UBS' notes link to Euro Stoxx 50 offer high return and loss potential, but barrier eases risk

By Emma Trincal

New York, Oct. 5 - UBS AG, London Branch's 0% trigger performance securities due Oct. 31, 2017 linked to the Euro Stoxx 50 index offer high potential returns but should only be aimed at investors willing to tolerate the possibility of big losses and be locked in for five years, said Suzi Hampson, structured products analyst at Future Value Consultants.

"The product received above-average overall, price and return scores mainly due to its uncapped upside and deep barrier for downside protection. But the risk is still there given the amount of losses an investor may incur once the barrier is breached," she said.

If the index return is positive, the payout at maturity will be par of $10 plus 184% to 194% of the index return, according to an FWP filing with the Securities and Exchange Commission. The exact participation rate will be set at pricing.

Investors will receive par if the index falls by up to 50% and will be fully exposed to losses from the initial level if the index falls by more than 50%.

British style

"We have the 50% final barrier, a level of protection that's very typical of a U.K. product but less often seen in the U.S.," she said.

"It's a five years, so you would expect a deeper barrier. You have it with 50%, a pretty attractive level.

"There seem to be quite a few deals linked to the Euro Stoxx index lately. It's probably because Europe is in the news. More and more investors I guess want exposure to the euro zone stock market. This index is slightly more volatile than the S&P, so it's easier to get better terms."

Looking at the 184% to 194% participation rate, she said, "The participation rate is in a range. I don't know how much difference it will make to the score. But this is almost two times leverage. If you just look at the terms, it appears to be quite a good offering. It's attractive to have a high participation rate given that there's no cap."

Hampson said that the simplicity of the structure makes it easier to compare the notes to similar investments.

"If you compare this to an ETF, which has no fixed maturity and no issuer risk, you are getting almost double gearing and a substantial range of protection with the 50% final barrier.

"This is definitely a product that could fit into an equity portfolio and compete with other types of securities, including an ETF."

Despite the low barrier, the product remains relatively risky, however, she said. The risk, which Future Value Consultants measure with its "riskmap" on a scale of zero to 10 - 10 being the most risky - is the sum of two risk components: market risk and credit risk.

Magnitude, occurrence

The notes have a 4.58 riskmap, which Hampson compared with the average of all products as well as with the average of similar products.

All products represent structured notes in various structures recently rated by the research firm. Similar types of products are any capital-at-risk growth products with a participation rate greater than 100%, she explained. This last group may include products of various maturities with or without downside protection.

The average riskmap for all products and similar products is 4.10 and 4.12, respectively.

"Our riskmap takes into account not just the probability of loss but also the magnitude," she said.

"You may not have as many chances of losing, but when you do lose, you lose at least 50%, which is a considerable amount and will have an effect on the riskmap."

This magnitude factor impacts the market riskmap, which at 3.29 is slightly higher than the 3.13 average of the same product type.

The credit risk component of the riskmap adds to the risk as well. At 1.28 versus 0.99 for the average score for the same product type, the credit riskmap plays an important role in elevating the overall risk, she said. Compared to the "all-products" group, which incorporates a great amount of shorter-dated notes, especially reverse convertibles, the gap is even greater, with the broadest category showing a 0.76 average credit riskmap.

"The relatively high credit risk reflects the longer duration, especially when you compare it to short-term products such as three-month reverse convertibles," she said.

High return

This note, however, offers a "very attractive" risk/return profile, she said, pointing to the 9.15 return score, compared with the 7.28 average score for similar products.

The return score is Future Value Consultants' measure of the risk-adjusted return. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

"This is for someone who expects European stocks to appreciate a lot. The lack of cap reflects that view," she said.

"Naturally, the most favorable market assumption for this type of product is high growth. Our return score therefore is based off the high-growth assumption," she said.

Future Value Consultants estimates in its probability chart how the product is expected to perform under the five key assumptions. It assigns a probability of return outcome to each of the payoff buckets. The chart is generated using a Monte Carlo simulation using various parameters such as volatility, dividends and interest rates.

The probability table associated with this product under the best scenario (high growth) shows a strong probability of high returns. The chances of earning 15% or more annually are 32.8% while the odds of losing more than 15% of principal are 10.2%.

"If you change the scenarios, there's a huge difference," she said.

For instance, when using the neutral assumption, which is a risk-free growth scenario, the chances of getting more than 15% a year are only 11.8% while the likelihood of losing more than 15% has a 19% probability.

Measuring expectations

The rationale for picking the best assumption to calculate the return score came from an effort at bringing more consistent and comparable tools, explained Hampson. The idea is to match investors' interests in the product with the return expectation associated with it.

"We used to rate the return based on the neutral assumption. But we found that some products would always score worse than anything else because the assumption was not appropriate," she said.

"You wouldn't buy a growth product if you had a bearish view. This is for a very bullish investor, so we want to show what it would return in a bullish market.

"In a bull market, getting almost two-times leverage, a five-year term and no cap is going to give you a high return score.

"The idea behind our methodology is to determine what type of product this investor is going to look at. A three-month reverse convertible would be a very different product, and the market assumption would also be different.

"With a reverse convertible, the optimal assumption is low volatility, not high growth. We want to be able to compare products of the same type effectively. It's up to the adviser to choose the kind of product for his investor and then choose the best score."

Price, overall

Future Value Consultants measures with its price score on a scale of zero to 10 the market value of the underlying components of the product. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per annum and is used to measure the value of the assets. The higher the score, the lower the fees and the greater value offered to the investor.

The product has a 9.68 price score versus 7.31 for the average of the same product type.

"The longer duration often comes out favorable for price scores. But it comes out very well, which suggests that the product was very aggressively priced. Obviously, it offers good value," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The product had a 9.42 overall score. It compared with 7.31 and 6.80 for the same product type and all products, respectively.

"It's outperforming the rest of the market," she said.

"It's very high up on the overall score scale. The risk is slightly higher than average, but it's not necessarily a bad thing if the investor is aware of it. You have a low probability of losing money, but if you do, you lose a lot. If you're willing to take on that risk, you can probably receive a high return."

The notes (Cusip: 90269V546) are expected to price Oct. 29 and settle Oct. 31.

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

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