Structured Product Analysis: March Structure No. 2, A Good Dual-Direction Note

by: Reid Guenther


Detailed analysis of structure No. 2 from the March survey.

Results detail why this is expected to be a good investment.

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

This analysis covers structured product No. 2 in my March structured products survey. This article should prove indispensable in helping you to understand the risks and rewards of this product and why this product should on average be a good investment.

The Structure

The following table contains the basic information about the product:

The principal is not protected ("NPP"). The product's payoff is dependent upon the return of the S&P 500 (SPX) where the return is computed using the closing prices on the trade and valuation dates. This dual-direction note has a 5-year term as opposed to the 2-year of structure No. 1. As you will see shortly this is a critical difference between the products. 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, 48128GQN3.

The relative payoff of the structure is detailed below:

Again apologies for putting the payoff logic in pseudocode, but it is quite succinct and easily understood. This graph of the structure payoff versus the underlier return should also help your understanding of the product.

This is similar to structure No. 1 except for two things. One, the downside barrier at which the investor can lose principal is now at a -30% underlier return whereas it is -20% for structure 1. And two, when the underlier return is positive, the payoff is a minimum of 30%.

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

As you see, both the historical and scenario relative values are well above 100%, indicating that this structure is a good value for the money. Why that is so can be understood by going through the product analysis.

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. Also, the underlier performance is shown to understand how the product performs in relation to it.
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 S&P 500 for this case. The annually compounded structure discount rate for this product is 4.5%. The payoffs in the graph have been discounted using that rate and thus show when the structure at least returns a fair value of above 100%.

As you can see, the majority of those returns are above 100%. The constant sections of the payoffs are the cases when the minimum payoff of 130% was made. Also of note, the discounted payoffs can get much higher than that, especially after the market bottomed out during the financial crisis that started in late 2008.

For start dates 5 years prior to the crash, the payoffs are not as good. However, except for one point in 2003, all are at or above 80% which, given the discount rate of 4.5% compounded over 5 years, indicates that at least the investors' principal was returned. That one point in 2003 corresponds to an investment almost exactly 5 years before the bottom of the market. The rising returns just around that one point cover the case when the underlier return was negative but not less than -30%. From all this, you should see that, historically, this structure would have been a relatively safe investment and gives credence to the listed relative historical value of almost 112%.

Examining the distribution of those payoffs in the graph below further justifies this conclusion.
Click to enlarge

The distribution shows two major peaks. One just above 100% and one just above 80%. Respectively, these correspond to instances shown in the previous graph where the undiscounted payoffs were at the constant 130%, and the periods when the underlier returns were negative but not less than -30%. As the legend of the payoff distribution graph states, over 64% of the discounted payoffs were at and above fair value. This fact and the fact that only once did the underlier have a 5-year return of less than -30% adds further support that historically this product would have been a good value.

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

The peak of the right hand distribution is just at 100%. But, as the legend states, over 63% of the discounted payoffs are at or above 100%. This indicates why the expected scenario value of the product is more than fair. However, even though this analysis uses the historically averaged underlier return and volatility in simulating the product performance, the peak in the left hand distribution is below 50%. This shows that among the 10,000 scenario simulations, there are a relatively large number of cases when the underlier return is well below -30%; thus, large losses are possible. This should serve as a warning that investing in this structure can result in losses of principal.

In Conclusion

As shown in the analysis, the valuation of this product indicates a good investment. This is a different conclusion than that of structure No. 1 which was also a dual-direction note. But three major difference -- the longer term length, the lower downside barrier of -30% and the minimum payoff of 130% for positive underlier returns -- all make this a good potential investment according to my analysis. The difference between structure No. 1 and structure No. 2 of the March survey should help emphasize why a separate analysis is needed for each structured product being considered as an investment. To help with that analysis, here is a link to the historical data and payoff logic used in this analysis.

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.