JPMorgan’s contingent coupon autocallables on Amazon provide short tenor with American barrier

By Emma Trincal

New York, Sept. 6 – JPMorgan Chase Financial Co. LLC’s autocallable contingent interest notes linked to the common stock of Amazon.com, Inc. provide exposure to a single underlier over a short tenor. The notes mature Dec. 10, 2020.

“The notes are likely to have a three-month duration and be called on the first call date,” said Suzi Hampson, head of research at Future Value Consultants.

Each quarter, the notes will pay a contingent coupon if the stock closes at or above the trigger level, 70% of its initial share price, on the review date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission. The contingent interest rate is expected to be at least 8.75% per year.

The notes will be automatically called at par if Amazon stock closes at or above its initial share price on any quarterly review date other than the first and final review dates.

Barrier option

“One way the issuer was able to price this note was through the use of an American barrier at maturity,” she said.

The repayment barrier at maturity is also set at 70% of the initial price. But as the term “American” implies, the barrier can be breached at any time during the life of the notes, in which case investors will be fully exposed to the stock’s decline from its initial share price if the price finishes negative.

“Amazon is not the riskiest stock. It’s a big name, a very popular name,” she said.

The implied volatility of the stock is 26.5%.

“It’s higher than the S&P 500 obviously but certainly not among the most volatile stocks.”

The issuer relied on the contingency of the coupon in order to stretch the yield higher, she said.

She compared the product with a traditional reverse convertible.

“In terms of the call, this product has a lot of similarities with a reverse convertible. It’s a conditional income, but it has a similar payout structure,” she said.

One of the similarities is in the chances of the automatic call occurring sooner rather than later.

“If we look at the probabilities of calling at point one, we see the same distribution. You always find the highest probability in the first call, regardless of the payout,” she said.

“Getting paid after three months is the most likely outcome here.”

Call at point one

Hampson used her firm’s stress-testing methodology to demonstrate this point. She created a report for the product and examined the probabilities of a first call. Later on, in her analysis, she also explored the probabilities of breaching the American barrier.

Each report contains 29 tests or tables. Hampson pointed to one of them, the “product specific table,” to analyze probability distribution for both calls and coupon payments. The table displayed probabilities of outcomes, which vary by structure type. For this product, outcomes include probability of barrier breach, probabilities of call at various dates and probabilities of coupon payments.

In a bullish scenario, the probability of a call at point one is 55.35%, exceeding all other probabilities, which are dispersed between points two, three, four and five. The chance of a first call in a bear market fell to 46.29% but still remained the most probable outcome.

Volatility assumptions

The Monte Carlo simulation also offers two market scenarios: one called “more volatile,” the other called “less volatile.”

For those, the probabilities of a first call were 50.23% and 51.63%, respectively.

“Those two are quite similar, and it makes sense because you don’t need the stock to move a lot in order to kick out. All you need is the stock to remain flat or go up,” she said.

The impact of an increase in volatility on the call outcome is not clear cut, she explained.

“Things are not linear. With high volatility you would expect a higher coupon since the probabilities and the magnitude of capital losses would be higher.”

Coupon payments

As the call at point one represents by far the most likely event in all market scenarios, the probability of getting only one coupon payment was also the highest. Such probability ranged from 56.69% in the bull scenario to 49.56% in the bear one.

Hampson noted a slight mismatch in probabilities between call at point one and payment of one coupon only.

“You would think those probabilities are the same. But they diverge by one to three percentage points,” she said.

“It’s only because in rare instances, the index may drop after three months, so you don’t call at that point but then it goes back up again at a later date. You can also receive your payment without being called if the index stays negative but above the 70% level.”

To breach or not to breach

She then commented on another outcome: the barrier breach, referring only to the principal repayment barrier at maturity. Unlike the calls, the chance of breaching the barrier was found to be very dependent on the market scenario, she noted.

“The autocall is less affected by the market environment because the trigger is higher and also because your first call is only after three months. But for the probabilities of breaching the American barrier, the market definitely has a greater impact,” she said.

