthe reverse convertible (compared to the implied volatility used in the pricing ofthe reverse convertible) because the lower the future vat, the lower the probability that the tock will decline toa level that would leave the investor FEATURE with some amount of stock ofa value tess than the investor's principal versus her principal returned upon the matu- ly of the note Special access notes (idea! for Investors seeking acces, through structured notes, to asset classes not ‘otherwise available or for investors everage not othersise avail- ble) Special access notes ae the final general category of structured notes ‘Since many investor are unable to benefit from (or can only benefit with

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