Constructing a capital-protected growth product

Capital-protected equity investment products incorporate two features – capital protection, on a zero coupon basis (ie interest rolled up and paid out at maturity), and the ability to participate in stock markets. The equity participation is ensured via the purchase of an equity option. The objective here is to ensure that 100 per cent of the funds invested can be repaid at maturity whatever happens to the underlying equity reference benchmark (usually a stock index, basket of indices or basket of equities), while at the same time providing investors with the opportunity to profit from a rise in the markets.

Factors that determine the extent to which an investor can benefit from a rise in the market while still keeping capital secure

1. Interest rates - taking a simple example of a five-year 100 per cent capital-protected investment linked to the S&P500, the first factor that will determine the overall pricing of the structure is the level of interest rates. The optimum method of providing full capital protection is to place funds on deposit. Quite simply, a sum is invested on day one that will grow to equal at maturity the total capital amount committed by the investor. Logically therefore, the higher the rate of interest, the smaller the proportion of funds required to guarantee 100 per cent at maturity.
   
   So, if the total amount placed by investors in an investment product is USD10 million and the five-year zero coupon rate is 5.16 per cent, the equity derivative structurer will need to invest USD7.74 million on day one in order to generate USD10 million in five years' time. The chart that follows demonstrates the affect of zero coupon rates in relation to what proportion of total funds need to be invested to preserve the capital value.
   
   
   
   Following on from this point, it is easy to comprehend why in these types of product the full capital sum is only protected at maturity, since before this date the zero coupon investment will not have grown to the required size. In the case of early redemptions therefore, the size of the capital sum available for repayment will depend heavily on how long the investment has been in place.
   
   Returning to our example, with USD7.74 million fully committed to safeguarding the capital element, this leaves an amount of USD2.26 million. This sum will be used to purchase the equity derivative, which will give the structure its investment performance. However, before the option can be purchased, a portion of this residual amount must be set aside to pay for administration costs.
   
   
2. Fees - packaging, marketing, administering and settling retail products is a labour-intensive enterprise and the fee levels charged by providers may vary between two per cent and seven per cent depending on the product, its maturity and its wrapper (ie legal vehicle – deposit, individual savings account [ISA], Life Bond, Fund, Medium-term Note [MTN] etc).
   
   NB large institutional trades or transactions for high net worth individuals in Private Banks will not require the same level of administration so fees will be substantially lower.
   
   Let us assume for the sake of this example that total fees are three per cent. Once these have been deducted, USD1.96 million will remain for the purchase of the option.
   
   
3. Option cost - in order to provide participation in the appreciation of the index, a call option will need to be purchased. The price of this option will be determined by the usual variables that affect option pricing - Strike Price, Maturity, Forward Pricing, Volatility etc. So it follows that in times of high volatility, options cost more and consequently, the funds available for purchasing the option buy less of the option than they would if volatility were to be lower and the call option cheaper.
   
   One further factor that also affects the option price is the method used to ascertain the reference price at maturity. Typically, structured equity investments are subject to an averaging methodology, which avoids the risk of the option payout being adversely affected by a sudden, sharp fall in the market at or close to maturity. Products of three years and less usually have a three- to six-month averaging period while longer-term deals will often be subject to 12-month weekly averaging. Not only does this smooth the risks when approaching maturity but also, conveniently, averaging has the additional benefit of cheapening the option. Some product structures in the European marketplace are subject to full averaging or as it is sometimes termed "full Asianing". This significantly reduces the option cost but also impairs performance as an investor can only benefit from the average rise in the market over the investment period.
   
   Let us assume that in our example a five-year at-the-money S&P500 call for USD10 million with 12-month weekly averaging costs USD2.02 million. Since we only have USD1.96 million to spend on this option, this will mean that the option purchased will not produce the opportunity to participate in the full appreciation of the index. Instead, this product will deliver 97 per cent participation.*
   
   (1.960/2.02 x 100 = 97).

*If the option costs less than is available to spend, then participation will be higher than 100 per cent – a concept that is sometimes difficult for some investors to comprehend.

If cost is greater than the amount available to spend then the investor will have less than 100 per cent participation.