O,apter 32: Structured Products 591
dramatically, or perhaps he needs cash for something else - both might be reasons
that the holder of the shares would want to sell before maturity.
Such aproduct has appeal to many investors. In fact, if one thought that the
stock market was a "long-term" buy, this would be amuch safer way to approach it
than buying aportfolio of stocks that might conceivably be much lower in value seven
years hence. The risk of the structured product is that the underwriter might not be
able to pay the $10 obligation at maturity. That is, if the major institutional bank or
brokerage firm who underwrote these products were to go out of business over the
course of the next seven years, one might not be able to redeem them. In essence,
then, structured products are really forms of debt (senior debt) of the brokerage firm
that underwrote them. Fortunately, most structured products are underwritten by
the largest and best-capitalized institutions, so the chances of afailure to pay at matu
rity would have to be considered relatively tiny.
How does the bank create these items? It might seem that the bank buys stock
and buys aput and sells units on the combined package. In reality, the product is not
normally structured that way. Actually, it is not adifficult concept to grasp. This
example shows how the structure looks from the viewpoint of the bank:
Example: Suppose that the bank wants to raise apool of $1,000,000 from investors
to create astructured product based on the appreciation of the S&P 500 index over
the next seven years. The bank will use apart of that pool of money to buy U.S. zero
coupon bonds and will use the rest to buy call options on the S&P 500 index.
Suppose that the U.S. government zero-coupon bonds are trading at 60 cents
on the dollar. Such bonds would mature in seven years and pay the holder $1.00.
Thus, the bank could take $600,000 and buy these bonds, knowing that in seven
years, they would mature at avalue of $1,000,000. The other $400,000 is spent to buy
call options on the S&P 500 index. Thus, the investors would be made whole at the
end of seven years even if the options that were bought expired worthless. This is why
the bank can "guarantee" that investors will get their initial money back.
Meanwhile, if the stock market advances, the $400,000 worth of call options will
gain value and that money will be returned to the holders of the structured product
as well.
In reality, the investment bank uses its own money ($1,000,000) to buy the secu
rities necessary to structure this product. Then they make the product into alegal
entity (often aunit trust) and sell the shares (units) to the public, marking them up
slightly as they would do with any new stock brought to market.
At the time of the initial offering, the calls are bought at-the-money, meaning
the striking price of the calls is equal to the closing price of the S&P 500 index on the

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592 Part V: Index Options and Futures
day the products were sold to the public. Thus, the structured product itself has a
"strike price" equal to that of the calls. It is this price that is used at maturity to deter
mine whether the S&Phas appreciated over the seven-year period - an event that
would result in the holders receiving back more than just their initial purchase price.
After the initial offering, the shares are then listed on the AMEX or the NYSE
and they will begin to rise and fall as the value of the S&P 500 index fluctuates.
So, the structured product is not an index fund protected by aput option, but
rather it is acombination of zero-coupon government bonds and acall option on an
index. These two structures are equivalent, just as the combination of owning stock
protected by aput option is equivalent to being long acall option.
Structured products of this type are not limited to indices. One could do the
same thing with an individual stock, or perhaps agroup of stocks, or even create asimulated bull spread. There are many possibilities, and the major ones will be dis
cussed in the following sections. In theory, one could construct products like this for
himself, but the mechanics would be too difficult. For example, where is one going
to buy aseven-year option in small quantity? Thus, it is often worthwhile to avail one
self of the product that is packaged (structured) by the investment banker.
In actuality, many of the brokerage firms and investment banks that undetwrite
these products give them names - usually acronyms, such as MITTS, TARGETS,
BRIDGES, LINKS, DINKS, ELKS, and so on. If one looks at the listing, he may see
that they are called notes rather than stocks or index funds. Nevertheless, when the
terms are described, they will often match the examples given in this chapter.
INCOME TAX CONSEQUENCES
There is one point that should be made now: There is "phantom interest" on astruc
tured product. Phantom interest is what one owes the government when abond is
bought at adiscount to maturity. The IRS technically calls the initial purchase price
an Original Issue Discount (OID) and requires you to pay taxes annually on apro
portionate amount of that OID. For example, if one buys azero-coupon U.S. gov
ernment bond at 60 cents on the dollar, and later lets it mature for $1.00, the IRS
does not treat the 40-cent profit as capital gains. Rather, the 40 cents is interest
income. Moreover, says the IRS, you are collecting that income each year, since you
bought the bonds at adiscount. (In reality, of course, you aren'tcollecting athing;
your investment is simply worth alittle more each year because the discount decreas
es as the bonds approach maturity.) However, you must pay income tax on the "phan-

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594 Part V: Index Options and Futures
Cash Surrender Value = $10 x Final Value/ 1,245.27
This shortened version of the formula only works, though, when the participa
tion rate is 100% of the increase in the Final Index Value above the striking price.
Otherwise, the longer formula should be used.
Not all structured products of this type offer the holder 100% of the appreci
ation of the index over the initial striking price. In some cases, the percentage is
smaller ( although in the early days of issuance, some products offered apercentage
appreciation that was actually greater than 100%). After 1996, options in general
became more expensive as the volatility of the stock market increased tremendous
ly. Thus, structured products issued after 1997 or 1998 tend to include an "annual
adjustment factor." Adjustment factors are discussed later in the chapter.
Therefore, amore general formula for Cash Surrender Value - one that applies
when the participation rate is afixed percentage of the striking price - is:
Cash Surrender Value =
Guarantee + Guarantee x Participation Rate x (Final Index Value/ Striking Price - I)
THE COST OF THE IMBEDDED CALL OPTION
Few structured products pay dividends. 1 Thus, the "cost" of owning one of these
products is the interest lost by not having your money in the bank ( or money market
fund), but rather having it tied up in holding the structured product.
Continuing with the preceding example, suppose that you had put the $10 in
the bank instead of buying astructured product with it. Let'sfurther assume that the
money in the bank earns 5% interest, compounded continuously. At the end of seven
years, compounded continuously, the $10 would be worth:
Money in the bank = Guarantee Price xert
= $10 xe 0-05 x 7 = 14.191, in this case
This calculation usually raises some eyebrows. Even compounded annually, the
amount is 14.07. You would make roughly 40% (without considering taxes) just by
1Some do pay dividends, though. Astructured product existed on acontrived index, called the Dow-Jones
Top 10 Yield index (symbol: $XMT). This is asort of "dogs of the Dow" index. Since part of the reason for owning a
"dogs of the Dow" product is that dividends are part of the performance, the creators of the structured product
(Merrill Lynch) stated that the minimum price one would receive at maturity would be 12.40, not the 10 that was
the initial offering price. Thus, this particular structured product had a "dividend" built into it in the form of an ele
vated minimum price at maturity.

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Chapter 32: Structured Products 595
having your money in the bank. Forgetting structured products for amoment, this
means that stocks in general would have to increase in value by over 40% during the
seven-year period just for your performance to beat that of abank account.
In this sense, the cost of the imbedded call option in the structured product is
this lost interest - 4.19 or so. That seems like afairly expensive option, but if you con
sider that it'saseven-year option, it doesn'tseem quite so expensive. In fact, one
could calculate the implied volatility of such acall and compare it to the current
options on the index in question.
In this case, with the stock at 10, the strike at 10, no dividends, a 5% interest
rate, and seven years until expiration, the implied volatility of acall that costs $4.19
is 28.1 %. Call options on the S&P 500 index are rarely that expensive. So you can see
that you are paying "something" for this call option, even if it is in the form of lost
interest rather than an up-front cost.
As an aside, it is also unlikely that the underwriter of the structured product
actually paid that high an implied volatility for the call that was purchased; but he is
asking you to pay that amount. This is where his underwriting profit comes from.
The above example assumed that the holder of the structured product is par
ticipating in 100% of the upside gain of the underlying index over its striking price.
If that is not the case, then an adjustment has to be made when computing the price
of the imbedded option. In fact, one must compute what value of the index, at matu
rity, would result in the cash value being equal to the "money in the bank" calcula
tion above. Then calculate the imbedded call price, using that value of the index. In
that way, the true value of the imbedded call can be found.
You might ask, "Why not just divide the 'money in the bank' formula by the par
ticipation rate?" That would be okay if the participation were always stated as aper
centage of the striking price, but sometimes it is not, as we will see when we look at
the more complicated examples. Further examples of structured products in this
chapter demonstrate this method of computing the cost of the imbedded call.
PRICE BEHAVIOR PRIOR TO MATURITY
The structured product cannot normally be "exercised" by the holder until it
matures. That is, the cash surrender value is only applicable at maturity. At any other
time during the life of the product, one can compute the cash surrender value, but
he cannot actually attain it. What you can attain, prior to maturity, is the market price,
since structured products trade freely on the exchange where they are listed. In actu
al fact, the products generally trade at aslight discount to their theoretical cash sur
render value. This is akin to aclosed-end mutual fund selling at adiscount to net

