ue Diligence Guidelines on Principal-protected Notes · Due Diligence Guidelines on Principal-protected Notes 5 I. WHAT IS A PRINCIPAL-PROTECTED NOTE? A principal-protected note (“PPN”)

ue Diligence Guidelines on Principal-protected Notes

André Fok KamMarch 28, 2007

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Investment Dealers Association of Canada

Due Diligence Guidelines on Principal-protected Notes

Table of Contents

PREFACE ..................................................................................................................................................... 3 FOREWORD................................................................................................................................................ 4 I. WHAT IS A PRINCIPAL-PROTECTED NOTE?................................................................................ 5

1.1 THE DUE DILIGENCE PROCESS ............................................................................................................. 5 1.2 CONSTRUCTING A PPN ......................................................................................................................... 6 1.3 LACK OF TRANSPARENCY OF PRICING ................................................................................................ 11 1.4 PARTICIPANTS .................................................................................................................................... 12

II. EVALUATING THE ISSUER ............................................................................................................. 13 2.1 PPNS FROM THE ISSUER’S PERSPECTIVE............................................................................................. 13 2.2 CREDIT RISK....................................................................................................................................... 14 2.3 HEDGE COUNTERPARTY RISK............................................................................................................. 17

III. EVALUATING THE PRODUCT STRUCTURER.......................................................................... 20 3.1 PPNS FROM THE STRUCTURER’S PERSPECTIVE................................................................................... 20 3.2 CONFLICTS OF INTERESTS................................................................................................................... 21

IV. EVALUATING PRINCIPAL-PROTECTED NOTES WHEN THE UNDERLYING ASSET IS A FUND........................................................................................................................................................... 23

4.1 DRAWBACKS OF OPTION-BASED PROTECTION STRUCTURES .............................................................. 24 4.2 CONSTANT PROPORTION PORTFOLIO INSURANCE............................................................................... 24 4.3 RISKS UNDER CPPI............................................................................................................................. 26 4.4 OTHER ISSUES WITH CPPI .................................................................................................................. 29

V. EVALUATING THE PRODUCT FEATURES OF PRINCIPAL-PROTECTED NOTES............ 30 5.1 UNDERLYING ASSET........................................................................................................................... 30 5.2 FINAL VARIABLE RETURN .................................................................................................................. 33 5.3 MINIMUM RETURN AT MATURITY ...................................................................................................... 36 5.4 COUPON.............................................................................................................................................. 37 5.5 TERM .................................................................................................................................................. 37 5.6 IS THE PRINCIPAL PROTECTION REDUNDANT?.................................................................................... 38

VI. EVALUATING THE LIQUIDITY OF A PRINCIPAL-PROTECTED NOTE............................. 41 6.1 EXCHANGE LISTING............................................................................................................................ 41 6.2 REDEMPTION RIGHTS ......................................................................................................................... 41 6.3 DEALER-MAINTAINED SECONDARY MARKET ..................................................................................... 43

VII. FEES AND EXPENSES..................................................................................................................... 46 7.1 COSTS EMBEDDED IN THE PRICE OF THE PRODUCT............................................................................. 46 7.2 SALES CHARGES ................................................................................................................................. 46 7.3 ANNUAL FEES AND EXPENSES ............................................................................................................ 47 7.4 ANNUAL FEES AND EXPENSES WHEN THE UNDERLYING ASSET IS A FUND OF HEDGE FUNDS ............ 47 7.5 BREAK-EVEN GROSS RETURN............................................................................................................. 48

VIII. TAX CONSIDERATIONS............................................................................................................... 51

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IX. INVESTORS AND PRINCIPAL-PROTECTED NOTES ............................................................... 53 9.1 BENEFITS TO THE INVESTOR ............................................................................................................... 53 9.2 RISKS TO THE INVESTOR ..................................................................................................................... 54 9.3 OTHER ISSUES .................................................................................................................................... 56 9.4 SUITABILITY CONSIDERATIONS .......................................................................................................... 57 9.5 OVERALL EVALUATION ...................................................................................................................... 58

APPENDIX I – BUILDING BLOCKS OF A PRINCIPAL-PROTECTED NOTE.............................. 59 1.1 ZERO-COUPON BONDS ........................................................................................................................ 59 1.2 OPTIONS ............................................................................................................................................. 61

