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A good structure for times of market turmoil

Julius Baer has recently added bonus enhanced notes to the Derivatives Toolbox in Asia. For intermediaries managing several portfolios with a moderately bullish view, it’s a good alternative to buying stocks outright.

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In the first few months of 2022, equity markets have plunged into another period of uncertainty. There has been a wild sell-off in the past few weeks as Covid-19 cases rise in China, inflation spikes in many markets and geopolitical tension escalates to heights not seen in a generation.

Chinese stocks, especially, are taking a beating. To give the benefit of a medium-term perspective, after the last few weeks domestic Chinese stocks (Shanghai Shenzhen Index) have given up all their pandemic era gains – measured since the beginning of 2020 – while Hong Kong shares (Hang Seng Index) are down over a third. US equities have also corrected in 2022, although their dramatic rally in 2020 and 2021 means they remain up over 20% (S&P 500 Index) for the pandemic era.

So what’s a good way for investors anticipating a recovery to position themselves? The bonus enhanced note, which has just been made available through Julius Baer’s Derivatives Toolbox in Asia, is a popular way to bet on a recovery in equity markets, also proving profitable if markets end up moving sideways.

As its name suggests, the bonus enhanced note pays out a bonus in moderately rising and sideways markets, provided the price does not fall below a pre-determined strike price. There’s flexibility to add a knock-in barrier (European or American) that will offer some downside protection if the knock-in price is not breached. Notably, the underlying can be either a single equity or a basket of equities.

How bonus enhanced notes react to rising, sideways and falling markets

If an equity were to recover from today’s levels, the investor would get back the full initial investment or principal, plus the pre-agreed bonus coupon when the note matures. Once the price of the underlying rises above the level of the principal plus bonus, then the investor enjoys the full upside of the equity rally.

In sideway markets, the bonus enhanced note pays the full principal plus the bonus coupon at maturity, provided the underlying equity is above, or at, the strike price.

But if the underlying equity price should fall, ending below the strike price, the investor takes delivery of the underlying at the strike price (the number of shares received is calculated by dividing the original investment by the strike price). If an American knock-in feature is added, the investor receives the full principal back as long as the knock-in barrier has not been breached, but there is no bonus coupon.

Investing USD 100,000

Take the example of a USD 100,000 investment in a bonus enhanced note. Let’s say the underlying stock’s initial price was USD 100, which is also the strike price, with a 30% bonus coupon and the note has a 70% American knock-in barrier.

If the underlying equity rises, closing at or above the initial price of USD 100 but below USD 130 when the note matures, the investor receives the 30% bonus coupon plus the initial investment back. That’s regardless of whether the USD 70 knock-in threshold was broken at some point during the investment period. If the underlying equity price ends above USD 130, the investor receives all the upside. If it reached USD 150, for instance, the investor would receive a total of USD 150,000.

If the equity price ends below USD 100 but has never breached the USD 70 knock-in threshold during the tenor, the investor receives just the initial USD 100,000 investment back. No bonus coupon is received.

Finally, if the equity falls sharply, breaching the USD 70 knock-in threshold during the life of the investment – and the final price is lower than the initial price of USD 100 (let’s say USD 50) – the investor would get a predetermined amount of stock. This would be calculated as USD 100,000 ÷ USD 100 = 1,000 shares.

Of course, what happens to equity prices from here depends on a complex range of factors – not least a hawkish Fed, geopolitics and the path of global inflation. But for those who believe things will improve, the bonus enhanced note offers a good way to express their view.

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