Barclays' reverse convertibles linked to Massey: one-month volatility move causes risk jump

By Emma Trincal

New York, Nov. 13 - The required consistency of research methodology may sometimes induce aberrant results when analyzing structured products that can only be explained with common sense, said structured products analyst Suzi Hampson of Futures Value Consultants.

"There are limits to what you can do with fixed parameters and you have to take outside factors into consideration. As analysts, we must stick to a methodology that makes our research stronger. However, you can't take the numbers completely at face value," she said.

Hampson took an example in which the pricing date made a big difference in risk between two quasi-identical structures.

The result was based on the choice of historical volatility as a fixed parameter, as part of Future Value Consultants' methodology to measure risk.

Two similar deals

Hampson looked at two reverse convertible transactions. Both are issued by Barclays Bank plc. Both are linked to the stock of Massey Energy Co. One of the deals, a three-month product, was priced last month; the other is set to price on Nov. 23.

Barclays Bank plc priced on Oct. 30 $1 million of 13.25% reverse convertible notes due Jan. 29, 2010 linked to Massey Energy shares, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par in cash unless Massey Energy shares fall below 70% 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 Massey Energy shares equal to $1,000 divided by the initial price.

In the week ahead, Barclays will be pricing a very similar deal. The difference is the maturity and coupon - the upcoming notes will be due May 26, 2010 and will have a higher coupon of 14.5%. Both the barrier level - at 70% - and the underlying stock - Massey Energy - are the same.

Great risk gap

But the deals differ in an important way, said Hampson, noting that the six-month deal is much riskier. She drew that conclusion looking at the respective riskmaps of the deals.

Riskmap is a Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10.

The deal coming up this month has a 7.95 riskmap versus 3.74 for last month's transaction.

"This is a huge difference for two structures that are quite the same, honestly," said Hampson. "It can only be explained by the difference in the stocks' historical volatility."

What a month

Massey's historical volatility on an annualized basis and measured last month was 66.99%, according to Future Value Consultants. For this month's deal, the annualized volatility has jumped up to 93.20%.

"The historical volatility has gone up quite a lot in a month, and this is why you have this huge difference in risk," said Hampson. "You wouldn't think a month would make such a difference but if you look at what happened last year, it makes sense," she said.

A year ago, the market went through shockwaves with the collapse of Lehman Brothers. "If you have a month of turbulence, it really has a big effect," Hampson added.

Index more neutral

Hampson said that with an index as the underlying instead of a single stock, historical volatility would have been much more stable. "But if you think of what happened last year, for a lot of stocks it's been quite a volatile year," she said.

Annualized basis

Hampson added that her firm could easily have decided to use a longer period of time to measure historical volatility, for instance, five-year rather than one year. Such a choice would have attenuated the short-term differences.

"If you took five year as an indicator of historical volatility, the gap between the risks in those two transactions would have narrowed considerably," Hampson said. "But we don't use a five-year volatility. We prefer one-year because it's more likely to be similar to the implied volatility," she said.

Historical versus implied

Different risk results could have also resulted from different tools to define risk.

Hampson noted that there are many different ways to measure risk.

Her firm's choice is to simulate returns using historical volatility, she said. However the input used in the formula is important, she added. "There is an argument to use implied volatility but we decided not to do that. We used historical volatility because it's more consistent," she said.

"Those two products are very similar and they priced one month apart. Common sense would not make you expect such a difference in the riskmap. But we have chosen a particular type of measurement for the historical volatility and we have to be consistent. Obviously here, the difference in risk reflects the difference in historical volatility. The more volatile the underlying stock, the greater the chance to breach the barrier and to suffer a loss of capital," she said.

Overall and value

Less atypical is the similarity in overall ratings between the two deals.

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 three-month reverse convertibles, which priced last month, have a 4.97 overall rating. It is 4.56 for the upcoming transaction.

Hampson said that the ratings were very similar, partly because what creates the slight difference - the value rating - is not linked to historical volatility.

The slight superiority of the three-month overall rating over the other deal is due to the fact that its value rating - at 6.20 - is higher than the value rating of the six-month notes - scoring 5.04.

The value rating on a scale of zero to 10 is Future Value Consultants' measure of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and profit margin on the underlying derivative.

"We calculate the fees per annum," she said. She gave the following example:

A five-year product pricing at 95 would have a higher value score than a one-year product also pricing at 95 as the first one takes a 1% fee versus 5% for the second one.

When a value rating is high, it means that the fees are low. Such is the case here, Hampson said, with the October deal offering more value and fewer fees to investors, according to her research.

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