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596 Part V: Index Options and Futures
asset value. Eventually, upon maturity, the actual price will be the cash surrender
value price; so if you bought the product at adiscount, you would benefit, providing
you held all the way to maturity.
Example: Assume that two years ago, astructured product was issued with an initial
offering price of $10 and astrike price of 1,245.27, based upon the S&P 500 index.
Since issuance, the S&P 500 index has risen to 1,522.00. That is an increase of
22.22% for the S&P 500, so the structured product has atheoretical cash surrender
value of 12.22. Isay "theoretical" because that value cannot actually be realized, since
the structured product is not exercisable at the current time - five years prior to
maturity.
In the real marketplace, this particular structured product might be trading at
aprice of 11. 75 or so. That is, it is trading at adiscount to its theoretical cash sur
render value. This is afairly common occurrence, both for structured products and
for closed-end mutual funds. If the discount were large enough, it should serve to
attract buyers, for if they were to hold to maturity, they would make an extra 4 7 cents
(the amount of this discount) from their purchase. That's 4% (0.47 divided by 11.75
= 4%) over five years, which is nothing great, but it'ssomething.
Why does the product trade at adiscount? Because of supply and demand. It is
free to trade at any price - premium or discount - because there is nothing to keep
it fixed at the theoretical cash surrender value. If there is excess demand or supply in
the open market, then the price of the structured product will fluctuate to reflect that
excess. Eventually, of course, the discount will disappear, but five years prior to
maturity, one will often find that the product differs from its theoretical value by
somewhat significant amounts. If the discount is large enough, it will attract buyers;
alternatively, if there should be alarge premium, that should attract sellers.
SIS
One of the first structured products of this type that came to my attention was one
that traded on the AMEX, entitled "Stock Index return Security" or SIS. It also trad
ed under the symbol SIS. The product was issued in 1993 and matured in 2000, so
we have acomplete history of its movements. The terms were as follows: The under
lying index was the S&P Midcap 400 index (symbol: $MID). Issued in June 1993, the
original issue price was $10, and $MID was trading at 166.10 on the day of issuance,
so that was the striking price. Moreover, buyers were entitled to 115% of the appre
ciation of $MID above the strike price. Thus, the cash value formula was:

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Gopter 32: Structured Products 597
Cash value of SIS $10 + $10 x 1.15 x ($MID - 166.10) / 166.10
where
Guarantee price = $10
Underlying index: S&P Midcap 400 ($MID)
Striking price: 166.10
Participation rate: 115% of the increase of $MID above 166.10
SIS matured seven years later, on June 2, 2000. At the time of issuance, seven-year
interest rates were about 5.5%, so the "money in the bank" formula shows that one
could have made about 4.7 points on a $10 investment, just by utilizing risk-free gov
ernment securities:
Money in the bank= 10 xe0-055 x 7 = 14.70
We can'tsimply say that the cost of the imbedded call was 4. 7 points, though, because
the participation rate is not 100% - it'sgreater. So we need to find out the Final Value
of $MID that results in the cash value being equal to the "money in the bank" result.
Using the cash value formula and inserting all the terms except the final value of
$MID, we have the following equation. Note: $MIDMIB stands for the value of $MID
that results in the "money in the bank" cash value, as computed above.
14.70 = 10 + 10 X 1.15 X ($MIDMIB 166.10) I 166.10
Solving for $MIDMIB' we get avalue of 233.98. Now, convert this to apercent
gain of the striking price:
Imbedded call price = 233.98 I 166.10 - 1 = 0.4087
Hence, the imbedded call costs 40.87% of the guarantee price. In this example,
where the guarantee price was $10, that means the imbedded call cost $4.087.
Thus, amore generalized formula for the value of the imbedded call can be
construed from this example. This formula only works, though, where the participa
tion rate is afixed percentage of the strike price.
Imbedded call value= Guarantee price x (Final Index ValueMIB / Striking Price - 1)
Final Index ValueMIB is the final index price that results in the cash value
being equal to the "money in the bank" calculation, where
Money in the bank = Guarantee Price xert
r = risk-free interest rate
t = time to maturity
Thus, the calculated value of the imbedded call was approximately 4.087 points,
which is an implied volatility of just over 26%. At the time, listed short-term options

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600 Part V: Index Options and Futures
Solving the following equation for $MID would give the desired answer:
Cash Value = 13 = 10 + 11.5 x ($MID/166.l - 1)
3 = 11.5 x $MID/ 166.1 - 11.5
14.5 x 166.1 / 11.5 = $MID
209.43 = $MID
So, if $MID were at 209.43, the cash value would be 13 - the price the investor
is currently paying for SIS. This is protection of 12.2% down from the current price
of 238.54. That is, $MID could decline 12.2% at maturity, from the current price of
238.54 to aprice of 209.43, and the investor who bought SIS would break even
because it would still have acash value of 13.
Of course, this discount could have been computed using the SIS prices of 13
and 15.02 as well, but many investors prefer to view it in terms of the underlying
index - especially if the underlying is apopular and often-cited index such as the S&P
500 or Dow-Jones Industrials.
From Figure 32-1, it is evident that the discount persisted throughout the
entire life of the product, shrinking more or less linearly until expiration.
SIS TRADING AT A DISCOUNT TO THE GUARANTEE PRICE
In the previous example, the investor could have bought SIS at adiscount to its cash
value computation, but if the stock market had declined considerably, he would still
have had exposure from his SIS purchase price of 13 down to the guarantee price of
10. The discount would have mitigated his percentage loss when compared to the
$MID index itself, but it would be aloss nevertheless.
However, there are sometimes occasions when the structured product is trad
ing at adiscount not only to cash value, but also to the guarantee price. This situation
occurred frequently in the early trading life of SIS. From Figure 32-1, you can see
that in 1995 the cash value was near 11, but SIS was trading at adiscount of more
than 2 points. In other words, SIS was trading below its guarantee price, while the
cash value was actually above the guarantee price. It is a "double bonus" for an
investor when such asituation occurs.
Example: In February 1995, the following prices existed:
$MID: 177.59
SIS: 8.75
For amoment, set aside considerations of the cash value. If one were to buy SIS
at 8. 75 and hold it for the 5.5 years remaining until maturity, he would make 1.25
points on his 8.75 investment- areturn of 14.3% for the 5.5-year holding period. As
acompounded rate of interest, this is an annual compound return of 2.43%.

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Cl,apter 32: Structured Produds 601
Now, arate of return of 2.43% is rather paltry considering that the risk-free
T•bill rate was more than twice that amount. However, in this case, you own acall
option on the stock market and get to earn 2.43% per year while you own the call. In
other words, "they" are paying you to own acall option! That'sasituation that
doesn'tarise too often in the world of listed options.
If we introduce cash value into this computation, the discrepancy is even larg
er. Using the $MID price of 177.59, the cash value can be computed as:
Cash Value = 10 + 11.5 x (177.59/166.10 - 1) = 10.80
Thus, with SIS trading at 8. 75 at that time, it was actually trading at awhopping
19% discount to its cash value of 10.80. Even if the stock market declined, the guar
antee price of 10 was still there to provide aminimal return.
In actual practice, astructured product will not normally trade at adiscount to its
guarantee price while the cash value is higher than the guarantee price. There'sonly
anarrow window in which that occurs.
There have been times when the stock market has declined rather substantial
ly while these products existed. We can observe the discounts at which they then
traded to see just how they might actually behave on the downside if the stock mar
ket declined after the initial offering date. Consider this rather typical example:
Example: In 1997, Merrill Lynch offered astructured product whose underlying
index was Japan's Nikkei index. At the time, the Nikkei was trading at 20,351, so that
was the striking price. The participation rate was 140% of the increase of the Nikkei
above 20,351 - avery favorable participation rate. This structured product, trading
under the symbol JEM, was designed to mature in five years, on June 14, 2002.
As it turned out, that was about the peak of the Japanese market. By October of
1998, when markets worldwide were having difficulty dealing with the Russian debt
crisis and the fallout from amajor hedge fund in the U.S. going broke, the Nikkei had
plummeted to 13,300. Thus, the Nikkei would have had to increase in price by just
over 50% merely to get back to the striking price. Hence, it would not appear that
JEM was ever going to be worth much more than its guarantee price of 10.
Since we have actual price histories of JEM, we can review how the market
place viewed the situation. In October 1998, JEM was actually trading at 8.75 - only
1.25 points below its guarantee price. That discount equates to an annual com
pounded rate of 3.64%. In other words, if one were to buy JEM at 8.75 and it
matured at 10 about 40 months later, his return would have been 3.64% compound
ed annually. That by itself is arather paltry rate of return, but one must keep in mind
that he also would own acall option on the Nikkei index, and that option has a 140%
participation rate on the upside.

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602 Part V: Index Options and Futures
COMPUTING THE VALUE OF THE IMBEDDED CALL WHEN
THE UNDERLYING IS TRADING AT A DISCOUNT
Can we compute the value of the imbedded call when the structured product itself
is trading at adiscount to its guarantee price? Yes, the formulae presented earlier can
always be used to compute the value of the imbedded call.
Example: Again using the example of JEM, the structured product on the Nikkei
index, recall that it was trading at 8. 75 with aguaranteed price of 10, with maturity
40 months hence. Assume that the risk-free interest rate at the time was 5.5%.
Assuming continuous compounding, $8.75 invested today would be worth $10.51 in
40 months.
Money in the bank = 8. 75 xert
where r = 0.05 and t = 3.33 years (40 months)
Money in the bank= 8.75 xe0-055 x 3-333 = 10.51
Since the structured product will be worth 10 at maturity, the value of the call
is 0.51.
There is another, nearly equivalent way to determine the value of the call. It
involves determining where the structured product would be trading if it were com
pletely azero-coupon debt of the underwriting brokerage. The difference between
that value and the actual trading price of the structured product is the value of the
imbedded call.
The credit rating of the underwriter of the structured product is an important
factor in how large adiscount occurs. Recall that the guarantee price is only as good
as the creditworthiness of the underwriter. The underwriter is the one who will pay
the cash settlement value at maturity - not the exchange where the product is listed
nor any sort of clearinghouse or corporation.
THE ADJUSTMENT FACTOR
In recent years, some of the structured products have been issued with an adjustment
factor. The adjustment factor is generally anegative thing for investors, although the
underwriters try to couch it in language that makes it difficult to discern what is going
on. Simply put, the adjustment factor is amultiplier (less than 100%) applied to the
underlying index value before calculating the Final Cash Value. Adjustment factors
seemed to come into being at about the time that index option implied volatility
began to trade at much higher levels than it ever had (1997 onward).

