Last time, we shared Julie’s stock market adventures. After soaking up wisdom from her alumni Mark, Julie's understanding of structured products deepened significantly. The vastness of this financial realm sparked a newfound curiosity within her. This time, Julie attended an alumni gathering and, bumped into Mark again. Let's see what frosty financial fun she uncovered about the autocallable/snowball feature from mark this time!

One crisp winter weekend, Julie attended a skiing event nestled in the picturesque mountains. The invigorating alpine air and snow-clad slopes offered the perfect escape from the hustle and bustle of city life. After several thrilling descents down the mountain, she paused with her fellow alumni to revel in the snowy wonderland.

Why Do Investors Fear Snowball Products?

Julie began building a snowman, starting with a small snowball and rolling it around to gather more snow. As the snowball grew larger, she couldn't help but ponder the recent buzz about snowball structured products earlier in the year. Fortuitously, she spotted Mark at the event, without hesitation, she approached him. "I've been thinking about those snowball products. I read they caused quite a stir earlier this year. Could you explain what happened?" Mark nodded, setting aside his skiing gear. He suggested they head inside a nearby bar to warm up. After ordering two drinks, Mark began, "Have you learned about the auto-callable feature, similar to the knock-out feature I mentioned before (Please refer to previous article Understanding Structured Products Series 3: Scarlett and Julie’s Investment Adventures)?" Julie shook her head, signaling her confusion. "No, I haven't. Could you explain it to me?"

Mark leaned in, eager to clarify. "An auto-callable structure can be terminated early if the underlying asset—let's say a stock index or a basket of stocks—hits a specific price level, known as the upside barrier. This early termination feature allows investors to lock in their gains." Julie nodded but still seemed puzzled. "Oh, it’s like the knock-out feature. But what is the difference between them?"

"Imagine this," Mark continued, "you invest $1,000 in an autocallable product linked to a basket of two stocks. Every month, we check the prices of these stocks. If their average price is above a certain level, the product is called, meaning it's terminated early, and you receive your initial investment back along with a nice coupon payment. Let's say the coupon rate is 12% per year. If the product is called after one month, you get your $1,000 plus $10. If it's called after six months, you get your $1,000 plus $60, and so on."

Mark paused to let the information sink in and then continued, "It's like the process of rolling a snowball. It starts small, but as it rolls, it picks up more snow and grows larger, provided the conditions are favorable. In the financial world, this means your coupon payments, also called snowball coupon, accumulate over time, leading to greater overall returns, as long as the product isn't called earlier."

Julie smiled, finally grasping the concept but becoming more curious, "It sounds very attractive to investors, allowing them to lock in the gain earlier, but how did it cause panic?"

Mark leaned back in his chair, a thoughtful expression on his face. "The panic was due to market volatility. Snowball products are enticing because of their high coupon rates, but they come with the risk of kicking in if the underlying asset performs poorly."

Julie listened intently, “Kick in? You mentioned this earlier, but how does it impact the return of the product?”

Mark leaned forward, his eyes lighting up with the opportunity to explain. “If the market experiences significant downturns, investors risk not receiving the expected snowball coupon. Worse, if the underlying asset's value drops below a certain level, they could face losses on their principal. Investors often hope the market won’t plummet but will rise, allowing them to earn the snowball coupon through autocall. However, we cannot exclude the possibility that if the asset price drops significantly after purchase, they could face substantial losses when the kick-in event occurs. If the time span is long, the probability of a kick-in is not low. Moreover, the tenor of the snowball product is very long, like 2-3 years. As time marches on, the risk snowballs, growing larger and larger. At that point, the snowball isn't a fluffy reward anymore—it's a frosty avalanche of risk!”

Julie smiled, understanding the analogy. “So, in simple terms, it's like investors are selling insurance to the market, promising to cover losses in case of a downturn. If the market crashes, they have to pay out, which means they face substantial losses themselves.”

Any New Ideas? Auto-callable Bonus Enhanced Note

However, Julie still thought the auto-callable feature was like a shiny lure for investors, promising juicy returns if used wisely and without the enormous potential risks. So she asked, “What if we ditch the kick-in feature and make the tenor shorter? You know, like trimming a wild beard—less unruly, more manageable!  You mentioned that the longer the tenor, the greater the risk because the market becomes more uncertain and volatile over a longer period.”

Mark's eyes lit up with excitement. “Yes, you’re thinking like a strategist now, Julie! The auto-callable feature can be integrated into various structured products to attract investors. It often makes the structure cheaper because it may terminate future potential gains, allowing investors to be compensated with a higher coupon.”

