A Principal Protected Free Lunch?

As I write this, the S&P 500 is threatening to touch 1000 again. That would represent a gain of 47.8% since it’s low on March 9th, essentially delivering a good five years of appreciation in five months. That’s probably inspiring feelings of enthusiasm for investing in the stock market in many of you.

On the other hand, the last time the S&P touched 1000 was on Election Day, NYSE-Mod-Small November 4, 2008, meaning the market has merely broken even over the past nine months. And it’s down 20% since this time last year. So maybe not so enthusiastic.

Oh what to do? You don’t want to miss out on the big gains if the market continues to recover, but you are really scared of the possibility that it won’t recover and will go down again.

Enter the miracle of principal protected notes, otherwise known as market indexed CDs. These allow you to have it both ways, more or less. You can’t lose money and you get at least some of the potential upside from the stock market. A typical proposition might be that you deposit $1000 today and in five years you will get half the gain in the S&P over the next five years or, should the market not go up, your $1000 back. Sounds like a free lunch, doesn’t it?

Last week the Wall Street Journal ran a piece about how these babies are being "snapped up" just now. I think that blurs the line between what seems reasonable under the circumstances and what is actually happening. Total sales volume of these things is probably only a few billion dollars, which is rounding error in the context of the stock and CD markets. I spent an entire 5 minutes on Google trying to find one on offer and failed.

Still, it’s something that I imagine has a lot of appeal right now. The challenge for most individual investors is understanding if a particular CD is a good deal or not.

As a general rule of thumb, the answer is no. Remember that the bank or pseudo-bank selling this to you is taking the other side of the deal. Every dollar you make is a dollar they lose. They will certainly be hedging their exposure in the markets, but a good bet for you is a bad bet for them, and they are not in the business of making bad bets. (Please, no cracks about AIG.)

Indexed CDs are one of those things, like car leases, that are profitable for the sellers because, although they sound intuitively attractive, they are complex enough that unwrapping them to work out the bottom line is too hard for most buyers.

To begin to get your hands around what an indexed CD that was a good deal might look like, let’s run through what it might cost to home brew your own fairly simple version. The recipe has only two ingredients: a zero-coupon bond and an S&P 500 call option. Let’s say you have $10,000 to invest.

Step one is to buy a zero coupon US Treasury bond due November 2011 with a face value of $10,000. That currently costs about $9740. No matter what happens, you will get your $10,000 back when the bond matures in November 2011.

Step two is you take the $260 left over and buy call options on the S&P 500, expiring in December 2011. You will have to trust me on the math, but this will get you about 18% of the upside from the S&P 500 over the next 28 months, assuming there is any.

18% may not excite you, but it’s a fair deal for a CD that will run about 2 1/2 years. Which is why most of these have longer durations. With a five year horizon, the zero coupon would cost only around $8650, leaving $1350 to buy options. The catch is that options dated that long are not traded on an exchange, meaning that an individual can’t buy them or even easily get a price for what one ought to cost.

Based on what the December ’11 option goes for and doing some math that you really shouldn’t take my word for, but may have to, the $1350 should buy about 48% of the S&P upside over five years. (Keep in mind that this is "price only" upside, you do not get dividends.)

Maybe 48% still isn’t what you had in mind. Well, there are even more complex versions of this scheme that give you a larger percentage of the upside, but cap it at some maximum gain. The recipe for this includes just one more ingredient, the sale of options with a higher strike price.

So instead of just buying S&P options with strike price of the current value (1000) you also sell  them with a strike of 50% higher than the current value (1500.) Do this with the five year version above and I calculate you ought to enjoy 89% of the S&P upside over the next five years, up to a maximum gain of 44.5%.

Don’t take my numbers too seriously. They are rough estimates.

The point is that there is nothing miraculous here. All the bank is doing is selling you a CD where instead of paying you interest, they go and buy you an option. You can do that, or something like it, yourself.

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