July 7, 2008

JP Morgan Asia Confidence note

I was reading the papers, and this advertisment caught my eyes. It is called "JP Morgan Asia Confidence note". So I called up to check it out.

This structure is as follow :

1)Tenure of 2.5years

2)7.5%p.a coupon fixed – payable quarterly.

3)Based on Singapore, Malaysia, Thailand and Taiwan Indices movement.
Buffer level for Principal to be affected @ 50% - i.e. index must fall by 50% for
Principal to be affected.

4)Early callable every quarter.

On the face of it, this structured notes looks good, so I asked more questions on the product. This is what I understand from the marketing officer :

The product pay 7.5% p.a. coupon fixed on a quaterly basis, but is callable every quarter. What does this mean? This mean that if at every quarter, if the 4 indices are above the initial price, the bank has the right to "call" the product, i.e., the product will no longer exist as the bank will pay you the principal to redeem the product.

If throughout the 2.5 years, any one of the indicies fell 50% from the initial price, the trigger comes in. You do not know your loss at this point in time, because you need to wait till the end of the 2.5 years to see where does the worst index ends. If the worst index ends above the initial price, than no loss is incured. If the worst index ends below the initial price, the loss will be the difference between the initial price and the price at the end of 2.5 years.

It sounds complicated in words, so a decision tree illustration may be helpful :

Assuming that the initial price for all 4 indicies are 100, and the initial investment is $100,000. Than

Step 1: Did an early redemption event occur? i.e. ALL indices close above Initial Price

*If YES, Note is early redeemed, Noteholder receives 100% principal

*If NO, proceed to next step

Step 2: Did a Trigger Event occur?i.e. Is conditional principal protection still valid? Did any Index close below 50% of their respective Initial Price?

*Note: There is NO need to proceed to step 3 if Step 2 does not occur.

Step 3: At maturity (Final Valuation Date), did Straggler (least performing index) close above its Initial Priceof 100?

*If YES, Noteholder receives 100% principal, i.e. $100,000.

*If NO, Noteholder receives (Straggler Final Price / Straggler Initial Price) x Principal.

Assuming that the final price of the worst index is say at price 60, than you receive $60,000 plus whatever coupon you received before the expiry date.

Is this a good product? Well, it really depends on your view of the market. Let me explain.

Because of the nature of this product is structured, the investor have limited upside but unlimited downside in theory. If the 4 market (Singapore, Malaysia, Thailand, Taiwan) close above the inital price of say 100 (this is just a price I use for illustration) immediately in the first quarter, investor only received the 7.5% p.a., i.e., $1,875 for 1 payment, and the bank than redeem the note.

Therefore, the only way for the investor to receive the full number of cipon payment if for the 4 market indices to trade below the initial price for the next 2.5 years. However, you do not want the market to trade too low to have the triggered event kicks in, if that is the case, you have a possibility of losing your capital. Remember that the triggered event is if any of the 4 indicies close below 50% of the initial price. If this is to happen, what is the chance of it rebound above the inital price before the 2.5 years is up? Say the Thailand market fell 50% after 1 year, thus the triggered event kicks in, and you must than hope that the Thailand market can rebound 100% in the next 1.5 years so that you will not loss money, quite an unlikely event.

Furthemore, the way it is structured, it is a "diversification in reverse". If you put money into the 4 market, you hope to diversify, in case any one market tank badly, you will not be affected that badly. However, in this structure, any one market tank will drag your whole porfolio down since it is basked on any one market that fell 50%. Therefore, if say Thailand market is affected by its political situation and tanked 50%, even if other market make 100%, 200% or 300%, it does not matter, you will not make a single dime because of the Thailand market.

In my view, this product is good if you think that the market will at least go lower and remain low for awhile, but not too low to let the triggered event kicks in. market may consolidate for a while, but it is unlikely that it will remain within a range for 2.5 years.

So do not expect to get 7.5% p.a. for the full 2.5 years, chances are that if market recovers, this structured notes will get redeemed sooner rather than later.

As an aside, this product looks like the investor is selling a call optionon the 4 market at the initial price of 100, and at the same time, also sell a put of the 4 market at the initial price of 100, but with a knock-in at 50% below the intial price, i.e., at 50.