Structured Product Analysis: March Structure No. 4 - A Good Minimum Digital Return Note

by: Reid Guenther

Summary

Detailed analysis of structure No. 4 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. 4 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 it should on average be a good investment.

The Structure

The following table contains basic information about the product:

The structured product is not principal protected ("NPP"). The underlier is the S&P 500 (SPX). The payoff is a minimum digital return as it pays a minimum of 100% of the initial investment plus the greater of 65% and the underiier return. Intuitively, this would seem like a good deal with the caveat that the term is rather long at 6 years. 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, 40054K4G8.

The relative payoff of the structure is detailed below:

If you have looked at the previous analysis articles, then hopefully the logic of this description of the possible payoffs should be reasonably clear though this is the most complicated yet. This graph of the structure payoff versus the underlier return should help to clarify the payoff logic:

As you can see from the graph or read from the payoff logic, when the return of the underlier is less than 0% but greater than or equal to -30%, the payoff is 100% of the initial investment. When the underlier return is below -30%, then the payoff is the same as that of the underlier. At and above an underlier return of 0%, there is a relatively large jump in the payoff that matches the underlier's return above 65%.

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

The estimate of the issuer's pricing indicates there is not much room for adjusting the terms of the structure in the investor's favor while still allowing the issuer to expect to hedge a profit. In this case, it indicates the structure is well designed as understood upon examination of the historical and scenario relative values. The historical value is well above a fair value of 100% at almost 126% while the scenario valuation is also relatively high at over 109%. These values indicate that the structure is a very good value. Justification of this conclusion is detailed 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. Also, the relative underlier performance is shown to help you understand how the product performs in relation to it.
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The payoffs have been discounted using a structure discount rate that was 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 3.8%. Thus, the 165% payoff actually has a discounted value of a little less than 131.6%. This value corresponds to the upper set of discounted payoffs from 2000 into 2008. The 100% payoff of the structure has a discounted value of almost 80% and corresponds to the lower set of discounted payoffs in the graph.

What should be apparent is that the 6-year term of the product can encompass large swings in the market and that in no case over this historical period was the return of the S&P 500 under -30% after 6 years. But whether the 6-year return is positive or negative tended to vary quite a lot during the middle of the given historical period due to those 6-year product terms covering the Great Recession. For the case when the structure would have started out at the bottom of the market at the end of 2008, the large jump in returns shows the positive effect of the long bull market which extended well over 6 years.

Now, let us examine the distribution of those discounted historical payoffs using the following graph:
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The graph clearly shows the three sets of payoff amounts described above, with the 80% discounted payment comprising 22% of the distribution, the 131.6% discounted payment making up about 63% and the payments above comprising the remaining 15% of the distribution. Thus it is easy to see why the historical relative value should be much more than fair, which it is at 125.91%.

Now onto the scenario analysis which can be summarized by examining the resulting payoff distribution computed from 10,000 simulations which utilized the historical average return and variances of the S&P 500 over the same period as well as the structure discount rate.
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The two large peaks correspond to the 80% and 131.6% discounted payoffs in the historical graphs. But these simulations show losses of principal as indicated by the values to the left of the 80% peak. This should serve as a warning that past performance certainly does not guarantee future performance. You should also note that the percent of discounted payoffs has dropped from 78% to a little less than 55%. Thus, the expected value of the scenario valuation drops as well to 109.44%. Though much lower than the historical value, it is still well above fair value.

In Conclusion

The high relative values computed from the historical and scenario analyses indicate that this structure is expected to be a good value. The underlying reasons for this are that the 6-year term is long enough that the underlier has a chance to recover from losses. The fact that that underlier is the S&P 500 is also a major reason why the discounted payoffs can generally be expected to be satisfactory. This is because of the S&P 500's generally expected positive performance and relatively low volatility compared to other indices over longer time periods.

To further assist with understanding this analysis, this
is a link to the historical data and payoff logic used in the historical portion of 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.