In our example on the previous page of a zero coupon bond + option combination for a capital protected product offering 100% of the rise in the FTSE100 after 5 years, 70% of the amount received from the investor is placed in a Zero Coupon Bond delivering the return of the capital at maturity; while 25% of that amount is invested in ATM call options to provide upside exposure. The total cost of 95% leaves 5% for the bank’s margin and the bank’s administrative costs.
Different currencies have different interest rates, resulting in a different cost for the Zero Coupon Bond element across currencies. For example, the UK central bank rate (Bank of England base rate) has traditionally been higher than the European central bank rate, resulting in a lower amount needing to be invested in that element in the UK compared to the Eurozone to offer the same level of capital protection at maturity. Obviously, within a given currency, rates can also change from time to time to account for varying economic conditions.
Just as importantly, in times of strong market volatility, the cost of the options will go up, leading to a rise in the cost of creating the structured product. Of course, product providers can implement changes to the structure of the product being offered to limit cost increases, such as:
Decreasing participation rates
By purchasing a smaller quantity of options the overall cost of the structure is reduced. The downside for the investor is that if, for example, only 80% of the options needed to provide full exposure to the rise in the index have been purchased, then the participation rate in that rise is decreased accordingly from 100% to 80%. Of course, when options are relatively cheap and interest rates high enough, then participations greater than 100% can be offered (known as the gearing effect).
Averaging initial or final levels
Averaging is commonly used to decrease the costs of the options in a structured product. The reduced cost is due to the fact that averaging effectively reduces the exposure of the option payoff to movements of the underlying towards maturity and hence reduces its expected return.
Another reason for the frequent use of averaging is that from the stand-point of the investor, this allows the product to smooth the effect of extreme fluctuations in the equity markets around the start of near the end of the product term.
Below are examples of the reduction in costs that can be associated with averaging on a five year, sterling, FTSE100 linked product offering 100% capital protection and 100% exposure to the rise in the index:
Introducing a cap on returns
- Asset Price with no Averaging = 93.08%
- Asset Price with 3 month Averaging = 92.82%
- Asset Price with 6 month Averaging = 92.56%
- Asset Price with 12 month Averaging = 92.03%
A cap can be added that will limit the return at maturity to a maximum pre-defined amount. This will decrease the overall cost of the structure, as the cap is provided by selling a call option with a higher strike than the current level of the underlying (i.e. an out of the money option). The premium received goes towards reducing the cost of that structure. On the other hand, the purchaser of the option will exercise its right if the underlying rises above that strike level, limiting any gain for the investor to a pre-defined maximum level.