The single greatest advantage of structured investment products over funds or direct investments is the capability to protect investor capital. Capital protection can be tailored to suit different requirements. There are three main types available:
1. Full, hard capital protection.
2. Partial, hard capital protection.
3. Full, soft (or conditional) capital protection.
Full, hard capital protection provides a 100% capital guarantee that invested capital will be returned if the underlying asset witnesses a negative return upon maturity. The main factor impacting the cost of a full, hard capital protection is the relevant interest rates with regard to the currency of the structure. The length of time to maturity and the financial strength of the issuer are the remaining factors. A full, hard capital protection is usually a simple structured product linked to the growth of a underlying asset. At maturity the investor receives 100% participation in the underlying asset with a capital protection of 100%.
Partial, hard capital protection protects only a proportion of the capital. In this case the amount of capital that is protected is reduced but the money available to be invested in the derivative component of the structured product is higher and this, in turn, tends to increase the performance potential. In the case of partial, hard capital protection imagine a structured product linked to the same underlying asset but with capital protection of say 90% of the initial invested capital. The participation level may then increase from 100% to 120% giving the investor greater performance potential.
Full, soft capital protection allows the investor to benefit from higher exposure to the underlying asset and full protection to their investment, provided that the underlying asset doesn’t fall by a certain percent from its initial value. Capital is protected from adverse moves in the underlying asset up to a certain level but is fully exposed to negative performance beyond that level. Full, soft capital protection may allow higher participation, while providing full capital protection of the initial invested capital as long as the underlying asset does not register a substantial loss of its initial value at any time during the life of the investment product. If this adverse scenario is realized, the investor no longer has the benefit of capital protection. For example, a product offering a full, soft capital protection at a barrier of 50% of the initial investment value would fully guarantee an underlying asset that fell by 30%. However, if the asset fell by 60% then the product would participate fully in any positive or negative performance.
It is quite obvious, and often stated, that the more risk an investor is willing to accept, the higher their potential return. While full or partial capital protection has been popular for some time now, full, soft capital protection is recently gaining popularity. As many investors believe we are near the market bottom, this type of guarantee will provide full protection provided there is not an “Armageddon” type scenario of markets falling by historically unprecedented amounts. Investors who currently hold this view should consider full, soft capital protection.