Equities · E8 · 9 min
Structured products and dealer flows
Build a capital-protected note from a bond and an option, work out what it pays, and say which risks the bank that sold it keeps.
In the news: Stories on savings products linked to the stock market: what they are made of, and what the banks that sell them are left holding.
The essentials
- Capital-protected note
- A note that returns at least the capital at maturity plus a share of any rise in an index. It is a that grows back to £100, plus a bought with what is left.
- Participation
- The share of the index’s rise the note pays: 16 left after the bond and fees, with calls at 20, gives 80%, so a 30% rise pays £124 per £100. The protection is only as good as the bank that issued the note.
- Rates and participation
- Lower rates make the zero-coupon bond dearer, leaving less for the option: at 1% a year for five years it costs about £95. Issuers then cap the upside with a call spread, lengthen the term or protect less.
- Reverse convertibles and autocallables
- A pays a high coupon but repays in shares if the stock ends below its start: the investor has sold a put. An repays early if the index is at or above its start on a check date.
- What the bank keeps
- The bank holds the other side of every option. Protected notes leave it short calls, so ; reverse convertibles and autocallables leave it owning puts, so long volatility. All leave it long dividends.
Participation on a capital-protected note
Participation = (N − zero − fees) ÷ call cost
- N
- the capital protected, such as £100
- zero
- price of a zero-coupon bond paying N at the end: N ÷ (1 + r)^years
- call cost
- price of a call on the index for the same term
How it works
1. Your money back, plus some upside
A bank offers you this: invest £100 for five years. At the end you get at least your £100 back, plus a share of any rise in the FTSE 100. If the index falls, you still get £100. This is a . The bank builds it from two simpler parts.
2. Part one: a bond that grows back to £100
A pays no interest along the way, just a fixed amount at the end, so it costs less today. To be sure of £100 in five years at 4% a year, the bank needs 100 ÷ 1.04⁵ = £82.19 now. That part secures your capital.
3. Part two: an option with the rest
The £17.81 left over, less the bank’s fees, buys a on the index: an option that pays whatever the index rises above today’s level. If the money left covers only part of a call, you get only part of the rise. That share is the : 16 to spend on calls costing 20 gives 80%.
4. Low rates, less upside
When rates are low, the zero costs nearly £100 and little is left for the option. At 1% a year for five years the zero costs £95.15, leaving under £5 for the option, and less after fees. Banks then often cap the upside: they also sell a call at a higher level, which pays for part of the first. That pair is a call spread.
5. What the note pays
With 80% participation and the index up 30%, the note pays £100 + 80% × £30 = £124 per £100. If the index ends lower, it pays £100. The protection is only as good as the bank: if the bank fails, so can the promise.
6. Reverse convertibles
A works the other way round. It pays a high fixed coupon, say 10%, but if the stock ends below its starting price you are repaid in shares, or their value, instead of cash. In effect you have sold the bank a , the right to sell you the shares at the starting price. If the stock ends at 70%, you get £10 + £70 = £80.
7. Autocallables
An adds a timetable. On each check date, if the index is at or above its starting level, the note repays early with a coupon. If it is never repaid early and ends below a barrier, say 60% of the start, you take the index’s full loss. In effect you have sold the bank a put that only starts to count once the barrier is broken.
8. What the bank is left holding
The bank holds the other side of every option in the note. Options gain value when markets are expected to swing more, which is called being long volatility. Selling protected notes leaves the bank short a call, so short volatility. Selling reverse convertibles and autocallables leaves it owning puts, so long volatility.
9. And long dividends
These notes pay on the index price, which leaves dividends out. Higher dividends lower the index’s future price, which cuts the value of a call the bank sold and raises the value of a put it owns. Either way the bank gains, so it is long dividends, and it sells to pass that risk on.
Worked example
A bank offers a 5-year note on the FTSE 100 with 100% capital protection. Suppose 5-year rates are 4%, a 5-year call on the index costs 20 per 100, and the bank keeps 2 in fees.
- Zero = 100 ÷ 1.04⁵ = 82.19.
- Left for the option = 100 − 82.19 − 2 = 15.81.
- Participation = 15.81 ÷ 20 = 79%.
- If the index rises 30%, the note pays 100 + 0.79 × 30 = 123.7.
- If the index falls, it pays 100.
About 79% of the index’s rise, with the £100 protected.
Check yourself
9 quick questions on the explanation above.
Practice
New numbers every set. Misses and guesses go into your review deck.
In the interview
Answer out loud in under a minute, then compare.
Build me a capital-protected note from simpler pieces.
Why are banks often long volatility after selling autocallables?
Why do low rates make structured products harder to sell?
Remember
Participation = (N − zero − fees) ÷ call cost
A structured note is a bond plus options; whatever the investor buys or sells, the bank holds the other side and must hedge it.