Part 4. Equity-linked notes • Callable dual accrual cash or share security • Early redemption equity-redeemable warrants • Super certificate (lookback minimum and lock-in level) • Target redemption notes • Guaranteed equity bonds 1
24 Month Callable Dual Accrual Cash or Share Security On Wal-Mart Stores, Inc and Intel Corp. issued by Merrill Lynch (Feb. 9, 2006) Payment/delivery on the maturity date • If the settlement prices of BOTH the underlying stocks are higher than or equal to the respective exercise price, each warrant holder will receive 100% of the notional amount per warrant held. • If either one of the settlement prices is lower than the respective exercise price, each holder will receive per warrant physical delivery of a number of the “Worst performing” stock equal to Notional amount / exercise price of worse performing stock It is a forced conversion when the share prices decline (opposite effect to that of a convertible bond). 2
Issue size: 10, 000 warrants Minimum subscription: 100, 000 warrants Notional Amount: USD 1 per warrant Issue Price: 100% of the Notional Amount Trade Date: Feb. 9, 2006 Issue Date: Feb. 23, 2006 Valuation Date: Feb. 11, 2008 Maturity Date: Feb. 19, 2006 3
Underlying stocks (uncorrelated) Reference price Exercise price Wal-Mart Stores Inc. USD 45. 48 USD 39. 5676 Intel Corp USD 20. 77 USD 18. 0699 • Exercise price = 87% x reference price Terminal payoff = min (1, min(S 1(T)/S 1*, S 2(T)/S 2*)) = 1 - max(1 - min(S 1(T)/S 1*, S 2(T)/S 2*), 0), where A 1* and S 2* are the reference prices of asset 1 and asset 2. The investor shorts a put on the minimum of two assets. 4
Additional coupon (accrual feature) Unless the warrants have been called, over each observation period (3 -month period), the holder receives 4. 075% x n /N of notional amount where N = number of New York Business Days in the period in the applicable Observation Period; n = number of New York Business Days in the applicable Observation Period on which the closing prices of BOTH the Underlying Stocks are at or above the respective Exercise Price. This is like an accrual note with the underlying index being the minimum of two share prices. The accrual feature can be viewed as a series of daily binary options which pay 4. 075%/N x notional amount when min(S 1(T)/S 1*, S 2(T)/S 2*) > 1. 5
Overall description • The investor believes that the prices of BOTH underlying shares at maturity will remain at a level above or equal to their respective Exercise Prices, earning an enhanced yield. • The warrant pays out a fixed 4. 075% coupon for the first quarter. • The coupon received would depend on the trading path of BOTH underlying stocks due to the accrual feature. 6
• Issuer’s Call: On any of the Observation Date, provided that BOTH underlying stocks are greater than or equal to the reference prices, the issuer can call by paying 100% of the Notional Amount. This occurs when the value of the embedded put is less than the present value of the enhanced yield over the remaining period. This “call” right given to the issuer is like a Bermudan put option. 7
Risks 1. Market risks – underlying shares 2. Credit risk – default of Merrill Lynch 3. Liquidity risk – will not be listed on any securities exchange and do not expect a trading market with only Merrill Lynch as a possible buyer. 4. Interest rate risk – bond component: par plus coupons and issuer’s call. 5. 6. warrant = bond (series of binary options – accrual feature) 7. - European put on minimum of two uncorrelated stocks 8. - issuer’s call (Bermudan put) 8
2 -Year JPY Early Redemption Equity-Redeemable (“ER”) Warrants Linked to a Basket of Japan Equities (Japan Basket ER Warrants) Type of investor extholds rsthat thethe sbelief o • He over all of the shares in the Japan Share Basket will not decline by more than 12. 00% from their respective Reference Price. • performing shares if any of the shares in the basket falls below their respective Strike Price at the Valuation Date. This product is not principal-protected. 9
Japan Share Basket : basket shares A 5 asin shown made the of up the table below: 10
Issue Size : 1, 000, 000 warrants Minimum Subscription : JPY 10, 000 Notional Amount : JPY 1, 000, 000 Issue Price : 100% Trade Date : 14 June 2005 Issue Date : 28 June 2005 following Date subject June 28 Maturity the to 2007, : business day convention arrear Periodic payment in quarterly Payable : Periodic Payment Date and accruing on 1 30/360 basis at the Periodic Payment Rate 11
Reference Price : Executed price of each Share in the Share Basket on Trade Date Settlement Price : Closing price of each Share in the Share Basket on the last Observation Date, as determined by the Calculation Agent Strike Price : 88. 00% of the Reference Price of each Share in the Share Basket Trigger Price : 98. 00% of the Reference Price of each Share in the Share Basket 12
Periodic Payment Rate : For the first period, from the issue date to the first Periodic Payment Date, 10. 00% p. a. fixed in the first period Thereafter, 10. 00% p. a. if the closing prices of all the Shares in the Share Basket are at or greater than their respective Strike Prices on an Observation Date. Otherwise, the Periodic Payment Rate is deemed to be 1. 00 p. a. . Early Redemption by Issuer : If the closing prices of all the Shares in the Share Basket are at or greater than their respective Trigger Prices on an Observation Date, the Warrants will be redeemed in full at 100% of the Notional Amount together with accrued interest 13 on the related Periodic Payment Date.
