RBC's $650,000 31.8% reverse convertibles tied to Amarin pay high coupon, reflect volatility

By Emma Trincal

New York, April 26 - Market participants took note when a three-month reverse convertible paying a coupon of nearly 32% per year priced last week.

"That's amazing. But given the volatility of the underlying stock, it's almost normal," a sellsider said.

Royal Bank of Canada priced $650,000 of 31.8% reverse convertible notes due July 26, 2011 linked to Amarin Corp. plc shares, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par in cash unless Amarin shares fall below the protection price of $11.84, 70% of the initial price of $16.92, during the life of the notes and finish below the initial price, in which case the payout will be a number of Amarin shares equal to $1,000 principal amount divided by the initial price.

Amarin is a clinical-stage biopharmaceutical company with a focus on treatments for cardiovascular disease.

The deal priced on Thursday. On Monday, the stock price soared to $17.40 after several analysts upgraded the stock and the company announced positive test results for one of its anti-cholesterol drugs. Some analysts even speculated that the company may represent a takeover target, according to news reports.

Chasing volatility

The company's share price is up 94% year to date. Sources pointed to the extreme volatility of the stock.

"Anyone buying this product is essentially chasing volatility for a high coupon payment," a structurer said.

"Implied volatility levels were at 151 on the strike date versus a historical volatility of 40.6, which is why RBC was able to sell a put guaranteeing a 31.8% coupon on an annualized basis," this structurer added.

The higher the implied volatility versus its historical level, the more expensive the option is due to the risk, this source explained. In the case of a reverse convertible, the issuer is selling a put at the knock-in level to finance the coupon payment to the client.

"Obviously the higher the implied volatility, the better the coupon payment," this structurer said.

While the pricing makes sense, the risk was also stressed by sources.

High risk

"It makes me a little nervous that the stock has doubled over 10 days, but for someone who completely understands the risks involved, this investment could make sense," the structurer said.

Philip Davis, hedge fund manager at Capital Ideas, said that the first factor of risk was the pharmaceutical sector itself. "These drug names are pure gambling. The shares trade up on drug approval expectations. If they turn the drug down, there's no value in the stock. You've got nothing. It's either up or down."

Davis looked at the barrier level at 30% below the $16.92 initial price, which was $11.84.

"With an implied volatility of 150, the stock can move 150% either up or down in 12 months. That's 10% a month. Here's your 30% downside risk. You can hit the threshold pretty easily."

Stressing that the coupon for the three-month period is 8%, he said that the risk/reward profile of the notes was not attractive.

"You're willing to bet your entire principal for 8%. Well, then you're not getting compensated enough for that risk," he said.

"The stock peaked on Tuesday last week, closing at $17.10. It's now $1.23 lower at $15.87. It fell by 7% in just five trading sessions."

Shorting a put

Davis said that a better alternative for an investor, simply because the payoff would be higher, would be to short a put on the stock.

"You could sell a September 11 put at 75 cents with an $11.00 strike. It gives you the obligation to buy the stock for $11.00. You make money if the stock stays above $11.00. If not, you buy the stock at $11.00, but since you collect your 75 cents premium, your cost is $10.25."

Davis went on explaining the financing of the trade. The put seller needs to put down 20% of the strike price, or $2.20. Since he collects the 75 cents premium, the "net outlay" is really $1.45, he said.

"You earned 75 cents in premium and your margin is $1.45. For the four months, your rate of return is 51.7%. That's better than 31% for a year."

Davis said that shorting a put is the only way he buys stocks. He uses the technique to lock in the purchase price of the stock at the strike while pocketing a premium.

"There's no reason to buy a stock in any other way because you're immediately taking a discount. It's free money. You pay me 75 cents not to buy it," he said.

Unique packaging

But some said that the reverse convertible offers simplicity and efficiency for retail investors who are not necessarily versed in options, especially when the option is not easily accessible on an exchange.

The structurer said that the reverse convertible as it was structured could not be replicated by a retail investor.

"You couldn't get an option premium of 31.8% and a buffer protection of 30%," the structurer said.

"It's not replicable because the put option the issuer is selling is not 'plain vanilla'- it is a customized knock-in put, which is not traded on an exchange.

"A knock-in put is a little more complex than a listed equity put option."

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