Full Capital Protection VS Soft Protection
Richard Baker, Executive Director at Morgan Stanley, looks at how soft protected products are constructed, including a historical analysis of how effective soft protection barriers on the FTSE 100 Index have been over time.
Downside protection on Structured Notes in the UK market typically falls into two camps: no downside exposure for fully capital protected products and full downside exposure if markets fall by more than a set amount via soft protected products. This capital protection is provided at maturity only: if an investment is sold earlier in the term, the investor may receive less than their initial investment. Of course, both types of protection are subject to counterparty risk and much has been commented on that topic recently. In this article, we aim to dig a little deeper into the difference between full protection and soft protection, explaining exactly how each type of protection is constructed. We also explain the difference between European and American barriers and look at some historical analysis to see exactly how effective soft protection has been over time.
Full protection
To start, we need to re-visit how a fully protected structured product is constructed. For simplicity’s sake, let’s assume the product pays 100% of any FTSE 100 Index increase over 6 years, uncapped.
There are two components to this product: First, a long call option on the FTSE 100 Index to give exposure to the upside performance and secondly, a zero coupon note that redeems at 100% of the initial investment amount in five years time, to provide the return of capital at maturity.
Counterparty risk aside, the long zero coupon note means that investors receive 100% of their initial investment at maturity. Any growth return is provided by the long call option position, which gives investors 1:1 exposure to any upside performance in the FTSE 100 Index over the 6 year term.
What is the cost of full capital protection?
As the previous diagram showed, the price of the zero coupon note at the outset is effectively the cost of capital protection. It reflects the price that an investor has to pay today, in order to provide a fixed capital return in 6 years time.
Several factors will impact the cost of the zero coupon note, including the length of the investment term, interest rates and the issuer’s credit spread. The more expensive the zero coupon note is, the less money left over to spend on the call option (and therefore the less upside potential for the investor).
Capital protection is cheapest when interest rates are high, the product has a longer investment term and the perceived credit quality of the issuer is lower. In recent market conditions, with interest rates remaining low, the cost of full capital protection has been high and thus, return potential has been squeezed. As a result, more soft protected products are being issued, offering greater risk to capital but more potential upside as a result.
How does soft protection work?
Soft protected products return investors’ capital in full at maturity, provided that the underlying asset does not fall below a pre-determined barrier (the ‘Knock In Barrier’). In the UK retail market, this barrier is commonly set at 50% or 60% and can be observed at the close of business every day during the investment term (an American barrier), or on the maturity date only (a European barrier). If the barrier is breached, investors’ return of capital at maturity will reflect any negative performance of the underlying asset on a 1:1 basis.
The construction of a soft protected product starts in the same way as a fully protected product – as per the previous example, with the purchase of a zero coupon note to repay capital and a call option to provide a return. However, this is now combined with the sale of a ‘Knock In’ put option. A knock in put option means that the seller will have to pay out any negative performance of the underlying asset at maturity, provided that the knock in barrier has been breached. If the knock in barrier is not breached, they have to make no payout at maturity.
The sale of this option generates a premium, which can be used to finance additional upside exposure. This means that a soft protected product allows for greater upside potential than the fully capital protected equivalent. For example, if the zero coupon bond costs £80 and the call option £20, a fully protected version will cost £100 for 100% upside participation. If an additional £10 is received for selling a knock in put option with European barrier, we can now purchase 1.5 call options as we have £30 to spend. The product will still cost £100 overall, but investors will get 150% upside participation. Alternatively, you might get an additional £12 for selling a knock in put option with an American barrier (you receive a higher premium because the risk of the barrier being breached is greater). In this case, 1.6 call options are purchased (as we have a total of £32 to spend), giving 160% upside participation.
Is it worth it?
We ran some analysis looking at how often a range of soft protection barriers would have been breached for a 6-year investment on the FTSE 100 Index. Although investment decisions should not be formed on the basis of such analysis, we thought the results were interesting to share. As always, speak to a Financial Adviser to explain further.
Based on these historical observations, a 50% European soft protection barrier (observed at maturity only) has never been breached. Neither has a 60% or 70% European barrier, although it has definitely come close to the latter. The maximum the FTSE 100 Index has lost over a 6 year term is 29.77% (based on an investment start date of 20th July 1998), meaning a 71% European barrier would have been breached.
For American barriers, it is important to note the difference between the columns showing the proportion of observations where the barrier is breached and the proportion that capital is lost. If we look at the 60% barrier as an example, the barrier was breached 14.62% of the time, but capital was only lost in 12.09% of cases. The difference is accounted for by the fact that the FTSE 100 Index might breach the barrier during the term, but then recover to get back above its initial level at maturity. In these cases, investors receive the repayment of their capital in full.
Summary
There will always be investors who do not want, or cannot afford, to put their capital at risk. These investors want to be sure that regardless of what happens to the underlying asset, they will receive at least the return of their initial investment at maturity. But there are also investors who are willing to take the view that equity markets will not fall by more than a certain amount over a 5 – 6 year investment horizon and soft protected products could be an attractive option for these investors.
Call Option: The right to buy a set quantity an underlying asset at a set price (the ‘strike’) on a set future date. If you are long a call option, your return at maturity is equal to the positive performance in the underlying asset from the strike price. Put Option: The right to sell a set quantity of an underlying asset at a set price (again, ‘strike’ price) on a set future date. If you are short a put option, you have to pay any negative performance in the underlying asset from the strike price at maturity.
The views expressed in this article are those of its author and do not necessarily represent those of the company he represents.