Falling interest rates will push firms to be more creative in structuring capital guaranteed products this year because the premium typically used to purchase options has shrunk substantially. Firms started working on innovative structures last year, but are expecting demand to pick up. "I don't think there's a day that goes by that we don't think about how to make options cheaper," said Stéphane Liot, global head of fund derivatives at BNP Paribas in Paris.
Another strategy for dealing with this problem is structuring more constant proportion portfolio insurance (CPPI) instruments for investors because these notes start off with 100% exposure to the hedge funds. However, if the value of the underlying funds begins to fall, putting the initial capital at risk, the fund manager purchases zero-coupon bonds to provide capital protection. Pierre Maliczak, head of European funding structures at Bank of America in London, said the majority of requests from investors for guaranteed products are for CPPI notes. These instruments can be structured with longer maturities, which better fit institutional investors' investment profiles. Currently investors are asking for instruments with seven-to eight-year maturities, Maliczak added.
Eduardo Bastida, global head of equity derivatives trading at Commerzbank Securities in London, explained that guaranteed notes structured with a low-premium option typically have a high payout, but a low probability of maturing in the money. Because they are inexpensive, however, they leave some premium to pay the investor a coupon payment--which is not a typical feature of a guaranteed note. Sabina Belussi, associate director responsible for Italian marketing at UBS Warburg in London, said many of these structures have been sold by a whole range of firms over the past six to eight months. Investors can get a guaranteed 4-5% payout in the first year, for example, and then the remaining premium can be used to purchase an option as an extra sweetener that could pay out at the fund's maturity date.
One banker said his firm came up with the idea of offering less of a guarantee in return for more upside potential when structuring products aimed at retail investors. Instead of a 100% capital guaranteed product, investors receive a 98% or 99% guarantee and that gives the structurer extra premium for the option on the fund.