Credit Suisse’s digital barrier notes on iShares EM, Stoxx enhance chances of positive return

By Emma Trincal

New York, Sept. 20 – Credit Suisse AG, London Branch’s 0% digital barrier notes due March 29, 2021 linked to the lesser performing of the iShares MSCI Emerging Markets exchange-traded fund and the Euro Stoxx 50 index increase the odds of getting a positive return due to the position of the digital trigger, or knock-in, below the initial price, said Suzi Hampson, head of research at Future Value Consultants.

If the final level of each underlying asset is greater than or equal to its knock-in level, 75% of the initial price, the payout at maturity will be par plus 13.25%, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of either underlying asset is less than its knock-in level, investors will lose 1% for every 1% that the lesser-performing underlying asset declines from its initial level.

Not growth-dependent

“These digital notes offer a potential for return if the underlying is down up to the barrier level. If it doesn’t drop more than 25%, you still make 13.25%,” she said.

Other structures called absolute return or dual directional also let investors make money if the underlying is down within the range existing between the barrier level and the initial price. But digital payouts reflect very distinct market views, she explained.

“The difference with an absolute return note is that it’s not participation-based,” she said.

“Whether the worst-performing underlying in this note drops 1% or 20%, you still make the same 13.25% digital amount.”

With absolute return notes, on the other hand, the greater the index decline (as long as the barrier is not breached) the higher the positive return. The maximum return is obtained at the barrier level.

“With the absolute return, growth is required in order to make the best return,” she said.

“Investors in an absolute return if they want to make money on the downside need to be as close as possible to the barrier, which is the riskiest place to be. With the digital, it’s not necessary to be near or far from the barrier to get the best outcome. You just don’t need the index to move, so this type of payout will work best in a flat market environment or when volatility goes down.”

Flattish

Both products may appear tempting to bearish investors. But it’s probably better to have a non-directional or muted view on the market if one wants to benefits fully from the downside benefits of either this note or an absolute return payout, she said.

“These are not bearish structures. You’re not betting that the index will go down because you don’t want it to go down too far. Past the barrier, your losses will be significant,” she said.

Also, unlike an absolute return note, this digital note does not require investors to be bullish at all.

“This product is more similar to an autocall because it’s less sensitive to growth. It’s very different from the absolute return where you need the index to go up or down within a range,” she said.

Defensive play

Despite having the exposure to the worst of, the notes offer a structure with several risk-mitigation elements.

“It’s a relatively defensive product,” she said.

“The 75% barrier is quite deep. Anywhere above it you will earn 13.25%.”

Having the exposure tied to the worst-performing asset is the condition required to be able to benefit from this relatively conservative structure, she said.

“In exchange for that you are subject to this worst-of kind of situation,” she said.

But some factors have been included to reduce the dispersion risk introduced by the two underlying.

“Both assets are quite correlated,” she said, pointing to a coefficient of correlation of 0.84, with 1 being perfect.

“In addition, the volatility of those two underlying [assets] is not outrageous.”

The implied volatility is 15.4% for the Euro Stoxx 50 and 17.9% for the iShares MSCI Emerging Markets ETF. In comparison, the CBOE Volatility index, which measures the implied volatility of S&P 500 index options, is at around 15%.

“To get this kind of barrier you can either introduce a worst of or use a single asset but one that’s much more volatile. They chose the first option,” she said.

Stress testing

Hampson examined the probabilities of return outcomes, running a report on the notes using Future Value Consultants’ stress-testing model. Each report contains a total of 29 sections or tests that encompass simulation tables as well as back testing analysis.

The Monte Carlo simulation uses market and implied data to run the tests, including risk-free rate, issuer credit spread, deposit rate, dividend yield and volatility as well as correlation matrix.

The model also runs four market assumptions based on different index growth rates and volatilities. Those are bullish, bearish, less volatile and more volatile.

Another scenario, the neutral scenario, is found in every test. Risk neutral, it is consistent with market pricing. As such it is not used to forecast the market since it relies on growth assumptions that are close to the risk-free rate.

Capital performance tests

Hampson looked at one of the tables called capital performance tests. It shows the probability of each of three outcomes: return more than capital, return exactly capital and return more than capital.

“This is a pretty simple structure. You either get the digital or you don’t, in which case you lose money.

“In terms of buckets, there are only two events we care about: return more than capital, which is the digital payout outcome, and return less than capital, or the loss scenario, when the barrier is breached.

“The probability associated with the third bucket, return exactly capital, is 0%.”

High chances to win

Because growth in this structure is not required to score a positive return, probabilities will be less market-sensitive than in other trades such as leveraged products, she said.

Probabilities of outcomes still vary across market environments. In the bear scenario, for instance, the digital will get paid 71.07% of the time. The probability rises to 89.66% in the bullish scenario and to 81.21% in the neutral scenario.

“The additional growth you get from the bull market will reduce the chances of hitting the barrier. This is why the probabilities of getting your positive return are higher,” she said.

“Despite the risky aspect of the worst of, what’s striking with this note is the high probability of getting paid,” she said.

Average payoff

With that comes smaller chances of losing money.

Investors will lose capital only 18.79% of the time in the neutral scenario and 10.34% of the time in the bull scenario, according to the table.

“But here’s the other side of the coin: if investors are less likely to lose capital, when they do lose, they lose substantial amounts of it,” she said.

The main explanation is the barrier type: since the barrier is European, it will trigger, if breached, a loss of at least 25%, she explained.

A European barrier is observed at maturity. In contrast, an American barrier is monitored during the life of the security. With an American barrier, the underlying could breach the barrier during the term yet finish positive, which would not generate a loss. Investors can’t expect not to lose money when a European barrier is breached since the observation is at maturity.

A separate table in the capital performance tests provides the average payoff across the various market scenarios.

On the positive return side, the average payoff will always be 13.25% regardless of the market environment since the digital is a fixed return.

Big, big losses

On the downside, loss amounts vary. The bull market showed the smallest average loss at 36.3%.

“Even in this optimal scenario, your average loss is pretty steep,” she said.

The neutral scenario itself, which is only indicative of options pricing, showed an average loss of 39.6%.

Under the bear assumption, losses will average 42.8% of principal.

“The effect of breaching the barrier is significant on your portfolio,” she said.

“It’s always the case when you have a European barrier. You’ll lose at least the barrier amount when the barrier is breached,” she said.

Back testing

Another table, the back-tested capital performance tests, displayed the results of a back-tested analysis over the last five years under the neutral scenario. Given the strong bull market during this recent period, the frequency observed for getting the digital payout is 95.21%. Losses occurred only 4.79% of the time.

In conclusion and despite the possibility of incurring severe losses, the structure would still be a relatively good fit for cautious investors.

“It’s a defensive structure. Each underlying, individually, doesn’t have a high volatility. Their correlation looks quite high. You have a European barrier of a reasonable size,” she said.

“All this gives you quite a good chance of getting your digital return. You could outperform in a flat or negative market.

“If you’re really bullish, however, you might be better off going with a growth product.”

Credit Suisse Securities (USA) LLC is the agent.

The notes will settle on Sept. 27.

The Cusip number is 22552FVF6.

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