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Case study: Structured product capital protection barriers

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The problem: A client is looking at investing in structured products but is unsure of how the capital protection barriers work.

The solution: One of the key attractions of structured products is that they offer a certain degree of capital protection. In today’s low interest rate environment, full capital protection is expensive. This has led to an increase in the issuance of structured capital at risk products, or Scarps. Most of them include a “soft protection” feature.

Soft protected products return investors’ capital in full at maturity provided the underlying asset does not fall below a pre-determined barrier. This barrier is usually observed either daily throughout the investment term (an American barrier), or on the maturity date only (a European barrier).

If the barrier is breached, investors’ return of capital at maturity will reflect any negative performance of the underlying asset on a 1:1 basis.

As the American barrier could potentially be breached daily throughout the term, it is higher risk than the European version – and therefore the payoff for a product with an American barrier will be higher than a product with a European barrier, all else being equal.

If and how often a barrier is breached depends on several factors, such as the underlying asset, the barrier level, and the term of the product.

In the UK retail market this barrier is commonly set at 50 per cent.

Whilst past performance should not be used as a guide to future performance, analysis on how often capital protection barriers have been breached historically can provide useful insights into their effectiveness.

For example, drilling down into a typical six year FTSE 100 Index investment and analysing daily rolling six year periods since the inception of the FTSE 100 in January 1984, there are 5,792 observation periods up to 6 November 2012.

This means that if a six-year product was created every day then there would be 5,792 products priced (with the last one issued on 6 November 2006, maturing on 6 November 2012). If periods from 7 November 2006 with less than 6 years left until maturity are included, this creates a further 1,516 observation periods in the data set, leading to a grand total of 7,308 observation periods since the inception of the FTSE 100 to 7 November 2012.

Based on this data, the maximum the FTSE 100 has lost over a 6 year term is 29.77 (based on an investment start date of 20th July 1998). Therefore, a 50 per cent European barrier (observed at maturity) would not have breached.

Examining the same data for an American barrier, observed at daily close, then the results are different.

Of the 5,792 6 year periods and the 1,516 periods with less than 6 years left until maturity, a 50 per cent American barrier would have breached and investors would have lost capital on 56 occasions (0.77 per cent of all observations).

The average capital loss was -15.58 per cent, and the greatest loss of capital was -27.41 per cent.

All of these capital losses were related to hypothetical products launched between April 1999 and September 2000.

The choice of barrier therefore has a tangible effect on a risk profile of a structured product: With an American barrier, investors expose themselves to a higher risk of capital loss than using a European barrier. Nevertheless, this does not come without benefits, as, all else being equal, American barrier products will offer a higher return potential in exchange for the increased risk that investors take.

In either case, the common 50 per cent barrier still requires the underlying asset to halve in value before any capital is at risk.

Nev Godley is vice president of the institutional equities division at Morgan Stanley

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Comments

There is one comment at the moment, we would love to hear your opinion too.

  1. Missold Investments 29th January 2013 at 10:04 am

    This story diverts attention from counterparty risk. The term ‘capital protected’ is misleading. No matter what the index does, if the counterparty fails, you will lose your money. Ask anyone with a ‘capital protected’ Lehman-backed product.

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