HSBC's AMPS linked to iShares FTSE/Xinhua China 25 offer enhanced return potential, high cap

By Emma Trincal

New York, July 2 - HSBC USA Inc.'s upcoming 0% buffered Accelerated Market Participation Securities linked to the iShares FTSE/Xinhua China 25 index fund are for mildly bullish investors in the Chinese equity market looking to outperform the fund and willing to take on some risk in order to achieve this result, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes are due Jan. 30, 2012, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus double any fund gain, subject to a maximum return of 22% to 27% that will be set at pricing, Investors will receive par if the shares fall by 10% or less and will be exposed to any decline beyond 10%.

Hampson analyzed the product based on the hypothesis that the cap would price at 24%, slightly under the 22% to 27% range's mid-point.

Moderate outlook

"This note presents two advantages: the leverage and the buffer," said Hampson.

"With the two-to-one leverage, all it takes is a 12% increase of the fund over the period, or an 8% annual increase, for the investor to hit the maximum return," she said.

"In addition, there's a buffer albeit a small one. So investors are protected against the first 10% fall in the fund."

Hampson said that given the level of growth required to hit the cap, investors in the note did not need to be very bullish.

"This is for a mildly bullish investor in emerging markets with a focus on Chinese equity," she said.

The FTSE/Xinhua China 25 index tracks the performance of 25 of the largest and most liquid Chinese companies that publicly trade on the Stock Exchange of Hong Kong Ltd. and are available to international investors.

"If the notes grow by less than 8% annually, investors in this product will outperform the fund. If at the contrary it grows by more than that, then you're better off investing in the iShares fund directly," she said.

Hampson said that investing directly in the fund is a more bullish play. "Since they're not getting the leverage but only a one-for-one return, they have to bet on a much higher rate of growth," she said.

Growth instrument

The product, however, is based on the premise that the underlying fund will grow over the 18-month term. As such it is a growth product, said Hampson, distinct from structured products designed for income-seeking investors such as reverse convertibles and autocallables, which require little to no growth of the underlying asset.

"With these notes, you have to be more bullish than an investor in a reverse convertible. You want your underlying fund or index to be more than just stable. You want it to grow in order to maximize returns," she said.

The reward is a potentially high return, she said, as the cap was set at a "pretty decent level."

The pricing of the cap is determined by the cost of the embedded options and the fund's implied volatility.

In this case, the relatively high level of implied volatility of the underlying - 33% versus 26% to 27% for the S&P 500 index - allowed the issuer to offer a "relatively high cap," she said.

But the cap, however high, remains a risk factor in the structure as investors' gains are limited.

Another disadvantage compared to a direct investment in the shares, Hampson noted, is the fact that investors are not entitled to receive dividend payments.

Relative risk

Hampson said that the risk for this product, compared to other recently rated structured notes, was "fairly average" as measured by riskmap.

The riskmap, a Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10, was 4.43 for this product.

"It's pretty much in line with our other products as we don't have notes scoring less than 3. But it really depends on what you're comparing this product to. Some other products recently examined had no buffer at all or were based on more volatile underlyings, such as stocks. You also had a rise in volatility for the S&P 500, which impacts the ratings overall," she said.

However, Hampson said that the notes were "still risky" because investors could lose 90% of their principal.

"This product is definitely aimed at investors willing to take on risk," she said.

Good return score

Future Value Consultants also publishes a return rating, which measures, on a scale of zero to 10, the risk-adjusted return of the notes. Its value of 6.25 for this product is based on a Monte Carlo simulation that uses various parameters such as volatility, dividends and interest rates.

"Right now our average for return ratings is about 3. So 6.25 is actually pretty good," Hampson said.

"The cap is high, and that's a factor even though it's balanced by a small buffer. If you had a buffer bigger than 10%, your cap would probably be lower," she said.

"This structure reflects the investor's view. You have to be fairly bullish compared to an income investor but only moderately bullish on Chinese stocks compared to the equity investor," she said.

70%/30% probabilities

Hampson said that the good return score was reflected in the probability tables, which were "good."

Future Value Consultants calculates the probability tables of return outcome based on the same Monte Carlo model.

"You have a 47% probability of making more than 15%, which is quite high, although it's limited to the cap," she said.

"But chances are even greater to reach the 24% cap because of the double leverage. It only takes a 12% rise of the fund during the one-year-and-a-half term to maximize the return. So the 24% return is the most likely. This is why the probability of making between zero and 15% gains is only 23%, compared to a 47% probability to hit the higher bucket," she said.

Hampson added up the probabilities, bucket by bucket, with gains on the one hand and losses on the other.

The chart, as published in the report, showed that investors had a 70% chance of generating gains versus a 30% probability of losing some of their principal.

While investors are more likely to hit the higher return bucket (more than 15%) than the lower return bucket (zero to 15%), they are also more likely to suffer a larger loss than a smaller loss.

Within the 30% probability bucket of losing some principal, investors had a nearly 24% probability of losing more than 5% of their capital.

High value

The value of the deal, as measured by the value rating, was also "very high," said Hampson, at 9.39 on a scale of zero to 10.

Value rating is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

"This value score is very good because, based on our estimated price of the assets, the issuer is taking up fewer fees per year than most other products," Hampson said.

Another rating used for the calculation of the final score is simplicity, which measures on a scale of zero to 10 the simplicity of a structure and how easily understood it is by investors.

The notes scored 8.50 in simplicity.

Those three ratings - return, value and simplicity - led to an overall rating of 7.96.

The overall rating, on a scale of zero to 10, is Future Value Consultants' opinion on the quality of a deal, taking into account costs, structure and risk-return profile. It's an average of three scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

"It's a pretty high overall score at 7.96 because both the value and the return ratings are good," said Hampson.

The notes are expected to price July 23 and settle July 28.

HSBC Securities (USA) Inc. is the agent.

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