Hi guys,
In the CFAI Mock 2013 AFTERNOON Q2 they state that there is no misrepresantion of the “minimum return of 5% guaranteed through a structured service underwritten by an investment grate firm”. My question is whether this is a violation considering that even the investment grade firm is keen for a default? I remember in the CFAI reading there was a similar example where the products were underwritten by the governement, but in the question there is no “virtually undefaultable”.
Thanks
Hi ryzhiy.
I have not looked at this particular question yet but have some experience with structured products so maybe I can help.
The 5% min return is guaranteed by virtue of the way the note is structured (essentiallly a combination of zero coupon bond plus option). However, to your point, the guarantee, is no better than the issuer is.
Here is a simplistic example. Let’s say the client gives the bank $100 today. Let’s say that the PV of $105 in 5 years (or whatever the maturity is) is $93 given where rates are and given where the bank is funding (i.e. you discount the future $105 min payment at the appropriate funding/discount rate). With the remaining $7 the bank can buy a call option - on the S&P, for example. Voila: you’ve got a structured note wich offers some upside market participation via the call option but also some downside protection and even a minimum return via the zero coupon. The whole thing (the note) is typically a senior unsecured debt obligation issued by bank XYZ. If XYZ defaults, your note is only worth a few cents on the dollar. If it’s still in business at maturity, you get what was promised to you, i.e. at least $105 even if the S&P is down.
There is no misrepresentation because a) the 5% is indeed guaranteed even in the event where the underlying index records a negative performance, and b) the disclosure clearly states who provides the protection (the investment grade bank) which allows the reader/investor to make a determination as to the strength of this protection and whether or not he/she is compensated fairly for the risk taken (which is not zero risk given that the issuer is not the government).
I hope this helps.
Oh, it is so subtile. Thanks for the explanation.
Maybe i’m not understanding the explanation. Doesn’t the fact that XYZ can default at some point remove the so called guarantee? One can make the same argument about the US govt but my understanding is that they’re the only ‘default-free’ entity.
In the worst case scenario you get the risk free rate, which is provided by the US govt.
Ah. I see.
Is the zero coupon bond a government issued bond or issued by bank XYZ? If it’s a govt bond, then I understand that.
Yeah, it’s a Zero Coupon Treasury usually, not the Issuing firm.
Actually, the zero coupon is usually not a treasury.
If you are buying an XYZ note, you are getting XYZ credit. A note can be collateralized with treasuries, but that’s not the typical route - in large part because the terms would be much less attractive due to the higher protection cost (the issuer can capture their own funding spread if they keep the money in house and can put it to work; they cannot if they have to go out and buy treasuries).
Ayodayo, regarding your question (doesn’t the fact that XYZ can default remove the so-called guarantee), think about it this way: if you are hiring me and Mike Tyson as bodyguards, we will both offer you “protection” - but his will be a lot stronger than mine… Same thing for the guarantee on a protected note. It protects you from a market downfall, but the protection is no stronger than the issuer is. And you’re right: the Govt is the only “risk-free” issuer.
Probably a lot more detail than we all need, but I hope this helps clarify it.