Mar 10

Capital Protected Products…nothing but an expensive put option

Capital protected products are in vogue at the moment thanks to the massive losses experienced and the scary economic times we face. Capital protection appears to come in all shapes and sizes…there are Constant Proportion Portfolio Insurance (CPPI) methods, sometimes called dynamic threshold management; futures and derivatives trading methods; Zero Coupon Bond and Call Option products; and then the plain vanilla good old fashioned Put Option.

It doesn’t really matter what method you use, at the end of the day they all attempt to replicate a Put Option. Unfortunately, with volatility at all time highs so too are the costs of put options. Many of the capital protection providers are trying to seduce the adviser by suggesting their method is not expensive but still provides adequate capital protection or low and behold a capital guarantee. Looks can be quite deceiving.

If a capital protected product is offering capital protection at a lower cost than a put option there is cause for concern. This is because you will be taking on counterparty risk by the provider so you better make sure they are financial sound.

On the other hand if the protection is more expensive than a put option then forget about it…buy the put option.

Lets expose what some of these methods really mean in this current environment….

CPPI or Threshold Management…this method is quite often cheaper than a put option…but guess what? It is inefficient and may not work…particularly in this environment! It is inefficient because the method requires selling down assets when prices are low and buying them back when they are high…selling low and buying high doesn’t sound particularly appealing. It may not work because if the sharemarket drops rapidly…like the 1987 crash and maybe many other examples…the protection provider may not have the chance to sell the growth assets and buy the bonds hence the protection fails. This is a real concern at the moment because the markets are very volatile and risk-free bond yields are extremely low. Therefore it doesn’t take much of a market movement to render CPPI useless so when/if it occurs…make sure your provider can still pay up.

Derivatives and Options methods…basically these methods replicate put options. If you sell a futures contract and purchase a call option you have effectively replicated a put option and guess what? It will cost pretty much the same without signficant arbitrage opportunities so make sure the costs are similar to a put option.

Zero Coupon Bond and Call Option…in this environment both of these items are very expensive…the bond has a very low yield which doesn’t leave much money to buy a call option to replicate your market returns. With an expensive call option overall there’s not much joy in this method.

Put Option…one transaction that provides the proteciton but is still expensive due to volatile markets.

Overall, in this environment with the cost of protection at highs, tactically, I would rather be a seller a than a buyer of volatility and that is what you are doing when you buy protection. Protection is expensive and it is important not to be seduced with lower cost inefficient, risky alternatives.

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