Worst Performing Share : Redemption at Maturity Date : The Share in the Share Basket which has the lowest value on Valuation Date according to the following formula: (Settlement Price / Reference Price) - 1 On the last Observation Date: (1) If the Settlement Prices of ALL the Underlying Stocks are higher than or equal to their respective Strike Price, each holder of the ER Warrant will receive 100. 00% of the Notional Amount per warrant held. 14
(2) If the Settlement Price of ANY of the Underlying Stocks are lower than their respective Strike Price, each warrant holder will on the maturity Date receive per Warrant physical delivery of the Worst Performing Share equal to: (3)Any fraction of a trading lot of the Shares to be delivered shall be paid out in JPY cash at a price calculated using the relevant Settlement Price. Settlement Currency : JPY 15
Payout at any Observation Date 16
Payout at Maturity if not Early Terminated (i. e. Warrant is held to Maturity Date) 17
Summary • Juicy coupons for potential short life if stock prices stay above the trigger prices (98%). The juicy coupons in the early coupon represents the premium of the put option sod to the issuer. • When the stock prices fall below the strike prices (88%), the coupon reduces to 1% pa. In addition, the investor receives the worst performing stock at maturity. 18
2 -Year USD Super Certificate Plus (with lookback minimum and lock-in Level) Linked to Basket 19
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Share Amount : If the Worst Performing Share is denominated GBP (HKD), Share Amount shall mean a quantity of the Worst Performing Share equal to (a) an amount in GBP (HKD), equal to the Note Denomination converted into GBP using the Final Reference Exchange Rate for EUR, divided by (b) the Reference Price of the Worst Performing Share; rounded to the nearest integer. If the Worst Performing Share is denominated USD, Share Amount shall mean a quantity of the Worst Performing Share equal to the Note Denomination divided by the Reference Price of the Worst Performing Share; rounded to the nearest integer. 24
Monitoring Period : The from period and Launch including Date the to and including the Valuation Date. Barrier Event Barrier : A the price of at least one Share at the Valuation Time is at or below its corresponding Barrier Price on any Exchange Business Day during the Monitoring Period. Look-back Period : The from period and Launch including Date the to and including 21 December 2005. Call Strike Level (b) : Means the lowest daily closing price level observed as compared against the corresponding Initial Spot Price during the Look-back Period, subject to a minimum of 90% and a maximum of 100%. 25
where and where is the lowest daily closing price observed in respect to the ith Share during the look-back Period. 26
ave to Event: A ed Lock-in deemedis Lock-in the prices of all Shares, at the Valuation Time on an Exchange Business Day during the Monitoring Period, are at or above their corresponding Lock-in Prices in respect of a particular Lock-in Level; such Lock-in Level is then deemed to have been reached. For the avoidance of doubt, more than one Lock-in Event can occur during the Monitoring Period. Actual Lock-in Level : The highest Lock-in Level reached among the (Performance. Locked) Lock-in Levels reached in respect of all Lock-in Events where applicable. 27
1): Redemption Amount : (Case at maturity occurred during the Monitoring Period, the Issuer shall pay the Note holder the following amount in respect of each Note held on Maturity Date. Case 1 occurs when at least one share has increased by more than 10%. This is called a lock-in event. In this case, it is principal protected plus extra percentage based on the stock performance. 28
(Case 2): If Lock-in Event has not occurred during the Monitoring Period and that (Case 2 a): Barrier Event has not occurred during the Monitoring Period, the Issuer shall pay the Note holder the following amount in respect of each Note held on Maturity Date. 29
(Case 2 b): at least one Barrier Event has occurred during the Monitoring Period. (Case 2 b-i): and if Performanceworst 0, that is the Worst Performance is greater than or equal to zero, the Issuer shall pay the Note holder the following amount in respect of each Note held on Maturity Date. or 30
(Case 2 b-ii): and if Performanceworst< 0, that is the Worst Performance is less than zero, the Issuer shall pay to the Note holder the Share Amount (fractional entitlement will be subject to cash settlement) AND shall pay the Note holder the follow amount (if the amount is greater than zero) per Note in respect of each Note held on Maturity Date. where 31
