Goldman Sachs’ digital notes tied to Stoxx Europe 600 offer alternative to equity fund

By Emma Trincal

New York, June 9 – GS Finance Corp.’s 0% digital notes due June 30, 2020 linked to the Stoxx Europe 600 index enable investors to outperform the index in a mildly bullish or even flat market, providing an alternative to a direct investment in the index, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index finishes at or above its initial level, the payout at maturity will be par plus a digital payout of 50%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will be exposed to any losses.

“The underlying used in the notes is not as popular as the Euro Stoxx 50 but it’s much more diversified,” said Hampson.

With a fixed number of 600 components, the Stoxx Europe 600 index represents large, mid and small capitalization companies across 17 European countries.

Simple deal

“It’s a pretty straightforward payoff in terms of figuring out what your return at maturity is going to be,” she added.

“For any suitable investors it’s quite easy to understand the one-to-one on the downside, just like an ETF. Unlike an ETF, your return on the upside is a fixed payment rather than growth participation.

“Anybody who is familiar with structured products would recognize this very common digital structure.”

Investors in the notes are motivated by the target return, she noted.

“We see more and more advisers interested in that type of fixed payout. If you expect only moderate growth in the market, the digital offers some form of return enhancement, which in some conditions can outperform the index,” she said.

Volatility input

Future Value Consultants produces structured product stress tests.

Pricing data for the analysis of the underlying includes risk free rate, implied divided yield and at-the-money implied volatility, according to the firm’s methodology disclosure.

“Unlike a leveraged return product, our analysis for this kind of product relies much less on volatility,” she said.

“The price of the option doesn’t change as much because you either get the digital or you don’t. Whether the index is flat, up 2% or 100%, your payout will stay the same.

“You only have two outcomes: digital payment or capital loss.”

Specific tests

A table among the 29 displayed in each of the firm’s reports, displays the probabilities for those two outcomes.

This table named “product specific tests,” usually varies based on the product type. Autocallable notes for instance would include additional tests such as probabilities of call at various dates, probabilities of barrier breach, probability of reaching any cap etc.

But the digital structure presents only two outcomes: loss or fixed return.

Investors in the notes, under the base-line scenario (neutral growth) have a 36.25% chance of getting paid and a 63.75% probability of losing some of their principal, according to this table.

Backtested

Another table shows the same outcomes but backtested over the past five years. It also includes four additional scenarios aside from the neutral, which are bullish, bearish, low volatility and high volatility.

Not surprisingly the chances of getting the digital return increase significantly under the bullish assumption to 58.76%. The probabilities drop to 18.21% under the bearish scenario. The two volatility results do not differ much from the neutral scenario at 38% for the more volatile and 32% for the less volatile.

“Even though you’re not participating in the index, the best performing test is still the bullish one because if the index increases you get your digital payment, which is the only positive outcome you have,” she said.

Pricing

The reason why the difference between the probability of payment under the neutral scenario (36.25%) and the bullish scenario (58.76%) is so great is a function of the digital option itself, she said.

“It doesn’t matter whether the underlying moves up a lot. But whether it’s up or down from the initial level is very important,” she said.

“The reason why volatility has little impact on the pricing is because gradual results are not relevant. You get paid the same. In fact you get paid the same even if it doesn’t move.”

The digital option for the Stoxx Europe 600 index is cheaper, she noted.

Because interest rates in Europe are low and the dividend paid on the underlying index, high, the forward is cheaper, which reduces the cost of the option.

Fund alternative

“This note has no downside protection. Compared to an ETF you have the same risk exposure. But on the upside, the digital allows you to outperform the fund in a low growth environment,” she said.

“This is very easy to put together in a structured note. It might be more difficult to find elsewhere.

“It’s a risky product compared to other structured products, but compared to an ETF, your risk is the same and you can get this chunky return.

“For investors who understand the risk and seek a target return, this product makes sense.”

Goldman Sachs & Co. is the underwriter.

The notes will be guaranteed by Goldman Sachs Group, Inc.

The notes will price on June 23 and settle on June 30.

The Cusip number is 40054LDN1.

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