JPMorgan’s enhanced notes on Taiwan Stock Exchange index use rare underlier, offer hedge

By Emma Trincal

New York, March 23 – JPMorgan Chase Financial Co. LLC’s 0% return enhanced notes due Sept. 25, 2019 linked to the Taiwan Stock Exchange Capitalization Weighted Stock index represent the first-time use of this index as a stand-alone underlying, according to data compiled by Prospect News.

The notes provide the opportunity to enhance equity returns by multiplying a positive index return by 4.22, according to a 424B2 filing with the Securities and Exchange Commission.

The upside return is not capped. There is a one-to-one exposure to the index price decline.

The Taiwan Stock Exchange Capitalization Weighted Stock index is a capitalization-weighted price return index of all common shares listed on the Taiwan Stock Exchange.

The index is highly concentrated on certain names and sectors. For instance, Taiwan Semiconductor Manufacturing Co. Ltd has a 20% weighting.

The weight of this company is not limited to this index. In the MSCI Taiwan index, Taiwan Semiconductor Manufacturing also makes up a significant portion of the index with a 32.5% weight.

New underlier

This deal offers for the first time direct and unique exposure to the Taiwanese equity market, according to data compiled by Prospect News since 2004, when equity indexes were incorporated in the database. Prospect News lists all deals registered with the Securities and Exchange Commission.

It is also the first time the Taiwan Stock Exchange Capitalization Weighted Stock index is used as a stand-alone underlying. The index was only employed once before, at the end of 2015 by JPMorgan Chase & Co. in a $1.5 million deal. But the index was one of the components of a basket of international equity benchmark accounting for a 10% weighting.

A significant number of deals have been linked to a different Taiwan index – the MSCI Taiwan Stock index. But in those cases, as well, the MSCI Taiwan index was part of an underlying basket, not a single reference asset, according to the data.

Market neutral strategy

A contrarian trader said the notes, if properly hedged, could present an interesting market neutral trade opportunity.

This is because the notes combine high leverage and the absence of any cap. In addition, the asymmetrical exposure between the downside (one-to-one) and the upside (four-to-one) increases the odds of a positive outcome.

“What I would do is purchase the notes and sell the Taiwan fund to hedge it,” said Steven Jon Kaplan, founder and portfolio manager at TrueContrarian Investments.

He was referring to the iShares MSCI Taiwan index exchange-traded fund, listed on the NYSE Arca under the symbol “EWT.”

If the notes’ underlying index (known as the TAIEX) dropped in price, the correlation between the index and the fund would offer an ideal hedging tool for the long exposure.

The short leg of the trade is not free, he noted: selling short requires paying out the dividends.

The ETF dividend yield is 2.9%. Over 18-months the short position would cost approximately 4.5%.

“You could have an interesting market neutral strategy shorting twice as much as your long position,” he said.

“It’s neutral in the sense that you really don’t care what the market does as long as it does something.”

In other words: the benefits of the investment idea are limited in a sideways market, he explained.

Long/short trade

He offered an example of this trade.

An investor would buy the notes for $10,000.

Simultaneously, he would short the very liquid iShares MSCI Taiwan index for $20,000.

Kaplan hypothetically used a bearish then a bullish scenario as hypothetical examples. In both cases the price was assumed to move by 40% at the end of the 18-month term.

In the down market, the 40% decline creates a $4,000 loss on the long position.

On the short side, the cost of shorting would be 4.5% the size of the short position or $900.

However the short side would “win” as the 40% price decline would translate into an $8,000 gain.

Overall the investor would lose the cost of dividends and the loss on the long position, which in total would be $4,900. But the negative part of the equation would be more than offset by the $8,000 positive return, leaving the investor with a net gain of $3,100.

In the bullish scenario, the investor would gain 40% of the $10,000 position size, which, after applying the 4.22 leverage factor would yield a total profit of $16,880.

On the short side, the $900 cost induced by dividend payments would remain the same. But this time, the 40% index price increase would hit the position with a loss (not a gain) of $8,000. In total, the short leg would post a $8,900 loss.

However, the highly profitable leveraged return on the upside would by far more than offset the loss, leaving the investor with a net positive return of $7,980.

It has to move

“You could lose a little if the market goes sideways since you have to finance your short. But if it moves either way with the asymmetric leverage and especially the no cap (the key is no cap) ...either way you win,” he said.

“It would be worth doing it just for that.

“You can trade with a limited potential loss. And this is the kind of trade that would be hard to replicate with options.”

The big picture

Does that mean Kaplan would buy the notes and use them in the strategy he described? Not necessarily, he said.

“I see minor problems with this trade plus a bigger one.

“The minor issues are the cost of the dividends – you don’t earn the dividends on the long side but more importantly, you have to pay them on the short side.

“Also your money is tied up for a year-and-a-half by holding both positions.

“But these are minor things.

“The big thing is timing. While emerging markets are not as overvalued as the U.S., Taiwan has its own characteristics and is much more volatile than the U.S.

“The ETF is close to its all-time high; so, you definitely run the risk of a major drawdown.

“It’s a trade with a good potential. Too bad the timing is not so favorable.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will settle on March 28.

The Cusip number is 48129MEW2.

© 2015 Prospect News.
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