When stock products can outperform index linked

From the Hub section

When stock products can outperform index linked

The use of single stocks, and worst-of combinations of stocks continues to attract attention and make up a significant proportion of issuance in all markets. Such construction tends to be seen in reverse convertibles and autocalls, the two most common capital-at-risk products. The reason for this is that in times of moderate volatility and low interest rates such alternatives are the only realistic way to generate higher yield.

Different markets

Some markets such as Germany, Switzerland and Hong Kong feature many thousands of warrants and certificates which are linked to single stocks. Such products tend to be of shorter maturity - that is two years or less. The way such products should be traded is by sophisticated investors who invest in a large number of such investments with a carefully considered portfolio approach. Investing in a spread of such products involves accurate assessment of the stock’s prospects and also the “non-linear” effects required for the structured products to outperform the stocks directly. This usually means selecting underlyings that have a better chance of not hitting the barrier and achieving the relevant hurdle, usually finishing above the starting level. Timing is of paramount importance and over the long term the losses that are inevitably suffered for some investments must be kept to a manageable proportion of the excess of the high headline yields that are received over the risk-free rate in order for the investment in structured products to be successful.

The type of products seen in the UK, US and longer dated investments in the markets mentioned above have a different purpose. They can be reasonably thought of as buy and hold investments to potentially take a somewhat larger part of a portfolio. Therefore their construction needs to be designed a little differently but the investor (or their adviser) still needs to think extremely carefully about making such an investment.

In many cases single stock linked products will have a 50% European barrier on the worst performing stock. A typical example is a reverse convertible paying a fixed high rate of interest over a four year term. Capital return is linked to the worst performing of four UK stocks, all in the FTSE-100 index from different sectors.

Example from the UK

An index linked alternative (for example linked to the FTSE-100 over four years) would either have to cut the yield significantly or to maintain it have an American or European barrier at a much higher level.

For an investor to put money into the stock-linked product there must be a very clear understanding of the risk to each stock and also the effect of correlation between them. There are a number of ways to approach such an analysis. The simplest approach is to be comfortable that each of the stocks will be extremely unlikely to breach the barrier. In the case of a 50% European barrier that is a reasonable test to apply. One can calculate the barrier level in absolute levels given the strike price and look historically as to when the stock was last at that level and what market (and benchmark index) conditions existed at that time. One could also calculate the number of times that each stock fell by 50% over a four year period and which type of market conditions caused it.

In summary, the rationale of selecting any stock based product over an index linked product comes from a general appreciation of the fundamental differences in risk and returns as well as specific research for the stocks in question and the precise nature of the products terms and risk taken on.

Tags: Product types Structured Edge

Related Posts: