Euro Stoxx 50 leveraged return note from Goldman Sachs offers 67% maximum return

Leveraged return notes dominated US structured products retail notional issuance in 2012, partly as a result of their relatively simple payout and high potential returns. The products are structured to maximise returns during periods of modest growth. While the S&P 500 index dominates underlyings in the US, the number of products linked to the Euro Stoxx 50 has been increasing.

This leveraged, buffered Euro Stoxx 50 index-linked medium-term note from Goldman Sachs offers participation in the growth of the underlying up to the maximum return of 67.5%. Any increase in the value of the index will be multiplied by the leverage factor of 1.5. Therefore, the product will pay a return of 15% in addition to principal if the index has risen 10% at maturity.

Principal is at risk, but the potential for loss to initial capital is reduced by the inclusion of a 10% buffer. Nonetheless, capital will be lost at a rate of 1.11% for every 1% fall in the index if its final level is below the buffer.

The chart below shows fairly steady growth in the European benchmark index since the end of May 2012. It also shows that the one-year implied volatility has fallen as the index level has increased.

The investment offers the potential for enhanced returns and would appeal to investors looking to benefit from small to moderate market gains. It pays returns of 1.5 times the growth in the index up to 45%, in which case investors would receive the maximum return of 67.5%. It will therefore outperform the index (excluding dividends) for growth up to the maximum, but any growth above 45% will not be passed to investors, so it will underperform a direct holding in the index (excluding dividends) in the event of growth above the maximum, which is equivalent to 29.42% compounded index growth per annum.

The product would also outperform direct holdings even if the value of the underlying asset falls slightly, owing to the buffer protection. However, principal remains at risk and the product will return nothing to investors if the underlying index level falls to zero. Principal will be lost if the final level of the index is lower than 90% of the initial strike, in which case investors will lose principal at a rate of 1.11:1 for any fall in value below 90%. For instance, if the final level of the index is 80% of its initial, investors would receive roughly 88.89% of their principal at maturity - a loss of 11.11%. This loss is calculated by multiplying the fall from the buffer (10%) by the downside gearing (-111.11%).

As a typical leveraged product, this one offers good upside potential while limiting downside exposure through a buffer zone of 10%, meaning the index can finish up to 10% below the strike without it having an impact on the principal. This test is applied only at the final observation point.

Pricing and risk

The pricing for this product can be broken down into three components. The zero-coupon bond accounts for the base payment of 100% that allows capital return at maturity. Added to this is the 1.5 times geared call spread, which provides the positive return. On the downside, there is a put with a strike of 90% and a gearing of 111.11%.

Leveraged return products generally offer higher returns if linked to high-volatility underlyings than low-volatility ones as the risk to capital is greater. Most in the US retail market are linked to the S&P 500, but the implied volatility of the Euro Stoxx 50 is currently higher than that of the S&P 500, meaning products linked to the Euro Stoxx 50 will generally offer higher potential returns. This product will therefore appeal both to investors looking for exposure to growth in European equities and those looking to achieve higher potential returns than those offered by similar products linked to the performance of the US benchmark index. 

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.