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604 Part V: Index Options and Futures
Or, thinking in the alternative, if the index triples, then the structured produc1
(before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25o/c
== 27.375.
This example begins to demonstrate just how onerous the adjustment factor is.
Notice that if the underlying doubles, you don'tmake "double" less 8.75% (the
adjustment factor). No, you make "double" times the adjustment factor - 17.5% -
less than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than
triple (i.e., the structured product is worth 27.375, not 30, so the percentage increase
was 173. 75%, not 200% - adifference of 26.25%, stated in terms of the initial invest
ment). How can that be? It is aresult of the adjustment factor being applied to the
$SPX price before your profit (cash settlement value) is computed.
THE BREAK-EVEN FINAL INDEX VALUE
Before discussing the adjustment factor in more detail, one more point should be
made: The owner of the structured product doesn'tget back anything more than the
base value unless the underlying has increased by at least afixed amount at maturi
ty. In others words, the underlying must appreciate to aprice large enough that the
final price times the adjustment factor is greater than the striking price of the struc
tured product. We'll call this price the break-even final index value.
An example will demonstrate this concept.
Example: As in the preceding example, suppose tl1at the striking price of the struc
tured product is 1,100 and the adjustment factor is 8.75%. At what price would the
final cash settlement value be something greater than the base value of 10? That
price can be solved for with the following simple equation:
Break-even final index value== Striking price/ (1- Adjustment factor)
= 1,100 / (0.9125) == 1,205.48.
Generally speaking, the underlying index must increase in value by aspecific
amount just to break even. In this case that amount is:
1 / (1 -Adjustment factor) = 1 / 0.9175 = 1.0959
In other words, the underlying index must increase in value by more than 9.5%
by maturity just to overcome the weight of the adjustment factor. If the index increas
es by alesser amount, then the structured product holder will merely receive back
his base value ( 10) at maturity.
The previous examples all show that the adjustment factor is not atrivial thing.
At first glance, one might not realize just how burdensome it is. After all, one might

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605
himself, what does 1.25% per year really matter? However, you can see that it
matter. In fact, our above examples did not even factor in the other cost that any
Investor has when his money is at risk - the cost of carry, or what he could have made
had he just put the money in the bank.
MEASURING THE COST OF THE ADJUSTMENT FACTOR
The magnitude of the adjustment increases as the price of the underlying increases.
lt is an unusual concept. We know that the structured product initially had an
imbedded call option. Earlier in this chapter, we endeavored to price that option.
However, with the introduction of the concept of an adjustment factor, it turns out
that the call option'scost is not afixed amount. It varies, depending on the final value
of the underlying index. In fact, the cost of the option is apercentage of the final
value of the index. Thus, we can'treally price it at the beginning, because we don'tknow what the final value of the index will be. In fact, we have to cease thinking of
this option'scost as afixed number. Rather, it is ageometric cost, if you will, for it
increases as the underlying does.
Perhaps another way to think of this is to visualize what the cost will be in per
centage terms. Figure 32-2 compares how much of the percent increase in the index
is captured by the structured product in the preceding example. The x-axis on the
graph is the percent increase by the index. The y-axis is the percent realized by the
structured product. The terms are the same as used in the previous examples: The
strike price is 1,100, the total adjustment factor is 8. 75%, and the guarantee price of
the structured product is 10.
The dashed line illustrates the first example that was shown, when adoubling
of the index value (an increase of 100%) to 2,200 resulted in again of 83.5% in the
price of the structured. Thus, the point (100%, 83.5%) is on the line on the chart
where the dashed lines meet.
Figure 32-2 points out just how little of the percent increase one captures if the
underlying index increases only modestly during the life of the structured product.
We already know that the index has to increase by 9.59% just to get to the break-even
final price. That point is where the curved line meets the x-axis in Figure 32-2.
The curved line in Figure 32-2 increases rapidly above the break-even price,
and then begins to flatten out as the index appreciation reaches 100% or so. This
depicts the fact that, for small percentage increases in the index, the 8.75% adjust
ment factor - which is aflat-out downward adjustment in the index price - robs one
of most of the percentage gain. It is only when the index has doubled in price or so
that the curve stops rising so quickly. In other words, the index has increased enough
in value that the structured product, while not capturing all of the percentage gain
by any means, is now capturing agreat deal of it.

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604 Part V: Index Options and Futures
Or, thinking in the alternative, if the index triples, then the structured product
(before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25%
= 27.375.
This example begins to demonstrate just how onerous the adjustment factor is.
Notice that if the underlying doubles, you don'tmake "double" less 8.75% (the
adjustment factor). No, you make "double" times the adjustment factor - 17.5% -
less than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than
triple (i.e., the structured product is worth 27.375, not 30, so the percentage increase
was 173. 75%, not 200% - adifference of 26.25%, stated in terms of the initial invest
ment). How can that be? It is aresult of the adjustment factor being applied to the
$SPX price before your profit (cash settlement value) is computed.
THE BREAK-EVEN FINAL INDEX VALUE
Before discussing the adjustment factor in more detail, one more point should be
made: The owner of the structured product doesn'tget back anything more than the
base value unless the underlying has increased by at least afixed amount at maturi
ty. In others words, the underlying must appreciate to aprice large enough that the
final price times the adjustment factor is greater than the striking price of the struc
tured product. We'll call this price the break-even final index value.
An example will demonstrate this concept.
Example: As in the preceding example, suppose that the striking price of the struc
tured product is 1,100 and the adjustment factor is 8.75%. At what price would the
final cash settlement value be something greater than the base value of 10? That
price can be solved for with the following simple equation:
Break-even final index value = Striking price/ (1- Adjustment factor)
= 1,100 / (0.9125) = 1,205.48.
Generally speaking, the underlying index must increase in value by aspecific
amount just to break even. In this case that amount is:
1 / (1 - Adjustment factor) = 1 / 0.9175 = 1.0959
In other words, the underlying index must increase in value by more than 9.5%
by maturity just to overcome the weight of the adjustment factor. If the index increas
es by alesser amount, then the structured product holder will merely receive back
his base value (10) at maturity.
The previous examples all show that the adjustment factor is not atrivial thing.
At first glance, one might not realize just how burdensome it is. After all, one might

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605
himself, what does 1.25% per year really matter? However, you can see that it
matter. In fact, our above examples did not even factor in the other cost that any
htvt?stor has when his money is at risk - the cost of carry, or what he could have made
he just put the money in the bank.
MIASURING THE COST OF THE ADJUSTMENT FACTOR
The magnitude of the adjustment increases as the price of the underlying increases.
It is an unusual concept. We know that the structured product initially had an
hnbedded call option. Earlier in this chapter, we endeavored to price that option.
However, with the introduction of the concept of an adjustment factor, it turns out
that the call option'scost is not afixed amount. It varies, depending on the final value
of the underlying index. In fact, the cost of the option is apercentage of the final
value of the index. Thus, we can'treally price it at the beginning, because we don'tknow what the final value of the index will be. In fact, we have to cease thinking of
this option'scost as afixed number. Rather, it is ageometric cost, if you will, for it
increases as the underlying does.
Perhaps another way to think of this is t.ovisualize what the cost will be in per
centage terms. Figure 32-2 compares how much of the percent increase in the index
is captured by the structured product in the preceding example. The x-axis on the
graph is the percent increase by the index. The y-axis is the percent realized by the
structured product. The terms are the same as used in the previous examples: The
strike price is 1,100, the total adjustment factor is 8.75%, and the guarantee price of
the structured product is 10.
The dashed line illustrates the first example that was shown, when adoubling
of the index value (an increase of 100%) to 2,200 resulted in again of 83.5% in the
price of the structured. Thus, the point (100%, 83.5%) is on the line on the chart
where the dashed lines meet.
Figure 32-2 points out just how little of the percent increase one captures if the
underlying index increases only modestly during the life of the structured product.
We already know that the index has to increase by 9.59% just to get to the break-even
final price. That point is where the curved line meets the x-axis in Figure 32-2.
The curved line in Figure 32-2 increases rapidly above the break-even price,
and then begins to flatten out as the index appreciation reaches 100% or so. This
depicts the fact that, for small percentage increases in the index, the 8.75% adjust
ment factor -which is aflat-out downward adjustment in the index price - robs one
of most of the percentage gain. It is only when the index has doubled in price or so
that the curve stops rising so quickly. In other words, the index has increased enough
in value that the structured product, while not capturing all of the percentage gain
by any means, is now capturing agreat deal of it.

