RBS' 11.25% reverse convertibles on Research in Motion has relatively moderate risk

By Emma Trincal

New York, Jan. 14 - Royal Bank of Scotland NV's 11.25% Knock-In Reverse Exchangeable Securities due July 29, 2011 linked to Research in Motion Ltd. shares offer a good risk/return trade-off to investors, said Suzi Hampson, structured products analyst at Future Value Consultants.

This conclusion is based on the fact that risk is not elevated while the return outcome is "decent," she said.

The payout at maturity will be par in cash unless Research in Motion shares fall below 75% of the initial price during the life of the notes and finish below the initial price, in which case the payout will be a number of Research in Motion shares equal to $1,000 divided by the initial price, according to an FWP filing with the Securities and Exchange Commission.

Volatility

Hampson looked at three other reverse convertibles with the same barrier and maturity the bank announced in this prospectus. The notes linked to Research in Motion did not have the highest coupon because they were linked to a less volatile stock, she said.

The other deals included reverse convertibles linked to SanDisk Corp. (15% coupon); Freeport-McMoRan Copper & Gold Inc. (12.75%) and Bank of America Corp. (10%).

"It's the second-lowest coupon and the second least volatile stock," she said.

Implied volatility for Research in Motion is 44%.

Reverse convertibles tied to more volatile stocks would offer higher coupons all things being equal, said Hampson.

"You're basically selling a put. The greater the chances of hitting the barrier, the higher the risk, hence the more premium you receive for selling the option," she explained.

Investing in risk

Yet, investors would be better off not focusing on just the coupon when shopping for a reverse convertible.

"A high coupon represents more risk. With a reverse convertible, you're really deciding the amount of risk you're willing to take," she said.

"Rather than investing in a stock as a growth investment, reverse convertibles invest in volatility. You don't need the stock to go up. You just need the stock not to go down more than a specific amount."

This is why investors also need to pay attention to the barrier and, most of all, they must be familiar with the stock, she said.

Most savvy investors who buy reverse convertibles look for securities in which the stock has an implied volatility that is expected to decline. If it's true, the chances of breaching the barrier diminish.

"The ideal is to have a good coupon initially but to anticipate a decline in the implied volatility level," she said.

The Knock-In Reverse Exchangeables tied to Research in Motion may not deliver the highest coupon compared to similar products, including some listed in the prospectus. But the combination of a 75% barrier, a less volatile stock and a short-term maturity all contribute to reduce risk.

Moderate risk

Future Value Consultants rates risk on a scale of zero to 10 with its riskmap rating. The product received a 3.52 riskmap.

"Riskmap here is good and below average. It's due to the barrier that partially protects investors and also to the underlying stock, which is not among the most volatile stocks used for this type of structure," she said.

The probability of return outcome for this product is dispersed between a 73% chance of hitting a positive annualized return in the 10% to 15% bucket and a 25% chance of losing more than 5% of principal.

"It's a good return outcome," said Hampson.

"However, if you're going to lose, the chances of losing at least 25% of your investment are the greatest.

"That's because if you breach the barrier, the probability of a recovery is slim due to the six-month duration. There's not enough time to make up for the losses."

This factor, however, was offset by the protection offered by the barrier, setting the return rating at 4.25, which Hampson said was above average compared to products her firm recently rated in various structure types.

Value and overall

The value score, on the other hand, was below average.

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

"At 4.58, value is not that great," said Hampson.

"But this could very well be due to the short duration of the product because of certain fixed costs associated with the transaction."

Future Value Consultants gave a 5.23 overall rating to this product. The score on a scale of zero to 10 represents the firm's overall opinion on the quality of a deal, taking into account costs, structure and risk/return profile.

"This is just in the middle. It's a pretty average deal," said Hampson.

The notes are expected to price on Jan. 26 and settle on Jan. 31.

RBS Securities Inc. is the agent.

The Cusip number is 78009KQH8.

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