Post on 19-Aug-2015
Leveraged Technologies Structured Product
Siqi Li - 213393996
Calvin Calce - 213849146
Farazi Ahmed - 213827340
Mathieu Fortier – 213849039
Daniel Monroy - 210919199
A product offering by Stratton Investment BankJune 30th 2015 meeting
The American economy has been recovering since 2008 US economy is recovering and we predict there is still room for the stock market to go up,
especially technology stocks
Conference Board Consumer Confidence IndexUnited States Department of Labor
Jan-11 Jan-12 Jan-13 Jan-14 Jan-153.00%
4.00%
5.00%
6.00%
7.00%
8.00%
9.00%
10.00%
US Unemployment Rate
Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-150
20
40
60
80
100
120
Consumer Confidence Index
Investment Current Landscape
Sector PerformanceHigh Demand Reasons
Technology industry has the highest return among all industry, except healthcare
Anticipated return for the next 18 months high
Provides an investor with the upside enjoyed by a risk-seeking individual, while limiting the downside
1.90%
12.40%
16.27%
10.35%
-10.92%
20.78%
28.58%
16.13%17.72%
26.92%
3.53%
Top 100 Market Cap Sector Return in the last year
DescriptionHPR – last
18 months
Tesla Motor Inc.
-American automotive technology company-Focus on producing electric powered vehicles-Trade on NASDAQ-Dominant positioning in renewal energy powered vehicle
72.65%
Apple Inc.
-American technology company-The world’s second largest technology firm based on global revenues-Trade on NASDAQ and DJIA-Enjoy leading market share with regards to consumer products
58.73%
LinkedIn Corporation
-World most popular business networking social media platform-Rely primarily on ad revenues-Enjoy success as public firm with a vast global reach with subscribers -Elected to go public in 2011
-0.49%
Investment Current Landscape
Structured Note Profile The Note has a maturity of 18 months
Features 3 of the most well-known companies in the industry incorporated in one basket Tesla Motors Inc. (60%)
Apple Inc. (20%)
LinkedIn Corporation (20%)
Leveraged of 3, 3:1 upside on a basket of very volatile and lucrative stocks with a 1:1 downside exposure
No principal protection is offered – Downside effect similar to an equity investment
Redemption payments are calculated based on the Holding Period Return after 18 months.
Return are capped at a value of 45%
Distribution in United States only
Modest gains will be transformed into respectable returns following an accelerated upside structure 3:1!
Leveraged Technologies Structured Notes
Suitability
Target Investors
Bullish or moderately bullish expectation in technology market for short term
Able to accept significant loss if the basket decreases below threshold value
Willing to sacrifice upside potential due to capped return
Willing to accept market risk, liquidity risk, and credit risk
Demand will be present from moderately bullish investors on the technology industry in the short-term
Highly attractive product for diversification or speculation purposes for investor who are not fully bullish on technology stocks
Average investor affordability
Notes provide very-attractive short-term bullish exposure to an industry
Notes position can be easily replicated by wealthy investors with a deep knowledge of derivatives products
Leveraged Technology product like this one are not currently offered on the market and investors are provided with a unique investment opportunity
"This product changed our life!We were able to diversify our portfolio and even though the stocks only gained an average of 5%, we received a 15% return on our principal!”
Bring a unique investment opportunity
Product Strategy Recap
Investments
• 18 Months maturity• 3:1 upside exposure with
capped return at 45%• 1:1 downside exposure,
No principal protection offered to customers
Underlying Stocks
• 60% Invested in Tesla Motors Inc.
• 20% invested in LinkedIn Corporation
• 20% invested in Apple Inc.
Call Options
• 2 Long-Calls options bought at-the-money for each underlying stock
• 2 Short-Calls options bought at a return of 15% for each underlying stock
• All the call are bought at time 0 in the same time then underlying stocks
• The whole position is built at the same time.
