JPMorgan’s $1.76 million notes on performance-weighted basket show rarely seen ‘best-of’

By Emma Trincal

New York, Feb. 7 – JPMorgan Chase Financial Co. LLC’s $1.76 million of 0% return notes due Feb. 3, 2028 linked to a weighted basket was one of the very few “best-of” or “allocator” notes to hit the market in a long time, sources said.

The basket consists of the iShares China Large-Cap ETF, the MSCI EAFE index and the MSCI Emerging Markets index, according to a 424B2 filing with the Securities and Exchange Commission.

The basket weights will be determined at maturity. The basket component with the best percentage change will have a weight of 60%, the next weighted at 40% and the least performing component weighted at 0%.

The payout at maturity will be par plus the basket return. Investors will be fully exposed to any basket decline.

No protection

While not unusual in those structures, the full downside exposure at maturity had to be considered.

For some advisers, it could be a deal breaker, a market participant said.

“The zero percent allocation to the worst index is not going to replace the downside protection.

“It’s better than getting 100% of the loser, but it’s still not the same as having a buffer or a barrier.”

Rainbow options

The structure better known as a “best-of” is reminiscent of the much more widespread “worst-of,” although they display different and somewhat opposite payoffs.

Both products are built on basket options often called “rainbow” options, where pricing and returns greatly depend on the relationship between the basket components.

When buying a best-of note, investors will benefit the most if the correlations between the basket components are low, explained the market participant.

Pricing

That’s because high correlations may defeat the purpose of the payout. If all three basket components behave the same way and generate similar returns, the advantage of maximizing the allocation to the best-performing basket component and eliminating the worst performance will be significantly reduced, he explained.

“If your basket is S&P, S&P and S&P, what’s the point?” he said.

But as a result, pricing is more attractive when correlations are high.

“It’s a tradeoff. You’ll get much better terms when the assets tend to move the same way,” he said.

Worst-of payouts are the opposite. The lower the correlation, the better the pricing and the greater the risk to investors, he noted.

This market participant looked at the relationships between the basket components, a key factor in assessing the value of the product.

Some overlap

“There is some overlap between those asset classes and that should improve the terms,” he said.

The MSCI Emerging Markets index and the iShares China Large-Cap ETF exhibited a fairly high correlation coefficient of 0.83 on a scale of 0 to 1. This result may be due to China’s 25% weighting in the MSCI Emerging Markets index.

On the other hand, the correlation between the Chinese ETF and the MSCI EAFE index was only 0.65. In this case, the cause may have been the very small overlap between the two components: the developed market index only shows a 2% allocation to Hong Kong-listed stocks.

The overall relationships between the basket components could not be clearly established without pricing the notes as many other factors come into play such as dispersion, volatility and dividends, he said.

Not common

While some advisers have expressed the desire to see more best-of products from banks, those notes remain relatively rare.

“I think you don’t see many of these because issuers can’t always create good optics. Best-of can be quite expensive and you need high correlations between the components to make it work,” he said.

But when correlations are too high, investors lose the benefit of the best-of.

Advisers may prefer worst-of because the terms are often more attractive, he added.

“When you have low or negative correlations in a worst-of, you can really do a lot. You can boost the coupon, increase the size of the barrier. It just looks much better,” he said.

Not so bad

A financial adviser was skeptical about best-of structures in general.

“Those so-called allocators don’t give you good terms, and there’s still risk or opportunity costs,” he said.

He offered an example.

“Let’s say that over four years, the best performing index is up 100%. You cut your return almost by half. You get 60%.

In addition, the exposure to the Chinese equity market was another risk.

“There is no leverage, just one-to-one on the upside. You’re not getting any dividend for four years.”

The full downside exposure however was not a concern, he said.

“To me these notes have protection because of the 0% allocation to the worst performer. It’s like having a barrier. Besides over a four-year period, you’re not very likely to have a negative return.”

“I wouldn’t say these are bad terms given the allocation feature. They’re decent. But it’s not without risk.

“I’m sort of neutral.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes settled on Feb. 1.

The Cusip number is 48134T3D4.

The fee is 0.6%.

© 2015 Prospect News.
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