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Published on 7/15/2013 in the Prospect News Structured Products Daily.

JPMorgan's dual directional notes linked to EM fund offer unlimited growth, risky knock-out

By Emma Trincal

New York, July 15 - JPMorgan Chase & Co.'s 0% dual directional knock-out buffered equity notes due July 30, 2015 linked to the iShares MSCI Emerging Markets index fund can be used as an alternative investment allocation for investors seeking growth in the emerging markets.

But the product requires a high tolerance for risk given the underlying asset class and the type of barrier offered, sources said.

A knock-out event occurs if the fund closes below the initial level by more than the knock-out buffer on any day during the life of the notes. The knock-out buffer will be between 23.85% and 24.85%, with the exact percentage to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the fund finishes at or above the initial level, the payout at maturity will be par plus the gain.

If the fund finishes below the initial level and a knock-out event never occurs, the payout will be par plus the absolute value of the fund return.

If the fund finishes below the initial level and a knock-out event does occur, investors will be fully exposed to the fund's decline.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that unlike most dual directional structures, this one does not cap the upside. As such, the product offers growth and could be used as part of his "alternative investment" allocation.

Enhanced growth

"I like it. It would not be something I would use to hedge my portfolio. It would not be my traditional use of structured notes either, which is fixed-income replacement," he said.

"With this one, I would look at my alternative investment bucket. It's not cash, not fixed income, not equity but it's my fourth bucket, my alternative investments."

These include real estate; hedged investments such as long/short strategies, hedge funds or hedge fund replication instruments; and global macro, he explained, adding that another category within alternative investments is "enhanced growth."

"This would belong there, to the enhanced growth portion of my alternative investment bucket. By enhanced growth, I'm referring to alpha generators where I look to pick up additional returns that I've given away elsewhere."

The notes would be suitable for an investor looking for moderate to aggressive growth, he said.

"You're not losing on the upside. That's why it's a growth product," he said.

"You're OK with the volatility, which gives you potential for growth. That's what volatility is. It's not just down. It's also up."

Investors get the same exposure as a long position but with additional benefits, he said.

"Emerging markets is a small but important piece of my allocation. I already made my strategic decision to put emerging markets in my portfolio. I'm already fine with the volatility of the asset class, and the notes give me more than a direct exposure because in addition to the unlimited upside, I'm picking up the safety net plus the potential absolute return.

"Emerging markets is projected to have significant growth. You're not capping the potential for growth, and you have a two-year time horizon.

"And by the way, you have a 25% safety net with the potential to make up to 25% if the fund is negative.

"What's not to like?"

Blood on the Street

Another appeal for Kunhardt is the current valuation of the exchange-traded fund, which is down 11% for the year and has lost 18% over the past two years.

"Getting in today is an absolutely great entry point. Peter Lynch used to say, 'The way you make money on Wall Street is to buy low and sell high.' Money is made when there is blood on the Street," Kunhardt said.

"Today is really a good time to get into emerging markets if you can take the risk.

"I think this is a very interesting, very attractive deal."

Credit

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the notes are too risky due to the volatile underlying fund and the nature of the barrier even if he likes the asset class and the credit risk associated with the notes.

"As far as the underlying asset class, I am a big fan of emerging markets. I have no qualms with investing in that space. A lot of people are skittish about emerging markets. This looks like a way of dipping your toes into it," he said.

"Second, JPMorgan has a single-A credit rating. That's good enough for me. It's one of the biggest banks out there. I have no qualms about putting some money with JPMorgan. All that is excellent.

"Another question we ask ourselves: Is there potential for risk reduction? Yes, on the first 25%, you definitely have the potential for risk reduction, and actually, it pays if you're negative because of the absolute return.

"But it's the American option that bothers me."

American-style options can be exercised any day prior to maturity as opposed to European options, which can only be exercised at expiration. As the knock-out of the notes can occur anytime during the term, the barrier is "American style." A point-to-point payout on the other hand would have fit the description of a European option.

American barrier

"If you look at past performances of this fund, there have been multiple months where the 25% barrier has been broken. At least with a European option you could make the argument how many times [has] this index has been down over a two-year timeframe? That's much harder to find," Kalscheur added.

"The chances of hitting that barrier are so much greater when it can happen any time. It's not worth taking that risk. If you breach that threshold, you lose all the benefits - absolute return gain potential and downside protection.

"One could make the case that you're not worst off than being long the index. No, except that I have been locked up for two years and I took some credit risk I didn't need to take.

"I would take more risk if I had more return. Or I could give up the absolute return for a better protection, either a plain buffer or a European-style barrier. Definitely, a European barrier would have been more appealing to me.

"In a structured note, what I really want is having a buffer or having the downside protection that I need. "It's clearly not the case with this particular structure and underlying."

J.P. Morgan Securities LLC is the agent.

The notes will price July 25 and settle July 30.

The Cusip number is 48126NJV0.


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