Risk Latte - New Equity Structured Product: Nifty Level Allocator

New Equity Structured Product: Nifty Level Allocator

Nikit Kothari*
November 20, 2009


Introduction


  • Equity markets in India are currently poised at a very critical juncture


  • While the current rally has come on the back of a number of positive news in the macroeconomic and political scenario, the fundamental story in the medium – term has some hurdles:



    • the deteriorating fiscal position might limit scope for further stimuli


    • Growth in investments which lead the 04 – 07 bull run, are expected to turn negative in major sectors in the medium – term due to over capacity


    • while earnings upgrades have started on the back of cost cutting, companies now need to achieve revenue growth to increase earnings


    • The forward P/E of Nifty is at ~18 levels currently which is above fair prices for the Indian equity markets


  • However, there is a large amount of liquidity in global markets on the back of large stimulus packages by governments around the globe


  • Due to this, markets may continue to rally up for some more time before correcting to their fair valuation


  • Amidst this uncertainty prevailing in the markets, this structure is ideal for all equity clients who may not be comfortable entering the markets at current levels but would be comfortable investing if a correction happens



Structured Products Strategy

Product Specifications

Underlying Index: S&P CNX Nifty

If Nifty Level never touches the 85% Upside Barrier during the first 13 months:

  • Structure ends
  • Investor gets his principal back along with a coupon of 13%(absolute) at the end of 13 months

If Nifty Level touches the 85% Upside Barrier during the first 13 months:

  • The structure tenure gets extended to 27 months where in
  • Investor captures 100% upside of the NIFTY returns above 85% of initial level till 24 months,(which is same as buying NIFTY at 85% of its Initial Level)
  • Investor is capital protected till 55% of the initial level of NIFTY

Tenure: 27 months. However, if NIFTY Level never touches the 85% Upside Barrier during the first 13 months, structure ends early after 13 months

How is this product better than a "Wait for a correction" strategy?

Investment Strategy Options

Strategy 1: Keep money in liquid funds and wait for markets to correct

Strategy 2: Invest in the product

Strategy Comparison

Scenario 1 – When markets fall by 15% in the next six months

Strategy 1: Keep money in liquid funds and wait for markets to correct


Downside risk below 85% of the initial Nifty Level


Strategy 2: Invest in the product



Capital Protected till Nifty never touches 55% of its initial Level


Scenario 2 – When markets rally without correcting by 15%


Strategy 1: Keep money in liquid funds and wait for markets to correct by 15%


Payoff – 104.33 (Assuming 4% p.a. return on money market instruments) at the end of 13 months


Strategy 2: Invest in the product


Payoff – 113 at the end of 13 months


Nifty View – 2 Years



  • Based on the long term average NIFTY PE of 15, as can be seen above, expected Nifty levels after two years come out to be 5449


  • According to most research estimates, India is expected to return to a high growth trajectory in 2 years. At such a juncture, even after assuming that Nifty trades at a reasonably conservative level of 15 PE, product returns will be (5449-4250)/4250 ~ 28% absolute returns (Assuming 85% Barrier is hit)


  • In comparison under similar assumptions, money invested today in Nifty would only give 8.98% absolute returns for 24 months (5449 – 5000)/5000


  • In such a case, even if the 85% barrier is not hit, product gives a higher return of 13% absolute after 13 months.


*Nikit Kothari is an alumnus of Indian Institute of Technology, Kharagpur, India and has two years of experience in trading exotic derivatives. Most recently, he was with Lehman Brothers.

Disclaimer: The ideas and opinions expressed in this article are solely those of the author’s and does not reflect the ideas and opinions of Risk Latte Company or any of its member and/or employees. Risk Latte Company and/or any of its employees or members will not be responsible for any inaccuracies, errors or omissions and/or any factual inconsistencies in the article nor will it be liable for any losses, direct or indirect, arising out of the usage and applications of any of these ideas and opinions by anyone. This article appears solely for educational purposes only. The author of this article has confirmed to Risk Latte Company that he holds the intellectual property rights to the product outlined here.

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