APPENDIX II – DUE DILIGENCE QUESTIONNAIRE ...................................................................... 66

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PREFACE

The Investment Dealers Association of Canada (IDA) has commissioned the production of “Due Diligence Guidelines on Principal-protected Notes” to assist Member firms and registrants in meeting their know-your-product requirements as they relate to principal-protected notes, a market which has experienced rapid growth in Canada. The guide will assist investment dealers, their registered representatives and investors to evaluate the merits and risks of a principal-protected note. The guide addresses due diligence questions such as evaluating the principal-protected note’s issuer and structurer, its product features and liquidity, fees and expenses and investor risks. Appendix II provides a comprehensive Due Diligence Questionnaire. The guide was developed to implement a recommendation made in “Regulatory Analysis of Hedge Funds”, a special study produced by the IDA in May, 2005. As securities, hedge funds and principal-protected notes fall within the ambit of IDA regulations as to suitability. Because an important component of suitability is due diligence, the study called on the IDA to issue guidelines to help firms and registrants make suitable recommendations to clients regarding these highly complex products. The guide was prepared for the IDA by André Fok Kam and builds partly on the research work on hedge funds and structured products, which he performed for the IDA sponsored 2006 Task Force to Modernize Securities Legislation in Canada. Mr. Fok Kam specializes in advising businesses and regulatory authorities on financial, strategic and regulatory matters. He holds a BSc (Economics) from the London School of Economics and an MBA from McGill University, and is a Fellow of the Institute of Chartered Accountants in England and Wales and a member of the Canadian Institute of Chartered Accountants.

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FOREWORD Securities commissions and self-regulatory organizations alike have emphasized the need for registrants to have sufficient knowledge of a product to assess its suitability for a client.1 The objective of this guide is to assist investment dealers in meeting their know-your-product requirements as they relate to principal-protected notes. The market for these products has experienced rapid growth in Canada in the past few years. The guide provides a structured approach to the due diligence of principal-protected notes. By following the procedures described here, investment dealers should be able to evaluate the merits of a principal-protected note and decide whether it should be placed on their list of approved products. It is also hoped that the guide will generally enhance registered representatives’ and investors’ understanding of these instruments. For the sake of convenience, the contents of each section are summarized at the end of the section in the form of due diligence questions. In addition, all the questions are regrouped in a Due Diligence Questionnaire at the end of the guide. Should an Executive Summary be desired, the final section on Investors and Principal-protected Notes will serve this purpose. I would like to thank the Investment Dealers Association of Canada for asking me to prepare this guide. The guide builds partly on the research work I performed on behalf of the Task Force to Modernize Securities Legislation in Canada (the Allen Task Force), to which I extend my thanks. Last but not least, I am grateful to all the industry people who shared their time and advice so generously with me during the preparation of this guide. Any errors or omissions are my sole responsibility.

ANDRÉ FOK KAM

1 See, for example, Canadian Securities Administrators, Notice 46-303 Principal Protected Notes, July 7, 2006, Investment Dealers Association of Canada, Regulatory Analysis of Hedge Funds, May 18, 2005 and Mutual Fund Dealers Association of Canada, Member Regulation Notice MR-0048 Know-Your-Product, October 31, 2005.

Due Diligence Guidelines on Principal-protected Notes 5

I. WHAT IS A PRINCIPAL-PROTECTED NOTE? A principal-protected note (“PPN”) is a debt instrument issued by a creditworthy issuer, the return on which is linked to the performance of another investment called the underlying asset. The main appeal of PPNs as an investment lies in the fact that they protect investors’ principal while at the same time providing them with an opportunity to participate in a possible increase in the value of the underlying asset. Basis of Principal Protection The principal is protected in the sense that the note is a direct, unconditional obligation of an issuer with a high credit quality, as evidenced, say, by its debt rating. Inflation Risk The principal protection applies only to the nominal value, and not the real value, of the principal. Investors are exposed to an erosion of the purchasing power of their investment over the term of the PPN in the event that the return is lower than the rate of inflation.

1.1 The Due Diligence Process It would be appropriate for the detailed procedures in the guide to be performed under a project leader with the participation of representatives from the relevant functions within the firm. Once the detailed analysis has been completed, the final decision on whether to place the product on the list of approved products will normally be taken by a committee, which includes members of senior management. Information Sources The main disclosure document for a PPN is the information statement. Unlike a prospectus, the contents of an information statement are not prescribed by securities regulations and they are not reviewed by the securities commissions. As a result, their quality varies enormously in practice. The completeness and quality of the disclosure is itself a factor in evaluating a PPN. When the issuer is a bank, regulations under the Bank Act prescribe minimum disclosures.2 In its March 2007 budget proposals, the Government of Canada announced its intention to replace these rules-based regulations with principles-based regulations.3 2 SOR/2002-102 Index-linked Deposits Interest Disclosure Regulations. 3 Finance Canada, Creating a Canadian Advantage in Global Capital Markets, March 19, 2007.


