Autocallable Structured Products

What are Autocallable Structured Products?

Autocallable structured products, also known as autocallable notes, represent a type of popular structured product with a distinctive feature of offering attractive coupons. These financial instruments typically involve a basket of stocks, indices, or individual stocks as the underlying asset. The autocallable feature embedded in these products provides the issuer with the right to withdraw on specific dates, known as auto-call dates, triggered when the underlying asset’s price surpasses the strike price. The frequency of these auto-calls typically ranges from a month to six months, providing investors with an opportunity to receive high coupon payments.

This autocallable structure offers investors a form of principal protection, enhancing its appeal. The autocallable note is designed to automatically mature if the predefined conditions are met, providing investors with the potential for enhanced yield. The auto-call mechanism allows for periodic assessments, and if the underlying asset price exceeds the strike price, the product is auto-called, providing investors with the promised returns. This structure combines elements of both risk analysis and yield enhancement, making it an intriguing option for those seeking a balance between capital protection and potential gains in the market.

Characteristics

• High Coupon Payments. Autocallable structured products often feature high coupon payments. If an automatic call option is triggered due to the underlying asset’s price surpassing the strike price, investors receive a substantial coupon. In case the auto-call fails, the coupon value typically increases to the nearest multiple until the next auto-call date.

• Put Option with Soft Capital Protection. These products commonly embed a put option with a trigger level tied to a fixed price, known as the knockdown level of the underlying asset. If the underlying asset’s price falls below this knockdown level, the put option is triggered, providing what is termed as soft capital protection.

• Low Minimum Investment. Autocallable structured products often have a low minimum investment requirement, making them accessible to a broad range of investors. The minimum initial purchase is typically $1000, with subsequent increments of $1000.

• High Credit Quality. Typically issued by banks with an investment-grade credit rating or better, autocallable structured products prioritize high credit quality. However, it’s essential for investors to consider various factors beyond credit quality when making investment decisions.

• Contingent Downside Protection. The coupon barrier level in autocallable structured products provides investors with a limited amount of downside protection. This contingent downside protection helps mitigate potential losses in the event of adverse market movements.

• Short to Medium-Term Investment. Autocallable structured products are generally designed for short to medium-term investments, with typical durations ranging from 1 to 3 years. This shorter investment horizon aligns with the periodic auto-call assessments and provides investors with the flexibility to adjust their portfolios relatively quickly.

Risks Associated with Autocallable Structured Products

1. Principal Risk. Autocallable structured products, specifically autocallable notes, do not provide 100% principal protection. Investors face the possibility of losing some or all of their initial investment.

2. Limited Return. The return on autocallable structured products is constrained to a fixed interest rate, potentially resulting in significantly lower returns compared to a direct investment in the underlying asset. Investors do not receive dividends or distributions from the underlying asset.

3. Liquidity. Autocallable notes are not designed for liquidity. While there may be a secondary market, issuers are not obligated to maintain one. Selling before maturity exposes investors to risks associated with marketability, including volatility of the underlying assets, interest rate fluctuations, and developments affecting the underlying securities.

4. Creditworthiness of the Issuer. The degree of principal protection is contingent on the issuer’s credit quality. Autocallable notes carry the risk that the issuer may be unable to meet scheduled interest or principal payments. Investors are advised to assess the creditworthiness of the issuer to gauge its ability to fulfill the terms of interest and principal payments.

5. Issuer Call. The possibility of an issuer call before maturity introduces the risk of reinvesting in a potentially lower interest rate environment. While the call price is typically par (100% of principal), there are instances where it can be above par, known as a "premium call."

6. Taxes. Investors should consult their tax advisor for comprehensive information regarding the tax implications of autocallable notes.

Who Needs Autocallable Structured Products?

Autocallable structured products may be suitable for investors who are:

• Looking for Enhanced Yield Opportunities. Investors seeking higher yields compared to traditional fixed-income products may find autocallable structured products attractive. The potential for enhanced yield is a key feature of these instruments.

• Willing to Risk Some or All of Their Principal Investment. As autocallable structured products do not offer 100% principal protection, they are suitable for investors who are willing to take on some level of risk, understanding that there is a possibility of losing some or all of their initial investment.

• Seeking to Diversify Their Investment Portfolio. Investors looking to diversify their investment portfolio may consider autocallable structured products. These instruments, with their unique features and potential for enhanced yield, can serve as a diversification tool within a broader investment strategy.

• Knowledgeable Concerning How Options Work. Autocallable structured products often incorporate options, and investors comfortable with the workings of options may find these instruments appealing. Knowledge of options can enhance the investor’s understanding of the product’s features and potential risks.

Role of Equity/Interest Rate Correlation

In the context of autocallable structures, the Equity/Interest Rate (EQ/IR) correlation is a critical factor that significantly influences the dynamics of the product. This correlation plays a crucial role in determining the expiration of the autocallable structure, which is contingent on the performance of the equity.

Consider a scenario with a 5-year autocallable structure featuring an auto-call trigger at 110% of the initial stock price, and a single auto-call observation occurring 2 years after inception. If the stock price exceeds 110% of the initial level after 2 years, the trade expires; otherwise, it continues until the end of the 5-year period.

In a situation where the EQ/IR correlation is positive, an increase in equity enhances the likelihood of the structure being autocalled after 2 years. To hedge this exposure, the seller adjusts their bond portfolio by selling some 5-year zero coupon bonds and buying more 2-year zero bonds. However, the positive correlation means that interest rates, on average, have increased. This results in a net loss for the seller, as selling 5-year bonds incurs a loss due to increased interest rates, and buying 2-year bonds remains cheaper.

Conversely, if the EQ/IR correlation is negative, an increase in equity is associated with a probable decrease in interest rates. The seller hedges by selling 5-year bonds and buying 2-year ones, making a net profit as the increase in equity aligns with falling interest rates.

In both scenarios, the EQ/IR correlation affects the hedging strategy and, consequently, the financial outcome for the seller. Pricing models that assume deterministic interest rates or an EQ/IR correlation of zero may lead to underpricing when the correlation is positive and overpricing when the correlation is negative. Therefore, understanding and incorporating the EQ/IR correlation are crucial for accurate pricing and risk management of autocallable structures.

Example

Consider an autocallable structured product with a duration period of 3 years. The strike price of the underlying asset is set at 100%. The coupon starts at 10% and has the potential to grow to 20% and 30% in the next 2 years if the auto-call feature does not trigger. However, there is a soft capital protection mechanism in place.

In this scenario:

• Duration Period: 3 years

• Strike Price of the Underlying Asset: 100%

• Coupon Growth: The coupon starts at 10% and increases to 20% and 30% in the next 2 years if the auto-call feature does not trigger.

• Auto-Call Feature: If the auto-call is not triggered, the coupon will grow as mentioned above.

• Soft Capital Protection: The put-knockdown level is set at 70%. If the price of the underlying asset falls below 70%, the put option is triggered, providing soft capital protection.

For instance, at the end of the first year, if the price of the underlying asset is above the strike price, the auto-call is triggered, leading to the automatic maturity of the structure, and investors receive their principal along with any accrued coupon payments. If the auto-call is not triggered, the coupon grows. At the end of the second year, assuming the underlying asset’s price remains above the put-knockdown level, the coupon increases to 20%. However, if the price falls below 70%, the put option is activated, offering soft capital protection.