When building a balanced portfolio for a client, a key driver for the adviser is ensuring upside exposure is catered for whilst minimising the downside risks.
There are a variety of protection barriers that can be built into structured products as outlined below.
The three key capital protection decisions a plan manager will take when constructing a retail product are
- the type of protection barrier
- the level of protection, and
- how frequently the underlying asset is observed during the investment term.
Products that offer a higher level of protection do so by sacrificing upside exposure, as the cost of purchasing the protection eats into the spend available for options providing the investment return.
Types of protection barrier
Hard protection – a hard protection barrier provides a fixed level of protection to a pre-defined level of capital invested irrespective of the performance of the underlying asset.
Soft protection – a soft protection barrier identifies the level of reduction in the performance of the underlying asset that can be tolerated before the investment capital is exposed to risk. Once the barrier is breached, the percentage of the initial capital returned at maturity will be determined by the performance of the underlying in relation to its opening level.
The barrier is usually expressed as a percentage to which the underlying asset can fall before a risk to the initial capital invested may become a possibility.
The frequency that the underlying asset is observed during the term of a product has a bearing on the pricing and can affect the suitability of a structure for certain investors.
European barrier – the return of initial capital invested is determined by comparing only two value points of the underlying asset – the opening level and final level. Any movement by the underlying asset between these points does not have a bearing on the return of initial capital.
American barrier – an American barrier uses either daily or intra-day observations to determine whether the performance of the underlying asset during the product term will have an impact on the return of initial capital. With daily observations the value of the underlying asset is noted at the close of business every business day, whilst intraday observations are taken continuously throughout the term.
Hard protection – a product with a 75% hard protection barrier will provide protection to 75% of the capital invested. The other 25% is potentially exposed to capital loss depending on the performance of the underlying asset.
Soft protection with a European barrier - a product with a 50% soft European protection barrier provides protection to the capital invested, as long as the final level of the underlying asset has not fallen by more than 50% from its opening level. If the 50% barrier is breached then the loss of initial capital will be proportionate to the decrease in the underlying asset’s value between the two observation dates.
Soft protection with an American barrier - a product with a 50% soft American close of business protection barrier provides protection to the capital invested, as long as the daily close of business level of the underlying does not fall by more than 50% or more from its opening level and throughout the investment term. If the 50% barrier is breached during the term then the loss of initial capital will be proportionate to the decrease in the value of the underlying asset between the opening level and final level.