What are the main different types of capital downside protection?
When building a structured product, you generally bear a risk to your capital stemming from the performance of the underlying. If the underlying performance goes below a certain threshold, some of your capital can be lost. However, there are various options to protect your capital when creating a structured product.
The three main protections used are the low strike, the European barrier and the American barrier. The low strike is the most conservative protection and the riskiest one is the American barrier. This goes hand in hand with the return, i.e. the higher the risk, the higher the return.
1. Introduction of the low strike
What is a low strike?
The low strike at a glance 🔎
- A low strike means that the strike of the short put is out of the money.
- The strike level is set below the spot price of the underlying on the launch date.
- The leverage is calculated as follows = 100% (reference value) / protection level.
Protection mechanism
Example:
Leverage: 100%/50% (protection level)= 2 (200%).
In this case, if the underlying finishes at 45% (5% below), the capital lost will be of 10% (5% x leverage)
Usecase - low strike
The investor purchased USD 100,000 in a Reverse Convertible low strike at 80% on a stock with an initial price of USD 100.
Scenario 1
The underlying closes above the low strike (80%).
- The investor receives the USD 100,000 initially invested (plus the coupons).
- There is no impact on the capital invested.
Scenario 2
The underlying closes below the low strike (80%), at 70 USD.
- The investor receives the performance (negative) of the underlying from the low strike:
70/80= 87.5% (=87,500 USD)
Here the loss is of 12,500 USD (12.5% of the invested amount) despite a stock performance of -30%.
2. Introduction to European barrier
What is a European barrier?
The European barrier at a glance 🔎
- Only the level of the underlying asset at maturity is taken into account.
- Below the protection barrier, the capital is at risk, otherwise, the capital is preserved.
Protection mechanism
Example:
In this case, if the underlying finishes at 45% (5% below the protection barrier), the capital lost will be 55%.
The investor will receive 45% of the initial amount invested.
Usecase - European barrier
The investor purchased USD 100,000 in a Reverse Convertible with a European barrier with 75% protection on a stock with an initial price of USD 100.
Scenario 1
The underlying closes above the European barrier (75%).
- The investor receives the USD 100,000 initially invested (plus the coupons).
- There is no impact on the capital invested.
Scenario 2
The underlying closes below the European barrier (75%) at 70 USD.
- The investor receives the performance (negative) of the underlying from the strike:
70/100= 70% (=70,000 USD)
Here the loss is of 30,000 USD (30% of the invested amount), same as stock performance of -30%.
3. Introduction to American barrier
What is an American barrier?
The American barrier at a glance 🔎
- The American barrier works like the European one except that the risk in capital can be activated throughout the life of the product. If the underlying breaches the Barrier level at any time, the barrier effectively disappears
- with an observation at the daily closing of the market (for the daily close one)
- with an intraday observation without interruption (for the continuous one)
If the risk in capital has not been activated, the capital is preserved. Otherwise, the capital is at risk from the strike level.
4. Things to remember
When creating a structured product, do not hesitate to test and price it on myPrivatam according to the different protections. This will enable you to understand what risks you are ready to take for what kind of return.
In the example of the product below, the low strike is the most conservative protection but also the one with less return:
