This is a second article about structured notes. As been stated previously in the article
“A Simple Guide to Structured Products”, there are four major classes of SPs.
One of them is Capital Protection Notes. According to the picture below, there are at least 7 types of such notes, each of them have its own specification.
Capital Protected Notes without cap (Uncapped) are very simple investments that offer the opportunity of protection combined with the performance of underlying.
This is easy to understand.
Take a deposit at some bank or buy bonds that offer some fix income.
You can easily calculate how much money you receive in the future if there is no default. It is assumed that bonds or deposits are usually placed in a secure place.
Once you know the sum you receive, say in 1 year, you can invest this sum of money in some financial instrument.
Usually it is options because options give possibility to have unlimited participation and leverage if only premium is paid, so there is uncapped profit.
If you are not ready to invest the sum but only half of it, it will be more than 100% Protection.
If you invest more money than you receive in the future, you will be partially protected, less than 100%. So easy.
It seems that “Capital Protection” has been misunderstood by many investors. Often, many see only advantages of buying these notes.
If there is no risk but unlimited profit possibilities, why to hesitate? Indeed, seems to be almost perfect for those who want to save money.
But what if in a 1 year you receive 100% protection but an options embedded in the note expired moneyness?
Of cause, there is inflation that has a tendency of reducing money purchasing power over time and this is exactly what is a loss in this investment.
Also, I recommend a short investment period like 1 year due to a substantial early redemption fee that can be charged if investor cancels the note prior to the end of the maturity.
Any other additional fees should be taken into consideration as well.
Credit risk is also a part of the negative side of such investment, so it is better to make investment over 1-3 years but always check how much you potential gain can be. For a short period like 1 year, it is almost impossible to have profit because deposits or bonds woudn’t pay coupons enough to invest in some kind of option. Therefore, usually the duration is 5 years.
Advantages:
-If you bet the market will be bullish, but wouldn’t like to be aggresive, this is a perfect investment.
-Can be unlimited upside potential
Disadvantages:
-Inflation
-Long investment period
Other types of capital protection notes from the picture above are:
-Exchangeable note offers additional guaranteed coupon along with uncapped profit.
-Capital Protection with Cap is alike bull spread where cap limits you potential profit if underlying continues to climbs higher and higher.
It is cheaper than simple uncapped protection because additional premium is received due to sold option with cap future.
-Coupon capital protection gives possibility to receive Coupons that vary over the time of the investment.
-Protected Range Notes offer a fix coupon only if an underlying is within some special range.
-Knock-out option embedded in protection notes (sometimes called Shark Notes) provide positive return if a certain level is not reached. Otherwise it gives only 100% protection.
-Absolute rerurn gives positive return only if lower and upper barrier are not reached.