HSBC's capped knock-out buffer notes linked to 12 stocks give sector exposure to energy bulls

By Emma Trincal

New York, April 8 - HSBC USA Inc.'s capped knock-out buffer notes due April 25, 2012 linked to a basket of 12 stocks, is designed for investors looking to gain exposure to the energy sector via equity and therefore comfortable with the risk associated with a volatile basket of stocks, said structured products analysts Suzi Hampson at Future Value Consultants.

The underlying companies are Chesapeake Energy Corp., Range Resources Corp., Southwestern Energy Co., Exxon Mobile Corp., Cenovus Energy Inc., ConocoPhillips, Baker Hughes Inc., Halliburton Co., Noble Corp., Arch Coal, Inc., Consol Energy Inc. and Teck Resources Ltd., according to an FWP filing with the Securities and Exchange Commission.

"This basket can be appealing to investors who do not want to manage a portfolio of stocks in this sector themselves. It gives them a way to replicate the returns without having to manage the stock portfolio themselves," she said.

There is principal protection but only in the absence of a knock-out event, she noted.

A knock-out event occurs if the basket ever falls by more than 30% during the life of the notes.

If a knock-out event occurs, the payout at maturity will be par plus the basket return, which could be positive or negative. Otherwise, the payout will be par plus the basket return, subject to a minimum payout of par.

In either case, the return will be capped at 20%.

Volatility

"Many of the stocks in the basket are quite volatile," said Hampson, adding that some had implied volatility of 40% or 50%. "Since there's a great correlation between the stocks, I would assume that the overall volatility of this basket is pretty high," she said.

"The higher the underlying volatility, the higher the chance to hit the 70% barrier, which means more risk," said Hampson. "At the same time, the higher the volatility, the higher the value of the options, which gives you a potential return of 20%, which is not bad for one year."

Barrier versus buffer

One additional factor of risk, she said, was that protection is established through a barrier, not a buffer.

She said that at a 70% protection level and assuming a final basket level down 40% from its initial value, investors with the notes would lose 40% while investors in a note that carries a buffer would only lose 10%.

Barriers involve more risk than buffers for another reason, she said: The barrier, as it is the case with this product, can be breached anytime during the life of the notes, while the price is measured against a buffer only once, at maturity.

"The buffer is obviously preferable for the investor. That's why issuers tend to offer less protection with a buffer - generally 10% or 15%," she said.

The underlying volatility of a sector-focused stock basket combined with the knock-out feature creates a certain level of risk for investors.

"As an investor, you're looking for the upside and you're comfortable taking the risk of losing your entire capital. Otherwise you wouldn't invest in these notes," Hampson said.

Lose big, win big

Risk is reflected in the 5.72 riskmap, Future Value Consultants' risk rating on a scale of zero to 10.

"It's quite high, and it's not surprising. With 12 stocks as the underlying, you would expect a high volatility," she said.

The returns are capped at 20%, which may suggest an asymmetrical risk/reward profile since the upside is limited while the downside is not, she said.

"But in reality, you still have principal protection if the basket falls by less than 30%.

"In order for the issuer to pay the principal back when the barrier is not breached, they probably had to price it with a cap," she noted.

The probability tables of return outcomes show that the notes may deliver hefty losses or elevated gains, a sign of the high risk/high reward profile of the instrument.

Future Value Consultants calculates the probability tables using a Monte Carlo simulation. The performance is modeled based on a series of parameters, which include for instance volatility, dividends and interest rates.

The odds of losing principal are 40%. In this loss scenario, there is a 32% chance of losing more than 5% of the initial investment, which is the maximum loss bucket in Future Value Consultants' chart.

The prospect of making money is 60%. Within that side of the chart, the 44% probability of nearing the maximum return of 15% to 20% shows how high the chances of generating a large return are, said Hampson.

"The riskier the product, the bigger the chance of losing and the bigger the chance of getting high returns," said Hampson.

The product received an "above average" return rating of 5.39, said Hampson, which is due to the high probability of a high return. The average rating of recently rated products is 4.25.

The return score is Future Value Consultants' indicator on a scale of zero to 10 of the risk-adjusted return of the notes.

Value and overall

The value rating at 6.23 was weak said Hampson.

Based on a scale of zero to 10, the rating represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis.

"The options for those stocks may have cost more than if you just had to hedge an index," she said.

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.

The product received a 6.35 overall rating, which is "average," said Hampson.

J.P. Morgan Securities LLC is the agent.

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