Principal protection
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Principal protection

Many structured notes come with a promise that at maturity investors would at least get their initial investment back. But the credit crisis combined with a dramatic increase in equity market volatility has presented structured note sellers with a number of challenges when it comes to offering principal protection.

Wealthy seek to profit from unstable markets

There are two main ways a structured note seller can engineer a product in order to protect principal. The first is the traditional structured note format of taking the investor’s money, using some of it to buy a zero-coupon bond (which costs less than par and rises in value to par at maturity) and using what is left to buy options to give exposure to whichever asset class the investor is keen on. So a classic structured note, for example, would combine a zero-coupon bond plus a call option on an equity index.

The other method is constant proportion portfolio insurance (CPPI), or variants thereof. CPPI works by maintaining a balance of assets between a risky portfolio, such as equities, and a riskless portfolio, such as cash. The mix of assets is managed dynamically, with the underlying portfolios rebalanced to maintain a minimum safety net depending on the movements of the underlying risky asset prices. The idea is to give optimum exposure to the relatively high-return market while maintaining capital protection.

The difficulty with early forms of CPPI products was the possibility that investors could end up being cash locked when there is a dramatic increase in equity market volatility, so the investor could end up with 100% exposure to cash until the note matures.

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