Product performance

The three products reviewed this month all have a strike date of 11 December 2009. The products are valued weekly and the results are shown along with the performance of the underlying asset. All three products are fairly typical of products that are issued regularly in the US retail market.

The first product is a six-year principal-protected note linked to the Financial Select Sector SPDR Fund. Participation is 100% in the index and the cap is set at roughly 131%, which is equivalent to 5.55% annually compounded. The two biggest influences on the price of this product are the spot price of the index and the risk-free rate. Since the strike date, the index has reached highs of 117% and lows of 97%. The fall in the risk-free rate since the strike date has the effect of increasing the value of the zero-coupon bond and therefore of the product. Products priced when rates are low allow less money to be spent on the purchase of upside options, ie. products priced between April and June.

The second graph shows the performance of a two-year accelerated growth product linked to the iShares Dow Jones US Real Estate Index Fund. This underlying is commonly linked to accelerated growth products in the US market. The product is double geared on the upside and has no protection barrier. Figure 2 illustrates how sensitive the price is to changes in the underyling. The value of the product remains above the spot level. However, as the spot rises there is a sharp fall in the price in mid-May as the spot level fell. As the product has no form of downside protection, investors will suffer a loss of capital on a 1:1 basis if the index has fallen below its initial level at maturity. This makes the price of the product more sensitive to falls in the spot level in comparison to a product with some form of buffer or barrier.

The final product is a one-year reverse convertible linked to the stock of JP Morgan Chase. The product includes a barrier of 80% which is observed on a daily basis. The investor will lose some of his capital on a 1:1 basis if the barrier is breached and fails to recover to at least its initial level by maturity. This products pays regular income but the investor does not benefit from rises in the stock. Figure 3 shows that as the spot price increases the price also rises as the probability of the barrier being breached diminishes. It also shows that for most of the time the spot value is below its initial level the price remains higher which reflects the payment of regular coupons.

Pricing focus

Taking a closer look at the pricing of the Merchant Capital Growth Plan: Principal Lock-in product. Capital is locked in if on any one of the product anniversaries the index is above 110% of its initial level. Returns of 135% of index performance are made if the final level of the index is above the initial level. The product comprises a knock-in put option with a barrier at 50%, an additional look-in feature and a call option.

The simplest way to calculate the additional value of the lock-in feature is to work out the value of the capital element without the lock-in and subtract this from the value of the capital element with the lock-in included. Using this method the value of the additional lock in element was calculated to be 3.5. The return component is the value of a call option with gearing of 135 and strike of 100. When pricing a product the issuer will include a fee element or profit and loss within the option price. For more complex options this is likely to be higher as the options are more difficult to hedge and therefore there is a higher chance that the issuer could suffer losses as a result. The price breakdown shown below is the fair value of the options so does not show the expected amount of any profit and loss added by the issuer.

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