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Crash Course :
Risk Management
Capital Guaranteed
Products
Capital Guaranteed Products
Yield Enhancement
Participation

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A "capital guaranteed product" is a safe investment that ensures you won't lose your
money. It's made up of a "zero coupon bond" and a "long call option".

So, we've previously talked about how a zero coupon bond and a long call option can
come together to create a sweet payoff diagram at maturity. Now, let's jazz things up
a bit by adding a line that represents the payoff at the issue date, and combining the
two diagrams into one.
With this new diagram, we can get a clearer picture of how this investment can pay
off for you from the get-go, all the way to maturity akin to seeing a before-and-after
photo of any investment journey!

20%
Product

Call During
Bond
Lifetime

0%
Product During
Lifetime
Call At
Maturity Market

-20% 80% 100% 120% 80% 100% 120% 80% 100% 120%

The zero coupon bond diagram is a horizontal line at 0%. This means that the final
value of the bond is not affected by market movements. The bond floor, which is the
amount needed to invest at the risk-free rate to get back 100% at maturity,
guarantees your capital in the product.

The long call option diagram is a smooth, curvy line. It represents the option's value at
the issue date and is all about participating in the positive performance of the index.
The line starts off a little below par and then gradually rises to match the underlying
asset's slope by the time you reach the right side of the diagram.

When we combine the two diagrams, we get the payoff at the issue date of the
product, which is based on the spot price of the underlying risky asset. This payoff
diagram looks quite different from the one we get at maturity.

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Product
3

Product During
2 Lifetime

Market

80% 100% 120%

There are three key points to note on the combined payoff diagram.

1 : at the middle of the graph, the payoff line intersects with the spot price of the
underlying asset. This is because the price of the product at issue is usually equal to
100% of the asset's spot price.

2 : moving to the left from the middle, the line drops below the capital guarantee level
and becomes almost horizontal. This happens as the call option loses most of its value
and the present value of the zero coupon bond becomes the main component of the
product.

3 : moving to the right from the middle, the line rises gradually as the call option gains
intrinsic value. However, it still falls short of the maturity payoff line because the zero-
coupon bond has not yet accrued its interest. This means the bond price must
gradually rise from, let's say 84% to 100% over the remaining years until maturity.

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The payoff line of a capital guaranteed product changes depending on the spot price
of the underlying asset. It starts at the spot price, drops below the capital guarantee
level, then flattens towards the bond floor. As time passes, the call option gains
intrinsic value but loses time value, so the line gradually rises with a steepening slope.

However, the actual participation in the underlying asset's performance at inception is

usually lower than stated on the product's term-sheet, at around half of the
participation at maturity. A good rule of thumb is to divide the stated participation by
2 to estimate the product's behavior in its early months. It's also important to
remember that the capital guarantee only applies at maturity, not before.

One crucial point for investors to understand is that the capital guarantee level of a
product remains fixed throughout its lifetime. For instance, if the capital guarantee is
set at 100% of the underlying asset's spot price for a four-year maturity product and
the spot price increases to 160% within the first year, the capital guarantee is
essentially useless unless the investor is willing to forfeit the 60% profit.

As previously mentioned, the volatility and interest rate are crucial factors for capital
guaranteed products. We'll see how these variables evolve over time so investors can
better understand how the product behaves and how it's valued in the market. By
tracking these key parameters throughout the product's lifetime, investors can get a
better sense of how it will perform on a mark-to-market basis.

Volatility

In the world of capital guaranteed products, volatility is a big deal. In fact, it's the
second most important factor affecting the value of the call option, right after
changes in the price of the underlying asset. The bond part of the product doesn't
care about volatility, though. Since these products tend to have long maturities, even
small changes in volatility can have a big impact on the price.

Price as a function of maturity

When an embedded call option is far out-of-the-money, the product tends to be

valued at its bond floor, making the call practically worthless. However, as time goes
on, the product's price gradually increases towards the thick top payoff line at
maturity. With a lot of time remaining until maturity, even at poor performance, the
call still holds some value. However, with only a short time left until maturity, the call
becomes almost worthless, especially if the underlying asset has significantly dropped
in value.

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At the at-the-money point for an embedded call, the passage of time is beneficial for
the product, as the time value lost on the call is smaller than the interest gained on the
zero-coupon bond in the first years of the product's life. The bond's increase in value
is greater than the call's decrease in value until approximately three-quarters of the
time to maturity has elapsed, making the product more valuable overall. As the time
value of the call decreases at a faster rate than the interest from the bond accrues, the
product's value converges back to the center line of the payoff at maturity.

When the embedded call is deep in-the-money, the product's value tends towards the
thick payoff line at maturity, but virtually all time value in the call is gone. The
underperformance of the product during its lifetime compared to its value at maturity
is due to the bond still needing to accumulate interest. At this point, the capital
guarantee becomes practically useless, and the delta increases to between 90% and
100%, increasing the participation in the underlying asset's price.

