Building an Autocall

Catley Lakeman Winter Offsite – January 2014

INTRODUCTION

“I believe each contract we own was mispriced at inception,

sometimes dramatically so. I both initiated these positions and

monitor them. If we lose money on our derivatives, it will be

my fault.”

Warren Buffett – BH annual letter to investors, 2008

2

Probabilities

3

Index Performance over 6 years

“Derivative Market” ProbabilityFTSE only*

“Derivative Market” Probability

FTSE / S&P*

More than 70% fall 8.07% 12.53%

60% to 70% fall 3.14% 4.47%

50% to 60% fall 3.70% 5.36%

40% to 50% fall 5.47% 6.49%

30% to 40% fall 7.39% 7.37%

20% to 30% fall 9.24% 8.78%

10% to 20% fall 10.93% 9.71%

Flat to 10% fall 10.85% 9.74%

Positive performance 41.21% 35.55%

* Based upon CLS pricing models as at 30th December 2013

What can you buy?

Currently Possible:

• FTSE / S&P 500 Defensive Autocall

• 8.2% per annum potential return

• Soft protection at 60%, observed at maturity only

Autocall barriers:

Year 1: 100%

Year 2: 95%

Year 3: 90%

Year 4: 85%

Year 5: 80%

Year 6: 75%

4

In Pictures

5

100.0Index

108.2

100%

Yr 1

95%

116.4

Yr 2

124.6

90%

Yr 3

132.8

85%

Yr 4

141.0

80%

Yr 5

59.99

60%

149.2

75%

Yr 6

0

In Numbers

6

Year Discount Factor

Prob of autocall

Return Current Value of Coupons

Prob of ZCB

return

Current Value of

ZCB

Put Price

Total Price

1 99.36% 45.06% 8.2% 3.67% 45.06% 44.78%

2 98.39% 16.89% 16.4% 2.73% 16.89% 16.62%

3 96.63% 8.16% 24.6% 1.94% 8.16% 7.89%

4 94.12% 5.09% 32.8% 1.57% 5.09% 4.79%

5 91.19% 3.46% 41.0% 1.29% 3.46% 3.16%

6 88.05% 2.59% 49.2% 1.13% 21.33% 18.78%

Total 12.33% 96.01% 9.34% 99.00%

The model gives a 15.33% probability of the put knocking in

In Building Blocks

7

Index100.0

108.2

100%

Yr 1

8.2

100%91.8% Index0.0

Building Block 1 = Strip of digital options ≈ Strip of call spreads

Trader buys a lot of 1 year call spreads, fewer 2 year, etc

In Building Blocks

8

100.0Index

0

59.99

60% 75%

Building Block 3 = Knock-In Put

Trader sells puts at strike and barrier at different maturities

Building Block 2 = Strip of zero coupon bonds

Trader buys a lot of 1 year zcbs, fewer 2 year, etc

Summary

9

• Probabilities are key, to all derivative pricing

• Buy an autocall, you are short volatility

• Small probability of calling in later years

• When markets move the expected life changes!

The information in this document is derived from sources believed to be reliable but which have not been independently verified. Catley Lakeman Securities makes no

guarantee of its accuracy and completeness and is not responsible for errors of transmission of factual or analytical data, nor is it liable for damages arising out of any

person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data. The opinions in this document constitute the

present judgment of Catley Lakeman Securities, which is subject to change without notice. This document is neither an offer to sell, purchase or subscribe for any

investment nor a solicitation of such an offer. This document is intended for the use of institutional and professional customers and is not intended for the use of

private customers. This document is not intended for distribution in the United States of America or to US persons. This document is intended to be distributed in its

entirety. No consideration has been given to the particular investment objectives, financial situation or particular needs of any recipient.

Catley Lakeman Securities is a LLP registered in England and Wales, Registered Office : One Eleven Edmund Street, Birmingham, B3 2HJ. Registration

Number: OC336585, FSA Reference: 484826

DISCLAIMER

10

BUILDING BLOCKS

11

100.0Index

108.2

100%

Yr 1

95%

116.4

Yr 2

124.6

90%

Yr 3

132.8

85%

Yr 4

141.0

80%

Yr 5

59.99

60%

149.2

75%

Yr 6

BUILDING BLOCKS

12

100.0Index

108.2

100%

Yr 1

95%

116.4

Yr 2

124.6

90%

Yr 3

132.8

85%

Yr 4

141.0

80%

Yr 5

59.99

60%

149.2

75%

Yr 6

BUILDING BLOCKS

13

100.0Index

108.2

100%

Yr 1

95%

116.4

Yr 2

124.6

90%

Yr 3

132.8

85%

Yr 4

141.0

80%

Yr 5

59.99

60%

149.2

75%

Yr 6