RBC is offering an income product that relies on the stock performance of 3D printer manufacturer 3D Systems for the return of capital, but has no such restriction on the quarterly income payment. The annualised coupon is 13.75% Royal Bank of Canada has issued reverse convertible notes linked to the common stock of 3D Systems Corporation. This type of product is known as 'income generating' and generally pays a fixed income while placing principal at risk, the repayment of which is linked to the performance of the underlying stock. This product pays a monthly income with an annualised rate of 13.75%. The coupons are paid regardless of the performance of the underlying asset. Principal is at risk if the closing day barrier of 70% is breached during the monitoring period, in which case principal is lost at the rate of 1:1 for any fall in the underlying below its initial level. In the worst-case scenario where the underlying finishes at zero, the investment will return no principal. The barrier is observed at the close of business of each day and, if breached, principal is at risk if the underlying fails to recover to at least its initial level by maturity. For example, if the underlying breaches the barrier and finishes at 65% of its initial level, investors would be returned 65% of their principal investment, a loss of 35%. Only the principal repayment is variable. Owing to the fixed coupons, some principal can be lost at maturity without investors suffering losses on a total-return basis. If the barrier has been breached, the stock needs to finish above 96.56% of its initial value for investors to be returned their principal. Whether the barrier is breached is therefore critical to the performance of the investment. If it is breached, 30% of capital would be lost if the stock remained unchanged until the end of the investment. The income level on offer is significantly higher than the risk-free rate. This is possible as a result of the risk to the principal given a sufficient fall in the stock. This type of product is common in the US market and lends itself well to the short investment terms that are typical of US structured products. This is because the coupon rates that can be offered are generally higher for shorter maturities. Reverse convertibles would appeal to investors who are looking for interest above the risk-free rate and can risk loss to their principal. Pricing and risk For issuers, pricing is a critical factor in the structuring process. The benefit of structured products lies in their flexibility and tailored investment approach. Structures vary greatly and there are products that cater for cautious, aggressive, bullish, bearish, income- or growth-seeking investors, as well as those looking to diversify their exposure to certain assets. All capital-at-risk products involve some kind of downside risk. There is a trade-off between risk and return and, in general, the greater the risk associated with the investment, the higher the required return to compensate for the amount of risk taken by the investor. The pricing of this product can be broken down into three components: a zero-coupon bond returning invested capital at maturity in full, a put option with a 70% closing day barrier, and a coupon stream of 13.75% paying fixed returns in monthly intervals. It is also important to assess credit risk and to understand the risk/return implications. Since the start of the financial crisis, there has been more emphasis on counterparty credit risk. Diversifying risk among different institutions reduces over-reliance on a single counterparty. High-income products can offer the most attractive terms when interest rates are high as the zero-coupon bond will be cheaper, enabling more money to be spent on the income stream. Better terms can also be offered when the implied volatility of the underlying asset that a product is linked to is high, as the put option will be more expensive, thereby increasing the amount to be spent on the income stream upon its sale. This capital-at-risk structure has a fixed term and offers a high income rate and no participation in underlying growth. You can read a PDF of this article with supporting information, charts and statistics here. 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....
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