Morgan Stanley’s dual directional trigger PLUS on Developed Markets can hurt on the way down

By Emma Trincal

New York, June 30 – Morgan Stanley Finance LLC plans to price 0% dual directional trigger Performance Leveraged Upside Securities due July 6, 2020 linked to the Vanguard FTSE Developed Markets exchange-traded fund, according to an FWP filing with the Securities and Exchange Commission.

The notes will be guaranteed by Morgan Stanley.

If the final share price is greater than the initial share price, the payout at maturity will be par of $10 plus 200% of the ETF return, subject to a maximum return of 22%.

If the final share price is less than or equal to the initial share price but greater than or equal to the trigger share price, the payout will be par plus the absolute value of the ETF return. The trigger share price will be 80% of the initial share price.

If the final share price is less than the trigger share price, investors will be fully exposed to the ETF’s decline from the initial share price.

Easy

“These notes are for someone who thinks there will be either a slight market decline or a slight to moderate market growth,” said Tim Mortimer, managing director at Future Value Consultants.

Marketed alternatively as “dual directional” or “absolute return,” those types of notes are expected to appeal to investors who have little conviction about the direction of the market.

“Yet investors should keep in mind that they have better chances at getting a positive return on the upside than on the downside,” he said.

Better be up

In terms of range, the upside cap of 22% offers more return than the 20% range of absolute return above the barrier.

With the two times leverage, he added, the fund does not have to grow much over three years.

“You stand to benefit from the first 11% of growth because of the double gearing,” he said.

But it is the risk-adjusted return that should make investors cautious.

“The upside is safer because if you hit the cap you stay there while on the downside, if the market falls below the 80% level you’re going straight off the cliff.”

Not for bear, choppy markets

This should put off bearish investors.

“If you think the market will be down even 10%, it’s best not to use those notes,” he said.

While the absolute return barrier is more attractive than a regular barrier as it provides a positive return rather than just investors’ return of principal, making directional bets is probably not the best way to use those notes, he said.

“The idea is to bet on a slowly moving market. A low volatile underlying could give you good results except if it goes nowhere. You’re buying volatility. One bad outcome would be if the index ends where it started. It would be the worst result apart from coming below 20%,” he said.

“If the index moves in either direction you stand to gain. You’re betting on volatility not direction.”

Stress-testing

Future Value Consultants provides stress-test reports on structured products. Those calculate a number of probabilities of outcomes which vary depending on the structure of the product and the market environment used in the model.

In most sections, Future Value Consultants runs its Monte Carlo simulation based on a neutral assumption. The neutral or base-case assumption for any underlying asset is a function of the growth rate calculated off the risk-free rate minus the dividend yield.

The model may also use four other market assumptions, which are: bullish, bearish, low volatility, high volatility.

Finally other sections of the report provide backtesting results displayed for the past five, 10 or 15 years.

Capital performance

Mortimer analyzed one section of the stress test report on this note called capital performance tests.

The table shows the probability of each of three outcomes: return more than capital, return exactly capital, return less than capital.

The probability of getting more than capital includes both the upside and downside scenario: positive returns up to the cap added to the absolute return gains at or above the barrier level.

The system does not distinguish between the two directions. Intuitively however it is easy to imagine that the upside will yield greater probabilities in a neutral market due to the leverage and slightly higher maximum return.

This can be confirmed by the fact that a bullish assumption will raise the probability of getting more than capital to 91% versus 79% in the neutral scenario, the report shows.

Payoffs

The table also displays average payoffs. In the neutral scenario, the average loss is 38%, which by far exceeds the average amount of gains of 15.5%.

After the bull, the second best market scenario for making money either way is the less volatile market with an 85% probability. In contrast a more volatile market reduces those probabilities to 74%.

“That’s because you’re less likely to breach the barrier,” Mortimer said, explaining the advantage of the less volatile market.

At the same time, the 16.3% average return is greater in the more volatile test than it is in the less volatile environment, where it stands at 14.2%.

“Although you buy volatility if the index goes sideways you wouldn’t make anything,” he said.

“This product is a little bit odd.

“A little bit of movement will help you. Too much of it will hurt you.”

Morgan Stanley & Co. LLC is the agent.

The notes are expected to settle on Thursday.

The Cusip number is 61766X236.

© 2015 Prospect News.
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