JPMorgan's autocallables tied to Lorillard show low risk-adjusted return despite low barrier

By Emma Trincal

New York, June 17 - JPMorgan Chase & Co.'s 0% trigger autocallable optimization securities due June 21, 2012 linked to the common stock of Lorillard, Inc. combine several risk factors that lower the risk-adjusted return of the investment in spite of an above-average level of protection, said structured products analyst Suzi Hampson at Future Value Consultants.

If Lorillard shares close at or above the initial share price on any monthly observation date, the notes will be called at par plus an annualized call return of 22% to 27%, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the final share price is greater than or equal to 65% of the initial price, the payout at maturity will be par. Otherwise, investors will share fully in losses.

"The 65% barrier is very low, which is a good thing for investors. But it may not be enough to offset some of the risks," said Hampson.

High volatility

First among them, she said, is the implied volatility of the underlying stock, which at 44% is twice as high as the volatility of the S&P 500 index.

"In a volatility product like this one, you're selling a put, which allows you to offer a high coupon," she said.

"But on the other hand, the more volatile the underlying, the greater the chance to breach the barrier."

The high implied volatility factor explains why this deal received a higher riskmap than the average product with a similar structure.

Riskmap is a Future Value Consultants rating that measures the risk associated with a product on a scale from zero to 10. The higher the riskmap, the higher the risk of the product.

The rating compares the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels. Riskmap is composed of a market riskmap and a credit riskmap.

With these notes, the main risk factor is market risk - which is higher here than other products - rather than credit risk, which compared better with other deals.

The notes have a 6.01 riskmap, compared with a riskmap of 4.39 for products with a similar structure.

"This is simply a reflection of the volatility of the underlying. Autocallable notes are not always structured around one stock. A good chunk of them are based on indexes, which makes them less risky," she said.

"Although your barrier is lower here, the volatility of the stock is quite high. "So compared with the entire category of autocallable notes, which includes index-linked products, your riskmap here is greater."

Higher riskmap

The riskmap rating is also higher than the 5.22 riskmap observed for the average of all products. The "all-products" category includes all other structures, including reverse convertibles and growth products, the criterion being any product that has recently been rated by Future Value Consultants.

Hampson compared the product with a reverse convertible.

With a reverse convertible, she noted, investors get paid a coupon "no matter what," which adds protection to their investment, as the coupon can act as a cushion against losses the way a buffer would.

Overall, investors in reverse convertibles benefit from a double layer of protection: the coupon itself and the conditional downside protection represented by the amount between the trigger price and the initial price.

"If you add them up, you may end up with a greater level of protection than 35%, at least if you have a high coupon," she said.

Barrier penalty

The barrier itself, although set to limit losses, does not reduce the amount of losses when those occur, Hampson said.

"A 35% level of protection is quite good. But once you breach the 65% barrier, you're going to lose at least 35%, no less. So although there is a lower probability of losing capital, if you do end up losing money, you're going to lose a lot," she said.

The risk of losing a significant amount of principal is illustrated in the probability tables, which display in a chart the probabilities of returns across different return buckets.

Due to the autocallable structure, the firm's methodology with this product uses actual returns and not returns per annum as it usually does.

That's because the term of the notes varies depending on the occurrence and date of a call if any. With this particular structure, the chart gives the actual returns investors would get at redemption if their notes were to be called on a particular date as opposed to the returns per annum.

Overall, investors have a 90% probability of making or not losing money against a 10% chance of incurring losses.

However, Hampson said, all of the loss probabilities are concentrated in the worst performance bucket, which is losses in excess of 10%.

"Right there you have a 10% chance of losing 10% or more of your principal. But since a loss means you've breached the barrier at maturity, it's really a 10% probability of losing at least 35% of your capital. Not getting called is quite a big problem."

Weak return score

The notes show a return score of 5.59, which is less than the average of all products (at 6.08) and less than the average of similar products (6.25).

The return score is Future Value Consultants' opinion of the risk-adjusted return calculated from five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. FVC calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

Because of the various risk factors mentioned - the volatility of the underlying, a return contingent upon the stock's performance, the absence of a coupon and substantial losses if the barrier is breached - the notes have a low risk-adjusted return score, explained Hampson.

Reinvestment risk

But investors are also subject to another type of risk, which is common to all autocallable products, Hampson said, citing "the high likelihood to get a call early on."

Looking at the probability chart, Hampson said that about two-thirds of the probabilities were concentrated around gains in the zero to 5% return bucket.

Within that bucket, an unidentified percentage applied to the zero-gain scenario, in which investors get nothing but their principal at maturity because the stock finishes lower than its initial value but still above the trigger price. The bucket also includes gains above zero and below 5%.

Hampson said that the high probability of earning small gains results from the high likelihood of an early call, especially if the call condition only requires the stock to close at its initial level without necessarily having to close higher.

Because the notes are structured around monthly observation dates, the product could be called as early as one month after pricing, she said.

Assuming an annual call premium of 24%, it would give investors an actual return of about 2% versus 24% if the call occurred at maturity, its latest possible date.

"If you get called with only 2% after a month, it's not as good as getting 2% a month for one year," she said.

"The first seven coupons will pay less than 15%.

"The probability of kicking out at maturity and getting the full call premium are small. You're more likely to get kicked out after a month."

When the notes are called early, investors not only get less, they also incur reinvestment risk, she said.

"This risk is greater with monthly call dates. If it was quarterly, you would have a greater probability of getting a higher return because you would have fewer call points," she said.

All those factors contribute to a disappointing return score, she said.

"These notes are designed for people who have a short-term investment timeframe. They should be ready to reinvest their capital. This is not like a growth product where you can sit down and wait for the notes to mature. This is for a much more active type of investor," she said.

Price, overall

Despite the low return score, the notes received a high price score of 8.74, which enhanced the overall rating to 7.17.

The price score is Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative.

The overall score is Future Value Consultants' opinion on the quality of a deal based on the average of the price score and the return score.

UBS Financial Services Inc. and J.P. Morgan Securities LLC are the agents.

The notes (Cusip: 46634X161) were scheduled to price on Friday and are expected to settle on Wednesday.

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