Structured Products

Callable Yield Notes (CYN) are yield enhancement products, whose performance is capped by a coupon that is guaranteed by the issuer. As the name implies, the issuer, at its discretion, can call the product usually on predefined observation dates. The underlying assets are generally composed of several stocks or stock indices, thus making it a product based on a worst-of function. They are akin to Express Certificates.

The redemption is linked to a barrier (a down&in) and the callability: if none of the underlying assets ever broke through the barrier and all are above par at a predefined call date, then the CYN will most probably be called by the issuer at par and pay the full coupon for the period. However, if one or more underlying assets trade below the level at the issue date, the issuer will just pay the coupon and probably not call the CYN. An uncertainty exists for the investor as to the call of the product: it is not only linked to the level of the underlying assets, but also to their implied volatility, their implied correlation and to the level and shape of the yield curve. Even changes in the implied dividend yields may play a role. If one underlying assets breaks through the predefined barrier (often set at 70% or below of the initial asset levels), the protection of the barrier disappears (it is knocked-out) and the investor is simply long the worst performing asset. In that case, at maturity, the redemption will be linked to the performance of the worst performing asset. The redemption will occur in cash in the in case of indices, and may be in the form of the delivery of the worst performing share of the basket. The maturity of CYN is usually 2 to 3 years, and can be typically called on each anniversary date. The barriers are relatively far away from the spot price due to the longer maturity.

Payoff

The following is a numerical example: callable yield note on the Eurostoxx50 Index and the Nikkei Index, quanto Euro, two years maturity, a barrier set at 65% of spot and a coupon of 6% p.a.

• Scenario 1: none of the indices breaks through the barrier or both end above their initial levels at maturity: the product is redeemed at par.
• Scenario 2: at least one of the indices breaks through the barrier anytime during the life of the product and at least one ends below its initial level: the note redeems according to the performance of the worst performing index.
• The coupon is paid in any case (usually on a per annum base or semi-annually).

Note that the example features only two indices. In practice, three or four indices are usually included in the product. However, the addition of one or more assets in the structure is most of the time not recommendable from a risk-reward view for the investor. It raises the coupon marginally but increases the risk of the structure substantially. This is a general rule that applies to all structured products that feature a worst-of option.

Do’s

• Invest is a CYN when the included assets are thought to move sideways, the volatility is high or expected to fall and the correlation is low or expected to increase.
• Limit the maturity preferably to two years, maximum three. The additional protection or coupon, when calculated on a per annum basis decreases with the time to maturity; 40% protection over three years is less than 30% over two years.
• Prefer indices to single stocks. Empirical data suggests that the worst-of feature priced on single stocks does not compensate the investor for the risk he takes for having the worst performing stock delivered.
• Do invest only in products that correspond to your reference currency, or hedge your currency risk; that is, unless you willingly take the currency risk.
• Do favor a better barrier over a higher coupon.  

Don’ts

• Don’t invest in callable yield notes that include more than three assets. If at all, prefer those with two assets. Why not try a callable yield note on a single asset? It makes the risk management of your portfolio easier.
• Don’t invest in CYN whose coupon amounts to more than six times the risk-free interest rate if your target is to beat money-market. The higher the coupon, the higher the chances that a barrier event (which is defined as an asset breaking through the barrier, annihilating the conditional protection). On average, the products offered on the market have a 40% chance of breaking through the barrier.

Classical variant

• Callable Return Note: similar to the callable yield note, but the coupon is not guaranteed. It is paid as long as no barrier event occurs. Since the coupon is at risk, it is usually higher than for a comparable CYN.

Main impact factors

• Volatility: the higher the volatility, the higher the coupon and also, the more the callable option is worth.
• Correlation: the lower the correlation, the higher the coupon. Dividend yields: the higher the yield, the higher the coupon.
• Option volatility skew: the higher the skew, the higher the coupon (selling the barrier will be worth more).