Capital at risk structures

By placing capital at risk potential returns through a structured product can be increased. The following are the most common methods employed in this regard:

Soft floors

A soft floor is a predefined barrier which when breached triggers capital loss conditions. For example a product may be capital protected so long as the underlying market does not fall by more than 40 per cent (this may be described as a 60 per cent soft floor). If this level is breached and the market fails to recover to the original level (strike level), then capital may be lost on a one-for-one basis based on the level at which the product settles at maturity.

Reverse convertible

Capital is lost on a one-for-one basis if the market is lower at maturity. Many of today's reverse-convertible structures incorporate a soft floor, as above.

Downside barriers

Some structured products select a level of capital protection below 100 per cent. For example, a product that pays 100 per cent participation on the FTSE may contain 90, rather than 100 per cent capital protection, and this lower level of protection would boost the investors' potential investment returns. This would mean that the first 10 per cent of downside risk is not covered. There are two approaches to putting capital at risk in this way:

• Partial zero coupon deposit  - a sufficient proportion of capital is placed on deposit to ensure that, for example, 90 per cent of the invested capital can be paid back at maturity. This increases the amount of cash available to spend on the derivatives which give performance. Note that, if the underlying equity performance is flat the investor will be reunited with only 90 per cent of their initial capital.
• Put spread  - capital is placed on deposit as it would be to ensure 100 per cent protection. The investor also sells a put spread. This provides that capital is lost percent for each percent the underlying performance is negative, but floored at, say, a 10 per cent loss, thereby giving it 90 per cent capital protection. The proceeds from the sale of the put spread are reinvested to increase the allocation to the derivatives giving performance. In this case, if the underlying equity performance is flat, the investor will be reunited with 100 per cent of their initial capital.

Clearly the effect of Partial zero coupon deposit is greater on the terms of an investment.

Geared downside

By gearing the downside, returns may be significantly increased, but quite obviously, this is because more downside risk is being taken. These type of high-risk strategies risk capital by a multiple of capital invested, eg for each one point fall results in a four-time loss of principal. Of course, a corresponding improvement in returns would result from a rise in the market.