PRODUCT FOCUS: Knock-Out Discount Accumulation Notes

Asian markets have been awash with a variety of vanilla equity-linked notes and capital guaranteed structures in the last three years in an attempt to meet investor demand for yield in a low interest rate environment. However as stock and index volatilities have declined and equity markets have rallied, equity-linked products have evolved that allow coupons to be accrued or stock accumulated over the life of the note.

Accrual products moved through Asia in the first half of this year. Typically these products paid a guaranteed coupon in the first period with coupons thereafter being dependant upon the number of trading days the underlying security remaining within a pre-specified range.

Accumulation products are currently in vogue throughout Asian markets. Rather than accruing coupons these structures typically allow the investor to accumulate the underlying asset. Perhaps the most popular of these structures has been the Knock-out Discount Accumulation note (KODA).

 

The KODA Note

As interest rates have softened and the flow of new corporate paper and convertible bonds have declined, investors moved into hybrid structures to enhance returns. As equity markets have rallied however, asset allocations have moved modestly toward equities with investors looking for value added accumulation products.

The KODA note allows for the daily accumulation of a pre-specified amount of the underlying asset at a discount to the initial spot price (the Discount Accumulation feature) for every day that the asset remains below a predefined knockout level. Typically, the underlying asset has been shares listed in the U.S. and Europe and leading Asian markets. If the knockout level is not breached throughout the note period the investor (usually a high-net-worth individual, institution or hedge fund) will accumulate shares each day until expiry. The shares will typically be delivered on a monthly basis so that the investor can participate in future dividends or liquidate the position and take profits. Should the knockout be breached the investor retains those shares accumulated prior to the knockout date and will receive a return of the unused capital. Thus, the investor may accumulate shares at, for example, 90% of the initial spot price for each day that the stock closes below the 110% knockout level.

 

Scenario One. Microsoft does not close above USD30.25 before expiry.

In this instance the investor will have accumulated 2.4 million Microsoft shares at a price of USD24.75. The breakeven price on the downside will be USD24.5025 (58,806,000/2,400,000). Share delivery will occur every month thus the best result for the investor is for Microsoft to rally but not breach the Knockout level.

If we assume that the stock price at maturity is unchanged (USD27.50), the investor will have an unrealized gain of USD7,194,000 ((27.50*2.4 million)- 58,806,000) versus zero if the investor had simply bought 2.4 million shares at spot on the trade date (does not account for any dividends paid on the stock).

 

Scenario Two. Microsoft breaches the Knockout level of USD30.25

Assume that after Microsoft rallies to close above the knockout level of USD30.25 on the 11^th trading day during the month four. In this instance the investor will have accumulated 10,000 per day for 70 trading days day prior to the knockout date. Shares accumulated during the first three months will already have been delivered (the investor may not necessarily still be long these shares) and shares accumulated over the current half month will be delivered following the knockout. The investor will also receive a cash payment of USD42,075,000 (59,400,000-(70*10,000*24.75)) to reinvest.

In this scenario the investor has bought 700,000 shares for USD17,325,000 consideration. If we assume that the investor is still long all accumulated shares on the knockout date, he will have an unrealized gain of USD3,850,000 or 22.22%. If we compare the outcome to the situation in which the investor had simply bought 2.4 million shares on the trade date at USD27.50, he will have an unrealized gain of USD6.6 million on the position ((30.25-27.50)*2.4 million) but will have outlaid USD66 million. So via the KODA note the investor has achieved 58.33% of the gain with only 26.25% of the capital (again this does not account for any dividends that may have been paid on the stock).

Summary

As yields have declined and the issuance of new corporate paper and convertibles has softened, investors have allocated an increasing proportion of their portfolios to equity structured notes. The Knock-Out Discount Accumulation (KODA) note is the latest in these offerings providing a structure that has an increased exposure to the underlying share when compared to yield driven structures. It is envisaged that, if equity market conditions continue to improve, the degree of equity exposure provided by structured products will continue to increase.

  This week's Product's Focus was written by Matthew Long, head of equity derivative sales at Macquarie Equities (Asia)in Hong Kong.