Credit Suisse's $9.11 million prepaid put warrants tied to S&P 500: a play on volatility skew

By Emma Trincal

New York, June 10 - Credit Suisse AG, Nassau Branch's capped reverse prepaid put warrants linked to the S&P 500 index offer a hybrid structure between options and structured investments, giving mildly bullish investors a way to make relative value option trading plays on the S&P 500, sources said.

Credit Suisse priced $110 million notional amount of the warrants, which expire Dec. 22, 2010, according to an FWP filing with the Securities and Exchange Commission.

The warrants have a notional amount of $1,000 each. They were sold for $82.78 each for total proceeds of $9.11 million.

The warrants will be automatically exercised on the expiration date. If the final index level is greater than or equal to 850, the payout will be $93.02 per warrant.

If the final index level is less than 850 and greater than 750, the payout will be $93.02 minus the product of the underlying strike change multiplied by $1,000.

The underlying strike change is a) 850 minus the final index level divided by b) the initial index level. If the final level is less than 838.992 - 78% of the initial level - this calculation will result in a loss.

If the final index level is 750 or less, the warrants will expire worthless and investors will receive nothing.

JPMorgan Chase Bank, NA is the agent. There is no fee.

Not a note

Sources said that the product is out of the ordinary because it is not delivered in a traditional note format.

Unlike a traditional note, investors are not putting down principal but prepaying a warrant, according to the prospectus.

"The issuer is not embedding an option in a note here. There's no principal involved. The people who buy this are willing to lose their money," said Michael Iver, a former structurer at JPMorgan.

In a traditional note format, the issuer uses the principal to earn interest, a sellsider said.

When the option is embedded in a note, another advantage for the issuer is that "it collateralizes the deal," said Iver.

"Take the case of a reverse convertible where the investor is basically selling a knock-in put. The way the issuer is protected is by collecting the principal. If there is a knock-in, the issuer can redeem the notes for less than par. The issuer doesn't need to go back to the investor," said Iver.

With the Credit Suisse structure, investors are paying upfront for warrants at a cost of $82.78 each.

"It's not an embedded option in a note format because the investor is paying the option upfront," said Iver.

The main rationale for doing that, he said, was probably the investor's need to limit the liquidity to be put upfront. In other words, the investor may have requested additional leverage.

Risk and leverage

The prospectus warned of the high level of risk involved with the warrants. Investors must have an options-approved account in order to purchase the warrants, the prospectus said.

"The warrants are designed for investors who seek a leveraged and capped return at expiration based on the performance of the S&P 500 index," the prospectus said.

The best-case scenario is when the underlying index - whose initial value is 1,075, according to the terms of the deal - ends higher than the upper strike of 850. In such case, investors can claim the maximum payout of $93.02, which represents a 12.37% return on the initial warrant investment.

When the index ends between the two strike prices, investors can lose some of their investment.

When it finishes lower than the lower strike level of 750, investors will lose everything, according to the prospectus.

"The warrants are risky investments and may expire worthless," the prospectus warned.

"The reason why it's different from an embedded option in a note is simply because there is higher leverage," the sellsider said.

"The firm is requesting that the investor put out the option upfront. And the investor can lose it all," the sellsider said.

This sellsider explained that the product differs from the traditional "combination of cash and bonds" that applies to structured notes. However, even if there is no principal down as with a typical note, "there's money at risk," he said.

"Every dollar you put down, if the trade goes against you, if your final level is less than the lower strike, you lose everything," he said.

While not embedded in a note format but rather traded outright by the investor, the option component is key to understanding the rationale of the trade, sources said.

Put spread

"It's a short put spread," the sellsider said. "I imagine it was done for a specific client."

Iver described the put spread as follows: "The investor is selling a December put at a strike price of 850 and he is buying another December put at a 750 strike. The selling of the 850 put gives him the maximum return. The buying of the 750 strike allows him to limit his losses," he said.

Could be retail

Iver said that he had "no idea who the investors may be" and that he did not rule out retail appetite for these types of products.

Asked whether the absence of a fee indicated that the offering was designed for institutional investors, he said, "It doesn't mean much. The fee is embedded in the economic price."

For Iver, the investment is designed for mildly bullish investors but also for investors willing to make bets on volatility. Because volatility is so important, he did not rule out a mainstream interest for these types of products despite their complexity.

"Investors are becoming more sophisticated. With volatility so high, people are hesitant to buy options because they're afraid of losing money. The trend now is relative value options trading," he said.

View on the skew

For Iver, the key of the trade is a bet on the level of the volatility skew, or the relative volatility between the two put strikes.

"These investors bought the 750 put because they believe the level of volatility of this put is too low," he said.

"They've sold the 850 put because they anticipate that it's too high and will go down. This is a trade for investors with a view on the relative implied volatility between the December 750 and December 850 put strikes."

Too complicated

While it is unclear whether the deal was sold to one or several investors, or to retail clients versus institutional investors, some financial advisers said that they did not like it because it is too complex to be understood by their clients.

"I can't figure out what the payout is based on the filing," said Steve Doucette, financial adviser at Proctor Financial.

"So I would not be interested in it. It's that simple. The terms are not clear enough to make a decision on whether it's worth showing to a client or not. I wouldn't recommend it because simplicity is important to me," he said.

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