Question

A bank asks you to design a five-year principal-protected note on the S&P 500. Assume the note has a $1,000 face value, the risk free rate is 3% with continuous compounding, and the bank wants to earn a sales commission of 5%. What do you suggest? Diagram out the instrument you developed and clearly explain the risks inherent in such a note. Does this seem like a good deal for the bank’s clients?

Answer 1

In the excel sheet the way to find out the future value of note has been shown.

The function shows the formula of continuous compounding. Future value is $1161.83

Since brokerage to be added with the face value. Therefore, brokerage is 5% of $1000 = $50

So an investor has to pay $1050 for a bond to earn $1161.83 after 5 years

Risk inherent in such a note

Generally in case of risk free debt instrument the degree of risk is very low. Still there exists two types risk relating to risk free note

1) Default risk

    It may arise when the issuer of the note fail to make the required payment of such note. This type of situation occurs for the poor performance of business on the part of issuer.

Therefore, it is required to check the credit rating performance of the particular business where an investor wants to invest.

2) Variation of return may occur due to change in the market interest rate. This type of risk is called market risk. It means when market interest increases bond price will decline below the face value vice versa. When market interest rate increases the bond holder has to sell it at a lower price. When market price decreases a bond holder makes a profit by selling such bond at a higher price.

Another feature is that when the market price moves up the bond holder has an option to reinvest the interest at a market price rate therefore he gains on such activity. On the other hand when market price declines such investment of interest at the declined market rate creates loss for the investor. It is suggested to sell the bond as the bond price is greater than market rate. Therefore two types of risk arise in these two situations.

a) reinvestment risk

b) price risk

In case of bond we see a holding period where these two risks compensate each other. Therefore during holding period there exists no interest rate risk. A bond holder should take the benefit of this period.