Structured Products incorporating Call Spreads May 2009.

Structured Products incorporating Call Spreads

May 2009

Call Spreads

Content

What is a Call Spread?

Uncapped vs Capped – a comparison

Summary


A call option gives the holder of that option the right to buy an asset at a specified time

in the future at a certain price (STRIKE price).

But what if at the same time as buying a call option on an asset at a certain STRIKEprice, a call option on that same asset is SOLD at a DIFFERENT strike price?

For example, let us assume that an investor buys a call option on the FTSE with a strike

of 4,500 whilst simultaneously selling a call option on the FTSE with a strike price of

5,500.

What are the returns for different market levels on the expiry date of those optionscompared with the returns of an uncapped call option with strike of 4,500?


Table of possible returns:

Index at maturity Uncapped call return

Call spread return

6,000 1,500 1,000

5,750 1,250 1,000

5,500 1,000 1,000

5,000 500 500

4,500 0 0

4,000 0 0


You can see that for index levels at maturity up to 5,500, there is no differencebetween the return on the 4,500 call and the return on 4,500 / 5,500 call

spread.

Therefore, if the investor thinks that the FTSE will not be above 5,500 at maturity he

will be equally well off buying the call spread as buying the uncapped call.

The benefit to the investor is that the call spread will be cheaper than buying the

uncapped call.

Let’s use some example figures to see how the investor could enhance his returns by

investing in a call spread through a structured product compared with buying an

uncapped call within a similar structured product.


GBP1.00Investor’s

Cash

Share Price at Issue 100.00p

Zero-Coupon Bond 75.00p

Aggregate Costs 1.50p

a)Uncapped call price 23.50p

b)100/150% call price 11.75p

GBP1.00Zero-coupon

Bond

OptionProvidingEconomic

Return

The option providing the economic return could be a number of things, two of which are an uncapped call or a call spread


The previous diagram can be described using the numbers below:

• Amount to spend = 100p• Zero coupon bond (ZCB) cost = 75p• Costs = 1.5p• Therefore cash remaining to spend = 100 – 75 – 1.5 = 23.5p

Let us assume also that:

• a) Cost of one FTSE 100% call option = 23.5p• b) Cost of one FTSE 100%/150% call spread = 11.75p

This means that the investor could buy either:

• a) 1 x ZCB + 1 x 100% FTSE call, or• b) 1 x ZCB + 2 x 100%/150% FTSE call spread


The table below shows a comparison of returns at the maturity for these two structuredproducts for different FTSE Index levels at maturity.

FTSE at maturity

Uncapped call product

payoff

Call spread product payoff

Difference (Call spread – Uncapped)

50% 100% 100% 0%

75% 100% 100% 0%

100% 100% 100% 0%

125% 125% 150% 25%

150% 150% 200% 50%

200% 200% 200% 0%

250% 250% 200% -50%


From the table you can see that the product incorporating the call spread does better

than the product incorporating the uncapped call unless the FTSE more than doubles

over the term of the trade.

If the investor’s view is that the FTSE will not double over the term of the trade, but

will show some appreciation, then of the two products he would be better advised to

buy the product incorporating the call spread, were the two products available.

Summary

There are a number of advantages to buying call spreads compared with buying

uncapped calls if you are of a certain investment view:

a) Potential to buy GEARED UPSIDE to an asset’s appreciation.b) Width of call spread can be tailored to the investor’s view on the

underlying.c) When volatility is high (as it is now) buying uncapped calls is expensive, so

structured products investing in uncapped calls do not look as attractive now as they have in the past. Capping the upside via call spreads can mitigate this to some degree.

Disclaimer

The information in this document is derived from sources believed to be reliable but which have not been independently verified. 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 a LLP registered in England and Wales, Registered Office : One Eleven Edmund Street, Birmingham, B3 2HJ. Registration Number: OC336585, Vat Number: 936371705, FSA Reference: 484826

Structured Products incorporating Call Spreads May 2009.

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