Balancing correlation

Credit Suisse is offering US investors a 5.5-year structured product that is based on a basket that is balanced by the inclusion of the iShares Barclays Tips Bond Fund ETF. As well as proving to have low volatility, the fund is not correlated to the other four underlyings in the basket.

Principal is 100% protected at maturity, subject to credit risk. If the underlying is above the strike level of 100% then the investor has a participation rate of 130%. Since this is added to 100% of the principal amount this represents the potential return for the investor.

This basket of underlyings is used by Credit Suisse in several products, with the five components as follows: S&P 500 (50%), iShares Barclays Tips Bond Fund (25%), iShares MSCI EAFE Index Fund (10%), SPDR Gold Trust (10%) and the iShares MSCI Emerging Markets Index Fund (5%).

All principal-protected products are positioned as lower risk versions of direct investment in the underlying. The cost of principal protection is paid for by giving up any dividends.

The product scores low on the riskmap rating, which reflects the principal return feature of the product. This investment would therefore probably appeal to cautious investors seeking a known minimum return at the end of the investment term.

Pricing and risk

The components of this product are relatively simple, a zero coupon designed to repay 100% of principal at the end of the 5.5-year term and a call option on the basket paying 130% of basket growth.

This product offers uncapped returns and a participation rate of 130%. These headline rates exceed those being offered by similar structures on the market linked to the benchmark US index the S&P 500: products with a similar maturity offering 100% capital protection and 100% participation include a cap in the region of 50% on returns. The terms achieved by this Credit Suisse product are possibly due in part to the selection of the funds in the basket and also the use of final level averaging throughout the product term.

The table below shows the one-year historic correlation and historic volatility using weekly values of the five basket components. The most important thing to note from this is the negative correlation between the iShares Barclays Tips Bond Fund and three of the other basket components. Correlation indicates the behaviour of one instrument in comparison with another so the negative correlation suggests that if the iShares Barclays Tips Bond Fund rises, negatively correlated instruments should move the other way. The iShares Barclays Tips Bond Fund makes up 25% of the basket while the combined weighting of the components negatively correlated to this fund is 65%.

For a simple growth, principal-protected structure such as this, the price of the call option will be less if the volatility of the underlying basket is low. Including a fund in the basket that is negatively correlated with other components will reduce the overall basket volatility, and so reduce the cost of a call option, enabling the provider to offer better terms.

Historic volatilities show that of the five underlyings the iShares Barclays Tips Bond Fund has the lowest volatility by a considerable margin. This suggests that, although it is negatively correlated with other basket components, the investor might hope that its movement will not be strong enough to cancel out growth in other underlyings.

To determine the final level of the basket the average of the performance of each of the funds measured annually over five years is calculated. Final level averaging such as this will reduce the price of the option compared to if final day readings had been used. The use of final level averaging will reduce the expected return of this product. However, depending on which way the markets move, averaging can protect investors from late falls in the market.

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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.