Autocall differences

Disparities between autocall headline coupon rates

Introduction

Credit in context

Autocall components

Funding

Estimating the Zero-Coupon Bond

Funding methods and assumptions

Cost of coupons

Optionality

What is ‘pin-risk’?

Delta

Volatility

Explanation of disparities between trading desks / issuers

Appendix – full methodology of different funding assumptions

2

Introduction

4

Autocall market - size

Over two-fifth of Catley Lakeman business

Autocall market – payoffs

5

Market participants comfortable with the many autocall iterations

Step-down autocall barriers

Flat autocall barriers

Counterparty Credit Suisse

Underlying Indices Multi-index

Currency GBP

FTSE 100/EuroStoxx (worst-of)

6

Credit since financial crisis

Since the financial crisis the credit spreads of banks have compressed.

Autocall component parts

FIRST STEPBuy Zero Coupon Bond from Bank

8

Component 1: Long a zero coupon bond, the duration of which is dependent on when or if the

structure autocalls.

Component 2: Long a strip of escalating coupons, payment of which are contingent on the

FTSE 100 index being above pre-defined levels.

Component 3: Short a knock-in put which gives the investor some downside risk. This

downside risk disappears in the event of an autocall.

As with all Structured Notes, the Zero-coupon Bond [ZCB] will be the important component

when considering funding.

9

100.0Index

108.2

100%

Yr 1

95%

116.4Yr 2

124.6

90%

Yr 3

132.8

85%

Yr 4

141.0

80%

Yr 5

59.99

60%

149.2

75%

Yr 6

0

As with all Structured Notes, the Zero-coupon Bond [ZCB] will be the important component when considering funding

Funding

11

Breaking down the Autocall components and revealing the ZCB leads us nicely to the implication of

funding to the terms of an autocall.

How much of an investor’s 100p investment goes into a variable maturity Zero-coupon bond?

Depends on the Autocall!

Example:

Estimating the Zero-Coupon Bond

Underlying indices FTSE 100 / EuroStoxx 50 (worse-of)

Snowball return [X] snowball coupon

Autocall barriers

1st anniversary 100%

2nd anniversary 95%

3rd anniversary 90%

4th anniversary 85%

5th anniversary 80%

6th anniversary 75%

Soft capital protection65% of initial (observed at maturity only)

Currency GBP

Maturity 6 year maximum

The important factor is when is the ZCB expected to mature

Expected Life!

Only the barrier levels are important for the maturity date (in conjuction with which underlying’s are used of course!) – it will either autocall early or go to it’s full 6 year term.

12

Estimating the Zero-Coupon Bond

Underlying indices FTSE 100 / EuroStoxx 50 (worse-of)

Snowball return [X] snowball coupon

Autocall barriers

1st anniversary 100%

2nd anniversary 95%

3rd anniversary 90%

4th anniversary 85%

5th anniversary 80%

6th anniversary 75%

Soft capital protection65% of initial (observed at maturity only)

Currency GBP

Maturity 6 year maximum

‘Expected life’ or average life/maturity of the autocall

3.23 years in the case of our example, as of July 2015 pricing

What if we estimate our ZCB element as being 3.23 years in maturity?...

Zero-Coupon Bond

Expected maturity 3.23 years

No. of days 1180

Start 30th July 2015

End 22nd October 2018

Capital/ZCB 95.46%

Present Value of receiving 100p invested

The question now is how do we discount the ZCB to ascertain funding pickup from the various Issuer’s?

Funding methods & assumptions

13

To put funding and CDS levels into context, this graph show the 2 year CDS reference levels for our main issuers (RBC excluded here as it does not have a Bloomberg listed CDS reference).

2 year CDS as an approximation of shorter term credit (remember our autocall does not have an expected life of years at inception)

Funding methods & assumptions

14

Let’s consider two hypothetical banks, one that funds near to a high average CDS and one that funds near to a low average CDS as measured by the CDS graph.

