Locally Capped Investment Products and the Retail
Investor

Abstract

This article explores a different type of structured retail product with a payoff that is heavily path dependent. Formally, these securities are “locally capped and globally floored.”That is, the payoff consists of an overall minimum guaranteed return over the contract’s lifetime, plus a variable return cumulated over a series of subperiods, which is calculated as the lower of the actual percentage change in an underlying index in that period or a fixed ceiling rate. Again, this highly path-dependent payoff is difficult to value. The contracts are typically substantially overpriced relative to their fair values, by about 6.5% on average. But beyond showing that average investor returns are below what they should be, the authors offer some insight into why unsophisticated investors buy products that they don’t fully understand. They show how the issuers offer cherry-picked examples in their promotional literature in which the investor’s return from the contract is better than that from alternative strategies, without explaining how improbable the scenarios are relative to the much more likely cases in which the instrument underperforms.