In our first article of this series on Alternate Investments, we covered an overview of the world of structured products and the basic principles involved in creating these structures (Click Here). In this article, we discuss a popular structure called Yield Enhancer - Contingent Coupon. While most investors may fret and fume with the stock market adamantly refusing to move out of its 3 year old range - thus depriving them of an opportunity to make healthy returns, there are structured products that are designed to make you good money in precisely such conditions. How would you like a scenario where you make 28% when markets rise by 10%, but have your capital protected, when markets fall 20%? Interested? Read on to understand how this structure operates and also the circumstances under which these pay-offs occur and importantly - the circumstances under which they don't.

Product : Yield Enhancer - Contingent Coupon

Aims to generate superior yields as compared to debt market instruments by offering various option types linked to equity markets

Features

• Offers a coupon in case the underlying (could be the Nifty, for example) stays above a contingent level during the tenor of the product

• It provides opportunity for upside participation on the performance of the underlying with a cap on maximum returns

• The upside participation can be restricted up to a threshold upside on the underlying

• The downside and upside conditions are typically observed on a daily or weekly or monthly basis

• 100% Capital is protected even if the underlying gives negative performance during the tenure of the product

Investment Rationale

• Multiple Advantage: Benefit of debt instruments i.e. coupon with capital protection of principal and opportunity to participate in upside potential of underlying performance along with it - in a single product

• Range Bound View: Offers coupon and market participation to maximize returns on a specific range bound market view

• Higher Yield: Contingent Coupon offers the potential of superior yield to the debt yields available in the market; even in case the product gets knocked out on the upper threshold level.

Typical Product Specifications

Lets understand this product a little better. This is a 24 month lock in structure, whose returns will be determined by the manner the Nifty will behave over the first 21 months - ON A DAILY BASIS. The starting point is a return of 18% - which itself looks attractive. Returns can range above or below 18%, based on the Nifty's behaviour in the next 21 months.

Lets say the Nifty is at 6000 on day 1 of the 24 months. The view backing this product is that over the next 21 months, the Nifty is likely to trade within a narrow band of 15% lower than 6000 (which is 5100) and 25% over 6000 (which is 7500). If you happen to have a view that the Nifty is likely to have a mild upward bias, but is unlikely to cross 7500, and you are very confident that the floor level for Nifty is 5100, this product is structured to deliver results if this view comes good.

The important thing to note here is that for you to make decent money in this structure, the Nifty must be within this band of 5100 to 7500 on every single day of these 21 months. Further, for you to make healthy returns, you not only want the Nifty to trade within this range every single day, but also that on the last date of these 21 months, ideally you want the Nifty to be as close to the upper ceiling of 7500 - but not above 7500. If the Nifty closes at the end of 21 months within this range, but it had even 1 day outside this band, then either the Upper Barrier level was observed or the Contingent level was observed - which means the pre-condition for getting the extra returns is not met.

Payoff Scenarios - For Illustration

In the above payoff scenarios based Final Nifty close at Exit date:

• Investor will earn returns (Coupon or Coupon + Market linked returns) only if Nifty remains above 5100.

• Investor will earn higher returns than coupon when Nifty trades above 6000 and makes maximum return when Nifty trades at slightly below 7500.

• Investor will earn will earn 0.00% returns, if Nifty trades at 5100 and below, in such case Investor would be better off investing in a pure assured return debt product.

Payoff Scenarios Graph

As can be seen from the payoff scenarios graph, the payoffs are higher than market so long as the market remains within the predicted band. The payoffs are higher than debt instruments, so long as the market remains within the predicted band. If the market moves higher than the predicted upper band level, you would have been better off having invested in the market directly. If the market falls below the lower band level, you would have been better off investing in a pure debt product.

These are complex products - and are tailored to offer an investor a handsome payoff, if his view comes good, but will protect principal anyway, if the view does not come good. There are clearly risks of opportunity loss on both sides - but, you can argue that if you had a strong view of the market heading firmly in either direction, you should participate in a structure that plays to that particular theme. You would want to participate in this product only if you believe that markets are likely to remain range bound and you want a better yield in a range bound market than what the market can offer.

Share your thoughts and perspectives

Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !

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