Risk Latte - Deconstructing a Capped Bull Note

Deconstructing a Capped Bull Note

Team Latte
May 16, 2007

We have talked about capped bull note in some detail on this site. Why then again another article on this? This is because of late we have received a large number of requests from readers to explain to them the mechanics of capped bull notes (or floored bear notes) and many have sent us term sheets for our perusal and subsequent analysis. It is interesting to note that recently, across some parts of Asia , capital guaranteed capped bull notes have once again caught the fancy of retail investors.

Many investors want to benefit from the current stock market, even though in some markets the stock indices are touching the sky. They believe that there is still lot of steam left in the stocks and therefore would like to capture the upside even more. Anyway, we will acquiesce to the wishes of the readers and try to explain capped bull notes once again.

Say, an investor wants to benefit from the upside of a stock or a stock index, like the Hang Seng index. Say, the index is standing at 20,900 as of today. This is the initial value of the index, . The investor believes that the index will go higher in two years time. The bank íV or the seller of the capped bull note - sells a two year note, with principal protection clause, to the investor with a terminal payoff as:

In the above payoff is the notional principal which is guaranteed (if the note is held to maturity) and is the cap level on the index. The value of the index (stock) at the end of two years, which is unknown today, is and is the participation rate. A note can be issued with a participation rate of 100% or it could be greater than or less than 100%. This also reflects the leverage factor.

The cap level is crucial to the above payoff and determines the overall upside. The above payoff says that not matter what the investor at maturity will get back his principal plus he will get a minimum return equal to the cap level. The above note is a vanilla note and its payoff can be easily deconstructed as a combination of a zero coupon bond and a short put option.

Note the mathematical relationship,

Using this relationship and a little bit of algebra we can write the above payoff as:

Therefore the strike price of the put option is and it will have a maturity of two years. This is how the note can be replicated and hedge (as well as priced).

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