I was looking at investments offered in my offshore account and came across the following structure:
- 5 year investment into china fund
- capital preservation (built-in floor at initial investment level)
- max 55% return total across 5 years, the bank pockets the excess above
For someone not in the financial business this may seem to be a good deal (seeing the 55% and capital preservation). I think it is a relatively poor deal though. The continuously compounded effective annual rate is only ~8% and that is only achieved if the market does indeed appreciate 55%.
I began thinking about how closely could replicate this structure on my own, but with a much higher max payoff. Though the payoff function I am going to indicate is not perfect (I can go under my initial capital if the timing of my protection is not right), would do as follows:
- buy into FXI index
- allow some appreciation and then buy the 1 month put option at the initial point of entry
On an ongoing basis:
- roll put option at initial investment point + cost of option premiums thus far, maybe with longer maturity
- if FXI drops below initial investment, sell FXI, sell option, coverage should be close to offsetting
- as and if FXI approaches entry point buy in again and buy protection
Of course one can structure this more advantageously:
- additional protection (by adjusting strike upwards as FXI gains)
- reentering trade if FXI falls at lower level rather than initial investment level
The cost of the options is paid for out of the returns or in the worst case through the adjusted strike price. That said, increasingly, the options are going to be deeper and deeper out of the money if FXI continues to be a good investment (meaning cheaper hedging costs).