Principal Protected Notes (PPNs):
- Appeals to the conservative investors.
- The return earned by the investor depends on the performance of a stock, a stock index, or other risky assets, but the initial principal amount invested is not at risk.
Example:
- Suppose that the 3-year interest rate is 6% with continuous compounding. This means that 1,000e-006×3 = $835.27 will grow to $1,000 in 3 years.
- The difference between $1,000 and $835.27 is $164.73. Suppose that a stock portfolio is worth $1,000 and provides a dividend yield of 1.5% per annum. Suppose further that a 3-year at-the-money European call option on the stock portfolio can be purchased for less than $164.73.
- A bank can offer clients a $1,000 investment opportunity consisting of:
- A 3-year zero-coupon bond with a principal of $1,000
- A 3-year at-the-money European call option on the stock portfolio
- If the value of the portfolio increases the investor gets whatever $1,000 invested in the portfolio would have grown to. (This is because the zero-coupon bond pays off $1,000 and this equals the strike price of the option.) If the value of the portfolio goes down, the option has no value, but the payoff from the zero-coupon bond ensures that the investor receives the original $1,000 principal invested.
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Principal Protected Notes from the Investor Perspective:
- In some situations, an investor will be better off if he or she buys the underlying option in the usual way and invests the remaining principal in a risk-free investment. However, this is not always the case.
- The investor is likely to face wider bid-offer spreads on the option than the bank.
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The economic viability of the structure- Bank
- Depends critically on the level of interest rates and the volatility of the portfolio.
- If the interest rate is 3% instead of 6%, the bank has only 1,000 – 1000e-003×3 = $86.07 with which to buy the call option.
- If interest rates are 6%, but the volatility is 25% instead of 15%, the price of the option would be about $221.
- In either of these circumstances, the product described in Example cannot be profitably created by the bank.
Related: What are Eurobonds?