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608 Part V: Index Options and Future;
FIGURE 32-4.
Comparison of adiusted and unadiusted cash values at maturity.
50
40
20
0 1100 2200 3300
Cost of the
Call Option
4400 5500
Index Final Price (Unadjusted)
6600
est. In this section, acouple of different constructs, ones that have been brought to
the public marketplace in the past, are discussed.
THE BUI.I. SPREAD
Several structured products have represented abull spread, in effect. In some cases,
the structured product terms are stated just like those of acall spread in that the final
cash value is defined with both aminimum and amaximum value. For example, it
might be described something like this:
"The final cash value of the (structured) product is equal to aminimum of abase
price of 10, plus any appreciation of the underlying index above the striking price,
subject to amaximum price of 20" (where the striking price is stated elsewhere).
It'sfairly simple to see how this resembles abull spread: The worst you can do
is to get back your $10, which is presumably the initial offering price, just as in any
of the structured products described previously in this chapter. Then, above that,
you'dget some appreciation of the index price above the stated striking price - again

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609
the products discussed earlier. However, in this case, there is amaximum that the
c,1.,;hvalue can be worth: 20. In other words, there is aceiling on the value of this
1tructured product at maturity. It is exactly like abull spread with two striking prices,
one at 10 and one at 20. In reality, this structured product would have to be evaluat-
using both striking prices. We'll get to that in aminute.
There is another way that the underwriter sometimes states the terms of the
structured product, but it is also abull spread in effect. The prospectus might say
something to the effect that the structured product is defined pretty much in the
standard way, but that it is callable at acertain (higher) price on acertain date. In
uther words, someone else can call your structured product away on that date. In
effect, you have sold acall with ahigher striking price against your structured prod
Ut1:. Thus, you own an imbedded call via the usual purchase of the structured prod
uct and you have written acall with ahigher strike. That, again, is the definition of abull spread.
When analyzing aproduct such as this, one must be mindful that there are two
calls to price, not only in determining the final value, but more importantly in deter
mining where you might expect the structured product to trade during its life, prior
to maturity. An option strategist knows that abull spread doesn'twiden out to its max
imum profit potential when there is still alot of time remaining before expiration,
unless the underlying rises by asubstantial amount in excess of the higher striking
price of the spread. Thus, one would expect this type of structured product to behave
in asimilar manner.
The example that will be used in the rest of this section is based on actual "bull
spread" structured products of this type that trade in the open marketplace.
Example: Suppose that astructured product is linked to the Internet index. The
strike price, based on index values, is 150. If the Internet index is below 150 at matu
rity, seven years hence, then the structured product will be worth abase value of 10.
There is no adjustment factor, nor is there aparticipation rate factor. So far, this is
just the same sort of definition that we've seen in the simpler examples presented
previously. The final cash value formula would be simply stated as:
Final cash value = 10 x (Final Internet index value/150)
However, the prospectus also states that this structured product is callable at aprice of 25 during the last month of its life.
This call feature means that there is, in effect, acap on the price of the under
lying. In actual practice, the call feature may be for alonger or shorter period of time,
and may be callable well in advance of maturity. Those factors merely determine the
expiration date of the imbedded call that has been "written."

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610 Part V: Index Options and Futures
The first thing one should do is to convert the striking price into an equivalent
price for the underlying index, so that he can see where the higher striking price is
in relation to the index price. In this example, the higher striking price when stated
in terms of the structured product is 2.5 times the base price. So the higher striking
price, in index terms, would be 2.5 times the striking price, or 375:
Index call price = ( Call price / Base price) x Striking price
= (25 I 10) X 150
= 375
Hence, if the Internet index rose above 375, the call feature would be "in effect"
(i.e., the written call would be in-the-money). The value at which we can expect the
structured product to trade, at maturity, would be equal to the base price plus the
value of the bull spread with strikes of 10 and 25.
Valuing the Bull Spread. Just as the single-strike structured products have
an imbedded call option in them, whose cost can be inferred, so do double-strike
structured products. The same line of analysis leads to the following:
"Theoretical" cash value = 10 + Value of bull spread - Cost of carry
Cost of carry refers to the cost of carry of the base price (10 in this example).
By using an option model and employing knowledge of bull spreads, one can
calculate atheoretical value for the structured product at any time during its life.
Moreover, one can decide whether it is cheap or expensive - factors that would lead
to adecision as to whether or not to buy.
Example: Suppose that the Internet index is trading at aprice of 210. What price can
we expect the structured product to be trading at? The answer depends on how
much time has passed. Let'sassume that two years have passed since the inception
of the structured product (so there are still five years of life remaining in the option).
With the Internet index at 210, it is 40% above the structured product'slower
striking price of 150. Thus, the equivalent price for the structured product would be
14. Another way to compute this would be to use the cash value formula:
Cash value= 10 x (210 / 150) = 14
Now, we could use the Black-Scholes (or some other) model to evaluate the two
calls - one with astriking price of 10 and the other with astriking price of 25. Using
avolatility estimate of 50%, and assuming the underlying is at 14, the two calls are
roughly valued as follows:
Underlying price: 14

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Cl,opter 32: Structured Products
Option
5-year call, strike = 10
5-year call, strike = 25
Theoretical Price
7.30
3.70
611
Thus, the value of the bull spread would be approximately 3.60 (7.30 minus
3.70). The structured product would then be worth 13.60- the base price of 10, plus
the value of the spread:
"Theoretical" cash value= 10 + 3.60 - Cost of carry= 13.60 - Cost of carry
It may seem strange to say that the value of the structured product is actually
less than the cash value, but that is what the call feature does: It reduces the worth
of the structured product to values below what the cash value formula would indi
cate.
Given this information, we can predict where the structured product would trade at
any price or at any time prior to maturity. Let'slook at amore extreme example, then,
one in which the Internet index has atremendously big run to the upside.
Example: Suppose that the Internet index has risen to 525 with four years of life
remaining until maturity of the structured product. This is well above the index
equivalent call price of 375. Again, it is first necessary to translate the index price
back to an equivalent price of the structured product, using either percentage gains
or the cash value formula:
Cash value = 10 x (525/ 150) = 35
Again, using the Black-Scholes model, we can determine the following theo
retical values:
Underlying price: 35
Option
3-year c~strike = 10
3-year call, strike = 25
Theoretical Price
25.50
14.70
Now, the value of the bull spread is 10.80 (25.50 minus 14.70). The deepest in
the-money option is trading near parity, but the (written) option is only 10 points in
the-money and thus has quite abit of time value premium remaining, since there are
three years of life left:
"Theoretical" cash value = 10 + 10.80 = 20.80 - Cost of carry

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612 Part V: Index Options and Futures
Hence, even though the Internet index is at 525 - far above the equivalent cal
price of 375 - the structured product is expected to be trading at aprice well belo\\
its maximum price of 25.
Figure 32-5 shows the values over abroad spectrum of prices and for various
expiration dates. One can clearly see that the structured product will not trade"near
its maximum price of 25 until time shrinks to nearly the maturity date, or until the
underlying index rises to very high prices. In particular, note where the theoretical
values for the bull spread product lie when the index is at the higher striking price of
375 (there is avertical line on the chart to aid in identifying those values). The struc
tured product is not worth 20 in any of the cases, and for longer times to maturity, it
isn'teven worth 15. Thus, the call feature tends to dampen the upside profit poten
tial of this product in adramatic manner.
The curves in Figure 32-5 were drawn with the assumption that volatility is
50%. Should volatility change materially during the life of the structured product,
then the values would change as well. Alower volatility would push the curves up
toward the "at maturity" line, while an increase in volatility would push the curves
down even further.
FIGURE 32-5.
Value of bull spread structured product.
At Maturity
25
1 Year Left
20 3Years Left
15
5
100 150 200 250 300 350 400 450 500 550 600
Price of Index

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Gtpter 32: Structured Products
MULTIPLE EXPIRATION DATES
613
In some cases, more than one expiration date is involved when the structured prod
uct is issued. These products are very similar to the simple ones first discussed in this
chapter. However, rather than maturing on aspecific date, the final index value -
which is used to determine the final cash value of the structured product - is the
average of the underlying index price on two or three different dates.
For example, one such listed product was issued in 1996 and used the S&P 500
index ($SPX) as the underlying index. The strike price was the price of $SPX on the
day of issuance, as usual. However, there were three maturity dates: one each in April
2001, August 2002, and December 2003. The final index value used to determine the
cash settlement value was specified as the average of the $SPX closings on the three
maturity dates.
In effect, this structured product was really the sum of three separate struc
tured products, each maturing on adifferent date. Hence, the values of the imbed
ded calls could each be calculated separately, using the methods presented earlier.
Then those three values could be averaged to determine the overall value of the
imbedded call in this structured product.
OPTION STRATEGIES INVOLVING STRUCTURED PRODUCTS
Since the structured products described previously are similar to well-known option
strategies (long call, bull spread, etc.), it is possible to use listed options in conjunc
tion with the structured products to produce other strategies. These strategies are
actually quite simple and would follow the same lines as adjustment strategies dis
cussed in the earlier chapters of this book.
Example: Assume that an investor purchased 15,000 shares of astructured product
some time ago. It is essentially acall option on the S&P 500 index ($SPX). The prod
uct was issued at aprice of 10, and that is the guarantee price as well. The striking
price is 700, which is where $SPX was trading at the time. However, now $SPX is
trading at 1,200, well above the striking price. The cash value of the product is:
)ox (1,2001100) = 11.14
Furthermore, assume that there are still two years remaining until maturity of
the structured product, and the investor is getting alittle nervous about the market.
He is thinking of selling or hedging his holding in the structured product. However,
the structured product itself is trading at 16.50, adiscount of 64 cents from its theo-