The new regulations will cover the fees, returns, risks, and cancellation and redemption rights associated with PPNs. In addition, they will require the disclosure of certain information after purchase in order to help investors monitor and track their investments on an ongoing basis. All information statements include a Risk Factors section, which should be carefully analyzed. Additional information on the PPN may also be available in its marketing documentation. When the PPN’s underlying asset is a mutual fund or fund of hedge funds, additional information on the underlying fund will be available in the simplified prospectus or offering memorandum respectively. In order to perform the due diligence procedures in this guide, it will usually be necessary to make direct queries with the entities participating in the PPN – the product structurer, the issuer and, where applicable, the fund manager. It may also be necessary to seek information from independent parties.

1.2 Constructing a PPN Two building blocks are used to construct a PPN:

• A zero-coupon bond; and • A call option.

The zero-coupon bond provides the principal protection. The call option provides the exposure to the underlying asset. The fundamentals of zero-coupon bonds and options are explained in Appendix I. If you are unfamiliar with these financial instruments, you should read the appendix before proceeding further. This section illustrates how the buildings blocks may be assembled to construct a PPN. Product Features of the PPN Suppose a product structurer believes that the stock of ABC Limited (ABC) is undervalued and will generate above-average returns over the next few years as the market recognizes its potential. Accordingly, the structurer designs a PPN whose return is linked to the performance of ABC.4 At maturity, the investor will receive a return equal to the percentage increase in the stock price of ABC between the issue and maturity dates. 4 For ease of exposition, the illustration uses a single stock as the underlying asset. In practice, PPNs whose underlying asset is a single stock, as opposed to, say, an index, a basket of securities or an actively managed fund, are relatively rare in Canada.


Assume that the other features of the note are as follows:

• It is issued in denominations of $1,000; • It does not pay any coupon; • It has a seven-year term; and • The participation rate is 100%.

The participation rate is a fixed percentage of the increase in value of the underlying asset. Since the participation rate in this case is 100%, the investor will receive at maturity a return equal to 100% of the percentage increase in the stock price of ABC. Assume that ABC currently trades at $50 per share. If the price per ABC share at maturity is $75, this means that the stock price has increased by 50%. In addition to the principal of $1,000, the investor will receive a return of $500 (i.e., the investment of $1,000 times the return of 50% times the participation rate of 100%). If the price per ABC share at maturity is less than $50, the investor will receive only the principal. Protecting the Principal The protection of the principal at maturity is achieved by means of a zero-coupon bond. Assume that the annual rate of interest on a zero-coupon bond with a term of seven years is 6%. Appendix I explains that, for every $1,000 of face value, such a bond can be purchased for $665. When the bond matures in seven years’ time, it will be redeemed for its face value of $1,000 and the proceeds used to repay the note’s principal. Hedging the Investment Risk It is necessary to protect the PPN’s issuer from the investment risk associated with the note, as represented by the obligation to pay at maturity a return equal to the percentage increase in the price of the underlying asset. This is done by means of a call option on the underlying asset. After investing $665 in the zero-coupon bond, there remains only $335 to invest in a call option. The investor will expect a return commensurate with the investment of $1,000. How can $335 provide the same investment exposure as $1,000? The answer lies in the leverage made possible through the use of options. Leverage means increasing the investor’s exposure without increasing the amount invested. Traditionally, leverage was achieved through borrowing. It can also be achieved through derivative instruments such as options. In order to gain a given exposure to ABC, less capital is required by purchasing an option on the share than by purchasing the share itself. An option on a share always costs less than the share itself because the purchase of a share gives the buyer ownership of the share whereas the purchase of an option merely gives the right to buy the share at the exercise price. An at-the-money call option provides full exposure to changes in the share


price while paying only a fraction of the share price. The downside is that, if the share price does not rise above the exercise price, the option will expire worthless. The available sum of $335 is used to buy an at-the-money European call option on ABC with a seven-year term and an exercise price of $50.5 Since $1,000 will currently buy 20 shares of ABC at the price of $50 per share, it is necessary to buy an option on 20 ABC shares. For now, assume that the option price is such that the available sum suffices to buy an option on exactly 20 shares. Fast-forward in time. Assume that in seven years’ time, the stock price of ABC has dropped to $45. Since the call option is out-of-the-money, it will simply expire unexercised. The PPN investor will earn no return. Now assume that in seven years’ time, the stock price of ABC has increased by 50% to $75. The price of a call option on one share will equal its intrinsic value6 of $25 (i.e., the stock price of $75 less the exercise price of $50). On being exercised, the option on 20 shares will generate total proceeds of $500 (i.e., 20 options times the option price of $25). This is equal to the return that needs to be paid to the note holder. Graphical Illustration of a PPN A graphical illustration of a PPN is provided in Figure 1.1.

