Five-way collateralisation

This is a five-year at-risk kickout that kicks out if the FTSE 100 is above the strike level on one of the first four anniversaries. Kickout will not occur if the index is equal to or below the strike level, and the product will continue until the trigger level is reached on one of the anniversaries.

If kickout occurs on the first anniversary, investors will receive a 10% return. If kickout occurs on second anniversary, investors will receive a 20% return, and if it occurs on the third or fourth anniversary, investors will receive a return of 30% and 40%, respectively.

If the product does not kick out and the final index level is above strike, the investor receives a return equivalent to 120% of the index performance. If the final index level is below the strike, the amount of capital returned to the investor will depend on whether the index has fallen by more than 50% – based on closing-day levels – from the strike. If it has not, investors will receive a full return of capital at maturity. If the 50% barrier is breached, the capital returned will fall on a one-for-one basis for any fall in the final level compared to the strike.

The final index level is subject to daily averaging over the final six months of investment, and the annual potential kickout levels are subject to five-day averaging. Averaging can protect investors from any late falls in the underlying index, but it can also constrict growth in a rising market.

The credit risk of this version of the product is not dependent on the solvency of Investec Bank but is diversified across five banks: HSBC, Barclays Bank, Santander UK, Royal Bank of Scotland and Lloyds TSB.

If Investec becomes insolvent, there is a collateralisation mechanism designed to protect investors against loss. The collateral is maintained daily and will consist of securities issued by each of the UK banks and, if necessary, holdings in cash or UK government debt. Usually, when providers refer to collateralisation it refers to the use of bonds or assets that are commonly accepted to be virtually risk-free, which means government debt of very strong economies. Here the product is collateralised debt from other issuers, a rather different proposition.

Pricing and risk

The structure looks fairly straightforward: a five-year kickout with a knock-in put option and the credit risk diversified across five banks. What is interesting is that instead of splitting the product paper five ways, the provider has chosen to fund it themselves and to provide collateral by purchasing debt instruments from the five banks.

For pricing purposes, the product can essentially be considered as purchasing five notes, one from each of the five banks. Each bank has a different funding level and the overall price is the average of these prices. Throughout the life of the product the issuer could collateralise the notes by holding debt with each of the banks to the value of the relevant price of the product with each bank. However, they are only obliged to hold collateral to the value of the product and could split the collateral over the five banks, cash or government gilts.

If Investec defaults, the investor’s money is safe – at least up to the amount calculated as the fair value of the product at the time of default. However, if one of the five banks default, the investor could lose a fifth of the value of the investment.

It is also important to consider that should one (or more) of the banks default, the quality of the debt purchased would come into play, determining where in the line of that bank’s creditors the investor stood and on what terms the investment would be settled.

The information in this analysis is taken from sources which Future Value Consultants Limited deems reliable but no guarantee is made that the information is complete or accurate and it should not be relied upon as such. Any opinions in the analyses represent those of Future Value Consultants Limited at the time of writing but are subject to change. All valuations and prices shown are indicative only and do not imply an offer or commitment of any kind. The analysis does not constitute advice or recommendations nor should it be relied upon for any purpose. No liability whatsoever is accepted by Future Value Consultants Limited or Structured Products magazine for any loss or expense incurred from using this analysis.

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