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's cost is not a fixed amount. It varies, depending on the final value 
of the underlying index. In fact, the cost of the option is a percentage of the final 
value of the index. Thus, we can't really price it at the beginning, because we don't 
know what the final value of the index will be. In fact, we have to cease thinking of 
this option's cost as a fixed number. Rather, it is a geometric 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 a doubling 
of the index value (an increase of 100%) to 2,200 resulted in a gain 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 a flat-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 a great deal of it.