Structured products [SP] are a mystery for many investors. They demand analyzing a combination of the underlying and derivatives. This research can bring an uncorrelated strategy to diversify the main portfolio.
The SP market size is huge, filling the gap between retail and institutional finance. The issuer of SP (e.g. investment bank) provides linking of some underlying asset and option in one product. Examples of the underlying assets are: fund, index, stock, commodity. The options can be put, call, exotic or vanilla.
European organizations are a starting point of the investigation into this topic. Swiss Structured Product Association [SSPA] creates definitions and methodologies. They are famous for the Swiss derivative map and definitely lead in transparency and accessibility of the structured instruments. In 2006 SSPA mapped the products and set 4 major groups: Capital Guarantee, Yield, Participation and Leverage.
According to the Swiss classification, Morgan Stanley (MS) range accrual is a capital protection certificate with coupon, part of the Capital Guarantee group. Issued as a bond, the security pays interest when the underlying stays above a certain level (conditions). Coupon interest can be of two types: percent (e.g. 8%) or formula based. In the latter case, the reference index (e.g. 30CMS-2CMS) is multiplied by the leverage factor (e.g. 5).
As a Capital Protection instrument, MS range accrual has low return and low risk compared to other products. But planned coupon payments are higher than a simple MS bond. The bank guarantees capital redemption on the maturity date, but the instrument price can fluctuate depending on this issuer rating and the closeness to the reference level.
This article provides examples of linking Constant Maturity Swap and S&P 500 index in one security. There are several CUSIPs from MS built on this logic.
For trading purposes fresh (latest) issues provide higher liquidity with the brokers coding range accrual as RGE ACRL NT.
Example of the recent range accrual structured products, issued by Morgan Stanley:
CUSIP | Issue - maturity year | Payment | Comment |
2012 - 2032 | Quarterly | 1) 10% 2) after 2016: (30CMS - 2CMS) * 5 if SPX > 750 (max 10%) | |
2012 - 2027 | Quarterly | 8% if 30CMS > 2CMS & SPX > 950 | |
2011 - 2031 | Monthly | 1) 8% 2) after 2014: 8% if 6 month LIBOR < 7 % & SPX > 950 | |
2011 - 2031 | Monthly | 9% if 30CMS > 2CMS & SPX > 850 | |
2011 - 2031 | Monthly | 1) 8.5% 2) after 2013: 8.5% if 30CMS > 2CMS & RUT > 615 | |
2011 - 2031 | Monthly | 8% if SPX > 890 | |
2011 - 2031 | Monthly | 1) 8% 2) after 2014: 8% if SPX >825 | |
2011 - 2031 | Monthly | 8.5% if 30CMS > 2CMS & SPX > 950 | |
2010 - 2030 | Monthly | 9% if 30CMS > 2CMS & SPX > 800 | |
2010 - 2030 | Monthly | 10% if 30CMS > 2CMS & SPX > 850 |
30CMS means 30Year Constant Maturity Swap Rate.
2CMS - 2Year Constant Maturity Swap Rate.
SPX - S&P 500.
RUT - Russell 2000.
Using CUSIP 61760QAW4 as an example, let's take a basis analysis of this instrument. MS provides two reference charts to help investors.
First chart shows the historical difference between the 30-Year Constant Maturity Swap Rate and the 2-Year Constant Maturity Swap Rate for the period from January 1, 1997 to April 27, 2012 (the "historical period").
Historical period | |
Total number of days in historical period | 5,596 |
Number of days CMS reference index was greater than 0.00% | 5,583 |
Number of days CMS reference index was less than or equal to 0.00% | 13 |
According to the table and chart, we expect coupon payments most of the times if the future performance is similar to past data.
Second chart tracks the well-known SPX daily closing values for 15 years.
Historical period | |
Total number of days in the historical period | 5,568 |
Number of days during the historical period that the index closing value was greater than or equal to 750 | 5,543 |
Number of days during the historical period that the index closing value was less than 750 | 25 |
Based on the SPX values, it is reasonable to expect the high levels of S&P 500 index due to the future inflation pressure.
Hedging structured note
Two parts of the strategy can be implemented here: hedging principal with LEAPS on MS stock and coupon protection with LEAPS on SPY. Considering the positive correlation during market fall, most investors can stay only with MS LEAPS as their hedge.
Understanding of instrument construction
The basis of range accruals consists of buying corporate bond and selling binary option for every day till the maturity date. Bond coupon payment covers option payment if reference level is triggered. Otherwise, range accrual coupon payment combines bond and option premium.
Consider reading the prospectus before making investment decision.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
