A threshold structure is an intuitively appealing alternative to standard equity put options for creating a guarantee. An investor defines a target asset that needs downside protection. This target asset is often an equity index but it could also be a pool of hedge funds or almost any other type of investment that can be traded. Downside protection is achieved by systematically rebalancing the investor's portfolio into a security that will mature at some desired threshold level (e.g. the zero coupon bond) whenever the portfolio declines in value relative to that threshold. If the target asset rises in value, all else being equal, then funds are rebalanced out of the bond back into the target asset in order to maximize upside participation.
An attractive feature of this type of threshold structure is that generally if the target asset rises in value then there is no rebalancing and the protection is free. Of course if the target asset falls in value so that rebalancing is necessary then the protection will have a cost in that rebalancing activity will reduce the amount of capital in the fund and the potential upside.
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This week's Learning Curve was written by Andrew Harmstone, head of European derivatives and quantitative research at Lehman Brothers in London.
