Brokers are selling synthetic derivatives as structured notes to PMS clients. This is a common phenomenon – basically they sell a product in which they link returns to the Nifty or some such index, but cut-off the returns at an upper “barrier”. The article describes an example:
This means if the Nifty is at 5,000 at the time of the launch of the product and moves to 6,250 any time during the 12 months, the product expires and the investor gets his principal and a pre-decided coupon of 10.75 per cent after 15 months. In case the Nifty remains between 5,000 and 6,250 at the end of 12 months, the investor gets principal plus index return and 10 per cent extra on the index return. If the Nifty falls below 5,000, the investor gets back only his capital after 15 months.
To do this product, you just have to buy and sell long term Nifty options against a 15 month fixed deposit (Options have no mark-to-market payin/out, so the entire FD can be used as collateral, no cash required). In this particular case I can construct such a strategy buying a 1 year 5000 call at 548, selling 1.2x the 1 year 6000 call at 150 – these are friday’s rates – and using the rest of the money in a 15 month FD at 7% a year. The quantity of the options is 1.1 times the exposure and you unwind as the Nifty crosses 6,000. I know I should put it in a table or something, but I’m too lazy.
In doing so I will profit under any circumstances; it is a matter of max 4 trades and an FD, for which they charge you 3% upfront “load” saying it’s a “structured product”. Fabulous – The 3% for four trades and an hour with an excel sheet is a great deal, for nearly no risk!
The “barrier” makes me EVEN higher profits if the index crosses 6000 later on in the period compared to earlier. If the index crosses 6000 11 months after the process starts, I can make, including the 3% commissions, about 5% – again, with no risk.
There is risk, but it’s passed on to you – the risk that the FD defaults.
For this kind of “structured product” these brokers and banks charge a hefty 3% as commissions, and take profits % of your money beyond what they promise you. It’s amazing, this business.
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>Hi, Deepak reading your blog for the first time, but the work done on by you for the above post is excellent. I just want to be sure that what i have understood is right. based on the option rates you have provided, i have done the following calculations:
for a person starting with Rs.100,000, if the person starts then he will need to buy 22-5000 calls at Rs rs548 each, and sell 18.33 calls of Nifty 6000, and investing the same sum on FD @ 7%pa. for 15 months. Would this not yield a loss of Rs556.5 if the index does end at 5000?
Please correct me Sir if i am wrong
Regards
05.22.10 at 8:14 PM
>Sir, one more query you said "nearly no risk". Please throw light on what could be the possible risk?
05.22.10 at 8:16 PM
>Ankit, you'd sell 26.4 6000 calls…that gives you a profit of Rs. 232.
The risk – it's in the fact that the deposit could default. Typically the deposit is in non convertible debentures of banks such as Citi – and we now know how close Citi was to bankruptcy a couple years back…
05.23.10 at 3:23 AM
>Deepak arnt long dated calls in india illiquid? if no whts best way to buy them?
05.23.10 at 3:36 AM
>Hi Deepak,
I agree with you: the ones that come out today are total damp squibs. You're better off buying a few long term options yourself and putting the rest of the money in FDs. There are two things, though, that I wanted to run past you.
First, the tax angle. If I buy the option, hold for 3 yrs and book a profit, I pay full income tax on "speculative business income." If OTOH, I buy the "debenture," I pay 10% long-term capital gains. Correct?
Second, time was when these seemed impossibly attractive. I know of one from KMIL in late 2008, that promised 200% "participation" with a 100% "barrier" that capped returns at 75% with a capital guarantee. Basically that meant you'd get your money back and twice the appreciation of NIFTY in the intervening period, except if the NIFTY doubled, in which case, you'd get capital+75%. I'd be happy to share the prospectus if you're interested. I ran the numbers at the time, and there was simply no way that could have been synthesized given the option costs at the time. What gives? Or gave?
05.23.10 at 6:52 AM
>Thanks for the quick reply, I assume the amount of calls bought on 5000 strike is correct at 22. But i still didn't get how did u decide on 26.4 calls to sell?
regards and thank you
05.23.10 at 8:00 AM
>Fritz: reasonably liquid if you want to buy a few, and things are getting better every day nowadays.
Harikrishna: Agreed, tax is different on both instruments for now, the DTC will bridge some of it but not all. I think eventually they will classify some of this as long term capital gains (options held for 3 yrs for instance), but right now taxes are in favour of the debentures.
Yes, I remember seeing the heavily leveraged debentures. Only two things could have been the case – instead of 7% it's possible that in that time, when things were really illiquid, someone was willing to pay over 10% for money, so the debenture discount was heavier. And two, because of the volatility the IV curve of Nifty options was very steep, so you would get a great deal on selling OTM calls versus buying ATM calls. Put the two together, and you get greater leverage at lower cost, so the 200% participation makes sense, so does the cap guarantee. But please send me the prospectus (deepakshenoy at gmail) and let's see if there's some other catch?
ankit: 1.2x the lower strike calls – so 22 at the lower end, 26.4 at the higher. This is a variable that you can optimize of course.
05.23.10 at 11:38 AM
>Hello Deepak,
Citi Bank was the first to offer this sort of a "structured product" to me. Later seveal others have.
From first glance itself, the product appeared like a con job. I would suddenly became a loser if the index went ABOVE a level – illogical. To my mind, if index goes above, one should earn more! It sounded like betting on the index. If it goes above 6250, you lose all gains. All the risk is obviously with the unfortunate investor.
I wonder why people would invest such a product.
Thanks for taking the explaining the background.
Rajeev
05.23.10 at 4:22 PM
>You are 100% correct.
I kept wondering and did not realised this when I subscribed for Market Linked Debentures last year.
But anyways, for investors also, does'nt it makes a good investment. Where else can you make ~11% annual risk free returns with 100% capital protection guarantee?
05.24.10 at 6:46 AM
>Puneet: You pay 3% upfront. So it's really "Where else can you make 8% annual returns with max 3% loss and the risk of default remains?" Answer: There have been corporate bond and debenture offers at 10% yields with similar default risk. So you actually get a crappy deal in comparison.
05.24.10 at 6:50 AM
>Yeah :(
05.24.10 at 6:59 AM
>Deepak:Excellent post. Can I request you if you could post this in Steps, I am not clear how the allocation would work for options and FD to arrive at the return %. Need your inputs. Maybe next post can clarify.
05.24.10 at 8:33 AM
>I do not understand the product. Let me know if the following are the correct pay-offs:
Index <= 5000: Only Principal is returned
5000 < Index < 6250: Principal + Index Returns + 10% of Index Returns
Index >= 6250: Principal + 10.75% returned
I do not understand how they can make profit when Index is between 5000 & 6250 for the duration of the product. Or do I have the pay-offs for second scenario wrong?
05.25.10 at 1:29 AM
>those looking for capital protection i.e. scheme similar to what Deepak has described can also look for IDFC Capital Protection Fund. It was launched some times back, but not sure if still open. Its' a 3 year scheme, and they invest i think around 80-85% in debt and rest use in equity (may be f&o) to generate retaurn for investors. But i beleive that MF's generally have lower chares as compared to products designed by brokerages. I am not sure of either cause i dont invest in any of them, and prefer taking direct exosure.
05.25.10 at 6:32 AM
>Option exposure is 1.1 times the capital. Could you please list the allocation for given principal of say Rs.100. Thanks.
05.27.10 at 1:51 PM