ABN Amro reverse convertibles very low risk, but historical analysis limited, analyst says

By Kenneth Lim

Boston, Aug. 14 - A couple of reverse convertibles by ABN Amro Holdings NV have unusually low risk profiles, said structured products analyst Suzi Hampson of Future Value Consultants.

ABN Amro plans to price 17% annualized reverse convertibles due Nov. 30, 2009 linked to the common stock of Advanced Micro Devices and 10% annualized reverse convertibles due Nov. 30, 2009 linked to the stock of Sprint Nextel Corp.

At maturity, the reverse convertibles will return par if the underlying stock finishes above its initial level or never closes below a barrier. Otherwise investors will receive a number of shares of the underlying stock equal to par divided by the initial share price.

Both series of notes have barriers at 60% of the initial share price.

Low risk scores

Most of the reverse convertibles that Future Value analyzes have moderate to high risk profiles. The AMD-linked notes earned a low risk score of 1.78 out of a riskiest 10 from Future Value, while the Sprint Nextel-linked product did even better with a 1.6 risk rating.

Future Value predicted that holders of the AMD notes have a 92.4% probability of getting an annualized return above 15%, while the Sprint Nextel product has an estimated 94.7% probability of returning 10% to 15% annualized.

"It's not a mistake," Hampson said.

A key reason that the products have such low scores is that they have very short tenors of only three months, Hampson explained.

AMD's one-year historical volatility is about 54.9%, while Sprint Nextel's volatility is about 50.5%. But their volatility for three months should be considerably less than for a year.

"That's an annualized volatility figure," Hampson said. "Using our model, it's most likely the barrier is not going to be breached."

Key outlook

But Hampson cautioned about relying too much on historical data to assess such short-term products.

"We don't see anomalies like this with longer-term products," she said. "With a short-term product, it does make it a little more difficult to use historical data to look at such a short time frame."

Historical data is less meaningful in predicting short-term movements in the underlying stocks, and investors' opinions about those stocks make a bigger difference in these cases, Hampson said.

"As with many reverse convertibles, it's linked to one stock, so you'd think the investor would have an opinion on how the stock would behave," she said.

Implied underlying volatility is also a bigger factor in the pricing of such short-term investments, Hampson added.

"We use historical volatility to calculate our return probabilities and the risk map, so occasionally you will get some assets where there's a big difference between historical and implied volatility," she said.

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