Hypothetical Bank 1 – funding at 0.60% 2 years

Hypothetical Bank 2 – funding at 0.30% 2 years

Funding methods & assumptions

15

Funding levels and probabilities of maturities of an autocall described above.

Year Example funding spread of “higher” CDS

Example funding spread of “lower” CDS

Probability of autocall Probability trade still live

1 year* 0.50% 0.20% 39.91% 100%

2 year 0.60% 0.30% 16.68% 60.09%

3 year* 0.70% 0.40% 8.06% 43.41%

4 year* 0.80% 0.50% 5.20% 35.35%

5 year* 0.90% 0.60% 3.49% 30.15%

6 year* 1.00% 0.70% 3.00% 26.66%

*assumed funding curve extrapolated linearly for terms away from 2 year CDS for illustrative purposes

Expected life 3.23 years

These are inferred from the Autocall pricing models

Funding methods & assumptions

16

Funding levels and probabilities of maturities of an autocall described above.

1.1 year funding rate across the entire life of the trade – most conservative.

2.“Step-up” funding – more aggressive.

3.Fund to “Expected Life” – more aggressive.

Year Example funding spread of “higher” CDS

Example funding spread of “lower” CDS

Probability of autocall Probability trade still live

1 year* 0.50% 0.20% 39.91% 100%

2 year 0.60% 0.30% 16.68% 60.09%

3 year* 0.70% 0.40% 8.06% 43.41%

4 year* 0.80% 0.50% 5.20% 35.35%

5 year* 0.90% 0.60% 3.49% 30.15%

6 year* 1.00% 0.70% 3.00% 26.66%

*assumed funding curve extrapolated linearly for terms away from 2 year CDS for illustrative purposes

Expected life 3.23 years

**see appendix for full details of funding calculations**

Funding methods & assumptions

17

Summary

Funding method‘Higher’ CDS Bank pick-up

‘Lower CDS Bank pick-up

Difference

1st Autocall 1.48% 0.59% 0.89%

Step-Up 1.99% 1.10% 0.89%

Expected life 2.34% 1.37% 0.97%

What can we take from this summary of funding methods?

Whilst credit does indeed appear tight, the varying methods of applying funding levels by an issuer make more of an impact to the discount of the ZCB than you may initially assume.

Taking the difference between our hypothetical banks – the difference between them is as much as 1.75% (2.34 – 0.59%)

Cost of coupons

18

We have quantified a difference in funding as an “up-front” equivalent. We can quantify what this means in extra autocall coupon.

Our example 5% dropping FTSE/EuroStoxx dual index autocall:

1% extra UF discount to the ZCB will buy an extra 0.67% autocall coupon.

Funding method‘Higher’ CDS Bank pick-up

‘Lower CDS Bank pick-up

Difference

1st Autocall 1.48% 0.59% 0.89%

Step-Up 1.99% 1.10% 0.89%

Expected life 2.34% 1.37% 0.97%

>>> Our hypothetical banks have a maximum difference of 1.75% if they use different funding methods, doesn’t sound a lot, but this would translate into an extra 1.17% per annum to the autocall coupon headline rate! Not insignificant in the grand scheme of yields and market levels!

Optionality

19

What is ‘pin-risk’?

Delta

Volatility

‘Pin-risk’ – best described with an example.

Feb-11 May-11 Aug-11 Nov-11 Feb-1280.00%

85.00%

90.00%

95.00%

100.00%

105.00%

110.00%

Year one autocall of SG 297 FTSE Defensive Autocall (10.17%)

Feb-11 May-11 Aug-11 Nov-11 Feb-1280.00%

85.00%

90.00%

95.00%

100.00%

105.00%

110.00%

Year one autocall of SG 297 FTSE Defensive Autocall (10.17%)

Optionality

20

What is ‘pin-risk’?

