Citigroup's six-month 8%-12% ELKS tied to Chevron are a play on oil, volatility, analyst says

By Emma Trincal

New York, June 4 - Citigroup Funding Inc.'s upcoming Equity LinKed Securities linked to the common stock of Chevron Corp. may attract investors seeking short-term income and exposure to oil stocks on the view that volatility in this sector has been overpriced, said Tim Mortimer, managing director at Future Value Consultants.

Citigroup plans to price 8% to 12% annualized ELKS due Dec. 22, 2010 linked to Chevron stock, according to an FWP filing with the Securities and Exchange Commission.

Interest will be paid monthly.

If the price of Chevron stock declines by 20% or more during the life of the notes, the payout at maturity will be a number of Chevron shares equal to par of $10 divided by the initial share price or, at each holder's option, the value of those shares in cash. Otherwise, the payout will be par.

The notes are reverse convertibles, said Mortimer. As such, the coupon gets paid regardless of the performance of the underlying stock. The principal protection is limited to a 20% buffer, and there is no potential to participate in any appreciation of the underlying stock, according to the filing.

Implied volatility

Mortimer looked at the implied volatility of the underlying stock, which he said is an important factor to consider prior to investing in a reverse convertible, as it is used to value the underlying option that in turn will dictate the terms of the notes - in particular the size of the coupon paid to the investors.

"At 35%, the implied volatility of Chevron is higher than that of the S&P 500 index, which is in the mid-20s," said Mortimer. "You would expect any individual stock to be more volatile than an index. In the case of Chevron, the oil sector itself is volatile, which adds even more volatility."

Because the stock's implied volatility is "reasonably high," it gives the issuer more leeway to "generate more income as the put option is more expensive," said Mortimer.

With a reverse convertible, investors sell a put option to the issuer, which is the equivalent of selling volatility. The issuer in turn sells the option to the market. The more volatile the stock is, the higher the premium.

Capturing volatility

"Whenever volatility spikes in a sector, it gives you, the investor, better terms," explained Mortimer. "Now, if you believe that the stock prospects looking forward are still good, investing in a reverse convertible just when you can capture extra volatility to get a higher coupon is going to be the best opportunity.

"Investing in a reverse convertible linked to a stock is all about where implied volatility is, what the stock did in the recent past and how it is going to perform over the period."

The share price of Chevron fell over the past month by 12% to $71. Since the goal of a reverse convertible investor is essentially to pick a stock that will not to fall below the downside threshold, the lower the chances for the stock to do so and the bigger the buffer, the better the investment opportunity may be, explained Mortimer.

"In the past month, shares have already lost quite a bit. If you believe that the share price is going to be pretty stable, you've got quite a decent buffer," Mortimer said.

"You're looking at a lower share price level now than it was a month ago, something more than 10% lower. Plus you have a 20% buffer, which is good.

"You want a stock where volatility has already popped up. If the stock has already fallen or if you believe that volatility doesn't reflect reality in the sense that it's too high, then it's the best situation to enter into a reverse convertible investment."

Risk re-evaluated

Reverse convertibles tend to be risky, though, and the higher coupon often comes with increasing risk of breaking the barrier, said Mortimer.

The above-market coupon and the buffer are offered to compensate investors for the possibility of receiving at maturity shares in the stock that would be worth less than the principal, the prospectus said.

Future Value Consultants measures the risk associated with a product with its riskmap rating on a scale of zero to 10.

The riskmap for these notes is 2.47.

Mortimer, however, explained that the low risk score was due to his firm's methodology, which is in the process of being revised.

"In the methodology that we use, we employ historical volatility to calculate risk ratings. We're looking to change everything over. We'll use implied volatility soon across everything," he said.

"This will give us consistency between pricing and returns," he added.

Historical volatility is the realized volatility of a financial instrument over a given time period.

Implied volatility, on the other hand, is the volatility a stock price is expected to have over some future period.

Because implied volatility is what the market uses for the pricing of call and puts, it impacts the terms of a note such as its buffer, cap or coupon.

Mortimer said that if his firm had used implied volatility in order to calculate risk, the notes' riskmap would have been higher.

The underestimation of risk impacts the return score and the probabilities or returns as well, said Mortimer.

Return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

The Citigroup ELKS have a 7.54 return rating. If risk had been measured using implied volatility, the return score would have been lower, explained Mortimer.

Future Value Consultants publishes in its reports a probability table of product return outcomes.

For this deal, investors have a 91.4% chance of generating a 10% to 15% gain. On the downside, the odds of losing 5% or more are only 8.2%.

Again, if Future Value Consultants had used implied volatility instead of historical volatility, those probabilities would have been much more conservative, Mortimer said.

He added that the chances of losing 5% or more would have probably doubled to 16%. On the upside, the probability of generating gains between 10% and 15% would have dropped to approximately 83% from 91%, he said.

Good overall

Value rating on a scale of zero to 10 is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative. The notes have a high value rating of 7.69.

The simplicity of the structure, rated on a scale of zero to 10, is also high at 8.50.

The overall rating of the product is also high at 7.79.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

"This deal is good for someone prepared to take medium risk and who wants exposure to the stock," said Mortimer. "It would also work for someone who believes that volatility is overpriced and that they will be able to get their full principal back."

The notes are expected to price Thursday and settle three business days later.

Citigroup Global Markets Inc. is the underwriter.

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