Nev Godley, vice president at Morgan Stanley, looks at how soft protected products are constructed and how effective different barriers on the FTSE 100 Index have been.

Downside protection on structured products typically falls into two camps: no downside exposure for fully capital protected products and full downside exposure if markets fall by more than a set amount via soft protected products.

Full protection

Let’s look at how a fully protected product is constructed. For simplicity’s sake, let’s assume the product pays 100% of any FTSE 100 Index increase over six years, uncapped.

There are two components to this product: First, a long call option on the FTSE 100 Index to give exposure to any upside performance, and secondly, a zero-coupon bond that redeems at 100% of the initial investment amount in six years’ time, to provide the return of capital at maturity.

Cost of capital protection

The price of the zero-coupon bond at the outset is effectively the cost of capital protection. It reflects the price that an investor has to pay today in order to provide a fixed capital return in six years’ time.

Several factors will impact the cost of the zero-coupon bond, including the length of the investment term, interest rates and the issuer’s credit spread. The more expensive the zero-coupon bond, the less money left to spend on the call option).

Capital protection is cheapest when interest rates are high, the product has a longer investment term, and the perceived credit quality of the issuer is lower. In recent market conditions, with interest rates remaining low, the cost of full capital protection has been high and return potential has been squeezed. As a result, more soft protected products are being issued, offering greater risk to capital but more potential upside as a result.

Soft protection work

Soft protected products return investors’ capital in full at maturity provided that the underlying asset does not fall below a pre-determined barrier (the ‘Knock-In Barrier’).

This barrier is commonly set at 50%, and can be observed at the close of business every day during the investment term (an American barrier), or on the maturity date only (a European barrier).

If the barrier is breached, investors’ return of capital at maturity will reflect any negative performance of the underlying asset on a 1:1 basis.