The Anatomy of Principal Protected Absolute Return Notes

Abstract

Principal Protected Absolute Return Barrier Notes (ARBNs) are structured products linked to an underlying security or an index. While these notes guarantee principal protection – return of face value – their upside potential is dependent on the level of the underlying security never falling outside of a predefined range. This, combined with the credit risk of the issuer to which all structured products are subject, makes these products difficult to value.

In this paper we value ARBNs by decomposing the note into a zero coupon bond and double barrier linear segment options. We derive closed form solutions for ARBNs and their Greeks, then value 214 publicly-listed ARBNs issued by six different investment banks between 2006 and 2009. We find that the ARBNs’ fair price is approximately 4.5% below the actual issue price on average.

Keywords: Structured Products, Barrier Option, Absolute Return Barrier Notes, Principal Protected