Complex new investments ask a lot, but may offer little

PUBLISHED : Friday, 15 July, 2005, 12:00am
UPDATED : Friday, 15 July, 2005, 12:00am

The financial products on offer to the public are getting more and more complex, and for ordinary investors, analysing the potential risks and rewards is increasingly challenging.

Consider a new round of structured notes launched this week by HSBC. Called the 'Basket Equity Linked 10', they are being sold to investors on the basis that they pay an enhanced rate of interest.

Buyers of two previous rounds of similar instruments have no reason to complain. The original tranche was redeemed last month after just nine months, returning investors a payout of 20 per cent on top of their original investment.

That equates to an annual yield of 26.67 per cent, which in an era of low interest rates is hardly to be sniffed at.

The new round of notes carry a slightly lower maximum possible return of 19 per cent, again potentially payable after just nine months.

Naturally, to stand the chance of earning such a handsome profit so quickly, investors must run more risk than they would by simply putting their money into a term deposit. But assessing exactly how much more risk is where things can get tricky.

The extra juice on these notes comes from selling stock options. And to get investors a decent premium, the option HSBC is proposing to sell on their behalf is a particularly fiendish beast.

Known as a 'worst-of' option, its performance is linked to the worst-performing stock out of a basket of six Hong Kong-listed blue chips.

If the six stocks in the basket increase in value, flat-line, or even decline a little over the notes' two-year life span, then everything is fine. The investor pockets the option's sale price in the form of two payouts each worth 7.5 per cent of the initial investment, one after three months and another after six months.

Meanwhile, HSBC invests its customers' cash in the money markets at a moderate yield.

If after nine months HSBC can close out the option position and cash in the money market investments for an additional 4 per cent on top of the 15 per cent already earned, the notes will be redeemed early. Note-buyers will get back all their initial investment, plus a total return of 19 per cent.

Otherwise, the notes and their underlying options remain in force for their full two-year life span.

The problem comes if, when the two years are up, one of the six stocks in the basket has fallen in price by 10 per cent or more. This raises the danger that the worst-performing stock in the basket will have fallen below a pre-agreed 'strike price' at which the holder of the option has the right to sell the stock to the investor, and that the option will be exercised.

In other words, in exchange for an immediate return on their initial investment of 15 per cent, buyers of HSBC's notes run the risk that two years later, instead of getting their money back, they will be left holding a stock they have been forced to buy at well above its market price.

This may not be as bad as it seems. Investors are guaranteed their 15 per cent up front, and the worst stock must drop 10 per cent before the option is exercised, which means one of the six stocks must fall by 25 per cent over two years before investors lose money.

It is impossible to judge just how likely that is. All the stocks in the basket have performed strongly over the past two years, rising between 34 per cent and 193 per cent. On the other hand, at some point in the past two years, four of the six stocks have suffered steep peak-to-trough falls of 25 per cent or more.

In the worst-case scenario - unlikely though it may be - in which one of the six stocks collapses completely, investors will be left holding only their 15 per cent option premium, having lost 85 per cent of their initial investment. In contrast, if the stock market takes off, they cannot earn more than the maximum 19 per cent return.

Investors need to look carefully at instruments with asymmetrical returns like this, and think hard about how wise it is to limit their possible gains while exposing themselves to such big potential losses.