We could tell you that the last time we went fishing we caught a fish that was THIS BIG (motions with outstretched arms), but you probably wouldn't believe us unless we showed you. We wanted to take this opportunity to show some examples of truly complex structured certificates of deposit that have been constructed in recent months and years.
Let's take a look at JP Morgan's August 2012 fifteen year "Callable Variable Rate Range Accrual CDs Linked to 6-Month USD LIBOR and the S&P 500 Index" -- See the disclosure. The deposit was given the CUSIP 48124JHT8. This CD:
pays interest quarterly based upon the number of days the S&P 500 exceeds a certain level (80% of the pricing date level), an interest factor and a leverage factor;
has an interest factor that changes throughout the term of the deposit and, after the first year, that depends upon the difference between a fixed rate and six month LIBOR;
has a minimum interest rate of 0% and a maximum interest rate that changes during the term;
can be called on a quarterly basis at JP Morgan's discretion at face value (plus any accrued and unpaid interest).
Let's look at how complicated it can be to determine the interest owed during a given period. Consider the interest period from August 31, 2013 to November 30, 2013. Assume that the S&P 500 was above 1,127.44 (80% of S&P 500 level on August 28, 2012) for 80 days during the quarter which consists of 90 days. Assume that 6 month LIBOR was 4.5% as of August 29, 2013 (the interest reset date).
The interest rate that would be credited for this quarter on November 30, 2013 is the leverage factor (1.1) times the difference of (5.5% and 6 month LIBOR, 4.5%), so long as it is less than the maximum rate (6.05%) for this period. So this part would yield 1.1*(5.5%-4.5%) = 1.1%. This is larger than the minimum rate of 0% and so we would just multiply this rate by the fraction of days the "accrual provision" is satisfied (80/90), yielding 0.977777%. This would then be rounded according to the rounding formula used by the calculation agent to yield 0.978% per annum (day-count convention ACT/365). Of course all this assumes that the CD has not been called by that point (first call date is August 31, 2013).
Each of these features are very difficult for retail investors to value. Range accruals are not simply directional bets reflecting a bullish or bearish outlook on a particular asset or index, they are complex bets on the relationship between different assets and the statistical likelihood of breaching specific barrier levels. In addition, the embedded call provision grants JP Morgan the ability to redeem at par if market conditions change in the investor's favor.
According to Bloomberg, four million dollars worth of this CD were issued in August 2012 and the CDs paid interest on November 31, 2012 at a rate of 7.25% per annum. If any of these investors bought an amount that exceeds the current FDIC insurance limit, theprincipalamount beyond that limit will not be FDIC insured. Interest is not accrued until interest payment dates when the interest payment is calculated (see above) and as a result would not be covered by FDIC insurance should the bank go under.
So how complicated can structured CDs get? Really, really complicated.
