The Anatomy of Principal-Protected Absolute
Return Barrier Notes

Abstract

There are many different investment vehicles featuring downside protection of principal. Such a payoff pattern is especially appealing to retail investors. One such contract is a principal- protected absolute return barrier note (ARBN). As is typical of such instruments, repayment of the principal at maturity is guaranteed, but the interest component is a function of the performance of some underlying asset, usually a stock index like the S&P 500. In the case of an ARBN, the payment in excess of the principal is equal to the absolute value of the final index minus its initial value, as long as over the option’s lifetime, the index never traded outside a price range defined by a lower and an upper barrier. This odd structure leads to unusual Greek-letter sensitivities, since the contract loses value as it get close to the barrier. How such a path-dependent payoff should be valued is a significant problem that the article addresses. Not too surprising is the finding that the issuers typically sell the contracts at prices well above theoretical values.