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614 Part V: Index Options and Futurei
retical cash value. He is not too eager to sell at such adiscount, but he realizes tha
he has alot of exposure between the current price and the guarantee price of 10.
He might consider writing alisted call against his position. That would conver
it into the equivalent of abull spread, since he already holds the equivalent of alonf
call via ownership of the structured product. Suppose that he quotes the $SP)
options that trade on the CBOE and finds the following prices for 6-month options
expiring in December:
$SPX: 1,200
Option
December 1,200 call
December 1,250 call
December 1,300 call
Price
85
62
43
Suppose that he likes the sale of the December 1,250 call for 62 points. How
many should he sell against his position in order to have aproper hedge?
First, one must compute amultiplier that indicates how many shares of the
structured product are equivalent to one "share" of the $SPX. That is done in the
simple case by dividing the striking price by the guarantee price:
Multiplier = Striking price/ Base price
= 700 / 10 = 70
This means that buying 70 shares of the structured product is equivalent to
being long one share of $SPX. To verify this, suppose that one had bought 70 shares
of the structured product initially at aprice of 10, when $SPX was at 700. Later,
assume that $SPX doubles to 1,400. With the simple structure of this product, which
has a 100% participation rate and no adjustment factor, it should also double to 20.
So 70 shares bought at 10 and sold at 20 would produce aprofit of $700. As for $SPX,
one "share" bought at 700 and later sold at 1,400 would also yield aprofit of $700.
This verifies that the 70-to-lratio is the correct multiplier.
This multiplier can then be used to figure out the current equivalent structured
product position in terms of $SPX. Recall that the investor had bought 15,000 shares
initially. Since the multiplier is 70-to-l, these 15,000 shares are equivalent to:
$SPX equivalent shares = Shares of structured product held/ Multiplier
= 15,000 / 70 = 214.29
That is, owning this structured product is the equivalent of owning 214+ shares
of $SPX at current prices. Since an $SPX call option is an option on 100 "shares" of
$SPX, one would write 2 calls (rounding off) against his structured profit position.
Since the SPX December 1,250 calls are selling for 62, that would bring in $12,400
less commissions.

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615
Note that the sale of these calls effectively puts acap on the profit potential of
investor'soverall position until the December expiration of the listed calls. If $SPX
were to rise substantially above 1,250, his profits would be "capped" because the two
were sold. Thus, he has effectively taken his synthetic long call position and con
verted it into abull spread (or acollared index fund, if you prefer that description).
In reality, any calls written against the structured product would have to be
margined as naked calls. In avirtual sense, the 15,000 shares of the structured prod
Ut't "cover" the sale of 2 $SPX calls, but margin rules don'tallow for that distinction.
In essence, the sale of two calls would create abull spread. Alternatively, if one thinks
uf the structured product as along index fully protected by aput (which is another
way to consider it), then the sale of the $SPX listed call produces a "collar."
Of course, one could write more than two $SPX calls, if he had the required
margin in his account. This would create the equivalent of acall ratio spread, and
would have the properties of that strategy: greatest profit potential at the striking
price of the written calls, limited downside profit potential, and theoretically unlim
ited upside risk if $SPX should rise quickly and by alarge amount.
In any of these option writing strategies, one might want to write out-of-the
money, short-term calls against his structured product periodically or continuously.
Such astrategy would produce good results if the underlying index does not advance
quickly while the written calls are in place. However, if the index should rise through
the striking price of the written calls, such astrategy would detract from the overall
return of the structured product.
Changing the Striking Price. Another strategy that the investor could use
if he so desired is to establish avertical call spread in order to effectively change
the striking price of the (imbedded) call. For example, if the market had advanced
by agreat deal since the product was bought, the imbedded call would theoreti
cally have anice profit. If one could sell it and buy another, similar call at ahigh
er strike, he would effectively ~olling his call up. This would raise the striking
price and would reduce downside risk greatly (at the cost of slightly reducing
upside profit potential).
Example: Using the same product as in the previous example, suppose that the
investor who owns the structured product considers another alternative. In the pre
vious example, he evaluated the possibility of selling aslightly out-of-the-money list
ed call to effectively produce acollared position, or abull spread. The problem with
that is that it limits upside profit potential. If the market were to continue to rise, he
would only participate up to the higher strike (plus the premium received).

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616 Part V: Index Options and Futu,
Abetter alternative might be to roll his imbedded call up, thereby taking s01
money out of the position but still retaining upside profit potential. Recall that tstructured product had these terms:
Guarantee price: 10
Underlying index: S&P 500 index ($SPX)
Striking price: 700
As in the earlier example, the investor owns 15,000 shares of the structun
product. Furthermore, assume that there are about two years remaining until mat
rity of the structured product, and that the current prices are the same as in the pr
vious example:
Current price of structured product: 16.50
Current price of $SPX: 1,200
For purposes of simplicity, let'sassume that there are listed two-year LEAP
options available for the S&Pindex, whose prices are:
S&P 2-year LEAPS, striking price 700: 550
S&P 2-year LEAPS, striking price 1,200: 210
In reality, S&P LEAPS options are normally reduced-value options, meanin.
that they are for one-tenth the value of the index and thus sell for one-tenth the pricE
However, for the purposes of this theoretical example, we will assume that the full
value LEAPS shown here exist.
It was shown in the previous example that the investor would trade two of thest
calls as an equivalent amount to the quantity of calls imbedded in his structurec
product. So, this investor could buy two of the 1,200 calls and sell two of the 700 calli
and thereby roll his striking price up from 700 to 1,200. This roll would bring in 34(
points, two times; or $68,000 less commissions.
Since the difference in the striking prices is 500 points, you can see that he is
leaving something "on the table" by receiving only 340 points for the roll-up. This is
common when rolling up: One loses the time value premium of the vertical spread.
However, when viewed from the perspective of what has been accomplished, the
investor might still find this roll worthwhile. He has now raised the striking price of
his call to 1,200, based on the S&Pindex, and has taken in $68,000 in doing so. Since
he owns 15,000 shares of the structured product, that means he has taken in 4.53 p~rshare (68,000 / 15,000). Now, for example, if the S&Pcrashes during the next two
years and plummets below 700 at the maturity date, he will receive $10 as the guar
antee price plus the $4.53 he got from the roll - atotal "guarantee" of $14.53. Thus,
he has protected his downside.

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Otpt,r 32: Structured Products 617
Note that his downside risk is not completely eliminated, though. The current
prke of the structured product is 16.50 and the cash value at the current S&Pprice
11117.14 (see the previous example for this calculation), so he has risk from these lev
down to aprice of $14.53.
His upside is still unlimited, because he is net long two calls - the S&P 2-year
1,,EAPS calls, struck at 1,200. The two LEAPS calls that he sold, struck at 700, effec
tively offsets the call imbedded in the structured product, which is also struck at 700.
This example showed how one could effectively roll the striking price of his
structured product up to ahigher price after the underlying had advanced. The indi
vidual investor would have to decide if the extra downside protection acquired is
worth the profit potential sacrificed. That depends heavily, of course, on the prices of
the listed S&Poptions, which in turn depend on things such as volatility and time
remaining until expiration.
Of course, one other alternative exists for aholder of astructured product who
has built up agood profit, as in the previous two examples: He could sell the prod
uct he owns and buy another one with astriking price closer to the current market
value of the underlying index. This is not always possible, of course, but as long as
these products continue to be brought to market every few months or so by the
underwriters, there will be awide variety of striking prices to choose from. Apossi
ble drawback to rolling to another structured product is that one might have to
extend his holding'smaturity date, but that is not necessarily abad thing.
Adifferent scenario exists when the underlying index drops after the structured
product is bought. In that case, one would own asynthetic call option that might be
quite far out-of the-rrwney. Alisted call spread could be used to theoretically lower
the call'sstriking price, so that upside movement might more readily produce prof
its. In such acase, one would sell alisted call option with astriking price equal to the
striking price of the structured product and would buy alisted call option with alower striking price - one more in line with current market values. In other words,
he would buy alisted call bull spread to go along with his structured product.
Whatever debit he pays for this call bull spread will increase his downside risk, of
course. However, in return he ~sthe ability to make profits more quickly if the
underlying index rises above the new, lower striking price.
Many other strategies involving listed options and the structured product could
be constructed, of course. However, the ones presented here are the primary strate
gies that an investor should consider. All that is required to analyze any strategy is to
remember that this type of structured product is merely asynthetic long call. Once
that concept is in mind, then any ensuing strategies involving listed options can easily
be analyzed. For example, the purchase of alisted put with astriking price essential-