Mark continued, “There’s already a kind of product that does what you’re suggesting. It’s called an Auto-callable Bonus Enhanced Note, or Auto-callable BEN for short.  Let me break down BEN for you.” Mark grabbed a notepad and began sketching. “Alright, picture BEN as a note where the notional amount is USD 1 million, with a tenor of 3 months, a basket of stocks as the underlying assets, and the coupon is a flat 24% per annum.”

Julie nodded, following along. "So, here's the fun part," Mark said, grinning. "At the end of the 3 months, if the basket's final performance is at or above the initial performance, we compare the gain from the final performance with the return from the coupon." He jotted down some formulas:

• Final performance = final price/initial price
• Gain from final performance = final performance - 1
• Return from the coupon for 3 months = 24%/4 = 6%

At this moment, Julie interrupted, "Wait, what is the final price? Is it the average of the final prices of all the stocks in the basket at maturity? Or should we take the worst performance among all the stocks?"

"It should be the worst performance. You calculate all the final performances of the stocks in the basket and take the worst one," Mark explained.

Mark continued, his tone animated, “If the gain of the final performance is larger than the coupon, we get the gain of the final performance and the principal back. If not, we just get the coupon and principal.” He chuckled. “But if the basket’s final performance is below the initial performance, the investor receives a number of shares equivalent to their principal divided by the initial price, which means they might take a hit on their principal.”

Julie’s eyes narrowed as she processed the information. “What if we add an auto-callable feature?” she asked, curiosity sparkling in her gaze. Mark’s face lit up with enthusiasm. “Let me break it down into three scenarios for you.” He drew the first diagram to describe the trend of the stock price. “Let’s say at the end of the first month, the underlying price is higher than the initial price. The investor would get the coupon accumulated for only one month, which is 24% / 12 months = 2% per month, along with the principal.”

Julie’s mouth formed a small “O” of understanding. Mark continued, “Now, for the second scenario: if at the end of the second month, the underlying price is larger than the initial price, we should compare the gain from the final performance with the return from the coupon. Let’s say the gain from the performance is 6% (106% - 1), which is larger than the coupon accumulated for 2 months, which is 2% per month x 2 = 4%. We could get a 6% return and the principal.”

“And for the third scenario,” Mark said, drawing the final diagram, “if the underlying price is only larger than the initial price at maturity, let’s say the gain from the performance is 3% (103% - 1), which is less than the coupon accumulated for 3 months, which is 2% per month x 3 = 6%, we would get the 6% return and the principal.”

However, if the underlying price is less at the end of first month, the end of the second or the maturity, investors have to use the principal to buy back the shares at the initial price.”

Julie’s face lit up with a broad smile, her eyes twinkling like stars. “So, the auto-callable feature of BEN is like a supercharged snowball! We can boost the gains from the underlying performance to match the snowball coupon and still pocket the extra if the performance surpasses the coupon. Plus, with a tenor of just 3 months, cutting down the risk of a market nosedive if we’re feeling bullish about the underlying asset for a short term!”

How to Consider the Underlying Assets for a BEN?

“Exactly!” Mark said, nodding vigorously. “Haha, you’ve been asking some great questions, but now I have one for you. Which underlying do you think would be a perfect fit for this strategy?”

Julie pondered deeply. She felt that the current U.S. elections were causing instability in the international political landscape. The measures taken by the Democrats and Republicans, once elected, would differ significantly, benefiting various industries differently and rendering the outlook for the stock and bond markets uncertain. Additionally, the U.S. stock market was being dragged down by capital outflows and underwhelming tech earnings, making it difficult to adopt a bullish view on these assets.

Then Julie said, “I think gold is suitable. The market is currently shifting towards safe-haven assets like gold to hedge against geopolitical risks. Moreover, the demand for gold is increasing among central banks globally. Combined with the expectation of U.S. interest rate cuts already being priced in, leading to a weaker dollar, all these factors are favorable for gold. Therefore, I believe gold will experience a modest increase in the short term, allowing investors to avoid early auto-call and collect more coupons. If the price rises significantly, investors can also benefit from better returns compared to the coupon.”

Mark's expression brightened with admiration. “Julie, that’s an excellent insight!” he exclaimed, clearly impressed. “Gold indeed appears to be the ideal underlying asset given the current market conditions. Your analysis is right on target. This is precisely the kind of strategic thinking you need.”

As they concluded their discussion, the bar buzzed with an energy not fueled by drinks, but by the exciting blend of creative ideas and insights.