Merchant Capital offers an agriculture basket

Merchant Capital is offering investors the opportunity to take a view on agricultural commodities. The five-year bond underpinning the simple growth product comes from Barclays Bank

This is a five-year growth product linked to a basket of four commodities: corn, sugar, cotton and soybeans. At maturity, if the final value of the underlying basket is greater than its starting level, investors will receive a return equal to 1.3 times the increase in the underlying basket plus 100% return of capital. There is no cap on returns.

Capital returned to investors decreases by 1% for each 1% fall from the initial value of the basket subject to a capital protection feature that returns 95% of capital if the index falls by more than 5%.

The final basket level is subject to monthly averaging over the final year of the investment. Final level averaging can constrain growth in a rising market, resulting in lower potential returns although it protects investors from any late falls in the basket.

The product is ideal for investors who want to invest in an alternative asset class and expect commodity prices to rise. Commodities usually have a negative or low correlation to bonds and equities, which means it could be worthwhile to include a reasonable level of exposure to them in a balanced portfolio.

In addition, Merchant Capital is offering a deposit linked to corn, sugar and soybeans. This plan is 100% capital protected and pays a fixed return of 18.5% if the final level of the index is above its starting level at the end of the product term.

 

Pricing and risk

This product consists of a zero-coupon bond to pay 95% of principal at maturity, a call option and a put option spread. Returns are generated through a call on the commodity basket that has a strike at 100% and gearing of 130%. The downside comes from the put spread on the basket, one with a strike at 100% and gearing of -100% and the other with a strike at 95% and a gearing of 100%.

The basket volatility is derived from the implied volatilities of the individual components and the correlation between each of the commodities. For an equally weighted basket such as this, the volatility will be less than the average of the volatility of the component parts unless all the correlations are all 100%. Returns are earned through an uncapped geared call, so the higher the basket volatility the higher will be the value of this call to the investor. The correlations between the four commodities range between roughly 29% (corn and cotton) and 57% (corn and soybeans). The relatively low correlation between the commodities means the basket volatility is almost 25% below the average of the commodities' individual implied volatilities.

For equities, implied pricing parameters can usually be derived from listed options on the relevant underlying. For commodities, the level of forward prices can be the most important. These give the implied level of the instrument over a given maturity. At the time of scoring, all four basket components had decreasing forwards - not unusual for commodities and termed ‘backwardation'.

Options on well-known equity indexes, such as the FTSE 100, are reasonably liquid. For more unusual underlyings, such as this basket of commodities, there will be less options available which may make the pricing less competitive as the counterparty may take a higher margin.

This product has a riskmap of 2.04. This is higher than the majority of capital-protected products but lower than most capital-at-risk products, which reflects the 95% capital protection level.

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The information in this analysis is taken from sources which Future Value Consultants Limited deems reliable but no guarantee is made that the information is complete or accurate and it should not be relied upon as such. Any opinions in the analyses represent those of Future Value Consultants Limited at the time of writing but are subject to change. All valuations and prices shown are indicative only and do not imply an offer or commitment of any kind. The analysis does not constitute advice or recommendations nor should it be relied upon for any purpose. No liability whatsoever is accepted by Future Value Consultants Limited or Structured Products magazine for any loss or expense incurred from using this analysis.