Tesla Motors IncNASDAQ: TSLA
Produces High Quality Electric Vehicles
Increase in Revenue (59% in 2014)
In 2015, Tesla announced the Powerwall
a battery product for home use
Began construction of a gigafactory:
to support production of a mass-market affordable vehicle
to produce battery packs intended for use in stationary storage
to improve robustness of the electrical grid
to reduce energy costs for businesses and residences
to provide a backup supply of power
LinkedIn CorpNYSE: LNKD
Business-oriented Social Networking Service
In March 2015, more than 364 million users in more than 200 countries and territories
Increase in Revenue (2014: +45%) with a market capitalization of $27bn
Forward P/E Ratio of 64.94
Filed for an initial public offering in January 2011
Latest acquire: Lynda.com (an e-learning website) for 1.5 bn (April 9th 2015)
Lynda.com helps users to understand business, technology, software, and creative skills through videos
Apple Inc.NASDAQ:AAPL Produces consumer electronics, computer software, online services, and personal computers
Moderate increase in Revenue (2014: 7%)
Market Advantage & Brand Power
Well-known hardware products:
Mac line of computers
iPod media player
iPhone smartphone
iPad tablet computer
Apple Watch smartwatch
On the way to be the first company to reach a $ 1 Trillion Market Capitalization
Latest Release: Apple Music (June 30th 2015)
A music streaming service with the Internet radio station Beats 1
Capital Market Assumption – Pricing Model
Tesla Motors Apple LinkedIn
Inception Price (S) $268.26 $125.43 $206.63
Strike Price (K) $268.26 $125.43 $206.63
Strike Price at the Cap $308.2 $144.2 $237.6
Risk-Free Rate (RF) 0.6% 0.6% 0.6%
Volatility 49.85% 22.62% 41.01%
Dividend yield 0% 0% 0%
Investment Period (T) 18 months 18
months18
monthsWeighted
Stocks 60% 20% 20%
Risk-free rate (0.6%) All 3 stocks of our underlying are sensitive to the
American economy and therefore US interest rates will be used.
A 0.6% risk-free rate corresponds to the rate on a horizon of 2 years from the Federal Reserve.
Stock price follow random walk and are log normally distributed
Dividends (0%)
Variance: For each stock in the basket, we first averaged and then
annualized their historical volatility in the last 2 years. Assuming respective variance would be constant with their
last 2 years average over the next 18 months investment period.
Option Long position in At-the-money European Call Option Short position in European Call Option At the Cap Rate
Structured Note Implementation-Step 1
1. Breakdown of components Purchase of the underlying assets: Tesla Motors Inc., Apple Inc. and LinkedIn Corporation
Purchase of two long call options at-the-money for each underlying assets purchased
Sell (short) of two call options at a return of 15% for each underlying assets purchased to hedge risk and be able to repay customer
Implementation Steps
Tesla Motors
Stock Price: $268.26
At-the-Money Call
Short Call at the Cap:
Stock Price: $206.63
At-the-Money Call
Short Call at the Cap
Apple
Stock Price: $125.43
At-the-Money Call
Short Call at the Cap
Structured Note Implementation-Step 2
2. Allocation of weights Weights were allocated based on stocks volatility
Highest volatile stock was allocated 60% of the weight in order to maximize note’s volatility, Tesla Motors Inc. (60%)
Minimum weight of 20% allocated to the least volatile stock, Apple Inc. (20%)
The remaining stock was allocated 20% of the weight, LinkedIn (20%)
Weights allocated to the stocks will maximize the likelihood of significant upward movements.
Implementation Steps
Apple
20%
20%
Tesla
60%
Structured Note Implementation-Step 3
3. Calculation of Correlations between stocks Co-movement were calculated based on the correlation of the daily log-normal returns of Tesla
Motors Inc., Apple Inc. and LinkedIn Corporation for the past 2 years
Implementation Steps
Correlation Matrix
Tesla Apple LinkedIn
Tesla 1 0.16306 0.29877
Apple 0.16306 1 0.08986
LinkedIn 0.29877 0.08962 1
7/1/2013 7/1/20140
50
100
150
200
250
300
350
Tesla Motors Apple LinkedIn
Sto
ck P
rice
s
Structured Note Implementation-Step 4
4. Cholesky Decomposition Correlation matrix decomposed to get a lower-
triangular L matrix. Cholesky Decomposition is the decomposition of a positive-definite matrix into a lower triangular matrix. A = LL* . L is the lower triangle and L* is the transpose.
