Chapter 16 - Principal-Protected Notes (Done) Flashcards
What is constant proportion portfolio insurance?
An investment in which the principal
is guaranteed by the use of a trading
strategy in which allocations to a
risky asset and a risk-free position are
adjusted periodically. Adjustments
to the allocations are based on the
market value of the risky exposure
and the cost of buying a zero-coupon
risk-free bond which can be used to
repay the principal of the security at
maturity. This technique is often used
to create principal-protected notes
based on hedge fund investments.
What are market-linked GICs?
GICs whose interest is linked to the
performance of a market index, mutual
fund, basket of securities or some
other underlying asset.
What is a participation rate?
Percentage indicating the portion
of the upside growth in a PPN’s
underlying asset that will be paid to
the PPN’s investors.
What is a principal-protected note?
A debt-like instrument with a maturity
date on which the issuer agrees
to repay investors the principal. In
addition to the principal, investors
may receive interest, the rate of
which is tied to the performance of an
underlying asset.
What is a zero-coupon bond plus call option?
The oldest PPN structure and the
simplest. When this type of PPN is
issued, a large portion of the principal
is used to purchase a zero-coupon
bond whose maturity date and value
matches that of the PPN, thereby
guaranteeing the PPN principal is
returned. The remaining funds—minus
fees—are then used to purchase call
options on a risky underlying asset to
provide a return.
Describe a PPN.
A PPN is a debt instrument that provides a return that is linked to the performance of a specific underlying asset
such as a market index, a basket of stocks or a mutual fund. As the name implies, the issuer of a PPN guarantees
the return of at least the principal value of the PPN on its maturity date. As a debt instrument, any return is
paid in the form of interest. In some cases, the issuer may guarantee a minimum positive level of return, but
otherwise, the total return on the instrument is known only on or close to the maturity date.
Identify the entity that normally acts as “guarantor” and provides the principal protection at maturity
for the PPN.
In Canada, PPNs are issued almost exclusively by Schedule I banks, although in the past they have been issued
by Schedule II banks as well as Canadian Crown Corporations such as the Canadian Wheat Board and Business
Development Bank. Banks provide a guarantee on PPNs equal to that of their deposits, including savings
accounts and guaranteed investment certificates (GICs). However, unlike many of those deposits, including the
closely related market-linked GICs, PPNs are not insured by the Canada Deposit Insurance Corporation. In all
cases, the value of the guarantee is a function of the creditworthiness of the issuer.
Describe the two main PPN structures.
In the zero-coupon bond plus call option structure, the PPN issuer invests most of the proceeds in a zero-coupon
bond that has the same maturity as the PPN, which guarantees the return of principal at maturity. The remainder
of the proceeds is invested in an option on the underlying asset, which provides the upside for the note.
* With a constant proportion portfolio insurance (CPPI) structure, the issuer initially invests all of the proceeds
into the underlying asset. Generally, as the value of the investment in the underlying asset increases, or
interest rates rise, the allocation to the underlying asset increases, and the allocation to a zero-coupon bond,
if any, decreases. Likewise, as the value of the investment in the underlying asset falls, or interest rates decline,
the allocation to the underlying asset is reduced, and the allocation to the zero-coupon bond increases.
Identify the main components of the zero-coupon plus call option PPN.
The main components of the zero-coupon plus call option PPN are the zero-coupon bond and the call option.
The zero-coupon bond provides the principal protection, and the call option provides the upside potential.
Briefly describe the relationship between PPNs and market-linked GICs.
Apart from some basic structural and operational differences, market-linked GICs and PPNs are essentially the
same product. In Canada, both are issued by banks and both provide a return that is linked to the performance
of a specific underlying asset such as a market index, a basket of stocks or a mutual fund. Both market-linked
GICs and PPNs provide a guaranteed return of principal at maturity, and any return is paid in form of interest.
Finally, market-linked GICs are normally designed and managed by the same group that runs the bank’s PPN
program, and can be built using the same techniques.
Bank A issues a 5-year PPN based on the S&P/TSX Composite Index at a time when 5-year interest rates are
at 5%. Six months later Bank B issues a similar PPN, except that 5-year interest rates are now 6%. All else
being equal, which bank can offer its investors more exposure to the S&P/TSX Composite Index? Why?
All else being equal, Bank B would be able to offer investors more exposure to the S&P/TSX Composite Index
because 5-year interest rates are higher than they were when Bank A issued its PPN. The higher interest rate
means that the price of a 5-year zero-coupon is lower, which in turn means that Bank B has more to spend
on the option component of the structure. With more to spend on the option component, Bank B can offer
investors more exposure to the underlying index.
A 7-year PPN was issued with a CPPI structure. Two years into the PPN, about 80% of the note’s assets are
invested in the underlying asset. Which of the following statements is most likely true?
a. The value of the underlying asset has gone down and/or interest rates have risen.
b. The value of the underlying asset has gone up and/or interest rates have risen.
c. The value of the underlying asset has gone down and/or interest rates have fallen.
d. The value of the underlying asset has gone up and/or interest rates have fallen.
c. The value of the underlying asset has gone down and/or interest rates have fallen.
In a CPPI structure, the issuer must lower the exposure of the note’s assets to the underlying asset when
the value of the underlying asset goes down and/or when interest rates fall.