• The zero-coupon bond is issued at a discount to its face value. Its value will grow over time. At maturity, it will be redeemed for its face value, thereby enabling the repayment of the PPN’s principal.

• If the stock price of ABC is above the exercise price at maturity, the call option will have an intrinsic value. The option will be exercised and the proceeds used to provide a return to the investor. Of course, if the stock price is below the exercise price, the call option will have no value and the investor will get no return.

An Iterative Process In the example above, it was assumed that, by coincidence, the option price is such that the available amount of $335 suffices to buy an option on the required number of 20 shares. It is time to make a more realistic assumption. Assume now that the option price is such that the available amount is sufficient to buy an option on only 16 shares, which is 80% of the required number. This means that the product is not internally coherent. Before it is ready to be brought to market, it is necessary to revisit one or more of its features. This illustrates the iterative nature of the process of designing a PPN. 5 A European option is one which is exercisable only at the end of the term. See Appendix I. 6 See Appendix I for an explanation of the intrinsic value of an option.


One possibility would be to reduce the participation rate from 100% to 80%. Take the example where the stock price of ABC in seven years has gone up by 50% to $75. With an 80% participation rate, the return to the noteholder would be $400 (i.e., the investment of $1,000 times the return of 50% times the participation rate of 80%). This is identical with the proceeds from exercising the option on 16 shares (i.e., 16 options times the option price of $25). Another possibility would be to lengthen the term of the note. It is explained in Appendix I that, the longer the time to maturity, the lower the price of a zero-coupon bond. This will leave more money to be invested in the call option, making it possible to buy an option on more shares. A third possibility would be to place a cap on the return of the note. For instance, investors may be allowed 100% participation in the increase in the ABC stock price but only up to a price of, say, $80. This would be implemented by means of a second option involving the sale of a European call option on ABC with a seven-year term and an exercise price of $80. If the stock price rises above $80, the person that bought the option will exercise it. This means that the note holders will not benefit from increases in the stock price above $80. However, the proceeds of sale of the second option will make more funds available to purchase the first option. Three possibilities have now been identified for the product:

1. An 80% participation rate, a seven-year term and no cap on the return;


2. A 100% participation rate, a term longer than seven years and no cap on the return; and

3. A 100% participation rate, a seven-year term and a cap on the return when the ABC stock price reaches $80.

Obviously, all kinds of other combinations are possible. For instance, it would be possible to introduce a minimum return at maturity. This will obviously come at the price of something else, for instance a lower participation rate. PPNs are very flexible. They can be structured to generate a variety of return profiles to fit the preferences of different investors. Some PPNs are issued in different series. Each series offers a different return profile (in terms of participation rate, term to maturity, cap on the return, coupon, etc.), so as to appeal to different types of investor. By way of example, an actual product exists in two series. One series has a five-year term and a cap of 65% on the cumulative return. The second series has a ten-year term with no cap on the return. Another actual product gives investors a choice between a five and a half-year term with no coupon and an eight-year term with potential monthly coupons based on the return of the underlying asset. Replicating a PPN Is it possible for a retail investor to avoid the expenses associated with a PPN by buying its component parts separately in the market? Since an option is one of the component parts of a PPN, it would be necessary for the investor to be approved for option trading. Option trading is a risky business and may result in the loss of one’s entire investment. It should be undertaken only by investors with the required expertise and wherewithal. Given the wide range of assets underlying PPNs, there may not be an exchange-listed option on the specific asset concerned. If an exchange-listed option does exist, it will nevertheless not be available for the seven-year or so term of most PPNs. This will create a need to buy an option with a shorter term and roll it over as it expires. This procedure carries its own risks7 and there will be transaction costs. Product structurers do not face these problems. Options embedded in PPNs are often tailor-made instruments negotiated in the over-the-counter market which is out of bounds to retail investors.8 It is also possible for product structurers to replicate the payoff of an option synthetically.

