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The Anatomy of Principal Protected Absolute Return Notes

Published in the Journal of Derivatives, Vol. 19, No. 2, pp. 61-70, 2011


Principal Protected Absolute Return Barrier Notes (ARBNs) are structured products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.

The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.

The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies.

By Geng Deng, Ilan Guedj, Joshua Mallett, and Craig McCann

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Craig J. McCann
Joshua S. Mallett
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