Capital Guaranteed Notes Linked to Hedge Funds
Team Latte
Jan 27, 2005

Recently Capital guaranteed notes linked to hedge funds have become popular both in the west as well as Asia. There are three generations of such products:

1. First Generation: the naïve approach;
2. Second Generation: the option based approach;
3. Third Generation: the dynamic trading approach.

First Generation Products:

These products came into existence in the early 1980s. The basic mechanism underlying these products is very simply whereby the Issuers simply allocate the initial capital between the high-quality zero coupon bonds maturing at the same time as the note and the shares of the underlying hedge fund. The zero coupon allocation provided the principal protection while the hedge fund investment ensured participation in the fund's return.

Consider an investor purchasing $100,000 of a 3 year capital guaranteed note on a hedge fund (see the schemata). The three year interest rate is 5% per annum and therefore a 3 year zero with $1,000 face value is worth approximately $863.84. The issuer of the note receives $100,000 from the investor and then invests $86,384 in zero coupon bond and $13,616 in the underlying hedge fund. Three years later the zero coupon matures and pays back $100,000. This provides the capital guarantee. Now suppose the hedge fund gained 50% over the period. The fund investment is then worth $20,424 and the total repayment to the investor would be $120,424 (minus of course the up front management fees and costs). If the hedge fund lost 50% over the period, the fund investment would be worth $6,808 and the total repayment to the investor would be $106,808. Even if the fund gets totally wiped out for any reason the investor gets back his capital.

The major problem with this approach is that the total return on the guaranteed note is extremely limited, due a small fraction of the initial capital being exposed to the hedge fund. In the above example even when the hedge fund gained 50% over the period the notes return was 20.42% which is a mere 40.84% participation in the upside.

Second Generation Products:

The second generation of the capital guaranteed notes adopted an approach based on option methodologies, akin to notes linked to equity indices and individual stocks.

The Issuer allocated the initial capital between high quality zero coupon bonds and at the money (ATM) call options on the underlying hedge funds (either through a synthetic OTC call created with a broker or the fund manager or through traded instruments). Both instruments need to mature at the same time as the note. The zero provides the principal protection and the call option gives the upside value capture on the hedge fund.

Consider an investor investing $100,000 in such a 3 year capital guaranteed note. The three year rate is 5% and therefore the price of a three year zero is $863.83. The issuer upon receiving $100,000 from the investor invests $86,384 in the zero coupon bond maturing in three years and returning $100,000. Thus the zero, once again, guarantees the capital. With the balance of $13,616 the issuer purchases call options on the hedge fund.

Let us assume that the price of a 3 year ATM call option on the hedge fund (with a certain volatility parameter) is 20%. That is to ensure $1,000 investment in the hedge fund the premium to be paid is $200. So with $13,616 available the issuer buys options on $68,080 worth of the hedge fund. The participation rate, calculated by dividing the relative amount left for the options ($13.616%) by the relative option premium (20%), is 68.08%. And the best part is that the buyer of the note will know the participation rate right from the start.

After 3 years the zero coupon will pay back the principal to the investor. If the fund returned 50% over the period then the options would be worth the difference between the strike price ($68,080) and the new value of the fund shares ($120,120) a gain of $34,040. The total repayment to the investor would be $134,040, a return of 34%, which is much better than what he would receive if the investment strategy was the naive approach. If on the other hand the hedge fund lost 50% over the period then the options will be worthless, as the value will be blow the option strike price, and the investor will simply get back $100,000. Therefore, the second generation products were more risky in terms of the total returns generated; however, had a higher participation rate as well as potential return.

Third Generation Products:

The third generation of capital guaranteed products on hedge funds rely on dynamic trading strategies, like portfolio insurance (protective put option strategy), CPPI, etc. The Issuer invests the proceeds of the note sales in a portfolio comprised of zero coupon bonds and shares of the underlying hedge fund. Then the capital is dynamically shifted between the two investments according to a pre-specified asset allocation model.

There are two most popular strategies that the issuers employ:

1. Contingent immunization;
2. Constant Proportion Portfolio Insurance (CPPI);

In a contingent immunization strategy the issuer constantly compares the value of the portfolio against the amount of capital that would have to be invested in zero coupon bonds to guarantee the capital at maturity. As long as the portfolio value is higher the entire amount is invested in the hedge fund. However, if the hedge fund investment does not perform well and the portfolio value drops close to this minimum amount, the issuer withdraws completely from the hedge fund and allocated the total capital to the zero coupon bonds.

CPPI is a dynamic asset allocation strategy that is easier to understand and implement. There are three essential components to this strategy: a) a floor , that is the amount of money that has to be invested in zero coupon bonds to get a guarantee on the capital; and because of time value of money, as one gets nearer to maturity the floor value increases; b) the second component is the multiplier , that determines the aggressiveness of the strategy and finally, c) a rebalancing policy , such as the end of the month or end of the quarter rebalancing.

On each rebalancing date the issuer computes a quantity called the cushion, which is defined as the difference between the value of the portfolio and the current value of the floor. Then an amount equal to the multiplier times the cushion is allocated to the hedge fund and the remaining part is invested in the zero coupon bonds and this process is dynamically managed for the rest of the life of the note.

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