7 The risk of loss when buying a new option to replace an expiring option is known as “roll risk”. 8 See Appendix I for an explanation of the differences between exchange-listed and over-the-counter options.


1.3 Lack of Transparency of Pricing In the case of publicly traded investment funds such as mutual funds, the costs associated with buying and holding the investment are reflected in explicit charges such as commissions and management fees.9 This is unlike PPNs where some costs are embedded in the price of the product. The price of a PPN is simply the sum of the prices of its components. The components are a zero-coupon bond and a call option on the underlying asset. One of the main factors affecting the price of an option, and also the most difficult to estimate, is the expected volatility of the underlying asset over the life of the option. Suppose that the structurer succeeds in arranging on behalf of the issuer an option at a price which reflects a volatility of, say, 25%. This is known as “realized volatility”. When the issuer issues the PPN, it is effectively selling a zero-coupon bond and a call option to investors. The price of the call option embedded in the PPN reflects the volatility which retail investors are willing to pay. This is known as “volatility sold”. Volatility sold is usually higher than realized volatility. Retail investors are willing to pay a higher price for a number of reasons such as:

• Access to an underlying asset that would otherwise be inaccessible; • Exposure to return profiles that fit their preferences; and • The opportunity to buy options in small denominations.

The difference between volatility sold and realized volatility is known as the “volatility spread”. Assume that volatility sold is 35%. The volatility spread is therefore 10 points (i.e., 35% less 25%). Since the price of an option is positively related to the volatility of the underlying asset, the 10-point volatility spread represents a hedging profit to be shared between the structurer and the issuer. This hedging profit is embedded in the price of the PPN. Insight from Academic Studies A number of academic studies have attempted to calculate the size of the hedging profit by comparing the issue price of structured products with their theoretical value.10 The theoretical value is generally calculated by using an option pricing model such as Black-Scholes and the implied volatilities in listed options.11 All the studies found that the issue price was higher than the theoretical price. The embedded costs were found to be in a broad range from 2% to 6%.12

9 Even in the case of publicly traded investment funds, there are some embedded costs, e.g., soft dollars. 10 PPNs are part of a larger family of products known as structured products. 11 See Appendix I for a discussion of option pricing models and implied volatility. 12 For a Canadian study, see Moshe Arye Milevsky and Sharon Kim, “The Optimal Choice of Index-Linked GICs: Some Canadian Evidence”, Financial Services Review, Vol. 6 No. 4 (1997): 271-284. In this study,


Appropriate inquiries should be made from the product participants on the existence and size of any embedded costs.

1.4 Participants The main participants involved in a PPN are:

• The investor; • The issuer; • The product structurer; and • The fund manager (if applicable).

The next three sections (sections II to IV) will be concerned with the issuer, the structurer and the fund manager respectively. The role of each participant and its motivations for participating in PPNs will be explained. The risks and issues associated with each participant will be discussed from the investor’s perspective and the related due diligence work explained. Sections V to VIII will deal respectively with the risks and issues associated with the product features of PPNs, liquidity considerations, fees and expenses, and tax considerations. In the last section, the various threads developed throughout the guide will be pulled together and PPNs evaluated from the viewpoint of the investor. Due Diligence Questions Quality of Disclosure

• How complete and of what quality is the product disclosure? Embedded Costs

• What is the size of the costs, if any, embedded in the price of the product?

which is unfortunately rather dated, the authors examined two index-linked GICs issued by Canadian banks and concluded that the embedded costs were 2% and 6% respectively.


II. EVALUATING THE ISSUER In Canada, PPNs are usually issued by Schedule I banks (i.e., Canadian banks), Schedule II banks (i.e., Canadian subsidiaries of foreign banks), credit unions, and agencies of the Government of Canada such as Crown corporations.13 When the issuer is the Canadian subsidiary of a foreign bank, its obligations under the note are usually guaranteed by the foreign parent. Regulatory Risk Under securities legislation in the jurisdictions of Canada, the distribution of a security normally requires the filing of a prospectus with the securities commissions and the involvement of a registered dealer in the trade. There is an exemption from these requirements in respect of a trade in a debt security issued or guaranteed by certain entities.14 PPNs are usually distributed under this exemption. Regulatory risk is the risk of non compliance with regulatory requirements. In this case, the risk is managed by ensuring that the product satisfies the requirements of the exemption under which it is distributed. Organization of this Section The section first explains the issuer’s motives for participating in a PPN. It then discusses, from the investor’s perspective, the risks associated with the issuer. The main risk is the credit risk. Occasionally, hedge counterparty risk also applies.

