It is the 20th anniversary of the creation of the reverse convertible!
The author shares the history of the reverse convertible, and explores its possibilities for the future
- The reverse convertible is an innovative product that can easily be integrated in an advanced allocation framework that goes beyond the classic but lacking asset allocation model
- The reverse convertible allows the issuer to effectively deal with the counterparty risk as the structured product is fully capitalized from the beginning
- With time, the offering of the conventional reverse convertible has been extended with a version that brings partial capital protection
It is this Spring/Summer that the reverse convertible structure is celebrating its 20 years of existence! No doubt, it has been a huge success since the beginning and continues to benefit from its key position among the different types of structured products, especially in Switzerland…
And it is not a surprise that the reverse convertible has been launched in Switzerland. Switzerland with its tradition of creative minds: fulfilling a recognized real need of the investors - that is essential and not trivial to figure out. And in that case allowing effectively a win-win situation, that comes from extensive market and technical expertise. The reverse convertible is an innovative product that can easily be integrated in an advanced allocation framework that goes beyond the classic but lacking asset allocation model.
With a reverse convertible, the investor “implements” the view of a price-stable underlying at maturity. That (underlying) instrument being typically a stock or a stock index, even though it is of course not limited to equity exposure as it could as well be fixed income or commodities for example. A key characteristic is the sharply enhanced coupon (with possibly other benefits) as the reverse convertible takes the form of a bond. Given that the investor is basically long the underlying through a short-put type of risk, a loss in the underlying leads to a loss in the value of the reverse convertible. At maturity, the investor gets back either cash (typically the 100% of the issuing amount) if the view is fulfilled or, the underlying as it has lost in value (but it still could recover later on: that would be another investor view).
In fact, the very first three years reverse convertible in USD had Philip Morris as its underlying: a well-thought – as it is key to understand the underlying and option valuation characteristics - and successful choice. For example, the level of volatility and its potential development is one of the key drivers in the stock selection process: a high volatility gives the option that the investor indirectly sells … a higher value. Of course, both market risks and the credit risk of the bond issuer (typically the Bank itself) are to be well understood: something usual for the multi-assets institutional investors, especially because there is no leverage involved in the reverse convertible making it an integrated solution. On the other hand, the reverse convertible allows the issuer to effectively deal with the counterparty risk as the structured product is fully capitalized from the beginning.
In addition to the reverse convertible, the issuer could also simultaneously bring on the market a call warrant on the very same underlying: this would simplify the hedging process and the characteristics of the reverse convertible could very well be further improved (because of that).
With time, the offering of the conventional reverse convertible has been extended with a version that brings partial capital protection. In that case, the option isn’t a plain vanilla one anymore but an exotic one with its particular limitations, especially regarding the issuing volume.
As a conclusion, we may say that the future of the reverse convertible is likely to be as bright as its past, also because there are still numerous possibilities to be explored. One of the areas of interest is related to the implementation of different degrees of conviction regarding the moves of the underlying, beyond the partial capital protection. Also, there are other types of underlying that would be well adapted to this type of structure... Something the author knows very well… as he created the original structure.
Patrick Oberhaensli, founder and ceo of Evolids Finance LLC, was personally involved in the invention of the reverse convertible and has acquired an extensive cross-asset class expertise in multiple domains such as Derivatives/Structured Products, Quantitative Strategies and Valuation Techniques and Alternative Investments.
Keywords: BNY Mellon, Shanghai Stock Exchange, Shenzhen Stock Exchange
Institution: Reverse Convertible