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618 Part V: Index Options and Future
ly equal to that of the structured product would produce aposition similar to a 101
straddle. The reader is left to interpret and analyze other such strategies on his OWI
LISTS OF STRUCTURED PRODUCTS
The descriptions provided so far encompass the great majority of listed structure
products. There are many similar ones involving individual stocks instead ofJndice
(often called equity-linked notes). The concepts are the same; merely substitute
stock price for an index price in the previous discussions in this chapter.
Some large insurance companies offer similar products in the form of annuities
They behave in exactly the same way as the products described above, except tha
there is no continuous market for them. However, they still afford one the opportu
nity to own an index fund with no risk Many of the insurance company products, in
fact, pay interest to the annuity holder - something that most of the products listed
on the stock exchanges do not.
Both the CBOE and American Exchange Web sites (www.cboe.com and
www.amex.com) contain details of the structured products listed on their respective
exchanges. Asampling at the time of this writing showed the following breakdowns
of listed structured products:
Underlying Index Percent of Listed Products
Broad-based index (S&P 500, e.g.) 23%
Sector index
Stocks
43%
34%
If you browse those lists, an investor may find indices or stocks that are of particular
interest to him. In addition, it may be possible to find ones trading at asubstantial
discount to cash settlement value, something astrategist might find attractive.
PERCS
Part II: Products Designed
to Provide /,/Income"
At the beginning of this chapter, it was stated that most listed structured products~
fall into one of two categories. The first category was the type of structured prod
uct that resembled the ownership of acall option. The second portion, to be dis-

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0.,t,r 32: Structured Products 619
t'Ussed in the remainder of this chapter, resembles the covered write of acall
option. These often have names involving the term preferreds. Some are called
Trust Preferreds; another popular term for them is Preferred Equity Redemption
Cumulative Stock (PERCS). We will use the term PERCS in the following exam
ples, but the reader should understand that it is being used in ageneric sense - that
any of the similar types of products could be substituted wherever the term PERCS
is used.
A PERCS is astructured product, issued with amaturity date and tied to an
individual stock. At the time of issuance, the PERCS and the common stock are usu
ally about the same price. The PERCS pays ahigher dividend than the common
stock, which may pay no dividend at all. If the underlying common should decline in
price, the PERCS should decline by alesser amount because the higher dividend
payout will provide ayield floor, as any preferred stock does.
There is alimited life span with PERCS that is spelled out in the prospectus at
the time it is issued. Typically, that life span is about three years. At the end of that
time, the PERCS becomes ordinary common stock.
A PERC Smay be called at any time by the issuing corporation if the company'scommon stock exceeds apredetermined call price. In other words, this PERCS stock
is callable. The call price is normally higher than the price at which the common is
trading when the PERCS is issued.
What one has then, if he owns a PERCS, is aposition that will eventually
become common stock unless it is called away. In order to compensate him for the
fact that it might he called away, the owner receives ahigher dividend. What if one
substitutes the word "premium" for "higher dividend"? Then the last statement
reads: In order to compensate him for the fact that it might be called away, the owner
receives apremium. This is exactly the definition of acovered call option write.
Moreover, it is an out-of-the-money covered write of along-term call option, since
the call price of the PERCS is akin to astriking price and is higher than the initial
stock price.
Example: XYZ is selling at $35 per share. XYZ common stock pays $1 ayear in div
idends. The company decides to issue a PERCS.
The PERCS will have athree~ life and will be callable at $39. Moreover, the
PERCS will pay an annual dividend of $2.50.
The PERCS annual dividend rate is 7% as compared to 2.8% for the common
stock.
If XYZ were to rise to 39 in exactly three years, the PERCS would be called.
The total return that the PERCS holder would have made over that time would be:

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620
Stock price appreciation 139 - 35):
Dividends over 3 years:
Total gain
Total return:
Annualized return:
Part V: Index Options and Future.
4
7.50
11.50
11.50/35 = 32.9%
32.9%/3 = 11%
If the PERCS were called at an earlier time, the annualized return might be ever
higher. ·
CALL FEATURE
The company will most likely call the PER CS if the common is above the call price
for even ashort period of time. The prospectus for the PERCS will describe any
requirements regarding the call. Atypical one might be that the common must close
above the call price for five consecutive trading days. If it does, then the company
may call the PERCS, although it does not have to. The decision to call or not is strict
ly the company's. The PERCS holder has no choice in the matter of when or if his
shares are called. This is the same situation in which the writer of acovered call finds
himself: He cannot control when the exercise will occur, although there are often
clues, including the disappearance of time value premium in the written listed call
option. The PERCS holder is more in the dark, because he cannot actually see the
separate price of the imbedded call within the PERCS. Still, as will be shown later,
he may be able to use several clues to determine whether acall is imminent.
Most PERCS may be called for either cash or common stock. This does not
change the profitability from the strategist'sstandpoint. He either receives cash in
the amount of the call price, or the same dollar amount of common stock. The only
difference between the two is that, in order to completely close his position, he would
have to sell out any common stock received via the call feature. If he had received
cash instead, he wouldn'thave to bother with this final stock transaction.
In the case of most PERCS, the call feature is more complicated than that pre
sented in the preceding example. Recall that the company that issued the PERCS
can call it at any time during the three years, as long as the common is above the call
price. The holder of the XYZ PERCS in the example would not be pleased to find
that the PER CS was called before he had received any of the higher dividends that
the PERCS pays. Therefore, in order to give a PERCS holder essentially the same
return no matter when the PERCS is called, there is a "sliding scale" of call prices. -
At issuance, the call price will be the highest. Then it will drop to aslightly
lower level after some of the dividends have been paid (perhaps after the first year).

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621
This lowering of the call price continues as more dividends are paid, until it finally
reaches the final call price at maturity. The PERCS holder should not be confused
this sliding scale of call prices. The sliding call feature is designed to ensure that
PERC Sholder is compensated for not receiving all his "promised" dividends if the
PERCS should be called prior to maturity.
Example: As before, XYZ issues a PERCS when the common is at 35. The PERCS
pays an annual dividend of $2.50 per share as compared to $1 per share on the com
mon stock. The PERCS has afinal call price of 39 dollars per share in three years.
If XYZ stock should undergo asudden price advance and rise dramatically in avery short period of time, it is possible that the PERCS could be called before any
dividends are paid at all. In order to compensate the PERCS holder for such an
c>ecurrence, the initial call price would be set at 43.50 per share. That is, the PERCS
can'tbe called unless XYZ trades to aprice over 43.50 dollars per share. Notice that
the difference between the eventual call price of 39 and the initial call price of 43.50
is 4.50 points, which is also the amount of additional dividends that the PERCS
would pay over the three-year period. The PER CS pays $2.50 per year and the com
mon $1 per year, so the difference is $1.50 per year, or $4.50 over three years.
Once the PERCS dividends begin to be paid, the call price will be reduced to
reflect that fact. For example, after one year, the call price would be 42, reflecting
the fact that if the PERCS were not called until ayear had passed, the PERCS hold
er would be losing $3 of additional dividends as compared to the common stock
($1.50 per year for the remaining two years). Thus, the call price after one year is set
at the eventual call price, 39, plus the $3 of potential dividend loss, for atotal call
price of 42.
This example shows how the company uses the sliding call price to compensate
the PERCS holder for potential dividend loss if the PERCS is called before the
three-year time to maturity has elapsed. Thus, the PER CS holder will make the same
dollars of profit - dividends and price appreciation combined - no matter when the
PERCS is called. In the case of the XYZ PERCS in the example, that total dollar
profit is $11.50 (see the prior example). Notice that the investor'sannualized rate of
return would be much higher if he were called prior to the eventual maturity date.
One final point: The call price §lides on ascale as set forth in the prospectus for
the PERCS. It may be every time adividend is paid, but more likely it will be daily!
That is, the present worth of the remaining dividends is added to the final call price
to calculate the sliding call price daily. Do not be overwhelmed by this feature.
Remember that it is just ameans of giving the PERCS holder his entire "dividend
premium" if the PERCS is called before maturity.

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622 Part V: Index Options and Futures
For the remainder of this chapter, the call price of the PERCS will be referrea
to as the redemption price. Since much of the rest of this chapter will be concemec
with discussing the fact that a PERCS is related to acall option, there could be somE
confusion when the word call is used. In some cases, call could refer to the price at
which the PER CS can be called; in other cases, it could refer to acall option - either
alisted one or one that is imbedded within the PERCS. Hence, the word redemp
tion will be used to refer to the action and price at which the issuing compa:J)ly may
call the PERCS.
A PERCS IS A COVERED CALL WRITE
It was stated earlier that a PER CS is like acovered write. However, that has not yet
been proven. It is known that any two strategies are equivalent if they have the same
profit potential. Thus, if one can show that the profitability of owning a PER CS is the
same as that of having established acovered call write, then one can conclude that
they are equivalent.
Example: For the purposes of this example, suppose that there is athree-year listed
call option with striking price 39 available to be sold on XYZ common stock. Also,
assume that there is a PERCS on XYZ that has aredemption price of 39 in three
years. The following prices exist:
XYZ common: 35
XYZ PERCS: 35
3-year call on XYZ common with striking price of 39: 4.50
First, examine the XYZ covered call write'sprofitability from buying 100 XY2 and
selling one call. It was initially established at adebit of 30.50 (35 less the 4.50
received from the call sale). The common pays $1 per year in dividends, for atotal of
$3 over the life of the position.
XYZ Price Price of a Profit/loss on Total Profit/loss
in 3 Years 3-Year Call Securities Incl. Dividend
25 0 -$550 -$250
30 0 -50 +250
35 0 +450 +750
39 0 +850 + 1,150
45 6 +850 + 1,150
50 11 +850 + 1,150