2.1 PPNs from the Issuer’s Perspective A Cheaper Source of Financing Issuers are willing to lend their name and credibility to PPNs because the latter often constitute a cheaper source of financing than traditional financial instruments.15

In the classic structure, a portion of the proceeds of issue of the PPN is used for a call option on the underlying asset and the balance is used for a zero-coupon bond. Think of the zero-coupon bond as being issued by the same entity that issues the PPN. The issuer uses the proceeds of issue of the zero-coupon bond for general corporate purposes. At 13 Currently, Crown corporations borrow separately from the Government of Canada. In its March 2007 budget proposals, the Canadian Government proposed to consolidate the borrowings of major Crown corporations with its own debt program. (See Finance Canada, Creating a Canadian Advantage in Global Capital Markets, March 19, 2007). Certain of these Crown corporations are important issuers of PPNs. 14 The dealer registration regime will be substantially affected by the Registration Reform Project currently being implemented by the Canadian Securities Administrators. 15 When the issuer and the structurer are one and the same entity, this consideration may be less relevant because the entity may be more interested in the benefits derived in its capacity as structurer.


maturity, it will repay the face value of the zero-coupon bond from its own funds. In effect, the issuer has borrowed money at the rate of interest used to calculate the price of the zero-coupon bond.

In the light of its target borrowing cost, the issuer will negotiate with the product structurer a rate of interest lower than that on a conventional debt instrument. The reduction in the issuer’s borrowing cost is ultimately borne by the investor. Ease of Issue Another benefit to the issuer is the ease and speed with which a PPN may be issued compared with other instruments requiring the filing of a prospectus. This is made possible by the regulatory exemptions enjoyed by PPNs. Risks to the Issuer The issuer faces two main risks:

• Hedge counterparty risk (about which more will be said in section 2.3); and • Reputation risk in the event that the product does not live up to investors’

expectations or the product is mis-sold by intermediaries.

2.2 Credit Risk The principal protection afforded by PPNs is always subject to the creditworthiness of the issuer. Unlike bank deposits, PPNs are not covered by deposit insurance. The issuer (or guarantor, if there is one) is the only party to which investors can turn for the repayment of the principal and the payment of the return. Thus, the investor is exposed to the credit risk associated with the issuer. For this reason, it is extremely important to evaluate the issuer’s creditworthiness. Issuer’s Debt Ratings The creditworthiness of the issuer may be assessed by referring to the rating of its debt. PPNs are usually not specifically rated. However, they may be included within a broader category of rated debt instruments of the issuer. The credit risk may also be evaluated by considering the ratings of similar debt obligations (in terms of rank, maturity, etc.) of the issuer. When the issuer is the Canadian subsidiary of a foreign bank and the parent is the guarantor, it is the parent’s debt ratings that are relevant. Credit ratings are forward-looking measures that assess an issuer's ability and willingness to make timely payments of principal and interest. They are based on quantitative and


qualitative analyses of the issuer and are issued by credit rating agencies such as DBRS, Standard & Poor’s, Moody’s and Fitch. Different rating agencies have different rating scales. Table 2.1 shows the rating scale used by DBRS for long-term debt. The rating scale is intended to give an indication of the risk that a borrower will not fulfill its obligations with respect to both interest and principal in a timely manner. The scale ranges from ‘AAA’ to ‘D’. ‘AAA’ is the highest credit rating and is enjoyed by the most creditworthy issuers, such as the Canadian Government and its agencies. ‘D’ indicates that the issuer is in default. Subcategories Each rating category (except AAA and D) is denoted by the subcategories “high” and “low”. If no subcategory is indicated, this means that the rating is in the “middle” of the category. Rating Trends Each rating category is appended with one of three rating trends – “Positive”, “Stable”, or “Negative”. This helps to understand the credit rating agency’s opinion regarding the outlook for the rating. Credit Watch When a significant event occurs that impacts the credit quality of an issuer but its outcome is uncertain, the rating of the issuer may be placed “under review”. This indicates that it is no longer reliable. Ratings may be under review with negative, positive or developing implications. This provides some initial guidance on the potential impact of the event on the credit quality of the issuer. What a Credit Rating Is Not A credit rating only assesses an issuer's ability and willingness to meet its obligations, i.e., make timely payments of principal and interest. It has no bearing on the likely performance of the PPN nor does it indicate the likelihood that there will be any return. Trend in Credit Quality of PPN Issuers Initially, PPNs were issued in Canada by issuers with a credit rating of ‘A’ or better and the creditworthiness of the issuer was not generally an issue. However, issuers now include entities with a credit rating lower than ‘A’. This makes the due diligence work all the more important.


