The Barrier Reverse convertible is one of the simplest and oldest form of a yield enhancement structured product.
Example of Barrier Reverse Convertible
An example of such a product is defined by the following elements:
- Issuer : Bank ABC
- Maturity : 18 months
- Underlying : Microsoft Corp (MSFT)
- Currency : USD
- Denomination : 100,000
- Coupon rate : 4% per annum
- Coupon Frequency : quarterly
- Barrier Type : Continuous
- Barrier Level : 65%
To make the description of the payoff easier, let’s note S(t) the price of the underlying S at time t.
S(0) will then ben the price the underlying at time 0.
S(T) will be the price of the underlying at maturity.
The payout of such a product will be (and subject to the issuing bank ABC not defaulting) :
- During the life of the product
The coupon of 4% per annum will be paid on a quarterly basis (1.00% per quarter). That coupon is guaranteed in the sense that it is paid irrespective of the performance of the underlying security (here Microsoft)
- At maturity,
- If the underlying has never traded below the barrier during the the life of the product, the redemption of the note will be 100%
- If the underlying has traded below the barrier at some time during the the life of the product, the redemption of the note will be
- 100% if S(T) is greater or equal to S(0)
- S(T)/S(0) if S(T) is strictly less than S(0)
For the investor, buying a reverse convertible is equivalent to
- Being long a zero-coupon bond issued by the issuing bank
- Receiving regular guaranteed coupons from that issuing bank
- Being short an at-the-money put option , with continuous Knock-In on the underlying security
The barrier can have different types, depending on how it is observed :
- Continuous or American: The barrier is observed continuously and any intraday tick is observed
- Final or European: the barrier is only observed once at the maturity of the product
- Daily on close: This variation is very similar to the continuous observation but only the closing prices of the security are considered