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O.,,ter 32: Structured Products 623
TI1is is the typical picture of the total return from acovered write - potential losses on
the downside with profit potential limited above the striking price of the written call.
Now look at the profitability of buying the PER CS at 35 and holding it for three
(Assume that it is not called prior to maturity.) The PER CS holder will earn atotal of $750 in dividends over that time period.
XYZ Price Profit/Loss on Total Profit/Loss
in 3 Years PERCS Incl. Dividend
25 -$1,000 -$250
30 -500 +250
35 0 +750
>=39 +400 + 1, 150
This is exactly the same profitability as the covered call write. Therefore, it can be
concluded with certainty that a PERCS is equivalent to acovered call write. Note
that the PER CS potential early redemption feature does not change the truth of this
statement. The early redemption possibility merely allows the PERCS holder to
receive the same total dollars at an earlier point in time if the PERCS is demanded
prior to maturity. The covered call writer could theoretically be facing asimilar situ
ation if the written call option were assigned before expiration: He would make the
same total profit, but he would realize it in ashorter period of time.
The PERCS is like acovered write of acall option with striking price equal to
the redemption price of the PERCS, except that the holder does not receive acall
option premium, but rather receives additional dividends. In essence, the PERCS
has acall option imbedded within it. The value of the imbedded call is really the
value of the additional dividends to be paid between the current date and maturity.
The buyer of a PERCS is, in effect, selling acall option and buying common
stock. He should have some idea of whether or not he is selling the option at area
sonably fair price. The next section of this chapter addresses the problem of valuing
the call option that is imbedded in the PERCS.
PRICE BEHAVIOR
The way that a PERCS price is often discussed is in relationship to the common
stock. One may hear that the PERCS is trading at the same price as the common or
at apremium or discount to the common. As an option strategist who understands
covered call writing, it should be asimple matter to picture how the PERCS price
will relate to the common price.

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Oapter 32: Structured Products 625
Another observation that can be made from the figure is that the PERCS pric
ing curves level off at the redemption price. They cannot sell for more than that
price.
Now look on the left-hand side of the figure. Notice that the more time remain
Ing until maturity, the higher the PERCS will trade above the common stock. This is
because of the extra dividends that the PER CS pay. Obviously, the PERCS with three
years until maturity has the potential to pay more dividends than the one with three
months remaining, so the three-year PERCS will sell for more than the six-month
PERCS when the common is below the issue price. Since either PERCS pays more
dividends than the common, they both trade for higher prices than the common.
When the common trades above the issue price (point 'T'), the opposite is true.
The six-month PERCS trades for aslightly higher price than the three-year PERCS,
but both sell for significantly less than the common, which has no limit on its poten
tial price.
One other observation can be made regarding the situation in which the com
mon trades well below the issue price: After the last additional dividend has been
paid by the PERCS, it will trade for approximately the same price as the common in
that situation. ·
Viewed strictly as asecurity, a PERCS may not appear all that attractive to some
investors. It has much, but not all, of the downside risk of the common stock, and not
nearly the upside potential. It does provide abetter dividend, however, so if the com
mon is relatively unchanged from the issue price when the PERCS matures, the
PERCS holder will have come out ahead. If this description of the PER CS does not
appeal to you, then neither should covered call writing, for it is the same strategy; acall option premium is merely substituted for the higher dividend payout.
PERCS STRATEGIES
Since the PERCS is equivalent to acovered write, strategies that have covered writes
as part of their makeup are amenable to having PERCS as part of their makeup as
well. Covered writing is part of ratio writing. Other modifications to the covered writ
ing strategy itself, such as the protected covered write, can also be applied to the
PERCS.
PROTECTING THE PERCS WITH LISTED OPTIONS
~
The safest way to protect the PERC Sholding with listed options is to buy an out-of
the-nwney put. The resultant position - long PERCS and long put - is aprotected
covered write, or a "collar." The long put prevents large losses on the downside, but
it costs the PERCS holder something. He won'tmake as much from his extra divi
dend payout, because he is spending money for the listed put. Still, he may want the
downside comfort.

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626 Part V: Index Options and Futures
Once one realizes that a PERCS is equivalent to acovered write, he can easily
extend that equivalence to other positions as well. For example, it is known that acovered call write is equivalent to the sale of anaked put. Thus, owning a PERCS is
equivalent to the sale of anaked put. Obviously, the easiest way to hedge anaked put
is to buy another put, preferably out-of-the-money, as protection.
Do not be deluded into thinking that selling alisted call against the PERCS is
asafe way of hedging. Such acall option sale does add amodicum of downside pro
tection, but it exposes the upside to large losses and therefore introduces apotential
risk into the position. It is really aratio write. The subject is covered later in this
chapter.
REMOVING THE REDEMPTION FEATURE
At issuance, the imbedded call is athree-year call, so it is not possible to exactly
duplicate the PERCS strategy in the listed market. However, as the PERCS nears
maturity, there will be listed calls that closely approximate the call that is imbedded
in the PERCS. Consequently, one may be able to use the listed call or the underly
ing stock to his advantage.
If one were to buy alisted call with features similar to the imbedded call in a
PERCS that he owned, he would essentially be creating long common stock. Not that
one would necessarily need to go to all that trouble to create long common stock, but
it might provide opportunities for arbitrageurs.
In addition, it might appeal to the PERCS holder if the common stock has
declined and the imbedded call is now inexpensive. If one covers the equivalent of
the imbedded call in the listed market, he would be able to more fully participate in
upside participation if the common were to rally later. This is not always aprofitable
strategy, however. It may be better to just sell out the PERCS and buy the common
if one expects alarge rally.
Example: XYZ issued a PERCS some time ago. It has aredemption price of 39; the
common pays adividend of $1 per year, while the PER CS pays $2.50 per year.
XYZ has fallen to aprice of 30 and the PERCS holder thinks arally may be
imminent. He knows that the imbedded call in the PERCS must be relatively inex
pensive, since it is 9 points out-of-the-money (the PERCS is redeemable at 39, while
the common is currently 30). Ifhe could buy back this call, he could participate more
fully in the upward potential of the stock.
Suppose that there is aone-year LEAPS call on XYZ with astriking price of 40.
If one were to buy that call, he would essentially be removing the redemption fea-
ture from his PERCS.
Assume the following prices exist:

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Gapter 32: Structured Products
XYZ Common: 30
XYZ PERCS: 31
XYZ January 40 LEAPS call: 2
627
If one buys this LEAPS call and holds it until maturity of the PERCS one year
from now, the profit picture of the long PERCS plus long call position will be the fol
lowing:
Total Value
XYZ Price in PERCS January 40 of long PERCS
January Next Year Price LEAPS + long LEAPS
25 25 0 25
30 30 0 30
35 35 0 35
40 39 0 39
45 39 5 44
50 39 10 49
Thus, the PE RCS + long call position is worth almost exactly what the common
stock is after one year. The PERCS holder has regained his upside profit potential.
What did it cost the investor to reacquire his upside? He paid out 2 points for
the call, thereby more than negating his $1.50 dividend advantage over the course of
the year (the common pays a $1 dividend;'the PERCS $2.50). Thus, it may not actu
ally be worth the bother. In fact, notice that if the PERCS holder really wanted to
reacquire his upside profit potential, he would have been better off selling his
PERCS at 31 and buying the common at 30. If he had done this, he would have taken
in 1 point from the sale and purchase, which is slightly smaller than the $1.50 divi
dend he is forsaking. In either case, he must relinquish his dividend advantage and
then some in order to reacquire his upside profit potential. This seems fair, however,
for there must be some cost involved with reacquiring the upside.
Remember that an arbitrageur might be able to find atrade involving these sit
uations. He could buy a PERCS, sell the common short, and buy alisted call. If there
were price discrepancies, he could profit. It is actions such as these that are required
to keep prices in their proper relationship.
1
CHANGING THE REDEMPTION PRICE OF THE PERCS
When covered writing was discussed as astrategy, it was shown that the writer may
want to buy back the call that was written and sell another one at adifferent strike.