Table 2.1 DBRS’ Rating Scale for Long-Term Debt AAA The highest credit quality, with exceptionally strong protection for the timely repayment of principal and interest. There are few qualifying factors present that would detract from the performance of the entity. The entity has established a credible track record of superior performance. AA Superior credit quality. Protection of interest and principal is considered high. The entity typically exemplifies above-average strength in key areas and is unlikely to be significantly affected by foreseeable events. A Satisfactory credit quality. Protection of interest and principal is still substantial. The entity is considered to be more susceptible to adverse economic conditions and have greater cyclical tendencies than higher-rated entities. BBB Adequate credit quality. Protection of interest and principal is considered acceptable, but the entity is fairly susceptible to adverse changes in financial and economic conditions. BB Speculative and non-investment grade. The degree of protection afforded interest and principal is uncertain, particularly during periods of recession. B Highly speculative, with a reasonably high level of uncertainty as to the ability of the entity to pay interest and principal on a continuing basis in the future, especially in periods of recession or industry adversity. CCC CC C Very highly speculative and in danger of default of interest and principal. D The issuer has either not met a scheduled payment of interest or principal or made it clear that it will miss such a payment in the near future. Source: DBRS Although an issuer’s credit rating is public information, it is not always disclosed in the PPN’s information statement. For instance, the information statement of an actual PPN issued by an issuer with a ‘BBB’ rating makes no mention at all of the issuer’s credit rating.


You should ascertain the credit rating of the issuer and ensure that its debt instruments are of investment grade. A debt instrument is of investment grade when it is considered safe enough for institutional investors to invest in. Institutional investors, e.g., pension funds, need to be particularly careful with their investments because they manage the money of other people to whom they owe a fiduciary duty. According to DBRS, anything equal to or higher than ‘BBB (low)’ on a long-term rating is considered to be investment grade. Also, satisfy yourself that the issuer is likely to maintain its credit rating until the maturity of the note. For instance, is the credit trend negative? Is the issuer’s rating under a credit watch? Note that the longer the term to maturity, the greater the risk of a downgrade in the issuer’s credit rating in the intervening period. Ranking of PPNs PPNs are direct, unsubordinated obligations of the issuer, ranking pari passu with its other direct, unsubordinated obligations. In other words, the investor is an ordinary creditor of the issuer. PPNs must be unsubordinated in order to benefit from the regulatory exemptions. No Access to the Assets in the Protection Structure The existence of a protection structure underlying the PPN sometimes misleads investors into believing that they may, in a worst case scenario, protect themselves by accessing the assets in the structure, i.e., the zero-coupon bond and the call option. As a matter of fact, the investor has an interest only in the PPN which is itself an unsecured obligation of the issuer. The investor depends entirely on the creditworthiness of the issuer (or the guarantor, if there is one) for the principal protection. In the worst case scenario, which is the bankruptcy of the issuer, the investor will rank as an ordinary creditor with no preferential access to the zero-coupon bond or the call option.

2.3 Hedge Counterparty Risk The issuer does not bear the risk associated with having to deliver the return on the underlying asset to the investor. The issuer hedges or protects itself by transferring the risk to a third party. This may be done by means of a swap transaction or by purchasing a call option on a derivatives exchange or, more usually, on the over-the-counter market.16 When a swap transaction or an over-the-counter option is used, the issuer faces swap counterparty risk (or hedge counterparty risk), which is the risk of default on the part of the counterparty to the transaction. In the event of a default by the counterparty, investors

16 It would make sense for a counterparty which owns the underlying asset to earn some premium income by selling a call option on the asset. This strategy is known as covered call writing.


will still expect to be paid the return to which they are entitled. The issuer will then need to use its own funds to pay the investors. The issuer manages the counterparty risk by ensuring the creditworthiness of the counterparty. This is done by a careful analysis of the financial condition of the counterparty, including its capital, the composition of its assets and liabilities, and its off-balance sheet exposures. While the hedge counterparty risk is usually borne by the issuer, it has occasionally been transferred to the investor. Here is an excerpt from the information statement of an actual PPN:

“The performance of the [Fund] will be realized by [the Issuer] having entered into a swap agreement (the “Swap Agreement”) with a counterparty (the “Swap Counterparty”) … The Swap Counterparty will pay to [the Issuer] … at Maturity an amount equal to the positive value, if any, of the [Fund] per Note, which amount is based on the performance of the [Fund] from the date the Notes were issued until … Maturity … The obligation of [the Issuer] to pay to Holders the positive performance on the [Fund] is limited to the proceeds, if any, received by it from the Swap Counterparty.”