1. To the note holder, it is most desirable to have (a) A small value of b. This occurs when there are drops in the share prices during the lookback period. (b) A higher performance. Locked value (which can be greater than 10%). It is easier to be achieved when the share prices are more correlated. 2. Cases 2 a and 2 b-i are principal protected. 3. When knock-out event occurs and performanceworst < 0 [Case 2 b(ii)], the note holder acquires the share plus some cash compensation. In this case, the note is not principal protected. Remark Complexity almost for the sake of complexity. The structures are “opaque” for both parties – cannot really work out where the value lies. Product controllers have trouble marking to market. 32
Target redemption notes Example 7. 5% USD Target Redemption Index Linked Deposit (issued by Bank of East Asia, 2004) Selling points - Enjoy potentially higher returns with Index Linked Deposit • 100% principal protection plus 7. 5% guaranteed coupon return over a maximum of 5 -year investment period. • 1 st year annual coupon is guaranteed at 6. 5% (very juicy), payable semi-annually. 33
• The remaining coupon rate of 1% will be based on the LIBOR movement. The inverse floater formula is max{7% − 2 × 6 -month LIBOR (in arrears), 0} However, the total coupon received will not shoot beyond the target rate of 7. 5%. If the coupon payment accrued during the deposit period is less than the target rate, then the remaining amount will be paid at maturity. Early termination Once the accumulated coupon payment reached the target rate, the deposit will be terminated automatically. 34
Worst scenario The deposit is held for 5 years until maturity so that the annual return for the deposit is only 1. 5% per annum. Market background The US Fed policy makers voted unanimously to keep the Fed Fund Rate unchanged at 1% on 28 October 2003, the lowest level in the past 45 years. They had indicated that the interest rate would remain at a low level for a considerable period. Potential risk If the 6 -month LIBOR rises beyond 3. 5% one year afterwards and never come down again. The deposit is then held for 5 years until maturity. 35
Equity target redemption notes SG Product • 10 -year fund that is 100% capital guaranteed • Pay a juicy fixed coupon of 10% in the first year • For Year Two, the coupon payment is referenced to the average performance of the 6 worst stocks in a basket of 24 blue-chip stocks. max{0, 10% + 0. 5 × average performance of the 6 worst stocks} • From Year Three onwards, the investor gets the better of the previous year’s coupon or the payout formula. • Once the aggregate coupon payments reaches or exceeds 20%, the fund terminates with full payment of the coupon for that year. 36
Worst scenario: 10 -year fund with total coupon of 20% Blending equity and rates • Design products that have both equity and fixed-income risk. • The equity and fixed-income markets typically offset each other during economic downturns, therefore hedging the investor against excessive downside in one market. 37
Guaranteed equity bonds (GEBs) • The issuer (usually an insurance company) guarantees a stated interest rate and some protection from loss of initial capital, and provides an opportunity to earn additional interest based on the performance of an equity market index (say, Standard and Poor’s 500 Composite Stock Price Index). • GEBs credit interest using a formula based on changes in the index to which it is linked. It enables investors to achieve potential capital appreciation by participating in the positive performance of the index but also provide investors with a guaranteed minimum return of their investment at maturity. 38
Term The index term is the period over which index-linked interest is calculated. Interest is credited to the investor at the end of a term. Participation Rate The participation rate decides how much of the increase in the index will be used to calculate index-linked interest. For example, if the calculated change in the index is 9% and the participation rate is 70%, the index-linked interest rate for the contract will be 6. 3% (9% 70%=6. 3%). • The company usually guarantees the participation rate for a specific period, from one year to the entire term. • When that period is over, the company sets a new participation rate for the next period. • Some contracts guarantee that the participation rate will never be set lower than a specified minimum or higher than a specified 39 maximum.