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628 Part V: Index Options and Futu,
If the action results in alower strike, it is known as rolling down; if it results in ahi§
er strike, it is rolling up.
This rolling action changes the profit potential of the position. If one rolls dov;
he gets more downside protection, but his upside is even more limited than it prei
ously was. Still, if he is worried about the stock falling lower, this may be aprop
action to take. Conversely, if the common is rallying, and the covered writer is mo
bullish on the stock, he can roll up in order to increase his upside profit potenti~(
course, by rolling up, he creates more downside risk if the common stock should sue
denly reverse direction and fall.
The PERCS holder can achieve the same results as the covered writer. He ca
effectively roll his redemption price down or up if he so chooses. His reasons fc
doing so would be substantially the same as the covered writer's. For example, if th
common were dropping in price, the PERCS holder might become worried that hi
extra dividend income would not be enough to protect him in the case of furthe
decline. Therefore, he would want to take in even more premium in exchange fo
allowing himself to be called away at alower price.
Example: XYZ issued PERCS when both were trading at 35. Now, XYZ has fallen t<
30 with only ayear remaining until maturity, and the PERCS holder is nervous abou
further declines. He could, of course, merely sell his stock; but suppose that ht:
prefers to keep it and attempt to modify his position to more accurately reflect hb
attitude about future price movements.
Assume the following prices exist:
XYZ Common: 30
XYZ PERCS: 31
XYZ January 40 call: 2
XYZ January 35 call: 4
Ifhe buys the January 40 call and sells the January 35 call, he will have accomplished
his purpose. This is the same as selling acall bear spread. As shown in the previous
example, buying the January 40 call is essentially the same as removing the redemp
tion feature from the PERCS. Then, selling the January 35 call will reinstate aredemption feature at 35. Thus, the PERCS holder has taken in apremium of 2
points and has lowered the redemption price.
If XYZ is below 35 when the options expire, he will have an extra $200 profit
from the option trades. If XYZ rallies and is above 35 at expiration, he will be effec
tively called away at 37 (the striking price of 35 plus the two points from the rollr,
instead of at the original demand price of 39. In actual practice, if the January 35 call

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629
were assigned, the trader could then be simultaneously long the PERCS and short
common stock, with along January 40 call in addition. He would have to unwind
pieces separately, an action that might include exercising the January 40 call (if
It were in-the-money at expiration) to cover the short common stock.
The conclusion that can be drawn is that in order to roll down the redemption
fiature of a PERCS, one must sell avertical call spread. In asimilar manner, if he
wanted to roll the strike up, he would buy avertical call spread. Using the same
example, one would still buy the January 40 call ( this effectively removes the redemp
tion feature of the PERCS) and would then sell a January 45 call in order to raise the
redemption price. Thus, buying avertical call spread raises the effective redemption
price of a PERCS.
There is nothing magic about this strategy. Covered writers use it all the time.
It merely evolves from thinking of a PERCS as acovered write.
SELLING A CALL AGAINST A LONG PERCS IS A RATIO WRITE
It is obvious to the strategist that if one owns a PERCS and also sells acall against it,
he does not have acovered write. The PERCS is already acovered write. What he
has when he sells another call is aratio write. His equivalent position is long the com
mon and short two calls.
There is nothing inherently wrong with this, as long as the PERCS holder
understands that he has exposed himself to potentially large upside losses by selling
the extra call. If the common stock were to rally heavily, the PERCS would stop ris
ing when it reached its redemption price. However, the additional call that was sold
would continue to rise in price, possibly inflicting large losses if no defensive action
were taken.
The same strategies that apply to ratio writing or straddle writing would have to
be used by someone who owns a PERCS and sells acall against it. He could buy com
mon stock if the position were in danger on the upside, or he could roll the call(s) up.
Adifference between ordinary ratio writing and selling alisted call option
against a PERCS is that the imbedded call in the PERCS may be avery long-term
call (up to three years). The listed call probably wouldn'tbe of that duration. So the
ratio writer in this case has two different expiration dates for his options. This does
not change the overall strategy, but it does mean that the imbedded long-term call
will not diminish much in price due to thepssage of time, until the PERCS is near
er maturity.
Neutrality is normally an important consideration for aratio writer. If one is
long a PERCS and short alisted call, he is by definition aratio writer, so he should

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630 Part V: Index Options and Futures
be interested in neutrality. The key to determining one'sneutrality, of course, is tc
use the delta of the option. In the case of the PERCS stock, one would have to usE
the delta of the imbedded call.
Example: An investor is long 1,000 shares ofXYZ PERCS maturing in two years. He
thinks XYZ is stuck in atrading range and does not expect much volatility in the near
future. Thus, aratio write appeals to him. How many calls should he sell in order to
create aneutral position against his 1,000 shares?
First, he needs to compute the delta of the imbedded option in the PER CS, and
therefore the delta of the PERCS itself. The delta of a PERCS is not 1.00, as is the
delta of common stock.
Assume the XYZ PERCS matures in two years. It is redeemable at 39 at that
time. XYZ common is currently trading at 33. The delta of atwo-year call with strik
ing price 39 and common stock at 33 can be calculated (the dividends, short-term
interest rate, and volatility all play apart). Suppose that the delta of such an option is
0.30. Then the delta of the PER CS can be computed:
PERCS delta= 1.00- Delta of imbedded call
= 1.00 - 0.30 = 0.70 in this example
Assume the following data is known:
Security
XYZ Common
XYZ PERCS
XYZ October 40 call
Price
33
34
2
Delta
1.00
0.70(!)
0.35
Being long 1,000 PER CS shares is the equivalent of being long 700 shares of
common (ESP= 1,000 x 0.70 = 700). In order to properly hedge that ESP with the
October 40 call, one would need to sell 20 October 40 calls.
Quantity to sell = ESP of PER CS/ESP of October 40 call
= 700/(100 shares per option x 0.35)
= 700/35 = 20
Thus, the position - long 1,000 PER CS, short 20 October 40 calls - is aneutral one
and it is aratio write.
One may not want to have such asteep ratio, since the result of this example is
the equivalent of being long 1,000 common and short 30 calls in total (10 are imbed
ded in the long PERCS). Consequently, he could look at other options - perhaps
writing in-the-money October calls - that have higher deltas and won'trequire so
many to be sold in order to produce aneutral position.

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Cl,apter 32: Structured Produds 631
To remain neutral, one would have to keep computing the deltas of the options,
both listed and imbedded, as time passes, because stock movements or the passage
of time could change the deltas and therefore affect the neutrality of the position.
HEDGING PERCS WITH COMMON STOCK
Some traders may want to use the common stock to hedge the purchase of PERCS.
These would normally be market-makers or block traders who acquire the PERCS in
order to provide liquid markets or because they think they are slightly mispriced. The
simplest way for these traders to hedge their long PERCS would be with common
stock.
This strategy might also apply to an individual who holds PERCS, if he wants to
hedge them from apotential price decline but does not actually want to sell them (for
tax reasons, perhaps).
In either case, it is not correct to sell 100 shares of common against each 100
shares of PERCS owned. That is not atrue hedge. In fact, what one accomplishes by
doing that is to create anaked call option. A PERCS is acovered write; if one sells
100 shares of common stock from acovered write, he is left with anaked call. This
could cause large losses if the common rallies.
Rather, the proper way to hedge the PERCS with common stock is to calculate
the equivalent stock position of the PERC Sand hedge with the calculated amount of
common stock. The example showed how to calculate the ESP of the PERCS: One
must calculate the delta of the imbedded call option, which may be along-term one.
Then the delta of the PERCS can be computed, and the equivalent stock position can
be determined.
Example: Vsing the same prices from the previous example, one can see how much
stock he would have to sell in order to properly hedge his PERCS holding of 1,000
shares.
Assume XYZ is trading at 33, and the PE RCS has two years until maturity. If the
PERCS is redeemable at 39 at maturity, one can determine that the delta of the
imbedded option is 0.30 (see previous example). Then:
Delta of PE RCS = 1 - Delta of imbedded call
= 1- 0.30
= 0.70
Hence, the equivalent stock position of 1,000 PERCS is 700 shares (1,000 x
0.10). 1 Consequently, one would sell short 700 shares of XYZ common in order to
hedge this long holding of 1,000 PERCS.

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632 Part V: Index Options and Futures
This is not astatic situation. If XYZ changes in price, the delta of the imbedded
option will change as well, so that the proper amount of stock to sell as ahedge will
change. The deltas will change with the passage of time as well. Achange in volatili
ty of the common stock can affect the deltas, too. Consequently, one must constant
ly recalculate the amount of stock needed to hedge the PERCS.
What one has actually created by selling some common stock against his long
PERCS holding is another ratio write. Consider the fact that being long 1,000
PE RCS shares is the equivalent of being long 1,000 common and short 10 imbedded,
long-term calls. If one sells 700 common, he will be left with an equivalent position
of long 300 common and short 10 imbedded calls - aratio write.
The person who chooses to hedge his PER CS holding with apartial sale of com
mon stock, as in the example, would do well to visualize the resulting hedged posi
tion as aneutral ratio write. Doing so will help him to realize that there is both upside
and downside risk if the underlying common stock should become very volatile (ratio
writes have risk on both the upside and the downside). If the common remains fair
ly stable, the value of the imbedded call will decrease and he will profit. However, if
it is along-term imbedded call (that is, if there is along time until maturity of the
PER CS), the rate of time decay will be quite small; the hedger should realize that
fact as well.
In summary, the sale of some common against along holding of PERCS is aviable way to hedge the position. When one hedges in this manner, he must contin
ue to monitor the position and would be best served by viewing it as aratio write at
all times.
SELLING PERCS SHORT
Can it make sense to sell PER CS short? The payout of the large dividend seems to
be adeterrent against such ashort sale. However, if one views it as the opposite of along-term, out-of-the-money covered write, it may make some sense.
Acovered write is long stock, short call; it is also equivalent to being long a
PERCS. The opposite of that is short stock, long call - asynthetic put. Therefore, along put is the equivalent of being short a PERCS. Profit graph Hin Appendix Dshows the profit potential of being short stock and long acall. There is large down
side profit potential, but the upside risk is limited by the presence of the long call.
The amount of premium paid for the long call is awasting asset. If the stock does not
decline in price, the long call premium may be lost, causing an overall loss.
Shorting a PERCS would result in aposition with those same qualities. The
upside risk is limited by the redemption feature of the PERCS. The downside prof
it potential is large, because the PER CS will trade down in price if the common stoek

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