Recipes for Participation

Tracker certificates, airbag, twin-win, outperformance, bonus and outperformance bonus certificates — the Hemingway products of the structured product world.

Hemingway travelled extensively throughout his life but was most at home on a barstool. The premise behind Philip Greene's book To Have and Have Another is that Hemingway liked to write about what he was drinking — the daiquiri at Floridita in Havana appears in Islands in the Stream, the gin & tonic at the Museo Chicote in Madrid appears in The Denunciation, and his favourite Harry's Bar in Venice appears in Across the River and into the Trees.

Investors in participation products are similar to Hemingway — eager to engage directly with a market. The simplest product is the tracker certificate, which gives investors direct exposure to the indexes tracked in the IndexesIQ stock market guide. But the bartenders of the structured product world have created various modifications that add non-linear elements to the strictly linear payoff.

The basic idea of a long tracker is to capture the return of the underlying asset 1:1. The short tracker offers the inverted return. Trackers don't contain options and are typically open-ended (no fixed maturity). Long trackers are low-fee and suited for long-term strategies; short trackers enable tactical short positions that most private investors couldn't otherwise achieve. The SSPA Swiss Derivative Map classifies trackers as the foundational participation product.

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The airbag certificate takes the tracker and adds an "airbag" below the current asset price (= the strike). If the asset ends above the protection level P at maturity, the negative return is absorbed by the airbag. Below P, losses occur at an accelerated rate of X/P. The product always pays at or above the underlying asset — but the No Free Lunch Rule applies: the airbag certificate costs more than the asset itself, reducing the profit at maturity by the net option premium.

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The twin-win certificate enhances the airbag concept: instead of absorbing downside losses, it converts them into gains. The product doubles the at-the-money put investment and removes the short option — but uses a down-and-out put instead of a standard put to reduce the cost. The result: the product profits from both rising and falling asset prices, as long as the barrier B is not touched.

Once the barrier is touched, the put option knocks out and the twin-win converts into a standard tracker — with the disadvantage that the investor paid a premium at issuance. The twin-win suits investors who expect large price swings but are unsure of direction — for instance, after a market crash when a rebound is possible but further downside cannot be ruled out.

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The outperformance certificate adds a non-linear element above the strike: an enhanced upside participation P > 1. The product buys (P−1) units of an at-the-money call on top of the underlying asset. The total investment exceeds the asset price by the option premium paid.

Below the strike, the profit distribution mirrors the underlying — shifted left by the premium paid. Above the strike, the distribution is stretched horizontally by factor P. During its lifetime the product profits from rising rates and rising volatility due to the long call component.

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The bonus certificate adds a non-linear element at a bonus level above the current asset price. A zero-bond investment grows to this bonus level at maturity. The non-linear feature consists of a short down-and-in put (providing the bonus protection) and a long call at the bonus level (providing upside participation). As long as the barrier is not touched, investors receive at least the bonus level at maturity.

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The outperformance bonus certificate is a hybrid of the outperformance certificate and the bonus certificate — it combines a bonus level with an upside participation P > 1. Unlike the bonus certificate, it uses an at-the-money strike (not a strike above the asset price) because the interest rate effect finances the enhanced upside participation through the bond-option handshake rather than the bonus level.

Investors in the bonus certificate have a slightly more defensive view (higher bonus level, lower upside participation). Investors in the outperformance bonus certificate have a slightly more bullish view — they accept a lower bonus level in return for stronger upside participation.

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Tourists in Havana often hear that Hemingway's favourite drink was the mojito, which he allegedly drank at La Bodeguita del Medio. Yet Hemingway never wrote about mojitos. He did enjoy a similar drink, especially when spending time on his beloved boat, Pilar. The boat's skipper, Gregorio Fuentes, created the Gregorio's Rx cocktail for Hemingway when he was under the weather. Many believe that Fuentes and fellow skipper Carlos Gutierrez were the basis for the old fisherman Santiago in The Old Man and the Sea.

While notoriously fond of drinking, Hemingway knew his limits — he refrained from drinking while writing. Asked in an interview if rumours of him taking a pitcher of martinis to work every morning were true, he answered:

For educational purposes only. Not investment advice. Derivative products carry significant risks and may not be suitable for all investors.