This section will detail how various building blocks are combined to offer a structured product offering a coupon during the term of the investment, combined with a capital return at maturity. Either or both of the level of the coupon and of the capital return at maturity may be linked to an underlying variable such as an equity index or single share.
For example, a typical product may offer a coupon of 10% after each year of investment, combined with either a capital return of 100% if the FTSE100 has not fallen over the investment period, or of 100% decreased by the fall in the FTSE100 over the investment period otherwise. These products are known as reverse convertibles and are commonly linked to single shares.
In this case the money received from the investor is split into two main building blocks:
A higher level of income can be achieved through gearing up the downside exposure via the sale of more put options than would be needed to provide 1 for 1 downside exposure. In this case, the higher proceeds received from the sale of the option can be put towards providing higher coupons throughout the investment, the flip side being a steeper decline in the capital return in case of a fall (“precipice bond” structures).
- The purchase of a series of Zero Coupon Bonds, each with different maturities to create the flow of coupons plus the final return of capital (i.e. the first one matures after one year and delivers the first 10% coupon, the second matures after two years and delivers the second 10% coupon, and so on ), and
- The sale of a put option, which provides the additional upfront income needed to decrease the overall cost of the structure. The sale of the option leads to a potential risk to the capital return since in the case of a fall in the underlying, the purchaser of the put option will exercise its option at maturity to deliver the underlying to the product provider at a higher price than its market value at the time.