How does a Share Accumulator Structured Product Work
The Strait Times reported today that an Indonesian couple has sued UBS Singapore for losses in currency derivatives called Accumulators. Accumulators can be linked to Shares or currency. This form of structured product has also caused Citi Pacific to potentially lose US$2 billion when the Australian dollar plunged against the US dollar recently. It has even been termed “I Kill You Later” in Hong Kong.
What is an Accumulator and how it works? The following illustrates how a typical Accumulator linked to shares work.
The key terms to know:
- Reference Share – The share that the investor is ‘accumulating’
- Strike Price – The price that the investor buys the Reference Share if the share price is lower than the Knockout Price
- Knockout Price – The share price that will trigger the the termination of the Accumulator contract. Usually just a few percentage points above the issue price
- Observation Period – The tenor or term of the contract
The figure below explains how the Accumulator works.
- When the Reference Share price is higher than the Strike Price, the investor gets to buy the share (accumulate) at a lower price (the Strike Price) than the actual share price
- When the Reference Share price is lower than the Strike Price, the investor buys at a higher price than the actual share price. The investor also has to buy 2X the number of shares as compared to when the share price is higher than Strike Price
In effect, the investor has Bought 1 Call option and Sold 2 Put option.
What is a call/put option?
A Call Option is the right, but not the obligation, to BUYa quantity of a financial instrument (eg stock, bond, commodity) at a specific price (Strike Price) within a specific time period.
A Put Option is the right, but not the obligation, to SELLa quantity of a financial instrument (eg stock, bond, commodity) at a specific price (Strike Price) within a specific time period.
What does buying or selling an Option mean?
Buying an option simply means you Pay a premium in exchange for the right to buy (Call) or sell (Put) at the Strike Price.
Selling an option would mean you provide that right by COLLECTING a premium. You have to buy back (Put option) or sell (Call option) the instrument to the buyer.
How does all these work out?
In a Bull market, the investor is happy as he gets to buy the share at a lower price than what is in the market. However, the maximum benefit is limited by the Knockout Price.
In a Sideway market, the investor is disadvantaged as he has to buy twice the amount of shares at a higher price than what is available in the market. Dollar Cost averaging does not work.
In a Bear market, the investor is likely to make a substantial loss as he is forced to purchase twice the number of shares at above market rates at most if not all the time.
Who holds the risk?
The investor holds most of the risk.
The benefit that the investor holds is limited by the Knockout Price. Once the Reference Share price hits or exceeds the Knockout Price, the contract will end, meaning that he will not be able to buy shares at below market price anymore. This also means that the maximum downside the bank (or another third party) is exposed to is limited by the Knockout Price. In fact, the banks could be doing a risk free business if they do not hold the Reference Share but is structuring the deal for a third party. By selling 2 times the number of Put options compared to buying Call options, the bank gets to collect the extra Put option premium. Even if the bank holds the Reference Shares, it can still be profitable to sell the shares at the Strike Price if the Strike Price has been set higher than the original share price that the bank paid for the Reference Share.
Some investors have leveraged their investments by borrowing from the bank. In such a case, they may lose more than the original principal during the current market. The bank can just collect the extra interest for the borrowing.
So, who is the sucker here?
You tell me…
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Tags: Accumulator, Structured Prd
