Wells Fargo’s $1.22 million market-linked notes on S&P use Asian options to price protection

By Emma Trincal

New York, Aug. 7 – Wells Fargo priced $1.22 million in equity-linked leveraged notes providing full principal protection through the use of so-called Asian options, a pricing mechanism called averaging.

Wells Fargo Finance LLC’s market-linked securities due Feb. 6, 2025 linked to the S&P 500 index will pay par plus 1.02 times any gain in the average ending level of the index, according to a 424B2 filing with the Securities and Exchange Commission.

The average ending level will be the average of the index closing levels on the 30th day of each January, April, July and October, commencing October 2019 and ending October 2024.

Otherwise, the payout will be par.

In this structure, investors trade the point-to-point observation for a performance based on the average return of the index during the life of the notes.

“It’s a trade-off. Your return may not be as good on the upside. But you get the full principal protection on the downside,” explained a structurer.

Asian options

“These are called Asian deals. They’re cheap compared to point-to-point,” he said.

The term derives from options jargon. So-called Asian options have a payoff that depends on the average price of the underlying. The vast majority of structured notes use European options (observation at maturity) or, far less frequently, American options (observations at specific dates). Asian options are hardly utilized in structured notes although market-linked certificates of deposits employ this technique more often, according to data compiled by Prospect News.

“It’s a very, very old technology,” the structurer said.

In this case the Asian options allowed for the pricing of the full repayment of principal over a five-and-a-half-year period with no cap and some slight leverage, he explained.

“They can do that because the options are cheaper. You can imagine that averaging the returns is going to smooth out volatility. Therefore, you may make less money,” he said.

“If it was point-to-point you could expect the price to jump. Not so with the averaging which is why they can deliver the protection over a relatively short time.”

Leverage, no cap

The 1.02 times leverage seemed very small. But it was designed to partially offset the loss of dividends over the period, he said.

“It’s not going to compensate you entirely for the dividends. But it’s an effort in that direction,” he said.

The S&P 500 index yields 1.88%.

Another interesting aspect of the structure was the uncapped upside.

“That’s why they made it Asian. It’s full principal-protected, shorter term, no cap. Asian options give you a lot of flexibility,” he said.

But one gets what one pays for.

“Anyone long a call wants the underlying to move high and fast enough to hit the strike price. You need the vol. and you pay a premium for that. If you dampen the volatility, the cost of your call options is going to be much less. That’s what averaging can do,” he explained.

The cost of an Asian option is nearly 0.6 times cheaper than a European option, all things being equal, he calculated.

“You don’t get the same benefits. It’s cheaper for a reason,” he said.

Limited use

It would be hard to apply the Asian options tools to other structures however. For instance, using averaging to price structures that use a buffered capped note would make no sense, he explained.

“Asian options work with low volatility. You buy the options. With riskier products, those that short options, you need higher vol. to make it work. So Asian deals are not the solution for everything. They’re better suited for lower-risk products,” he said.

Not a cliquet

Matt Rosenberg, sales trader at Halo Investing, was surprised about one of the notes’ significant advantage over their distant cousins, the so-called “cliquet” CDs.

In a cliquet CD, the averaging works just the same: returns are observed at different points in time. The difference is that an “autocap” is applied on each observation. Unfortunately, explained Rosenberg, while each observation is capped, there is no floor. As such, a big drawdown on just one observed period could eliminate a significant amount or even all of the previously accumulated upside.

“I’m just impressed that there isn’t a cap on each quarter. This is a true average. That’s really good,” he said.

The use of averaging in structured notes is not very common, he said.

“We see it a lot more with CDs.”

He said he liked the deal.

“By putting in Asian options, you get more reference points, and that’s a nice way to mitigate the risk. You can even get 100% principal protection, and that’s very compelling,” he said.

The notes are guaranteed by Wells Fargo & Co.

Wells Fargo Securities, LLC is the agent.

The notes (Cusip: 95001H6T3) settled on Wednesday.

The fee is 2.62%.

© 2015 Prospect News.
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