Benefits And Risks Of Investing In Defined Returns Essay.

What is a Defined Returns Plan and its Risks?

The report seeks to present the benefits and cons of investing in defined returns plan along with valuation of embedded option under such plan based on range of assumptions. The report is in relation to a large investment house which in order to promote long term investment among the UK private investors has launched a scheme to provide returns higher than the market subject to certain conditions being satisfied as on date of exit from such investment scheme.

Defined returns plan may defined as the scheme wherein the investor receives a fix return after a period of certain time frame. The return is fixed and does not vary with market circumstances. The common example of such return plan are fixed deposits, government deposit schemes which provide an assured rate of return. However, there are certain return schemes under the defined return plan category which carries an additional caveat wherein certain conditions are required to be satisfied for receiving a certain threshold return. For instance in the current case, the return shall be assured when the index is higher from the current level at the expiry of the plan otherwise there shall be no return to the investor. Thus, under such circumstances the return to the investors are contingent on happening of certain events in the future. These schemes come under structured investment category and have following risk associated with them:

• Defined return scheme seeks to provide higher return as compared to market when certain threshold are satisfied otherwise the original capital may be return with no additional return. Thus, the plan is more like a gamble where one either win the prize or does not win the prize. Accordingly, the risk involved under such plans are higher as compared to safe investment category;
• Defined returns schemes are structured schemes and have lot of caveats and conditions and one needs to be an educated investor while investing under such schemes;
• Return under such schemes is dependent on a benchmark and performance of that benchmark at the end of the expiry period;
• Defined returns schemes are complex instruments as compared to normal instruments;
• There are only two outcomes possible and there is lower chances of mid results;
• Not Considered goods for low risk profile investors and is preferred by medium risk profile investors;
• Accounting of such investments are complex as one does not understand whether he will receive the interest in his investment or not;

These are some of the risks which are associated with the concerned category of investments and thus one shall consider these risk before investing.

An embedded option may be defined as a feature which is included in the financial instruments which enables the issuer or the holder to have power to take specified action against the other party in a certain future time. These are the provisions which are included in the fixed income securities that provide the issuer of such security or the issuer of such security necessary liberty such as call back the security before maturity or redeem the security. There are various types of embedded options for instance callable security, puttable options etc. Further, these options are usually and inseparable part of another security and cannot exist on standalone basis.

In the present case, the four year and six year options have different payment schemes and there returns are benchmarked or contingent to the performance of FTSE 100. Under this scheme, the four year plan has two payout options i.e either an investor receives 24% return during the tenure of investment or nil returns. Further, the return of 24% is higher than the market return and accordingly there is an option embedded in such instrument which has a valuation. The scheme has two nodes from origination and each node has certain probability of pay off and there is pay off scheme. For the purpose of computation of pay off one has to consider the relevant circumstance to determine the binomial tree.

Similarly under six year scheme there are three pay off possible which originate from the starting i.e return of 45%, return of 22.5% or no return and one has to consider the probability of these return while computing the value of option embedded in such security, Also, the returns of such instruments are higher than market risk free return and thus the valuation of options needs to be determined accordingly.

What are Embedded Options?

The embedded optionality under such scheme is call option embedded which allows for higher pay out in case the FTSE 100 expires at a certain premium or higher value on the maturity of the scheme one can exercise the call to receive higher pay or under averse circumstance, the option is expired worthless.

Similar arrangement exists under six year scheme where in there is additional feature of locking in return after a certain period and then the option moves in the forward direction.

Valuation of an option is complex process and there are two models to value the option namely binomial model and the other model is Black Scholes Model. Under the binomial model, a tree like model is created to understand the possible paths which the option can take over the period of time. In the present case, there are only two possible paths for the options over a period of time frame and also one need to estimate the probability of such paths along with the risk free rate of return of such market. Thus, under a binomial model tree the following details shall be required: Strike price, Price of underlying instrument, probability of up move, probability of down move, risk free rate of return and the time period.

The binomial option pricing model uses iterative approach to value the options. Under this model there are two possible outcomes which originate from each node and the movement is either an up move or a down move and this method is more practical and intuitive as compared to Black Scholes Model. These method are practically simple to implement and presents a graphic picture of the movement. However, binomial option pricing model can become complex in case of multi time period modelling. On the other hand Black Scholes Model provides numerical result based on data input and is compatible for multi period model also. In the present case as the time frame is small and the data available is less, the binomial option pricing model has been implemented to determine the fair value of the option.

Based on series of assumptions which shall be highlighted here in under the decision tree under binomial theorem has been presented as under: 

Assumptions Involved

Probability of Up Move is 50%

Probability of Down Move is 50%

Risk free rate of return on annual basis has been considered at 2%

Accordingly, the valuation of investment if no such scheme has been opted would have been 10000*(1.02)^4= $ 10824. However, in the present case there are two pay offs which are much different to the concerned case and thus one has to understand the valuation of embedded options under such scheme.

Thus, the upside pay off is $ 12400 and profit is 12400-10000= $ 2400.

Thus, the low side  pay off is $ 10400 and profit is 10000-10000= $ 00.

Accordingly, one need to consider the present value of such scheme and thus the present value of the two node originating from the start for a period of 4 years has been presented as under:

(12400*.0.3+ 10000*0.70/(1.02)^4=  $ 9904

Further, the present value of the investment is $ 10000 and thus the option value is 10000-9904= 96. Accordingly one may infer that the value of option embedded in the scheme stands at $ 96. A summary table has been presented as under:

Based on above table, it may be inferred that the present value of the scheme is lower than the amount invested under the risk free rate. Thus, the value determined under the binomial model through iterative process helps to correctly ascertain the fair value of the option.

As given to understand that there shall be no cost incurred at the time of entering into contract and there shall be 9.8% on pre breaking of contract and the amount returned shall be the original investment in the contract less the penalty amount. Accordingly, the amount to be returned in case of pre break of contract shall be 9020. Thus, investor shall break the contract and invest the money somewhere wherein return is such high that there is some additional profit at the date of maturity. Generally an investor shall break the contract when he expects the market to be low and at maturity the value receipt shall be $10000. Considering the said facts the computation of the scheme has been presented as under:

Based on above computation it may be inferred that at the time of breaking of contract the value received is 9020 and the said amount has been invested at 3.5% for a period of 4 years assuming that the contract has been broken at the same day when the contract was entered. The amount withdrawn from the scheme is invested for a period of 4 years at the rate of 3.5% and the value at maturity has been accordingly determined at 10350 which is higher than the investment. Thus, the investor shall break the contract under the circumstance when he understand that the market is going to be low and the alternative investment opportunity shall help him to generate return which shall be higher than the present case of scheme.

Conclusion

Based on above discussions, it may be inferred that the defined returns plans are complex instruments which carry embedded option and the return under such scheme is higher than the market and there is probability of such movement of direction. Further, such schemes are generally preferred by investors which love a little bit of risk.