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O.,,ter 32: Structured Products 623
TI1is is the typical picture of the total return from a covered 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 a
total 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 a covered 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 a similar situ­
ation if the written call option were assigned before expiration: He would make the
same total profit, but he would realize it in a shorter period of time.
The PERCS is like a covered write of a call option with striking price equal to
the redemption price of the PERCS, except that the holder does not receive a call
option premium, but rather receives additional dividends. In essence, the PERCS
has a call 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 a call option and buying common
stock. He should have some idea of whether or not he is selling the option at a rea­
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 a premium or discount to the common. As an option strategist who understands
covered call writing, it should be a simple matter to picture how the PERCS price
will relate to the common price.