HSBC's accelerated notes on iShares MSCI EM fund may attract moderately bullish investors

By Emma Trincal

New York, March 5 - HSBC USA Inc.'s planned notes linked to the iShares MSCI Emerging Markets index fund should appeal to modestly bullish investors hoping to benefit from the three-times leverage, said structured products analyst Suzi Hampson at Future Value Consultants.

HSBC plans to price 0% Accelerated Market Participation Securities due June 29, 2011 based on the iShares MSCI Emerging Markets index fund, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus triple any fund gain, up to a maximum return of 23.5% to 28.5%. The exact cap will be set at pricing.

Investors will be exposed to any losses.

Modestly bullish

Looking at the relationship between leverage and maximum return, Hampson said, "Three-times leverage is high. If we assume the cap is set at 24%, this would mean that 8% index [fund] growth would be enough to secure the maximum return.

"Therefore I would say that this investment is aimed at investors expecting small to moderate gains in this index [fund]. The returns are obviously capped, so any investor looking to participate in growth above 24% in the index [fund] would probably prefer a lower geared but higher capped product."

Volatility and return

The annualized underlying volatility of the iShares MSCI Emerging Markets index fund is 41.88%, according to Future Value Consultants' report.

"This is an emerging market fund. That type of underlying is quite volatile compared to the S&P 500 or other equity benchmarks," said Hampson.

"The more volatile the underlying, the more attractive the potential return and the higher the cap should be. Here, the underlying volatility suggests that the fund is likely to move a lot, hence the possible high returns. So a seriously bullish investor would not want to be capped or would want a higher cap," Hampson said.

The product has an average return rating of 5.26, noted Hampson. This is at the mid-point between zero and 10, which is the scale Future Value Consultants uses to produce this rating measuring the risk-adjusted return of a note.

Volatility, which gives the product its high return potential, is also what makes it riskier, said Hampson.

The lack of a buffer or barrier on the downside is a major contributor to the higher risk, she noted.

No barrier

"The return rating would be much higher if the capital was not completely at risk," said Hampson.

"There is no downside protection whatsoever on the product, and the higher the volatility the higher the chance of losing more capital," she added.

As a result, riskmap - Future Value Consultants' measure of risk on a scale of zero to 10 - is 7.21 for these notes.

"A 7.21 riskmap is among the riskiest scores that we see. This rating looks at the probabilities of losing large amounts of capital. You have no barrier and you have a volatility that is reasonably high - two reasons for the high riskmap," said Hampson.

While it is unusual for leveraged notes not to offer any barrier, Hampson said that it is becoming more common.

"We have seen a few of those recently," she said.

Return probabilities

One way to illustrate the high risk-return profile of the product is to look at the return probability tables, Hampson said.

Future Value Consultants calculates the probability tables using a Monte Carlo simulation, modeling the performance based on a series of parameters that include volatility, dividends and interest rates among others.

For these notes, the probability of losing more than 5% of principal was 36.2%, according to the tables.

On the upside, there is for this product a 53.2% chance of earning a return of more than 15%.

"You have a high probability of losing a considerable amount of money. At the same time, the odds of making very substantial gains are quite great. This is why your return score is only average and your riskmap is so high," said Hampson.

Hampson said that the notes would appeal to "someone who would invest in the fund directly."

"They understand the downside risk, and they like the three-time leverage factor on the upside. If the fund goes down, they have the same exposure to losses whether they invest directly in the fund or in the notes," she said.

Good overall

The product has an overall rating of 7.36.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile.

The rating is created from an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

At 8.50, the simplicity rating of the structure - which measures on a scale of zero to 10 how easy it is to understand or explain a product - partly contributes to the satisfying overall rating, said Hampson.

But the main driver for the high overall rating, Hampson said, is the 8.90 value rating.

More for the money

Value rating on a scale of zero to 10 measures how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

Hampson said that her firm calculates value scores by estimating the price of the product using the implied volatility and taking into account duration.

Future Value Consultants at the present time does not publish implied volatility figures. But Hampson said that for this transaction, the implied volatility is "significantly lower" than the historical volatility, adding that it ranges between 31% and 32% on an annualized basis.

The higher the value score, the lower the amount deducted by the issuer for margins and commissions, she said.

The notes will price on March 24 and settle on March 29.

HSBC Securities (USA) Inc. is the agent.

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