Reverse convertibles are highly sensitive to volatility, which is one of the reasons that the coupons promised can be so high, but it is also why capital is very much at risk. FVC compares the virtues and workings of three such products from the US In December 2010, the top three reverse convertibles in the US, based on potential yield, were linked to Las Vegas Sans, LDK Solar and McMoran Exploration. Each investment was priced on December 17, 2010 and is discussed here on the basis of hypothetical outcomes based on the movement of the underlying and the pricing parameters. All three products have been priced with an initial fair value of 98% and a funding rate of 100%. The Las Vegas Sans product has a six-month term paying out a total coupon of 15.2%. It has a barrier of 80% effective at the close of any day throughout the term, at which point investors would lose 1% of principal for every 1% fall in the underlying, based on the level of the stock on the final day of investment. The one-year implied volatility of the underlying on the strike date was approximately 60%. Reverse convertibles are very sensitive to volatility, and consequently offer high coupons. Once the product has struck, the best outcome for the investor is a period of low volatility until maturity, which makes a barrier breach less likely. Figure 1 shows the underlying spot, the net asset value (NAV) of the product and the evolution of implied volatility throughout the product term. At no point during the term did the stock fall below the 80% barrier, and so the product would have returned full capital in addition to the fixed coupons. During the life of the product, the NAV is affected by the level of the underlying stock and other key parameters. The prevailing risk-free rate and the implied volatility fell over the product term, which would have had a positive effect on the price in both cases. The implied volatility of the stock at the end of the six-month term was roughly 46%, a 23.5% fall from the level on the strike date. This would mean that if an investor tried to find a similar structure at the end of the product term the coupon is likely to be far less than that for the maturing product. The second reverse convertible is linked to LDK Solar and has a similar structure, with an 80% barrier and a six-month maturity. The product pays a fixed total coupon of 19%. On the strike date, LDK Solar had a volatility of roughly 74%, higher than the volatility of the previous underlying, which is why a higher coupon is offered. Figure 2 shows that the relative spot of the underlying breached the 80% barrier, putting investors capital at risk. The final price of the product was 86.85%, higher than the stock level (67.8% of initial values) due to the fixed coupons. However, investors in this product would suffer loss to capital on a total return basis. The third product is another six-month reverse convertible, this time linked to McMoran Exploration and paying a coupon of 17.4%. Like the first product, the volatility of the stock fell throughout the term, although the closing price of the stock did not breach the barrier, which would have put capital at risk. The finishing level of the stock was roughly 104% of its initial value, whereas the product outperformed this, paying the full 17.4% coupon and returning capital in full. The three stocks have relatively high volatilities. The coupons shown here are for a six-month period so the equivalent annual amounts would be roughly double. Considering that the risk-free one-year rate was roughly 0.5% in December 2010, the high rates indicate a significant amount of risk associated with each product. Product performance: reverse convertibles July 2011...
Start a FREE trial or subscribe to continue reading:
Start a 4 week free trial
Try Risk.net's premium content for a limited period. Register now for your FREE trial to one of our leading brands.
*not available to previous trialists or subscribers.
Log In or Subscribe Now
Subscribe to Risk.net Business now to access all our premium news & features content for 1 year.
Pay by Credit Card for immediate access.