Implementation Steps
Cholesky Decomposition
Tesla Apple LinkedIn
Tesla 1 0.00 0.00
Apple 0.16306 1 0.00
LinkedIn 0.29877 0.08962 1
Correlation Matrix
Tesla Apple LinkedIn
Tesla 1 0.16306 0.29877
Apple 0.16306 1 0.08986
LinkedIn 0.29877 0.08962 1
Structured Note Implementation-Step 5
5. Marsaglia-Bray Calculation Create a vector of 3 Gaussian randomly changing normally inversed variables
Multiply the vector by the Cholesky matrix and add the results
Implementation Steps
Cholesky Decomposition
Tesla Apple LinkedIn
Tesla 1 0.00 0.00
Apple 0.16306 1 0.00
LinkedIn 0.29877 0.08962 1
Gaussian Random #
0.20964
0.56770
-1.08948
Summation
0.20964
0.59428
-0.95241
= NORMSINV(RAND())
Structured Note Implementation-Step 6
6. Brownian Motion Implementation Once the three numbers are created using the Marsaglia-Bray, they are
implemented into the Geometric Brownian Motion to create the shock
This is implemented into each individual stock in the leveraged structured product
Implementation Steps
Summation
0.20964
0.59428
-0.95241
𝑆𝑡+Ϫ 𝑡=𝑆𝑡∗𝑒𝑥𝑝((µ𝑖− 12𝜎 𝑖
2)Ϫ 𝑡+𝜎 𝑖√Ϫ 𝑡𝜙 𝑖))Stock Starting
Stock PricesSimulated
Stock Prices
Tesla $268.26 $255.14
LinkedIn $206.63 $207.42
Apple $125.43 $96
Structured Note Implementation-Step 7
7. Payoff for Call Options Now that the three stock Prices have been simulated, start working on the
payoffs in order the price the options through Monte Carlo Simulation
Price both the two Calls at the money and the two short calls out of the money for each of the three stocks.
In order to price individual options, we look at the payoffs from each of the stock prices. For example:
Repeat Step, for the other two stocks
Implementation Steps
Stock Starting Stock Prices
Simulated Stock Prices
LinkedIn $206.63 $207.42
¿𝑃𝑎𝑦𝑜𝑓𝑓 𝐿𝑖𝑛𝑘𝑒𝑑𝐼𝑛=MAX ($207.42−$206.63 ,0)=$ 0.79
Strike At-the- money Strike at the Cap rate (15%)
$206.63 $237.62
¿𝑃𝑎𝑦𝑜𝑓𝑓 𝐿𝑖𝑛𝑘𝑒𝑑𝐼𝑛=𝑀𝐼𝑁 ($237.62−$207.42 ,0 )=$0
Structured Note Implementation-Step 8
8. Assign the number of simulations () Repeat steps 5 -7 in order to have number of observations for stock prices, and
therefore payoffs for both long call options and short call options.
Once number if simulations have been ran, the structure cost can be calculated
Structure Value Using Monte Carlo:
$250.72
Implementation Steps
𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒𝑉𝑎𝑙𝑢𝑒=∑ 𝐴𝑠𝑠𝑒𝑡𝑃𝑟𝑖𝑐𝑒𝑖+(𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗(𝑆𝑢𝑚𝑜𝑓𝐿𝐶𝑃𝑎𝑦𝑜𝑓𝑓 𝑖𝑁 )−𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗( 𝑆𝑢𝑚𝑜𝑓𝑆𝐶𝑃𝑎𝑦𝑜𝑓𝑓 𝑖𝑁 ))∗ h𝑤𝑒𝑖𝑔 𝑡𝑖
Structured Note Using Closed Form
Use Black-Scholes to Price Options Once the options are priced using the Black-Scholes model, the model
becomes really easy to price
The formula below is used for this pricing
$250.77
Implementation Steps
𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒𝑉𝑎𝑙𝑢𝑒=∑ 𝐴𝑠𝑠𝑒𝑡𝑃𝑟𝑖𝑐𝑒𝑖+ (𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗𝐿𝐶𝑂𝑝𝑡𝑖𝑜𝑛−𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗𝑆𝐶𝑂𝑝𝑡𝑖𝑜𝑛 )∗ h𝑤𝑒𝑖𝑔 𝑡 𝑖Company Tesla LinkedIn Apple
Stock Price $268.26 $206.63 $125.43
2 Call Options (ATM)
130.52 83.44 28.65
2 Short Calls (Cap) (103.24) (61.69) (15.25)
Total Cost 295.54 228.38 138.83
Weight 60% 20% 20%
Structured Note Fair Market Value
Use the closed form solution From the closed form solution, we add a markup to the price of around 2%,
for a total final structure price of:
$250.77 + $4.23
Total Price = $255
Why was Monte Carlo implemented, if we used Closed form?
