Thursday, February 28, 2013

Evolution of Absolute Return Structured Products

By Tim Dulaney, PhD and Tim Husson, PhD

From 2006 to 2009, a type of structured product known as an absolute return barrier note (ARBN) was issued by a variety of major investment banks.  ARBNs are interesting because they are linked to the absolute value of the return on an underlying, not just its return, and therefore are considered non-directional bets.  We've done a lot of work on ARBNs here at SLCG, including a research paper (PDF) that values a sample of ARBNs and finds they are worth on average 4.5% less than their purchase price on the issue date.

For an example ARBN, see the September 2008 Deutsche Bank Absolute Return Barrier Notes (CUSIP: 25154K635).  The following figure shows a typical ARBN circa 2007.
One of the strangest features of ARBNs is that they seemed to disappear from the market for about 18 months between 2010-2011.  Just before that time, several ARBNs were issued with a modified structure that replaces the principal protection with a buffered downside.  The following figure shows a typical modified ARBN circa 2009.  Again for an example, see the July 2009 Deutsche Bank Absolute Return Barrier Securities (CUSIP: 2515A0M59).

After the hiatus spanning 2010 and early 2011, a new type of ARBN appeared on the market that lacked principal protection and included a capped upside:

An example of such a structure is the April 2011 Deutsche Bank Absolute Return Barrier Securities (CUSIP: 2515A15U1).  This structure is exactly the same as another type of absolute return-based product, dual directionals (DDs).  DDs were issued sparsely starting in 2008, but exploded in popularity in 2012.  Just as we did for ARBNs, we have a paper on DDs (PDF) that value a large sample of products issued up to December 2012 and find that they are worth significantly less than their purchase price on the issue date.

So it seems that after 2009, the principal protection feature of ARBNs became less common and that the ARBN structure slowly evolved into what we see today as dual directionals.  While some dual directionals still use the ARBN brand (especially those issued by Royal Bank of Canada and Credit Suisse), it seems that DDs are an evolution of ARBNs that could be a result of changing market conditions.

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