Capital Protection Explained

Structured products help to manage risk in a portfolio by building in a degree of capital protection into the investment. The most popular forms of protection available in structured products use preset ‘barriers’ which define the level of protection available. These are commonly referred to as capital protection barriers and can be either hard protection barriers or soft protection barriers.

How Capital Protection Works

Different types of Capital Protection can be built into the structure to suit the requirements of the product and the risk profile of investors.  There are three elements to Capital Protection:
  • The type of protection barrier
  • The level of the protection barrier
  • The number of Observation Points i.e. How frequently the Underlying is measured over the Investment Term
The Capital Protection Barrier is defined as a percentage of the Start Value of the Underlying. The Underlying is monitored at pre-defined Observation Points during the Investment Term to determine its performance in comparison with the Capital Protection Barrier. If the barrier is breached (i.e. the value of the Underlying falls below the Capital Protection Barrier) it triggers an event determined by the type of Capital Protection in place.

Hard Protection Barrier

Hard protection defines the maximum loss that can be incurred by the investor, irrespective of the performance of the Underlying. The degree of protection provided is expressed as a percentage of the Investment Capital which is protected. In most cases (except 100% Hard Protection) losses can be incurred for any negative movement in the Underlying up to the level set by the barrier. The value of the Investment Capital will track the performance of the Underlying but the barrier caps the maximum loss at a pre-defined level.

Example:

  • A structured product with a 100% Hard Protection Barrier (sometimes referred to as 100% Capital Protection) protects all of the Investment Capital. Therefore, reference to the underlying asset is irrelevant as the Investment Capital is fully protected regardless of performance.
  • A structured product with an 80% Hard Protection Barrier will provide protection to 80% of the Investment Capital and the remaining 20% is at risk. If the value of the Underlying falls by 15% then the value of the Investment Capital returned will be 85% of initial Investment Capital representing a 15% loss. If the Underlying falls by 25% then the barrier has been breached and losses are capped at 20%.

50% Hard protection in a falling market. The chart illustrates the effect on Investment Capital (dark green line) in a falling Underlying (light green line) – Value of Investment Capital “tracks” the performance of the Underlying before barrier is breached. Losses are capped at 50% after the protection barrier is breached.

Soft Protection Barrier

Soft protection defines the change in value in the Underlying before Investment Capital is at risk. The degree of protection provided is expressed as a percentage of the Start Value of the Underlying. This percentage defines the fall in value of the Underlying before Investment Capital is at risk. Once the Capital Protection Barrier is breached, the value of the Investment Capital continues to track the performance of the Underlying until the end of the Investment Term. It is possible to lose 100% of the Investment Capital if the barrier is breached and the performance of the Underlying continues to fall.

Example:

  • A structured product with a 40% Soft Protection Barrier will provide protection to Investment Capital so long as the Underlying does not fall in value by 60% or more from its Start Value.
  • A structured product with a 60% Soft Protection Barrier will provide protection to Investment Capital so long as the Underlying does not fall in value by 40% or more from its Start Value.
If the barrier is breached then the value of the Investment Capital is at risk. The Investment Capital returned at the end of the Investment Term will reflect the final performance of the Underlying measured on the End Date of the structured product. If the value of the Underlying has recovered to its Start Level, capital will be returned in full.

Example – 50% Soft protection

50% Soft protection in a falling market. The chart illustrates the effect on Investment Capital (dark green line) in a falling Underlying (light green line) – Investment Capital is not at risk until 50% protection barrier is breached. Value of Investment Capital “tracks” the performance of the Underlying after the barrier is breached.

Observation Points

The Observation Points specify the dates and times on which the Underlying is monitored to assess its performance against the Capital Protection Barrier. The greater the number of Observation Points during the Investment Term, the greater the probability of the barrier breaching.
For more information about Structured Products, please contact us.

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