Valuing a Structured Note Against Dividends and Issuer Credit Risk

Summary

The note compares a five-year S&P 500-linked structured product with direct exposure to the index. The response argues that its apparent advantage comes with costs: holders give up dividends and bear the issuer’s credit risk. It estimates these costs at roughly three percent per year combined, or about fourteen percent of the bond’s initial value over the term, based on the figures stated in the document.

The analysis then estimates the payoff above a straight-line benchmark within a specified performance range and assigns that range a roughly thirty percent chance, using a simplified volatility calculation. The resulting expected excess payoff is presented as smaller than the estimated upfront cost, which could leave value for the issuer. These are rough estimates rather than a full pricing model: the probability is based on an informal calculation, and the note’s exact payoff terms and assumptions are not reproduced. The comparison also depends on the issuer’s credit quality and the value of foregone dividends.

Key ideas

• Structured-note payoffs should be compared with the costs of forgone dividends and issuer credit exposure.
• The response estimates those costs as a substantial upfront amount over the note’s term.
• It approximates the probability of landing in the enhanced-payoff range using volatility and the term length.
• A rough expected-payoff comparison suggests the note may not be mispriced, but the estimates are not a full valuation.

Tags

# This Structured Product Seems Too Good


# This Structured Product Seems Too Good












The following 5 year, zero coupon, structured note, issued at par (full terms of which are available at EDGAR) is linked to the S&P500, but seems to be at least as good as the underlying in all situations. I don't understand how the bank can afford to issue it. I know owners of the note forgo dividends and are exposed to the credit risk of the issuer, but it still seems too good of a deal. What am I missing?

## Answer by dm63 (score 8)

https://quant.stackexchange.com/a/74858

Well that’s the genius of marketing. But if you run the numbers, it’s not mispriced. As you point out, the holder receives no dividends and gets to take the risk of credit exposure to the issuer. I estimate the former is worth about 2% pa and the latter perhaps 1% pa , for a total of 3% over the 5yr term of this note, which is worth about 14% upfront or about usd140 per usd1000 bond. For this premium you get the payoffs that are in excess of the line. Eyeballing this I estimate the average payoff to be about usd225, given that you are in the performance zone (-30,+17). But the chances of being in this zone are quite small, I’d say about 30% using a back of the envelope calculation (one standard deviation after 5 years = annual vol *sqrt(5)= approx 20%*2.23= 44%. So the region covers about one standard deviation.) Well 30% of usd225 is less than usd140 so you can see there is plenty left for the bank.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.