Trade of the month: Range-defined products

Tim Mortimer outlines his trade of the month

Under consideration this month are products that have income potential defined by ‘range' type conditions. These products may or may not have capital protection. Income is calculated every coupon period - such as annually or semi-annually - and paid out if any income accrues. Instead of providing a fixed or Libor-based income stream, the size of each coupon depends on a range-defined condition. The range conditions can be defined in a variety of ways, but generally they are either ‘one-touch' or ‘accrual' conditions and one-way or two-way ranges.

The most common underlyings used in range-defined products are equity indexes, foreign exchange rates and interest rates. Equities and equity indexes are usually assumed to have an expected growth rate in excess of the risk-free rate, and would mostly be expected to grow over the long term. However, the same cannot be said of forex and interest rates, which, though they are expected to fluctuate, generally revert to long-term means (more strongly for interest rates). This is why this style of structure is typically more suited to forex and interest rates, since while they have the volatility needed to structure a product with decent terms they do not have the growth characteristics of equities. Range products are often symmetric and do not favour movements in one direction.

The ranges are defined at the product's outset, with the underlying required to be either greater or lesser than a given level or to remain between two levels. These levels can be either fixed, increasing in a defined fashion, or based on the level of the underlying at the start of the coupon period.

The Société Générale product examined this month is linked to the FTSE 100 and has ranges that are set at plus or minus 12% of the strike level for year one and increase by 3% for each subsequent year. The condition in this example requires the index to trade between the ranges on every day of the year. This is a one-touch example and is analogous to an American barrier, which can be breached at any time.

Rather more common are products where the range condition is tested daily but the total accrued is calculated and each day's contribution is independent of the others, meaning the underlying can go outside the range and then return and start accruing again.

For both types of condition, it is important to consider the payment prospects for later coupon periods. Because range conditions are usually set with reference to the initial level, it is quite possible for the range to be breached very quickly because of movements in the index prior to the coupon period starting. In the case of a one-touch range condition such as the SG product, if the index is up (or down) more than 18% at the start of year three the coupon will automatically be lost for that year. This is a perfectly reasonable scenario and demonstrates a typical feature of range-defined products, namely that the value and likely prospects of the coupon in the latter stages are much worse than at the beginning.

The range accrual construction provides more opportunity to recover, but the headline coupons will be lower, just as an American barrier carries more risk than a European barrier and therefore boosts yields more.

Range-defined products are an interesting way to provide the opportunity for a high yield in the case of low interest rates without risk to capital. They rely on an index to be range-bound, so they are suitable for investors who think markets will remain relatively calm. They also provide a way to generate returns when markets are not expected to grow significantly. On the minus side, such products are quite complex and subtle in their make-up, and it is not easy for an investor to get a clear idea of the return prospects or how to compare the return in different scenarios against simpler products.