Product performance

The products reviewed this month include full principal protection and an accelerated growth product that has no downside risk, alongside a three and a six-month reverse convertible

The first product this month is a principal-protected product linked to the Dow Jones Industrial Average index. The product has a five-year maturity and a gearing of 100%, with a maximum return of 17.7%, which is equivalent to 3.2% per annum.

In the US, there has been an increase in the issuance of principal-protected products linked to the Dow Jones Industrial Average rather than the S&P 500 index, which was previously the most common US equity index for these structures. This is probably a result of the lower volatility of the Dow Jones index, which means that products based on it offer more attractive terms and therefore a higher return. Figure 1 shows that the product closely tracks the performance of the underlying. This is because the underlying is mainly above its starting level and does not move above the cap. The product has a large proportion of its term remaining until maturity.

The second example is a two-year accelerated growth product linked to the performance of the iShares MSCI Emerging Markets Fund (figure 2). The product has a gearing of 500% and comes with no downside protection – if the fund is down on its initial level at maturity, investors’ capital is lost at a rate of 1:1. For the first 13 weeks, the price of the product quite closely follows the movement of the fund. On week 14, if the underlying falls below its starting level, the price of the product falls as well, but to a higher degree. The fall in the underlying coincides with a jump in its implied volatility, with a consequent reduction in the value of the accelerated growth product as the probability of losing capital is increased. From week 17, the underlying fund began to increase while the volatility of the underlying fell, which meant that the price of the product increased. The product price has increased at a faster rate than the underlying fund due to its high gearing.

Figure 3 demonstrates the performance of two reverse convertibles linked to the performance of United States Steel. Both products have barriers set at 80% and priced at 100% on the strike date. The first has a three-month maturity and pays a coupon of roughly 40% per annum. The second lasts for six months and pays a coupon which is equivalent to 32% per annum. These products are hypothetical and the rates would not be available in the retail market as the 100% offer price would be unrealistic as it includes neither fees nor costs. The three-month product has matured and, as the stock price of the underlying did not fall below the barrier, returned the full coupon and capital at maturity.

The six-month product is only a week from maturity and looks likely to pay back 100% of capital at maturity. Shortly after the product matured, the underlying stock fell below its starting level, reducing the value of the product. The price of the product then remained fairly constant due to the 80% barrier. Once the stock price fell below the barrier, the price of the product started to follow the performance of the stock more closly. This is because after the barrier has been breached, the amount of capital returned to investors is dependent on the final level of the stock.

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