Structured Product Analysis: March Structure No. 1, A Dual-Direction Note

by: Reid Guenther

Summary

Detailed analysis of structure 1 from the March survey.

Results detail why this is not expected to be a good investment.

Link at the end provides a tab separated data file that should be of use in helping you evaluate similar products.

This analysis covers structured product 1 in my March structured products survey. This article should prove indispensable in helping you to understand the risks and rewards of this product and to understand why this product should on average not be a good investment.

The Structure

This table contains the basic information about the product:

The principal is not protected ("NPP"). The product's payoff is dependent upon the minimum of the returns of the two underliers, the S&P 500 (SPX) and the Russell 2000 (RTY). The returns are computed using the closing prices on the listed trade and valuation dates. More details regarding the product and the issuer can be found using the SEC's EDGAR search engine by looking up the product's CUSIP, 06741U5Z3.

The relative payoff of the structure is shown below:
Please forgive me for presenting the payoff using pseudocode, but I believe this logic makes understanding these products much easier as you become familiar with it. Of course a picture is probably even easier to understand and in this case the payoff is simple enough to graph:

The meaning of "dual direction" becomes clear as you can see that as the return of the minimum performer goes negative, the payoff of the structure actually increases up to a negative underlier return of -20% where the payoff is 120% of the original principal. Of course, a negative return below -20% will cause a loss of the investor's principal in proportion to the loss of the minimum performing underlier. At that point, the final payoff drops over 40% from 120% to less than 80%.

Below are the valuation results of the product as of 03/11/2016, which were given in the aforementioned survey article:

One thing to note is that the issuer's relative value of 93% shows that the issuer has room to increase the investment value of this structure by perhaps decreasing the level at which the negative returns cut off, and they still could expect to make a reasonable profit. Another point is that the historical relative value indicates a good investment while the scenario indicates otherwise. The reason for this difference will become apparent in the next section.

The analysis

This graph shows how the product would have performed over a past period covering 10 years of start dates and thus encompassing a full economic cycle.
Click to enlarge

The payoffs have been discounted using a structure discount curve that has been generated using the capital asset pricing model. This allows the computed relative value to be a measure of the risk versus reward of investing in the structured product as opposed to investing in the underlying market, which is the Russell 2000 for this case. The structure discount rate at the 2-year maturity term has been calculated to be about 6%, suggesting that the fair value for this product corresponds to a payoff at maturity of around 112%. Getting back to the graph, it also shows the relative performance of the underliers which are highly correlated at around 90%. Thus, the graph allows you to see the product's discounted payoff in relation to the future performance of the market for each of the 121 historical start dates.

What should be most apparent from the graph is that the returns of this product can be quite high and correspond to periods when the market is steadily rising. Also apparent is that the payoffs are relatively volatile and can quickly go negative as the market returns drop below that 80% barrier over 2-year intervals. This is what happened 2 years before the financial crisis of 2008 when the markets hit rock bottom. As shown, the historical values dropped to almost 40% of initial notional. The dual direction feature is somewhat hidden but shows itself in the relatively small up-spikes before very large drops in the values due to future market behavior.

This next graph shows the distribution of the historical payoffs.
Click to enlarge

There are actually two separate payoff distributions due to the two distinct payoff regions. The distribution on the right that peaks at a relative discounted value just above 100% corresponds to payoffs at maturity at and above 100% of investor principal. The smaller distribution on the left corresponds to when the payoff at maturity was less than 80%. As indicated in the legend, almost 60% of the discounted payoffs are above 100%, which means that historically this product would have had fair to good value 60% of the time for the given historical period.

Now let us compare the distribution of historical discounted payoffs with the scenario distribution. The distribution of scenario payoffs is shown below.
Click to enlarge

As in the historical case, there are actually two distinct payoff distributions due to the aforementioned payoff regions of the structure. The scenario distributions show more steady variation on the left and right sides. This is due to the much larger sample size of 10,000 scenario simulations versus 121 historical valuations. The scenario graph also shows a wider distribution of positive payoffs.

But the peak actually occurs below a relative value of 100%, indicating why the scenario predicts a larger percent of cases where the structure returns, though positive, are still not good enough to represent a fair value. Thus, the scenario valuation is below 100% at 97.48%, which helps explain the difference with the historical valuation.

In Conclusion

Though the payoff structure of this dual-direction structured product is relatively simple, seeing how the structure would have performed over a past economic cycle really emphasizes how quickly a positive payoff can disappear for this type of structure. This link gives you access to the historical data as well as columns describing the payoff conditions. This data should prove useful should you wish to analyze similar products. Regarding the next product to be analyzed, it is also a dual-directional note but with a minimum return for positive underlier return. Contrasting that analysis with the results contained herein should provide you with further insights and help you achieve a better understanding of these types of investments.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.