Analysis of a $200m deal from the US SP market


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Analysis of a $200m deal from the US SP market

The largest deal in the US structured product market in the last 12 months was a five year note linked to the stock of JP Morgan issued by Deutsche bank raising USD 225m. The SEC filing can be found here.

Product terms

This note pays 1% interest p.a. semi annually and has a final payment calculated as an average over the last five trading days of the five year period. Based on the notional amount (par value) the final payment is the greater of 100% and the final rebased stock level divided by a factor of 1.16.

The use of the average stock price over the last five days is a common mechanism for large volume products, especially stock linked products. The main reason is that it helps reduce the hedging risk and impact because one-fifth of the hedge is redeemed on each of the five days rather than all at once. This helps the trading desk avoid potential losses by having to sell at levels that are lower than the final official close as measured by the VWAP (volume weighted average price). The use of the VWAP rather than the more standard daily close price also helps reduce any mismatch. The other benefit of the use of an average is that a large fall in stock price in the last few days will have a smaller effect on the payoff and be less likely to trigger investor misunderstanding or dissatisfaction.

However this short averaging period has a limited effect on the overall prospects of the note over five years and can be neglected for the rest of our analysis. The product is essentially a capital protected note with 5% total income paid over its lifetime and the prospect for par or greater at maturity. It should be remembered that the issue price of the note is 103% meaning that the minimum par return represents a small capital loss, however when the value of the income is added back in the note will return at least 2% on a total return basis.

The final payment will be in excess of 100% if the stock price increases by at least 16%. This means that the embedded call option is “out-of-the-money” which allows capital protection, the income stream and 100% participation uncapped relative to this threshold rate to be successfully priced and brought to market.

Target investors

This product is relatively simple and would appeal to an investor who is bullish on JP Morgan stock while still requiring capital protection, either because of concerns over possible price falls or because of their natural risk aversion.

The stated Estimated Initial Value of the note (as required to be published by the SEC) is slightly below the offer price and independent valuation by FVC is broadly in agreement with that. For investors to understand the merits of the note compared to either cash or direct stock investment a simple breakeven analysis is always useful.

Comparisons and backtesting

The most direct comparison is against cash. Calculating the sum of the USD risk free rate and Deutsche Bank credit spread we would expect a vanilla cash instrument to offer a coupon of around 2.5% p.a.. This note only pays 1% per year and so in order to match that return the total return of the note would need to be about 116% of par taking the 103% offer price into account. After allowing for income received, the note needs a final payment of 111.3% or more, which requires a growth in the stock price of 29% over the five year term.

This may seem quite a demanding hurdle rate, and in the 8 months since launch the stock has been volatile, falling by 16% by Christmas last year although at the time of writing, the loss has been trimmed to about 5%.

Historically the note would have performed very well, with the 10 year backtesting analysis (requiring 15 years of data between 2003-2018 in order to generate 10 years of full cycles) showing an average return of 34.68% (6.1% p.a. compounded) with maximum and minimum returns of 227.37% and 5.31% respectively.

Conclusion

In conclusion we can see that the cash alternative investment linked to JP Morgan stock would likely have wide appeal to those wishing to participate in the upside of one of the US best known companies with overall capital protection. Tags: Structured Edge Investment

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