BNP’s notes tied to BNP Multi Asset Diversified 5 index to offer partial hedge, protection

By Emma Trincal

New York, May 14 – BNP Paribas’ 0% notes due Nov. 24, 2026 linked to the BNP Paribas Multi Asset Diversified 5 index give investors full downside protection but at a cost of limiting the upside due to the volatility control embedded in the underlying proprietary index, said Clemens Kownatzki, finance professor at Pepperdine University.

The payout at maturity will be par plus the index performance with a floor of par, according to a term sheet.

The index tracks eight components that provide exposure to equity futures in Europe, the United States and Japan, government bond futures in Europe, the United States and Japan, and commodity futures.

Allocations to each of these components are rebalanced daily using a momentum strategy subject to a target volatility of 5%.

“A principal protected note is always attractive for the guarantee it offers. Some investors really like the idea and it’s hard to price. This one gives you 100% participation in the upside. But there’s also a volatility targeting mechanism. That’s the tradeoff, said Kownatzki.

Volatility control

The BNP Paribas Multi Asset Diversified 5 index has eight components: three in equities, three in bonds and two in commodities.

The bond bucket consists of the BNP Paribas EUR 10Y Futures index, the BNP Paribas USD 10Y Futures index and the BNP Paribas JPY 10Y Futures index.

The equity allocation comprises the BNP Paribas US Equity Futures index, the BNP Paribas Eurozone Equity Futures index and the BNP Paribas Japan Equity Futures index.

The two commodities components are the Bloomberg Commodity ex-Agriculture and Livestock Capped Index and the S&P GSCI Gold Index Excess Return index.

Return considerations

The exposure to this portfolio will be reduced if the annualized volatility of the portfolio exceeds 5%, according to the term sheet.

“The fact that the volatility in the portfolio can’t exceed 5% is going to dampen your returns,” he said.

The index follows a momentum strategy and offers a diversification across three main asset classes and three regions or countries, he noted, adding that such features were attractive.

But the volatility target should be taken into consideration.

“You could in theory have a portfolio that’s 100% cash. Or you could have a portfolio that’s significantly uninvested because you are going to reduce market exposure to any component showing more than 5% in annualized volatility.

“This will obviously diminish the overall return of the portfolio, he said,” he said.

Tradeoff

The volatility target represents a problem and a solution all at once, he explained.

“Without it, the issuer could not offer a five-and-a-half-year uncapped note tied to a single asset with the full principal protection. For investors there is no cap but there’s still a limitation on your return.”

“There’s always a tradeoff.”

The benefit of the protection should be closely analyzed.

“Keep in mind that you’re paying to protect a portfolio that has already a limited volatility,” he said.

Protection, bond replacement

Kownatzki examined all the reasons that may lead an investor to buy the notes. In some cases, it made sense, he said.

“If I want to invest money in the market, get some upside and have no downside risk, it’s very attractive,” he said.

“If that’s your goal, the 5% volatility target built into the notes is not going to matter unless you want to outperform the market. But you wouldn’t use this note if that was your goal.”

Could the notes outperform government bond returns?

“A Treasury bond would give you two advantages over the notes – perfect liquidity and absence of credit risk.

“If I want exposure to government bonds, I may want to take a long position directly. However, the note would probably give me a higher return.”

How much more is unclear since the index, in response to excess volatility, could allocate to a hypothetical cash position that earns no interest and no return, according to the term sheet. It’s even possible for the index to allocate 100% to cash, making the portfolio fully uninvested.

But comparing the notes with government bonds makes sense given the fixed-income bias of the index, he said.

Each bond component has a maximum component weighting of 50% while the cap is 25% for the equity components and 25% for the commodities components, according to the term sheet.

“The lower weightings on equity and commodity funds reflect the low volatility strategy of the index. It also suggests relatively smaller returns,” he said.

Motivation

“One way to assess the value of the notes is to think of what the best way would be to use them,” he said.

The notes would not be a good directional play. Their most likely benefit would be as a hedge, he said. But the hedge would be far from perfect.

“If you’re bearish, you want a negative delta,” he said.

“For a perfect hedge on the market, you could use the futures market to short the notional equivalent of your portfolio. But long-term hedges are difficult,” he said.

The notes on the other hand are easy to use. But they do not offer a perfect hedge because investors would be unlikely to employ them to protect their entire portfolio with the ensuing counterparty and liquidity risks, he explained.

Puts

Another common way to fully hedge a portfolio has its own drawbacks.

“Ideally you want to buy puts. But it’s costly,” he said.

He explained why.

“The natural inclination of investors is to be long the market. They don’t usually use calls to do that although we’ve seen a spike in call buying in March,” he said.

At that time, followers of social-media site Reddit purchased call options on the shares of GameStop Corp. and on silver. Volume was so heavy that it pushed up call option volatility at higher levels than usual.

“But in general, and since the 1987 crash, there’s more demand for protection than there is for speculation. Market makers are no longer pricing put options just based on the Black-Scholes model. They’ve put an additional premium on puts.”

So, if a pure hedge is either difficult to implement through short positions or expensive via put options, what are the alternatives?

“It could very well be that you can use this note as a hedge across the three different asset classes. It’s not a perfect hedge but it’s a hedge,” he said.

BNP Paribas Securities Corp. is the agent.

The notes will price on May 24 and settle on May 28.

The Cusip number is 05600MY32.

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