Retrospective analysis: Natwest's Asian index basket relies on minimum return feature

In June 2007, Natwest launched a five-and-a-half year product linked to the performance of a basket of four Asian indexes. The product was capital protected and offered a minimum return of 15% plus additional returns of 70% of any growth in the index basket above a certain level. It matures on December 28.

The index basket consists of the Hang Seng, Nikkei 225, Kospi 200 and Hang Seng China Enterprises indexes. The Hang Seng and Nikkei 225 both have 30% weightings, while the Kospi 200 and Hang Seng China Enterprises indexes have weightings of 20%.

The chart shows that each of the underlying indexes fell dramatically in 2008. The Nikkei 225 saw the biggest drop, falling by more than 48% since the strike date. The Kospi 200, which also plummeted in 2008, has made the best recovery and is currently 13.6% higher than it was at strike. However, the basket itself has never regained its starting level since the 2008 crisis.

On November 23, the level of the basket as a whole stood at 86.1% of its initial level. At the time of writing, just over a month remains until the maturity date, so the basket will need to grow by a considerable amount in a short period of time to alter the current return outcome. The product pays a minimum return of 15% in addition to capital and will deliver additional returns if basket performance exceeds 121.43% of its initial level. Additional returns will equal 70% of any growth in the basket above that trigger. As things stand, however, the basket will have to grow by a whopping 40% in the coming month if the product is to pay more than the minimum. It is therefore likely that investors will receive only the minimum return at maturity, which is equivalent to 2.57% per annum. Although this figure is low, it is perhaps less disappointing when considered in relation to the poor performance of the basket. But given that at the time of pricing the sterling risk-free rate was roughly 6.13%, a fixed-term, simple bond from Natwest would probably have performed better.

This is a good example of a structured product that provides investors with access to risky assets whilst changing their return profile and providing capital protection. Given the huge falls in some of the basket components over the investment term, a 50% American barrier - standard for capital-at-risk structured products at the time the product was issued - would have been breached, resulting in a loss to capital.

Arguably, the biggest difference between current pricing conditions and those at the product's strike date is the level of the risk-free rates. Although the underlyings are not sterling denominated, the largest component is the zero-coupon bond, which is dependent on the risk-free rate of the funding level of the issuer - roughly 50 basis points at the time of pricing. The fact that the risk-free rate was so much higher in 2007 than it is today made it more feasible to price minimum return products, while good participation rates were also easier to achieve. In the current market, minimum return products are less common and the potential for decent returns would be more reliant on the funding rate of the issuer than was the case in 2007.

This product was aimed at cautious investors seeking access to Asian equity markets. Although it will probably pay only the minimum return at maturity, investors will nonetheless have outperformed a direct investment in the basket over the same period.

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