The structure of the Monte Carlo simulation was used for the risk management department in order to arrive at an expected payoff
Fair Market Value
Payoff ProfileStructure
Initial starting value: $255 -weighting of the underlying stocks
Terminal value calculated using same weights at T (18 months)
Redemption values calculated based upon these weighted baskets
Positive returns: times a factor of 3
-capped return at 45%
Negative returns: on a 1-to-1 basis - principal amount returned to the investor; No principal protection
105114123132141150159168177186195204213222231240249258267276285294303312321330339348357366375384393402411420429438
($150)
($100)
($50)
$0
$50
$100
$150
$200
$250
Investor Payoff
Investor Payoff Stock Price at T
Share Price
Pay
off
𝑯 𝑷𝑹=(𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆¿¿𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏𝑫𝒂𝒕𝒆−𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆)
𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆
¿
Leveraged Basket Product PricingPricing the Product
Capped Return = 45% of $255 = $115Capped Rate = 15%
Below $255 ~> Stock Price
Above $255 ~> 2 Long Calls
Share Price > $ 2553X Return (1 Stock & 2 Call Options)
Capped Rate of 15% ~> 2 Short Calls
After Cap Rate: Effect of 1 Share & 2 Long Calls = Effect of 2 Short Calls
Price of Product = $255𝑯 𝑷𝑹=
(𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆¿¿𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏𝑫𝒂𝒕𝒆−𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆)𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆
¿
105119133147161175189203217231245259273287301315329343357371385399413427441455469483497
($150)
($100)
($50)
$0
$50
$100
$150
$200
$250
$300 Pricing the Product
Investor Payoff Stock Price at T 2 Long Calls + Share
Share Prices
Payoff
Basket Return: -9%
You Receive: -9%1-to-1 Downside
Scenario Analysis 1 - Downside
L = -7.5%A = +3.7%
0.0 0.3 0.6 0.9 1.2 1.5$0
$50
$100
$150
$200
$250
$300
$350
Tesla Linkedin Apple
Time in Years
Share
Pri
ce T = -
13.7%
A = +12%
T = +25%
L = -17%
Basket Return: 14%
You Receive: +42%3-to-1 UPSIDE
Scenario Analysis 2 – Upside (below cap)
0.0 0.3 0.6 0.9 1.2 1.5$0
$50
$100
$150
$200
$250
$300
$350
$400
Tesla Linkedin Apple
Time in Years
Share
Pri
ce
T = +52%
A = -25%
Basket Return: 28%
You Receive: +45%Capped Return
L = +11%
Scenario Analysis 3 – above cap
0.0 0.3 0.6 0.9 1.2 1.5$0
$100
$200
$300
$400
$500
$600
Tesla Linkedin Apple
Time in Years
Share
Pri
ce
Fee Structure
A total selling concession fee of 1.5% Underwriting Fee and Marketing Fee (0.5%)
Total amount invested to market the notes
Lower amount than usually required due to the simplicity of the product and relative ease of building the position
Broker Fee (1%) Distribution of the notes through usual market and known network
Notes are only made available on the American Market, and purchased by US Citizens
The fee structure was determined based on the special feature of the product and benchmark on what the bank usually charges
No discount will be provided to investors who purchase a substantial amount of notes in a single transaction
Trading
Not listed on any exchange market
No secondary market
May receive less than invested if
liquidate before maturity
Notes will be redeemed after 18 months
Plan of Distribution
2. Resell the securities
1. Able to buy structured notes on their own accounts
To Underwriters
To Agents
& Dealers
Direct Sales
Retail Investors
Suitability
3. Give additional underwriting fees
1. Dealers and agents buy the structured notes at principal
Institutional Investors
Pension Plan
Endowment
Insurance Companies
Risk Profile
2. Resell the structured notes
to the public
3. At variable prices to be determined
Legal Structures
US laws are applicable for the design and the distribution of this structured product
A U.S. Holder will recognize gain or loss upon the sale, exchange or maturity of its notes
The amount should be recognized at maturity.
Long-term capital gain or loss because the note is an 18-month product, longer than one year.
An interest charge would apply
The tax rates applicable is dependent on the state of residence of note’s holder
“The structured note is considered as open transaction that is no debt instrument for US federal income tax purposes.”
“The note could be treated as constructive ownership transaction”.
US Federal Income TaxImplications & Requirements
Internal Revenue Code“Section 1260”
Hedging Strategy In order to provide investors with the required return at maturity date
Purchased 2 long calls at-the-money for each underlying assets
Short 2 calls at a 15% return for each underlying assets
No perfect hedge strategy since we are hedging against a basket by hedging the assets individually
Main reason why competitors offers leveraged return based on Indexes
-100 100 300 500 700 900 1100
Stratton Investment Bank Note Histogram Payoffs
Return
Fre
quency
Monte Carlo Simulation Results
Simulation # 10,000
Average $6.10
Back Testing
Stocks Returns
Tesla Motors Inc. (60%)
72.65%
LinkedIn Corporation (20%)
-0.49%
Apple Inc. (20%) 58.73%
Total Weighted Return
53.08%
Leveraged Portfolio Return
45%
Investment Return if you had invested in the last 18 months – From Jan.1st 2014 to June 30th 2015
All past return data were retrieved from Yahoo Finance
Based on the returns and the model, the bank would have secured a return of $15.09 per issuance, generating an 8.9% return
Back Testing
Stocks Returns
Tesla Motors Inc. (60%)
23.76%
LinkedIn Corporation (20%)
11.97%
Apple Inc. (20%) 66.13%
Total Weighted Return
29.87%
Leveraged Portfolio Return
45%
But what if you would have invested in the company from May 19th 2011 to November 19th 2012
All past return data were retrieved from Yahoo Finance
Based on the returns and the model, the bank would have secured a return of $13.31 per issuance, generating an 11% return.