Under the bullish scenario, for instance, the barrier will breach 12.22% of the time. The probability in the bearish scenario will be almost twice greater at 24.28%, according to the test.

With the volatility pair, the probability of a barrier breach is 21.29% in the more volatile environment but only 12.32% in the less volatile one.

“As much as volatility has a limited impact on calling or not calling, you can tell its influence is significant with the barrier. Volatility comes to play when it comes to a 30% drop. If the stock loses that much, it will affect the chances of breaching.”

Back testing

Hampson looked at the back-tested results for the same tests. Back testing shows the same outcomes but over the last five, 10 and 15 years.

Over the past five and 10 years, the frequency associated with a call at point one was 73.57% and 71.09%, respectively. This figure dropped to 64.73% over the last 15 years.

Separately, the table showed no instance of barrier breach over the two shorter periods (five and 10 years). The frequency over the past 15 years at 6.8% was higher but still small.

“Over the 15-year period, the stock did not perform as well,” she said.

“There is a difference when you look at timeframes that include the financial crisis of 2008. This is what explains the divergence between the 15-year period on the one hand and the five- or 10-year on the other hand. It’s worse when you go back further in time.”

Two types of barriers

Hampson in a second part of her review sought to compare the probabilities of barrier breach between two different barrier types.

She ran a second version of the report with a hypothetical European barrier, everything else being the same.

“Obviously, the second report is a hypothetical simulation. In the real world, your coupon would be lower and the terms would not be the same,” she said.

A European barrier is measured point to point, which reduces the risk of a breach significantly, she explained.

“The product may not be as attractive with a European barrier. I don’t know. You may only have a 5% coupon instead of 8.75%. ... This is just a random example,” she said.

Each barrier type has an opposite impact on the probabilities of losing money but also on the magnitude of the losses, she said.

Chances of losing

She demonstrated it by comparing the two reports using the same product-specific tests.

The hypothetical report (European barrier) showed in the bull scenario a 6.09% probability of barrier breach versus the previously mentioned 12.22% probability associated with the existing product. In the bear market, investors have a 15.37% chance of a breach with the European barrier instead of the previously displayed 24.28% probability found with the American barrier.

“It makes sense. You’re more likely to breach with the American barrier than with the European. You have more data points [and] therefore more risk,” she said.

What is probably more interesting is to compare the magnitude of the losses between the two barriers, she added.

Loss size

This comparison can be done using another table called “capital performance tests,” which displays the probabilities associated with the loss outcome named “return less than capital.” The same table displays both the probabilities and the average payoff, which gives an idea of the average loss.

While investors are more likely to lose money with the current product, their average loss will be lower, she said.

In the bull market, the average loss will be 25.6% with the American barrier versus 36.3% with the hypothetical note structured around the more conservative European barrier, the table showed.

Similarly, the bear market showed a loss of 30.8% with the American barrier against 39.97% with the hypothetical European barrier.

Time to recover

“It may seem counterintuitive to lose more money when there is less risk to breach, but it makes sense when you think about it,” she said.

She provided the following explanation.

“With the European barrier, you breach only once, at maturity. As a result, you know that you’re going to lose at least 30% if you lose,” she said.

“With the American barrier, you may breach at some point during the life, but the index can recover. It could finish positive, in which case you don’t even lose any money at all. Or it could rebound and stay negative but above the barrier level. So, it’s more likely that you would lose less money,” she said.

“This note gives you a barrier that’s more likely to be breached. But the magnitude of your average loss is going to be lower.”

Not high on risk spectrum

In conclusion, the product may be less risky than it seemed at first glance.

“You’re getting 8.75% as a contingent coupon, well above the risk-free rate. You don’t get this type of return for nothing,” she said.

“Most of the risk has to do with the chances of breaching the barrier. But you may lose less.

“This is also a note tied to a single underlying. You don’t have the exposure to the worst of two stocks.

“The call itself helps mitigate the risk. Half of the time, you’ll kick out after three months, and that’s the end of that.

“Among a variety of autocallables notes, this one is probably not the riskiest.”

The notes will be guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will settle on Sept. 11.

The Cusip number is 48132FEJ1.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.