Delta

Volatility

‘Pin-risk’ – best described with an example.

On the year one autocall observation date, the FTSE was trading very close to the trigger level. As it happened, the close of business level was enough to cause an autocall event, by just 15 FTSE points!

Optionality

21

What is ‘pin-risk’?

Delta

Volatility

The VIX is the market’s expectation of the future 30 day rolling S&P 500 index volatility

As is always the case for derivatives, volatility (both realised and implied) is quoted as an annualised volatility figure.

For example, if the VIX is trading at 13, this implies roughly a 0.81% average daily move over the next 30 days of the S&P 500.

...not likely to be relevant to most Structured Notes!..

...remember our autocall example is linked to the FTSE and the EuroStoxx, with an expected life of >3years.

Optionality

22

What is ‘pin-risk’?

Delta

Volatility

Investors in an Autocall are “short” volatility

Bank therefore is naturally long volatility that it must sell

Dynamics between spot levels and therefore differing probabilities of autocall maturity and payoffs, means that this nature of hedging volatility is also very dynamic

Optionality

23

What is ‘pin-risk’?

Delta

Volatility

The price of the autocall must take into account the cost of hedging the future changes in the implied volatility impact on an autocall.

There is interplay between spot movements and the volatility profile that trading desks have to hedge. For example, if from strike, spots move down quickly, the expected life of the autocall increases as the larger autocall coupons in the later anniversaries become more probable to be activated (more likely to miss year one’s autocall). These larger coupons, especially if the autocall barriers are set at lower than strike levels, will exhibit a higher level of volatility hedging by virtue that they are larger coupons.

24

Explanation of disparities between trading desks/issuers

If we consider a world in which there exists two issuers pricing an autocall:

Issuer 2’s trading desk:

Large and establishedautocall book that it is currently hedging.

Large variation in strike levels, strike dates and differing autocall barriers.

Active in a number of other derivative flow Markets

Recently sold an Out-the-money Put option to a large pension fund.

Issuer 1’s trading desk:

No existing positions on the book.

Has to incorporate more hedgingcosts.Less competitive Autocall coupon.

Has overlapping Autocalls, overall book is easier to neutralise risk.More competitive Autocall coupon.

Day one price of an Autocall must reflect the cost of hedging through its life. Remember the ‘discontinuities’ (e.g. Digital pin-risk) associated with hedging an Autocall Issuer 2’s trading book has less overall discontinuity due to the overlapping individual

Autocalls that make up the book. >>> less discontinuity risks that need to be neutralised. Issuer 1’s trading book requires the full discontinuity to be neutralised in total.

This is a marketing communication and has not been prepared in accordance with legal requirements designed to promote independence of

investment research and is not subject to any prohibition of dealing ahead of the dissemination of investment research.

The information in this document is derived from sources believed to be reliable but which have not been independently verified. Any prices

included within this communication are for indicative purposes only. Catley Lakeman Securities makes no guarantee of its accuracy and

completeness and is not responsible for errors of transmission of factual or analytical data, nor is it liable for damages arising out of any

person’s reliance upon this information. All charts and graphs are from publicly available sources or proprietary data. The opinions in this

document constitute the present judgment of Catley Lakeman Securities, which is subject to change without notice.

This document is neither an offer to sell, purchase or subscribe for any investment nor a solicitation of such an offer. This document is intended

for the use of institutional and professional customers and is not intended for the use of private customers. This document is not intended for

distribution in the United States of America or to US persons. This document is intended to be distributed in its entirety. No consideration has

been given to the particular investment objectives, financial situation or particular needs of any recipient.

Catley Lakeman Securities is regulated by the Financial Conduct Authority. Firm FSA Reference No. 484826. Catley Lakeman Securities is the

trading name of Catley Lakeman LLP. Registered Office: One Eleven Edmund Street, Birmingham. B3 2HJ. Registration Number: OC336585

DISCLAIMER

25