Cap Rate Some contracts may put an upper limit, or cap, on the index-linked interest rate. This is the maximum rate of interest the contract will earn. Floor The floor is the minimum index-linked interest rate that will be paid. The most common floor is 0%. A 0% floor assures that even if the index decreases in value, the index-linked interest that can earn will be zero and not negative. Guaranteed interest compounding Some contracts pay simple interest during an index term. That means index-linked interest is added to the original premium amount but does not compound during the term. Others pay compound interest during a term, which means that index-linked interest that has already been 40 credited also earns interest in the future.
Dividends Depending on the index used, stock dividends usually are not included in the index value. For example, the S & P 500 is a tock price index and only considers the prices of stocks. It does not recognize any dividends paid on those stocks. Early withdrawal In most cases, investors cannot take all or part of the money out of contract at any time during the term. There will be a cost and the index-linked interest on the amount withdrawn will not be paid. Indexing method The approach used to measure the amount of change, if any, in the index. 41
Point-to-Point The contingent claim C(t) in year t for one unit of GEB can be represented as followed • While subject to the maximum cap rate z that can be earned under this design, the first random term allows the investors to have a participation rate a in any potential upside gain in the equity market. • In the event of an adverse market environment, the downside risk is constrained to the minimum guarantee floor component, that is, (1 + g)t. • The presence of the cap rate, although placing an upper bound on the rate of return of the contract, could reduce the cost of such 42 design substantially.
The payoff in year t for one unit of GEB is given by where the random variable RS again measures the appreciation of the referenced index fund in year s. • RS is solely determined by the index levels at the beginning and the end of year s: • The interest is credited each year for the annual reset GEBs. The credited interest cannot be lost even if the index subsequently goes down. • The index level used to determine the appreciation of the index is reset annually. This `lock in’ feature can be extremely valuable, 43 particularly in a more volatile market.
High Water Mark (Lookback) 44
Point-to-Point with Barrier To increase the participation rate, we apply an up-and-in barrier option to the point-to-point GEBs. An up- and-in barrier GEB provides purchasers with the greater of the index return times the participation rate and a minimum guaranteed return if the index rises above a barrier for the monitoring period and offers the minimum guaranteed return otherwise. where 45
Annual Reset with Barrier In each period, the GEBs will provide customers with the greater of either the annual index return times the participation rate or a minimum guaranteed rate if the index value for the monitoring period rises above a barrier. Otherwise, the GEBs will credit to the policyholder the minimum guaranteed rate as annual return. 46
Average 47
Cap rate 1. 3 Guaranteed annual return 1. 03 Number of simulation 100 Initial index level 5800 Barrier level 9000 Initial interest rate 0. 045 Initial volatility 0. 15 In general, we can see that the change of participation rate does not place great effect to 48 the point-to-point, lookback, and average contracts until 50%.
Impact of cap rate Participation rate = 0. 8 • The decreasing cap rate will lower the price of the contract. • For the average design, the price does not change so much when the cap rate decrease. • For ratchet design, the price also does not change so much when the cap rate decrease until 10%. 49
Annual Guaranteed Interest Some contracts pay guarantee interest during an index term if the index-linked return is less than the guarantee return or negative. The increasing guarantee interest will increase the price of the contracts. 50
Source: Structured Retail Products (April 2006) 51
Guaranteed annuity options • In the United Kingdom, the GAO guarantees a minimum conversion rate of lump sum of annuity. Typically, guarantees of £ 111 annual annuity per £ 1, 000 maturity lump sum have been offered for male policyholders, and around £ 91 annuity per £ 1, 000 maturity lump sum for females. The conversion rate is known as the guaranteed annuity rate of GAR. • Let g be the guaranteed annuity rate (e. g. , g = 1/9 for a rate of 111 annuity per 1000 lump sum), and let ax(t) be the market price at t of a whole-life annuity of 1 per year payable immediately to a life aged x. The value of separate fund at t FT. • The payoff under the GAO at the maturity of the separate fund account, say t = n (which is the annuity vesting date), for a life age 65 at vesting, is This option is in-the-money when a 65(t) is greater than 1/g and out-of-the 52 money otherwise.
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