Increase in Implied Volatility

When the call option in a product is far out-of-the-money, the implied volatility of the
underlying asset has little effect on the product's price. At this point, the product's
price is mainly influenced by the bond component. However, even with a large
increase in implied volatility, the effect on the product's value is limited since there is
little time value left in the option. Nevertheless, an increase in implied volatility can
still improve the product's value.

The effect of a change in implied volatility is highest when the option is at-the-money,
meaning the strike price is close to the current price of the underlying asset. At this
point, a change in implied volatility can have a significant impact on the product's
price, even without movement in the underlying index. This is because a change in
implied volatility affects the time value of the option, which is highest at-the-money.
Therefore, when designing a product with a call option, the strike price should be
considered carefully to maximize the potential gains from changes in implied volatility.

One advantage of capital guaranteed equity products for investors is that a drop in
the underlying asset's value can be somewhat mitigated by an increase in implied
volatility. This is due to the tendency of implied volatility to rise when prices fall.
Additionally, early in the life of an option priced at a high implied volatility, losses due
to time decay are smaller compared to an option priced at a low implied volatility.

When the call option is deep in-the-money, there is hardly any time value left in it.
Therefore, a change in the implied volatility has a minimal effect on the product's
price. This is because the implied volatility mainly affects the time value left in the
option, and with little time value remaining, any impact on the price is insignificant.
Investors should keep this in mind when considering the potential effect of changes in
implied volatility on the value of their investment.

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Decrease in Implied Volatility

When implied volatility decreases, it generally has negative impacts on the value of
capital guaranteed equity products. This is because implied volatility has a tendency to
rise when prices fall, and so a decline in value of the underlying asset is partly offset by a
gain in the implied volatility of the option.

However, when the implied volatility decreases, this offsetting effect diminishes, and the
value of the product can be negatively impacted. Additionally, if the product is deep in-
the-money, there is little time value left in the call option, and so a change in the implied
volatility will have only a small effect. Overall, the impact of a decrease in implied
volatility will depend on the specific conditions and timing of the product's issuance.

Interest Rates

The price of the embedded zero-coupon bond is primarily influenced by the interest rate
level, while the impact on the price of the call is less significant. The fundamental
relationship between interest rates and bond prices holds true, where rising interest
rates lead to falling bond prices and vice versa.

Zero-coupon bonds are particularly sensitive to interest rate changes, as their duration is
equal to the remaining time to maturity. Since most capital guaranteed products are
composed of at least 80% zero-coupon bonds, any change in interest rates can have a
substantial impact on the product's overall value.

Interest rate increase

The impact of changes in interest rates on capital guaranteed products is greatest when
the call option in the product is far out-of-the-money. At this point, the price of the
product is largely determined by the bond component, and any price difference in the
bond due to changes in interest rates will be fully reflected in the product. In this
scenario, the bond floor of the product may also decrease, meaning that the product can
potentially fall below its initial assumed lowest possible price.

At the strike price of the call option, the impact of changes in interest rates on the
product is smaller because the value of the product consists of a combination of calls and
bonds. However, even at this point, changes in interest rates can still cause the price of
the product to decrease, though to a lesser extent than at the out-of-the-money point.

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As the market performance becomes more positive, the weight of the bond
component in the capital guaranteed product decreases further, and the call option
gains more intrinsic value. At this point, the call represents a significant portion of the
product, accounting for roughly 40% of its value.

When there is a change in interest rates, the impact on the call option becomes more
positive, and the price decrease of the bond is nearly offset by the price increase of
the call. Consequently, the product's value drops only slightly by mild numbers.

It's important to note that the relationship between the market performance and the
weight of the bond component, as well as the impact of interest rate changes on the
product, can vary depending on the specific construction and time to maturity of the
capital guaranteed product. However, in general, a more positive market performance
and higher intrinsic value of the call option can lead to a decreased weight of the
bond component and a more favorable impact of interest rate changes on the
product.

Interest rate decrease

When interest rates fall, the impact on capital guaranteed products is generally
positive. As interest rates decrease, the price of bonds tends to increase, and since
capital guaranteed products are typically composed mostly of bonds, the value of the
product will also increase. As the value of the bond component increases, the weight
of the call option in the product decreases. At-the-money, the lines representing the
value of the product and the bond component tend to converge, indicating that the
option component is becoming less significant.

In addition, when interest rates decrease, the bond floor of the product generally
rises. This means that the product is less likely to fall below its minimum guaranteed
value. Time value also becomes less important as the bond component has already
made a significant portion of its expected gains. Overall, a decrease in interest rates
can have a positive impact on capital guaranteed products.

Conclusion

When it comes to capital guaranteed products, shifts in implied volatility tend to have
the greatest influence when the underlying asset's price is at-the-money. An increase
in implied volatility generally leads to an increase in the value of the product. On the
other hand, a positive shift in interest rates has the most significant impact on the
value of the product when the embedded call option is out-of-the-money.

However, if the call option is deep in-the-money, an interest rate shift has less impact
on the product's value. Holding everything else constant, the passing of time (without
any movement in the underlying asset's price) generally has a positive effect on the
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value of the product over time. This is because the time value lost on the call option is
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usually more than offset by the gain in the zero bond value.
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What's next ?
Yield Enhancement

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