In the year 2001 there were many innovations in the area of financial engineering as applied to hedge fund investing and one of them was the Capital-protected full participation notes.

As the name implies these notes guarantee the capital on maturity (100% capital redemption) plus the participation rate on these notes is 100%. These notes always have an underlying hedge fund to whose performance the participation rate and the performance of the note are indexed. Generally, the underlying hedge fund is not available to public and external investors and the hedge fund typically allocates capital to different trading advisors who all follow different strategies, such as long/short, convertible arbitrage, etc.

A typical such note was issued by Societe General Acceptance NV and guaranteed by Societe General Bank. The underlying hedge fund to the note was SCS Alternative Fund. The capital allocation policy of the fund was to seek trading advisors with the following strategies: European equities long/short, commodity trading and arbitrageurs.

The note was structured as follows:

**Currency:** USD

**Maturity:** 5 years

**Size:** $20 million with $10,000 per note

**Underlying:** SCS Alternative Fund

**Issue Date:** 17/01/2001

**Issue price:** 100% of the nominal (N)

The note payoff was:

**Capital guarantee:** 100% of nominal (N)

**Participation Rate:** 100% of the positive performance of the underlying fund

**Capital guarantee:**

Initial NAV is set at $100 per unit of the fund.

FNAV, the final NAV, is the net asset value settled by the fund for a redemption order sent on 10^{th} business day preceding the maturity date.

**A Possible Asset Allocation Strategy of the Fund:**

The fund managers adopt an active leverage policy independent of the leverage employed by the trading advisors. In other words, the fund manager dynamically allocates capital between trading advisors and short term deposits.

A reference level can be chosen in such a way that it starts at $50 (a possible value given a certain algorithm). This reference increases linearly with time in such a way that on maturity it becomes $100. Now a multiplier is chosen which determines the proportion of the fund’s assets in managed accounts (of the various trading advisors in which the fund is invested). This proportion of the fund’s net assets that are invested in the managed accounts is called the “trading level”.

Let’s say the multiplier is 2.00.

- At launch the NAV of the fund is set at $100, so the distance between the NAV and the initial reference level is $50.00. The trading level is thus given by 2*50/100 = 100%. Thus all the fund’s assets are invested in the managed accounts.

- After one year say the NAV of the fund is $114.00 and the reference level is now $60. Therefore, the distance is now 54 and the trading level is 108%. Therefore, the fund will borrow 8% of the net assets (8% of $114) and invest 108% of its net assets (i.e. 108% of $114) in the managed accounts.

- After two years, say the NAV of the fund is $80.00 and the trading level is $70. The distance is therefore -$15.00 (minus $15.00) and the trading level is -30%. Therefore, the fund must invest 30% of the remaining net assets (i.e. 30% of $80) in short term money market deposits and the rest (70% of $80) in the managed accounts.

The above policy uses leverage in such a way that in good times the leverage provided larger gains, which compensate for the capital guarantee costs. In bad times, the capital is progressively withdrawn from risky assets and invested instead in short term deposits.

**IRR of the Note:**

The problem with this kind note is that it would be difficult to calculate the internal rate of return of these notes at launch. Without a proper IRR calculation it is impossible to compare one note with the other as well as compare a note with other investment opportunities.

Normally, one would need to simulate a path for FNAV in the above payoff formula. In normal LIBOR linked notes (or other index linked notes) a Monte Carlo simulation of the underlying spot or forward rate is done and then the NPV and the IRR of the note is calculated. But in this case the underlying is FNAV which in turn is calculated from the returns of the various trading advisors (managed accounts) and who follow different strategies. Therefore, one needs to get a stochastic relationship of FNAV with the underlying managed accounts assets and then perform the simulation, though this may be quite difficult to do in practice. The volatility and the correlation of the individual managed accounts need to be taken into consideration in any kind of a relationship, which could be a compounding factor.

Reference: The example of the Note has been taken from *Hedge Funds* by Francois-Serge Lhabitant.

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