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