Defensive and step down auto-calls

Auto-calls remain very popular in most structured products markets. When this product type first appeared the most common treatment was to have auto-call points spaced regularly (perhaps quarterly or annually) and with auto-call index or stock levels set to exactly 100% of the underlying’s initial level. This was the simplest way to define them and the main moving parts were choice of underlyings, maturity, frequency of call as well as downside conditions such as the barrier. These then determined the annualised growth amount to be paid on successful call, which was also almost universally proportional to time that the product was live. For example an 8% annual yielding auto-call would pay capital plus 8% if called after one year, capital plus 16% if called after two years.

From standard auto-calls to variations

As with any product development process once the auto-call became popular and more widely understood by investors it was natural that variations would be sought. We will examine three of these within this article. These variations apply mostly to capital at risk auto-calls because they offer a higher growth amount to compensate for the risk taken on. These variations are step-down levels, defensive levels and a late starting first call point.

Introducing the step down and defensive

The first two of these are related since they show a trend for lower risk approaches in today’s markets. For most underlyings and maturities the difference in annualised yield that can be achieved in the level auto-call version when capital protected or not capital protected is quite significant, something of the order of twice the annualised amount. However, level auto-call products are reasonably aggressive strategies, since if the first one or two call points are missed (meaning the underlying has failed to get above 100% of its start level), that underlyings is by definition down and usually significantly so. This makes subsequent calling usually very unlikely and puts capital at risk. Even the presence of barrier protection, such as 60% of the initial level which will likely do a reasonable job in helping to preserve capital does not help provide a positive return.

Step-down auto-calls are one solution to bridge this gap. Typically the first one or two levels are set at 100% of the initial level but subsequent targets decline steadily such as 5% per auto-call time to 95%, 90%, 85% etc. This makes subsequent calls more likely by making the target easier as markets have declined already. Since a later call is more likely and will pay the annualised amount over a longer period it is quite a costly feature to put in. For example therefore, a product that may be able to offer 10% p.a. return with a level call schedule, may only show 7% p.a. with declining step down auto-call points. For many investors this is still a very healthy return and the fact that it can be achieved in markets that have been flat or somewhat down is a very strong selling point.

Defensive schedules operate a little differently, for example call levels at 100% all the way through except for the last date which may be at 75%. This is a similar idea and allows the chance for a final positive result at a significantly lower market target. Defensive variants can also feature a flat level less than 100% such as 90% all the way through the life.

Risk reduction and going after the “absolute return” sector

The step-down provides extra risk reduction, by calling successfully at a lower market level, not only is the return earned but by doing so it removes some paths which continue until full maturity and suffering capital loss. The flat defensive variation also reduces the chance of capital loss by increasing the chance of earlier calling.

There are very few products across the whole investment spectrum that offer realistic prospects of a strong return in some declining markets as well as bull scenarios, but these type of auto-calls provide this very effectively. As such they deserve to be thought of as “absolute return” investments, a popular investment aim which the conventional fund industry has not done a very good job in solving.

Finally we consider late starting auto-calls which simply start the first auto-call date at a later time, typically after two or three units of time (years, quarters etc). This changes the risk and pricing somewhat but makes sure that the investor comes away with a return worth having, particularly in a strong market. No investor wants to be called after three months when the underlying has doubled in value just to receive three months’ worth of yield.

These variations illustrate the versatility of auto-calls and structured products in general to achieve many different investment aims.

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