Structural variations

With the imaginative use of equity derivatives, returns may be altered to produce a variety of different payoffs. The most commonly used are as follows.

Minimum return

There is no doubting that potential returns from equity investment are high, however, the actual pay-off will be determined by the performance of the stock market or markets in question. Many investors, although attracted to the prospect of high returns, find the prospect of earning nothing if the market is lower at maturity to be relatively unpalatable. This problem can be overcome by guaranteeing a minimum return at maturity.

So, instead of promising 100 per cent participation in a five-year FTSE100-linked product, a structure can be created that pays either a minimum return of 20 per cent at maturity or 50 per cent of the appreciation in the index, whichever is greater.

Although the investor may take comfort from the fact that his funds will generate a guaranteed minimum return, it should be noted that in order to establish a fixed minimum, the upside potential is reduced. In this case, if the market were subject to strong appreciation the investor would only benefit from half the market gain.

For non-retail investors, minimum return structures can be tailored to produce higher or lower minimums depending upon the investor’s personal risk-versus-reward parameters.

A variation on this theme is a so-called ‘and’ pay-off as opposed to the ‘or’ structure described above. With an ‘and’ structure the investor receives a guaranteed return and a certain percentage of any appreciation in the market on top of this. Clearly with an ‘and’ structure the potential to participate in any appreciation of the underlying market is reduced.

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Capped call

Equity derivative returns can be enhanced by capping the overall payout. On the face of it this may not initially appear to be an attractive proposition, however, if the transaction is constructed realistically participation levels can be increased without the cap being breached.

With a capped call structure, the investor is actually writing an out-of-the-money call that constitutes the cap, ie he/she agrees to forgo gains above a defined market level in exchange for a premium. This premium is not actually paid out but instead is reinvested in the structure to boost participation rates.

For example: Let’s say a five-year vanilla call on the Eurostoxx50 would give participation of say 60 per cent in the rise in the market at maturity. This participation level would be increased to 80 per cent if returns were to be capped at a maximum return of 140 per cent.

From a product selection perspective it follows that a capped call structure is most attractive when a modest rise in the market is expected.

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Auto-callable (or early release)

Many investors place a high value on liquidity and view the fact that many structured equity investments are for five years or longer as a negative factor. One way of potentially shortening the maturity of the investment is to include an auto-callable feature.

An auto-callable feature is essentially a European barrier option written by the investor such that if on a set date in the future the equity market is above a defined trigger level, then the structure will automatically terminate and funds will be paid back to the investor together with a specified return.

For example, a five-year investment against the Dow Jones Global Titans 50 Index may incorporate an auto-callable feature after three years whereby if on the third anniversary the market has risen by 20 per cent or more the structure will automatically terminate. If the auto-callable feature is not triggered then 105 per cent of the appreciation of the index will be paid to the investor at maturity.

It should be noted that since the investor is writing the early termination option, an implied premium will be earned. This will not be paid out but will be invested in the structure to produce enhanced product terms.

Some products have multiple triggers giving for example an annual opportunity for early termination at gradually increasing levels.

Cliquets and reverse cliquets (also known as ratchet options)

With a cliquet option, the investor receives a return determined by the sum of a sequence of periodic settings (sub-periods), which are combined to pay a return at maturity.

For example: The performance of the S&P500 is measured every three months and each reading is compared with the previous quarter’s reading and is added to (if positive) or subtracted from (if negative) a running total.
Often, a cliquet structure incorporates a maximum periodic rise or fall for example plus or minus 2.5 per cent, which has the effect of smoothing out large movements from one reference period to another.

From a derivative point of view, a cliquet is a path dependent instrument being comprised of a series of at-the-money forward starting options.

A reverse cliquet structure, rather than accumulating returns, pays out a sum at maturity equivalent to a set percentage rate minus the sum of negative settings.

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Digital option (also known as a binary option)

A digital option is very simple to understand since its payout is determined by a defined trigger (or set of triggers). Basically, the structure pays out a fixed amount if the market is above (or below) a specified level at maturity or on specified reference dates; if it is not then there is no payout.

For example:
A three-year product linked to a basket comprised of 10 stocks of leading petrochemical companies will pay 30 per cent at maturity if the basket is higher at maturity than at inception.

Digital structures are generally used when a rise or fall in the market is expected but the magnitude of the move is uncertain. The size of the payout can be increased by introducing a higher digital strike price, for example paying a set return if the market rises by more than five per cent or 10 per cent.

Auto-callable digital

It is becoming increasingly common to combine digital payoffs with auto-callable structures. This significantly enhances the overall yield and leads to early termination of the structure if the digital condition is satisfied.

For example:
A three-year product linked to the FTSE100 will pay eight per cent after one year if the FTSE100 is higher than at inception. If this is the case, the transaction will early terminate upon payment of the coupon. If the FTSE100 has not risen after one year, the transaction continues for another year and after two years if the market is higher than at inception the investor will receive 16 per cent and the deal will then terminate. If not, the transaction runs for a third year when, if the market is higher than at inception, the investor will be paid 24 per cent.

Some product providers further enhance returns by placing capital at risk.