Product performance: May 2011

Future Value Consultant’s analysis of single-stock versus index-linked products shows favourable results for broad equity index exposure. This month, the firm reviews two accelerate growth products and a reverse convertible

The need for speed

This month, Future Value Consultants (FVC) has reviewed two accelerated growth products and one reverse convertible.

The first of the two growth products is linked to technology company Dell, which is a popular underlying for capital-at-risk income products in the US. Single stocks are also chosen as underlyings for growth products, accelerated growth and kickout/autocall structures in the US market.

Accelerated growth products are capital-at-risk structures which generate returns through growth in the underlying by way of a geared upside of more than 100%. In exchange for enhanced participation, there is usually a cap on returns. This is a two-year product with a participation rate of 200% and a cap on total returns of 142.6%, including capital. The product is capital protected, with a barrier of 80%, which means that should the underlying stock fall below 80% of its initial level during the product term, capital will be lost at a rate of 1% for every 1% fall in the value of the stock.

Figure 2 shows an accelerated growth product linked to the S&P 500 Index. This product also has a gearing of 200% and a barrier set at 80% of the initial value of the stock. The cap on returns is 131%, including capital. Both products were priced assuming a strike price of 95% and an issuer funding rate of 100 basis points.

At the time of pricing, Dell had an implied volatility of almost 40% whereas the S&P 500 was roughly 25%. Accelerated growth products are not as volatility sensitive as other product types because of the relationship between the cap, gearing and barrier. Volatility does have an effect on the terms the product can offer, however, as these two products show.

Using market data from October 8, 2010 and the two-year risk-free US rate, the results show that the product linked to Dell was able to offer a higher cap on returns because of the higher volatility of the underlying. The barrier for both products was set at the same level of 80% and owing to the higher volatility the put on the first product was worth more because there is a higher chance that the barrier will be breached and of larger losses to capital. Therefore more revenue is generated from the sale of the put to buy the call spread.

The price of both products has risen since the strike date. Accelerated growth performance is heavily dependent on the movement of the underlying, and the price of the structure closely tracks its movement.

Figure 3 shows the performance of a reverse convertible product, also linked to Dell. It is a one-year income product, paying a fixed coupon of 11.7% per annum. It has a barrier of 80%, which, like the accelerated growth products, can be breached on any day during the product term. Figure 3 also shows the change in implied volatility of the underlying over the monitoring period. Over five scenarios; neutral growth, high growth, low growth, high volatility and low volatility, FVC research has found that reverse convertibles perform best in low volatility environments. Volatility of the underlying stock has moved quite significantly over the term, though at the final weekly valuation date it was roughly 10% lower than when the product was priced, having a positive effect on the price of the assets. The product has six months left to run and the spot was 9% above its initial level after six months, so provided the stock does not fall by more than 29% from its current level, the maximum return will be paid plus full return of capital.

Product performance May 2011

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