Citigroup

Citigroup’s Guide to Structured Product Terminology

Times are changing. Retail and high-net-worth investors are

increasingly seeking investments that offer interesting ways to

generate attractive yield. They are also willing to consider products that

offer alternatives to traditional equity investments and, therefore, are not

necessarily looking for full principal protection. And, as a result, yield-

enhancing products, such as the auto-callable structure, have been winning

fans across Europe. Here we examine how such products work.

The definitionAn auto-callable (or ‘auto-call’) product is essentially a market-linked

investment, which can automatically mature prior to the scheduled maturity

date if certain predetermined market conditions are achieved.

The criterion for deciding whether the product is automatically matured

(‘auto-called’) is whether the underlying reference index is above a

predetermined trigger level (the ’auto-call barrier’). This auto-call test is

usually carried out on a set of predetermined dates (for example, annually,

quarterly, etc.) specific to that particular investment product, so that the

product can only mature on one of these ‘auto-call dates’. The underlying

reference index will typically be an equity index, but it can also be linked to

stocks, basket of stocks, funds, etc.

If a product is auto-called, the investor normally receives a predetermined

coupon along with the capital redemption on that auto-call date. That

coupon is typically proportional to the length of time from the start date to

the auto-call date.

Most auto-call products incorporate a protection feature so that, if the

auto-call trigger has not occurred before the scheduled maturity date,

capital is fully protected provided the underlying has not fallen below a

certain level (‘the protection level’) during the term of the investment. Only

if the underlying has fallen below that protection level, and the product

has not been auto-called prior to maturity, will investors be exposed fully to

the downside of the underlying market at maturity.

Behind the scenesFigure 1 demonstrates how a plain vanilla auto-callable product linked to

an index operates.

In this example of a five-year auto-call investment, the auto-call barrier is

100%. Therefore the product will auto-call if the underlying index is above

its original start level on any of the five annual auto-call dates.

The coupon payable is X% if the product is auto-called on the first auto-

call date, two times X% if the product is auto-called on the second date and

so on up to and including the maturity date. Its important to note that the

auto-call barrier condition is also tested on the maturity date.

At maturity, if conditions for an auto-call have not already been met,

then the investor is long the underlying index but with the benefit of full

capital protection, provided the underlying index has not fallen below the

protection level during the term of the investment.

If the underlying index ever traded below the protection level during

the term of the investment, then the capital protection no longer applies

and the redemption will be equal to the index performance over the life of

the investment.

Product rationaleAuto-call investment products offer investors the opportunity for a high

coupon linked to the performance of the underlying index. The coupon

is usually higher than the auto-call barrier, so that investors can achieve

Citigroup believes that product education is vital for the continued success of the structured investment product market. Kicking off its new monthly column, which will discuss a wide range of structures, Citigroup explores what are commonly referred to

as ‘auto-callable’ investment products

1. Example of vanilla auto-callable structure

Example : coupon = X% maturity(T) = 5 years

t=1 t=2 t=3 t=4 T=5t=0

1

2

3

100% capital + 4

100% capital + 5 x coupon X%

Maturity

Auto-calllevel 100%

Protectionlevel P%

100% capital +

no coupon

Long underlying+

no coupon

100% capital +

(n) x coupon

-

100% capital + x coupon X%



x coupon X%

the investment proceeds and the potential coupon are accrued for the next auto-call date

call date (t),When underlying < auto-call level at each auto-No early redemption, No coupon payment :

>

Corporate statement Citigroup

attractive returns for small movements in the underlying index.

If a coupon is not paid, because the auto-call barrier has not been

achieved by the underlying index on an auto-call date, then the investor gets

the opportunity to recoup the missed coupon on the next auto-call date.

In addition, the protection level ensures that the investment is

conditionally protected. If the underlying does not fall below the protection

level, investors will receive at least the full principal amount back at maturity.

Scenario simulationsWith each structure we examine in this monthly column, we will also

provide some simulations designed to show how the product can behave

in certain assumed market conditions. The following simulations are based

on a Monte Carlo approach. The Monte Carlo simulation involves generating

thousands of possible price paths for the underlying index, based on preset

volatility and trend assumptions. The simulation calculates how the product

would have performed using each of those simulated price paths and then

summarises the results. We assume that returns on the underlying single

index follow a process with constant growth rate and volatility.

The example we use here is for a five-year auto-call investment linked

to the Dow Jones EURO STOXX 50® with an auto-call barrier at 100%, a

potential coupon of 9% per annum and a protection level of 60%.

Three hypothetical scenarios are analysed below.n Flat market: the growth rate is zero per annum, representing a scenario

with no trend.

n Moderate growth market: the underlying has a positive drift of 2.50%

per annum, the trend is positive but weak.

n Bullish market: the growth rate for this scenario is equal to 7.50% per

annum, a clear uptrend is assumed.

For each scenario we have assumed a volatility level of 18% per annum,

which is similar to the current implied volatility of the Dow Jones

EURO STOXX 50®.

Parameters of the simulation

In all scenarios, the most likely outcome is that it is auto-called in year one

with a coupon of 9% (the dark-blue segment). If it is not auto-called in

year one, then figure 2 demonstrates the likelihood of it being called in

subsequent years (the remaining lighter-blue segments). The likelihood of

the product lasting until maturity is equivalent to the size of the red and pink

sectors combined in each scenario, with the size of the red sector showing

the probability of losing some portion of capital and the size of the pink

sector representing the probability of the product redeeming 100% capital.

VariationsAs with any popular structure, a number of variations on the original idea

exist. Some of the more commonly seen variations are:

Performance auto-call: The auto-call coupon is not fixed at a specific level

but pays the greater of X% and the actual underlying performance in case

of an auto-call event.

Crescendo auto-call: The auto-call event depends on two underlyings

being above the auto-call barrier. The additional condition on the second

underlying provides additional financing for higher auto-call coupons.

Escalator auto-call: The auto-call barrier decreases each year – increasing

the likelihood of an auto-call event and reducing the probability of capital

at risk.

Bonus plus auto-call: Besides the auto-call coupon, investors receive a

bonus coupon if auto-called early in the life of the product. The effective

per annum coupon is high in early years compared with a standard auto-

call note and reduces towards maturity.

Premium express: The auto-call barrier is below 100% of the initial strike

level aiming to provide a high auto-call probability with full capital protection.

2. Distribution of the payoff

0

10

20

30

40

50

60

70

80

90

100

Flat market Moderate growthmarket

Bullish market

Not auto-called with capital loss atmaturity

Not auto-called with capital protectionat maturity

Auto-called year 5 with 45% coupon





%

Contact details

Albert Plattner, managing director, head of European structured

sales, Citigroup

e: [email protected]

t: +44 (0)20 7500 5000

Financial terms of the hypothetical auto-callable structure

Underlying Dow Jones EURO STOXX 50®

Tenor, currency Five years, EUR

Auto-call barrier 100%

Protection level 60%

Auto-call coupon 9%

Flat market Moderate market Bullish market

0% growth rate pa 2.5% growth rate pa 7.5% growth rate pa

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