Growth products are market-linked investments that aim to return a formulaic growth payment and initial capital at maturity of the plan.
The amount of the growth payment is determined by the performance of the underlying, usually paying a multiple of the rise in the underlying from the close of business value on the start date of the plan. It is common for these plans to have a cap on the maximum growth payable.
Many growth products incorporate a conditional capital protection feature so that capital will be returned in full provided the underlying has not fallen below a certain level (‘the barrier level’). This barrier level can be measured at any point during the term of the investment (an American barrier) or only at maturity (a European barrier).
A growth plan is structured by combining a zero coupon bond with a derivative package of call spreads and put options. A zero coupon bond is a corporate bond that pays no coupon during the term of the bond, but returns a fixed amount at maturity (the original capital investment). A put option gives the holder the right (not the obligation) to sell a quantity of the underlying back to the seller at a predefined price on a specified date.
Selling a put option increases the amount of money available to invest in the options required to deliver the potential growth payment. It is also the sale of this put option that introduces risk to initial capital if the value of the underlying were to fall a significant amount.
The knock-in put option sold would 'knock-in', or become active, if the underlying asset has fallen below its barrier level prior to its expiration, giving the buyer of the option the right to sell the underlying asset back to the counterparty at its Opening Level price.
For an American option, if the closing level of the underlying at maturity has not recovered to above the Opening Level by the end of the plan, the counterparty will have a funding difference which will be passed on to the investor. Initial capital will be reduced by the same percentage that the Final Level is below its Opening Level. For a European option, the barrier level is only measured at maturity of the plan. If the Final Level is below the barrier level, capital will be reduced in the same way described above.
A call spread is created by buying a call option with a lower strike level, and selling a call option with a higher level. The number of call spreads equal the number of times the growth payment pays out on the performance of the underlying – in our example above, 5 identical call spreads would be bought to achieve 5 times gearing of the FTSE 100.
£10,000 is invested in a six year growth product, paying 5 times any rise in the FTSE 100 Index at maturity capped at 60%, with a 50% European capital protection barrier.
- If the Final Level of the FTSE 100 is 20% above its Opening Level the investor will receive back a total of £16,000. The is a combination of a capped growth payment of 60% (5 x 20% = 100% capped at 60%) and a full return of their initial capital.
- If the Final Level of the FTSE 100 is 55% below its Opening Level the client receives back £4,500. Here there is no growth payment, and capital is reduced by the same percentage as the Final Level is below the Opening Level.