SLCG Economic Consulting's Logo


SLCG Research: Principal Protected Notes

SLCG released today 'The Anatomy of Principal Protected Absolute Return Notes'.

Structured products are debt securities that often have unconventional and complex payoff structures. Their payoffs are often linked to a security or index, such as the S&P 500 or the Russell 2000, with asset classes ranging from equity, commodities, currencies and debt. A Principal Protected Absolute Return Barrier Note (ARBN) is one structured product that returns the absolute value of the return of the underlying index provided the index stays within pre-specified barriers during the life of the note. If the index exceeds the barriers then the note returns its initial face value. Structured products' complex payoff structures are difficult for unsophisticated retail investors to evaluate.

In this paper, we value 214 ARBNs issued by six investment banks. We derive closed-form solutions under four valuation approaches and apply these solutions to calculate the fair value and implied yields of the 214 ARBNs. We find that on average the ARBNs' fair value is 4.5% below their principal value at the time of their issuance across the four valuation approaches. This level of premium is close to the premia on U.S. dollar-denominated reverse convertibles. We find that the implied yields on these ARBNs were also less than the issuers' equivalent bond yields, indicating that a bank like the now-bankrupt Lehman Brothers that issued structured products like ARBNs to finance its operations was able to do so at below-market interest rates.