Investors Risk
• Investors’ returns on the notes may be less than what they would have been if they had directly invested in the underlying stocks.
• The increase in the value of one of the basket stock may be moderated and offset the return of other assets
Investment Risk
• The investment is directly linked to stock’s performance traded on the market and may result in a loss.
• Investors are exposed to market movement for 18 months. • Investors are exposed to volatile technology stocks and to their
respective price movements.
Market Risk
• Return on Investment is directly link to the correlation and return of the basket of stocks.
• If the correlation were to increase it would have a direct impact on the return of an investor.
Correlation Risk
• Ending payments owed on the Structured Note are subject to the credit risk of the issuing bank Stratton Investment Bank. Bank’s credit ratings could deteriorates in the next 18 months, leading to insolvency and an inability to meet obligations.
Issuer Credit Risk
• No secondary market will be provided. • If an investor wants to sell his note before maturity, it might be
impossible to do, or he would have to sell at a price lower than the actual price.
Illiquidity Risk
Issuer Risk
• Subject to a mispricing risk when issuing these notes• A mispricing of the cost required to build the position internally would
potentially affect the profit return the bank gets from selling the note Mispricing Risk
• Stocks chosen and put in the basket, with their respective weights, have high variances and low correlations among each other.
• Potential lowering effect on profit if correlations were to decrease• Margin of profit would be declining.
Correlation Risk
Stocks and Positions Total Cost
1 long call contract at-the-money to buy Tesla Motors for a maturity of 1.5 year (100 contract min)
$65.26 * 100 = $6,526
50 Shares of Tesla Motors $268.26 * 50 = $13,413
1 long call contract at-the-money to buy LinkedIn for a maturity of 1.5 years (100 contract min)
$41.72 * 100 = $4,172
50 shares of LinkedIn $206.63 * 50 = $10,332
1 long call contract at-the-money to buy Apple Inc. for a maturity of 1.5 years (100 contract min)
$14.32 * 100 = $1,432
50 shares of Apple Inc. $125.43 * 50 = $6272
2 short call options (per stock=6) – (100 contract min = 600 contracts)
$9008 (skipped steps for simplicity)
TOTAL COST OF REPLICATION $33,139
Cost as of June 30th 2015 required by clients to build this position
With Stratton, clients are only required an investment of $255 to have the same exposure
Benefit of the Structured Note
Benefits and Drawbacks
Leveraged Technologies Structured Note Benefits
• Small investment required to get a 3:1 leveraged exposure• Note affordability. Replication would require a massive investment• Average Investors have the ability to enjoy accelerated upside potential in equities• Basket leverage feature• Investors enjoy a 3:1 leverage return capped at 45% and still maintain the same initial
downside exposure of 1:1
Leveraged Technologies Structured Note Drawbacks
• As opposed to many notes available on the market, this note does not offer downside protection to investors
• The downside exposure is equivalent to an investment in a stock• Lack of liquidity as no secondary market will be provided to investors, and they should be
ready to hold notes until maturity when investing• Wealthy investors can replicate this position by their selves
Alternative Investments
Direct investment in a basket of stocks
Investors will have to invest in the same proportion and the same stocks.
Downside exposure will be the same, but upside will be 1 to 1 without being capped
Investors will not be able to replicate the exposure without substantial investment
Investors, by investing in only one security, would increase their risk and reduce diversification.
• Investors will not be able to find a unique exposure to a basket of technology stocks like our note does. However they could invest in similar equity alternative investments.
Conclusion
Stratton Investment Bank clientele is given a massive opportunity to invest in three technology stocks for which they could earn a return of 45% in 18 months.
Technology industry has been performing well in the last year
Highly volatile stocks included in the basket
Affordable product for averaged-income investors looking for an exposure to technology stocks.
Take the plunge, get into technology today!