Retrospective: Avoiding the barriers

This JP Morgan product from November 2008 linked to a basket of four Asian indexes and promised a 2.05% quarterly income payment. In the event of a kickout, however, capital was placed at risk and the amount returned to investors would depend on the worst-performing index

The second retrospective analysis this month is a capital-at-risk product linked to four Asian equity indexes: the MSCI Singapore Cash IX, China’s Hang Seng China Enterprises, Hong Kong’s Hang Seng and the MSCI Taiwan. The product pays a fixed coupon of 2.05% quarterly provided no kickout has occurred. If all four indexes are equal to or higher than their initial levels on any observation date, the product kicks out, resulting in an income payment for the previous quarter plus repayment of capital.

Capital is not protected if a 50% barrier is breached, at which point the product matures and capital is returned to the investor based on the final level of the worst-performing index.

Figure 1 shows the performance of the four indexes, while the table shows in percentage terms the value of each of the indexes against their initial levels on the six observation dates that have already passed. The product has not yet kicked out as not all the indexes have remained above their initial levels on the observation dates, the most recent of which was November 30, 2009, when three of the four were above their initial levels. The MSCI Singapore Cash IX was the only index below its strike and was 3.37% down on its initial level. At the end of January 2010 the MSCI Singapore Cash IX index was still below its level on the strike date. Five observation dates remain.

The barrier was also breached by the Hang Seng China Enterprises index, which fell below 50% of its initial level within two months of the strike date. If the product fails to kick out before its final observation date on March 2, 2011, and any of the indexes finishes below its initial index level, investors will suffer loss to capital. The amount of capital returned to the investor will depend on the worst-performing index, not necessarily the Hang Seng China Enterprises index.

The product has so far paid out five coupons of 2.05%, a decent return considering the risk-free rate. Due to the income payments, the product can still return more than the initial investment even if the barrier is breached and at least one of the products is below its initial level. If the product were to terminate with all the indexes at the level they were on November 30, 2009, investors would receive 96.63% of capital (based on the level of the MSCI Sing Cash IX index) plus 10.25% already accrued in income coupons, a total of 106.88%, which is equivalent to an annual rate of 5.4%.

View a PDF of this article here