Morgan Stanley’s trigger jump securities tied to Apple to fit range bound view on the stock

By Emma Trincal

New York, Aug. 4 – Morgan Stanley Finance LLC’s 0% trigger jump securities due March 4, 2020 linked to the common stock of Apple Inc. are designed for investors seeking exposure to the stock but having a moderately bullish outlook on its price, said Tim Mortimer, managing director with Future Value Consultants.

If the final share price is greater than or equal to the initial share price, the payout at maturity will be par of $10 plus 29%, according to a 424B2 filed with the Securities and Exchange Commission.

If the stock declines by up to 20%, the payout will be par. If the stock declines by more than 20%, investors will lose 1% for every 1% that the stock declines from its initial share price.

Recent high

The share price of Apple spiked on Wednesday, helping the Dow Jones industrial average hit the 24,000 milestone, Mortimer noted.

Apple gained nearly 5% on that day after releasing strong earnings results the night before. The stock is up 48% for the year, while the Dow has gained 20%.

“Apple outperformed. It is a very large stock with many consumers and investors,” he said.

The notes will price on Aug. 15, nearly two weeks after Apple climbed to its all-time high.

“The fact that Apple is up that much obviously shows it’s not a great value play,” he said. “The deal has yet to price and the timing may not be best... But I don’t know how relevant this is because Apple is a very popular stock...people buy it all the time.”

Digital is for the rich

If anything, the type of structure employed could be the appropriate response to the valuation concern.

“What the digital does is give you a return without the stock having to go up any further. When a stock is fully priced, it’s actually a good strategy to use a digital,” he said.

If the share price of Apple stays flat, investors in two-and-a-half years will receive the 29% digital payment, which represents a 10.7% gain on an annualized basis, he added.

“It’s a pretty good return especially if the stock moves sideways,” he said.

“You also have an 80% European barrier, so you can afford a 20% stock decline and still get your principal back.”

Stress testing

Future Value Consultants produces stress test report services for structured notes. Mortimer interpreted his report for this product.

Each full stress report contains a maximum of 29 sections or tables. Some are based on a Monte Carlo simulation. Others are backtested results. Five different market scenarios are being used. Some reports only use the neutral scenario while others are adding bullish, bearish, less volatile and more volatile assumptions.

Mortimer examined first the investor scorecard, a table made up of different mutually exclusive outcomes of product performance with their probability of occurrence and average returns. The simulation is based on the neutral scenario.

Three outcomes

This digital barrier note is a relatively simple structure, he said, with only three possible outcomes.

Investors may receive the digital payment. This will happen 45.30% of the time, according to the scorecard.

They also could receive only par at maturity if the stock prices finishes down but above the barrier level in the 80% to less than 100% range. That would be the “full capital return” outcome, which shows a 23.7% probability of occurring. Finally a barrier breach point-to-point (European barrier) will generate a capital loss. Such result may occur 31% of the time.

“It’s a straightforward structure. Other products, autocalls for instance, have many more moving parts,” he said.

Each stress test report will indeed have different outcomes and probabilities that depend on the structure.

In a digital note, investors can receive a fixed payment, lose money or just get par.

“It’s easy to read...And the most likely outcome is to be paid the 29% digital.”

The average payout attached to each outcome is self-explanatory. Investors will receive 129% if the digital payment is made and 100 if they get their full capital back. Otherwise the barrier has been breached. Investors will incur an average loss of 36.2% in this situation, the scorecard showed.

Bull market

Things change considerably with the next table, which displays the scorecard results but based on the backtested analysis over three different time horizons – the last five, 10 and 15 years.

On the last five and 10 year timeframes, the probability of receiving the digital payment is 100%. The chances dropped to 92.58% for the last 15 year period but not by a lot, he said.

“Apple has been up any two-and-a-half year period in the last five years and 10 years.”

Even over the past 15 years, those probabilities remain high.

“It just shows that Apple has been a favorite stock for many years,” he said.

Volatility

Another table, the “capital performance tests,” shed some light on the impact of the market. The simulation uses not only the neutral market scenario but the other four market assumptions as well.

The best chance of getting the fixed payment lies with the bull scenario, showing a 64.68% probability, well above the 45.30% probability in the neutral environment. But more interestingly, he said, the second “best” chance of earning the digital is found in the less volatile environment (47.11% probability). The more volatile assumption comes only after and shows a lower probability of 43.7%. Naturally, it is in the bear market that the chances of getting paid are the lowest. The probability is 27.36% in that case.

Mortimer explained why the prospects are better in the low rather than the high volatility scenario.

“If you have a highly volatile underlying, the expectation of being above 100 goes down,” he said.

“You’ll have a slight downward drift of the stock price to compensate for the volatility.

“This is because you can never lose more than 100 but the stock can in theory give you unlimited gains on the upside.

“To compensate for the convexity of the underlying, a more volatile scenario will lower the chances of getting the digital while you don’t suffer from that when volatility is low.”

To explain this in a different way, he said that in a theoretical case, in which the volatility of Apple would be zero, the notes would always pay the digital.

“The forward or the difference between interest rates and dividends would be going up. You would get paid all the time,” he said.

“Intuitively, if a zero-volatility gives you 100% chance of getting the digital, your chances will decrease as the volatility goes up.”

Defined outcome

This explanation applies to the average payoff described in the same table.

Investors would lose 32% on average in the less volatile scenario versus 40.1% in the more volatile.

“This product is designed for people who want to be invested in Apple without taking a straight stock position,” he said.

“They may think the stock is richly fully valued or they may need a significant downside protection. Either way this digital with a decent European barrier allows them to do that.”

Morgan Stanley & Co. LLC is the agent.

The notes will be guaranteed by Morgan Stanley.

The Cusip number is 61766X434.

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