Technical: Structured products – American or European Barrier?
26 September 2017
Which works best – American or European barriers in structured products? Ian Lowes, founder of StructuredProductReview.com, looks at how they both work and pits them against example market crashes.
In a year where, to date, every single FTSE 100-only capital at risk product has matured with a gain, it might seem like a strange time to highlight the issue of capital protection. However, along with consistently positive returns, one of the major draws to structured products for investors is the protection to capital in all but a severely underperforming market.
Known as the barrier, the index can fall to a pre-specified percentage of the initial index level, either during the term or on the final observation date, before having any potentially negative impact on the returns.
Historically in structured products, there have been two main types of barrier; American (also known as Full-Term) or European (also known as End of Term Only).
The American barrier is observed each day throughout the term, where a breach will affect the return of capital if the underlying index doesn’t recover, and the European is observed at the end of the maximum investment term only.
If the European barrier level is breached, capital will be reduced, in the vast majority of instances, directly in line with the fall in the underlying asset over the full investment term.
Figure 1: How do European (End of Term) and American (Full Term) barriers work? [Click to enlarge image]
This hypothetical case shown above in Figure 1 illustrates how the choice of barrier can have a significant impact on the returns. Despite having a ‘lower’ barrier level of 50% of the initial level, the American barrier is breached during the term and fails to recover to at least the initial index level. It is worth noting that the FTSE 100 Index has not fallen below 3500 in the last 10 years, not even during the financial crisis in 2008.
Taking a look at our maturity data since 2005, of the 742 matured FTSE 100-only linked, capital at risk plans with a Full-Term barrier, two plans returned a loss, meaning the index breached the barrier and did not recover to its original level. For the 506 FTSE 100-only linked capital at risk plans with an End of Term barrier there were no plans that returned a loss. Despite the fact only 2 plans produced negative returns there is clearly an increase in risk where a potential loss triggering barrier is observed throughout a term rather than on a single day.
There is, of course, a trade-off involved with the choice of barrier in that the use of the more risky American style is likely to lead to a higher potential coupon than a plan utilising the European counterparty.
Until recently, you would typically find either a 50% Full-Term Daily Close barrier or a 60% End of Term barrier being utilised in the UK retail structured products sector but over recent months the use of American barriers has all but disappeared in favour of the more attractive and easy to understand End of Term European style barriers.
Figure 2: Capital protection barriers of FTSE 100 linked products [Click to enlarge image]
The graph in Figure 2 shows the barrier levels for those FTSE 100-only linked products yet to mature. Full Term barriers, marked in yellow, can be breached during the investment i.e. on any day prior to the point, while End of Term barrier levels, marked in green, are only observed on that date. Even if the FTSE collapses to below a Full Term Barrier level, investors in the respective product would only lose capital if the index failed to recover back to the starting level recorded for that product – a breach does not necessarily dictate a loss.
Figure 3: would a 2008-style crash breach upcoming barrier levels? [Click to enlarge image]
If we take the same movement in the FTSE from the highest point before the 2008 crash (October 2007) onwards and translate that on to today’s levels, as shown in Figure 3, we can see that, albeit being a close call in a few cases, the upcoming barrier levels would offer enough protection to withstand an identical correction, and original capital would be returned as a minimum assuming all counterparties remain solvent.
Along with the potential to outperform the underlying asset, the extent to which capital is protected remains an attractive feature for investors in structured products.
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