Product performance

An examination of the pricing of an accelerated growth products and the effect that changes in volatility will have on these investments. Changes in rates will have the most effect, with volatility also in the mix

Product performance compared

This month's three products in review were priced in the week starting May 28, 2010 and allow an examination of the pricing of an accelerated growth product and the effect that changing volatility has on the price of such products.

The first product is a two-year, principal protected product linked to the SPDR gold trust fund, with a gearing of 100% and a cap on returns of 27.3%. The graph shows that as the spot of the underlying has risen so has the price of the product, although not as rapidly. Although the final payoff will depend on the performance of the underlying, the most influential effect on the price of the product after six months is the level of the relevant risk-free rate, which in the case of this product is the five-year US dollar.

Although important in all structured products, rates generally have the most effect on principal protected structures. The graph shows that since the products inception, risk-free rates have fallen by up to 40%, this is likely to be the main reason for the product price increase although the rising stock level will also have an effect.

The second product is a reverse convertible linked to Arch Coal, a stock commonly used in the US as an underlying for capital-at-risk income products. The stock has a relatively high implied volatility which is currently about 50%. As with most capital-at-risk products, this high volatility means that products linked to this underlying can offer attractive headline terms as there is a significant chance of loss of capital. The product shown in the graph is a one-year income product with a barrier at 80% offering a coupon equivilant to 29% per annum.

At the time of pricing, the implied vol was close to 70%, which is the reason the coupon is so high. As the stock volatility has decreased and the spot has risen over the product term, the value of the product has increased. This is because both factors reduce the chance of the barrier being breached and therefore make it more likely that investors will get back their full capital at maturity in addition to the fixed coupons.

The final product is an accelerated growth product linked to the iShares Russell 2000 Index Fund. The product has a two-year term and pays five times the rise in the index up to a maximum return of 60%. Capital is at risk if the 70% barrier is breached and the fund fails to recover to its initial level by maturity.

The movement of the price of the product and spot of the underlying are very similar, although the price remains higher than the spot due to the barrier. The typical accelerated growth product has three component parts: a zero-coupon bond, a call spread and a put.
At the time of pricing, the volatility of the underlying was roughly 47%. Volatility is an important factor in the pricing of this product and this month we look at the effect of changing the volatility on the price of the component parts.

If we increase the volatility by 50% (to roughly71%), the price of the call spread decreases by roughly 16% as the chance of reaching the cap is increased. The value of the put increases by 50%, and both of these factors contribute to lowering the overall price. This shows that in this case the put is more sensitive to changes in the underlying volatility than the call spread. If we halve the volatility, the value of the call spread increases by 15% and the value of the put decreases by 55%, again showing that the put is more sensitive to changes in the volatility. It is not the case that for any decrease in volatility the value of the call spread will rise; if the volatility goes below a given point the likelihood of return will be reduced enough to lower the value of the call spread.

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