Lehman $1.375 million notes' currency- and index-linked payout is unusual, analyst says

By Sheri Kasprzak

New York, July 9 - Lehman Brothers Holdings Inc.'s recently priced $1.375 million in zero-coupon principal-protected notes linked to a basket of indexes and currencies caught the attention of one analyst.

Tim Mortimer, managing director of Future Value Consultants, a London-based firm that analyzes derivatives products, said the notes are interesting because the exposure to equity and currency is split 50-50.

"The logic here, I think, is that whenever you link a product to an overseas index or asset, there are two ways of expressing the payoff," he said. "The most common is the quanto payoff, which simply means that you take the percentage gain or loss. For the investor, it's the easiest thing to do."

The other way to calculate the payoff, Mortimer said, is to use the composite value of the index, made up of the index value multiplied by the foreign exchange rate, similar to the way mutual funds hold assets in other currencies.

Different payoffs

Mortimer pointed out that the index portion of the basket - which includes the Dow Jones Euro Stoxx 50 with a 35.42% weight, the FTSE 100 with a 33.97% weight, the Nikkei 225 with a 21.42% weight and the S&P/ASX 200 with a 9.19% weight - pays off under the quanto calculation, taking the percentage gain or loss of the index.

The currencies correspond to the indexes, making the impact similar to a composite style of payoff calculation, Mortimer said.

The currencies portion of the basket includes the British pound sterling with a 33.97% weight, the Japanese yen with a 21.42% weight, the euro with a 35.42% weight and the Australian dollar with a 9.19% weight, all against the U.S. dollar.

"Depending on what the currency has done will affect the payoff," Mortimer added.

Mortimer noted that the indexes and currencies have been structured in pairs. For instance, if the FTSE 100 index goes up but the British pound sterling goes down, the basket performance is basically cancelled out.

Participation rate is split

Another interesting factor of the notes is the participation rate. The participation rate, which is 135%, is split - effectively making half of the rate in the equity portion and half in the index portion.

"When you take this basket, it's very close to the same as the [composite value of the index], but only on half," Mortimer said. "If the currency doesn't move, half of your basket is not moving."

The three-year Lehman notes pay par plus any positive return on the basket times the 135% participation rate. Investors will receive at least par at maturity.

Merrill's long-short notes

Mortimer also noted that Merrill Lynch & Co.'s $43.4 million in zero-coupon Long Short Notes linked to the S&P 100/Russell 2000 Long-Short Index series XIV is a "rather aggressive" strategy.

"It's basically a tracker on a long-short strategy," Mortimer said in an interview Monday. "You're taking a trading view that the large caps will outperform the short caps going forward. We just have a tracker on a spread play. The trading view is what is driving it. Clearly someone would be happy to take that exposure."

Mortimer pointed out that the notes are similar to 130/30 funds, which take 130% exposure to something and a 30% short exposure to something else.

"The main point is that it's quite an aggressive strategy," he added.

Note terms

The 18-month Merrill notes pay par plus any index gain or minus any index decline. If the index declines by 50% or more on any day at least seven business days before maturity, the notes will be redeemed and the payout calculated using the value of the index at that time.

Deutsche Bank's Currency Harvest Index

Mortimer also said he found interesting Deutsche Bank AG, London Branch's recently announced zero-coupon principal-protected notes linked to the Deutsche Bank Balanced Currency Harvest Index.

The strategy, Mortimer said, is one of the oldest strategies in the structured products marketplace and is now getting some play again.

The idea, Mortimer noted, is to take the currencies with the highest interest rates against the currencies that have relatively low interest rates.

The index pits three high interest rate currencies against three low interest rate currencies, all G10 currencies.

The two-year notes pay par plus any basket gain multiplied by the 135% participation rate. Investors can expect to receive at least par at maturity.

The notes are expected to price July 26.

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