In plain English, this means that, if the swap counterparty fails to perform its obligations under the swap agreement, the investors will bear the loss and will not receive the return to which they are entitled. When the counterparty risk is borne by the investor, this will normally be disclosed in the Risk Factors section of the information statement, although there may not be sufficient disclosure to evaluate properly the financial strength of the counterparty. In such cases, you should carefully consider whether you want to expose your client to this risk.17 Due Diligence Questions Regulatory Risk

• Does the product satisfy the requirements of the exemption under which it is distributed?

The Issuer and Credit Risk

• Who is the issuer?

17 In the UK, the Financial Services Authority has expressed concern over principal-protected products where the swap counterparty risk is borne by the investor. See Financial Services Authority, Consultation Paper 188 – Clarification and Revision of Financial Promotion Rules and Guidance, July 2003.


• What is the rating of the issuer’s debt instruments? (You should refer to debt instruments which are comparable with the PPN in terms of rank, maturity, etc.)

• As a minimum, does the rating indicate that the debt instruments are of investment grade?

• Is the credit trend negative? • Is the rating under review with negative implications? • Are there factors to suggest that there might be a significant deterioration of the

rating prior to the maturity of the PPN? Hedge Counterparty Risk

• Is the investor exposed to hedge counterparty risk?


III. EVALUATING THE PRODUCT STRUCTURER Product structurers are usually investment banks or investment dealers. Some fund managers also have in-house product structuring capabilities. The product structurer, together with its related entities, is responsible for:

• Identifying the investment opportunity; • Determining which product features are the most attractive to investors; • Designing the product; • Making arrangements with the issuer; • Hedging all relevant exposures; • Committing capital where relevant; • Distributing the product; and • Maintaining a secondary market for the PPN.

The structurer may be the same entity as the issuer, e.g., a bank or other financial institution. Organization of this Section This section first explains the structurer’s motivation for participating in PPNs. It then discusses, from the investor’s perspective, the conflicts of interests that may arise when the structurer plays multiple roles.

3.1 PPNs from the Structurer’s Perspective Sources of Revenue PPNs provide several sources of revenue to the structurer and its related entities. The main sources of revenue are:

• Sales charges on the sale of the product – see section 7; • Annual management or portfolio fees, which are usually calculated as a

percentage of assets under management – see section 7; • Trading profits in the secondary market – see section 6; • Interest rate spreads on loans to implement leverage – see section 4; and • Hedging profits – see section 1.

All the sources of revenue may not be present in a given product.


Ease of Issue Structurers design and bring new products to market on the basis of a perceived investment opportunity, such as the current weakness of a stock index or a currency. The window of opportunity is typically narrow. Structurers value the speed with which PPNs may be brought to market thanks to the regulatory exemptions. Risks to the Product Structurer If, for some reason, the issue of a new product is not closed, the product structurer will be unable to recoup the costs it has incurred to structure the product. The product structurer also faces operational risk, for instance if a mistake is made while hedging all relevant exposures. This risk is managed through proper systems of control. The product structurer faces reputational risk in the event that the product does not live up to investors’ expectations or the product is mis-sold by intermediaries.

3.2 Conflicts of Interests Banks are structurers as well as issuers of PPNs. This has certain advantages. For instance, new products may be brought to market more quickly and it is easier to keep any proprietary features within the entity. On the other hand, situations of conflict of interests may arise. In such situations, investors are protected to some extent by the fact that banks have a reputation to safeguard. The reputational damage to a bank if it is found to have profited from a conflict of interests situation is likely to be much higher than any profit it may have made. Pricing of the PPN Here is an excerpt from the information statement of an actual PPN:

“Each Deposit Note will be issued for a Subscription Price of 100% of the Principal Amount thereof (i.e., $100). The Subscription Price was determined by negotiation between [the issuer] and [the structurer].”

When the issuer and the structurer deal at arms length, this provides some comfort that the subscription price which emerges from the negotiation is fair. However, when the issuer and the structurer are related parties, there is a potential conflict of interests.18

18 In the US, most structured notes are listed investments. When the issuer and lead underwriter are affiliated to one another, NASD requires a Qualified Independent Underwriter to issue a written opinion to the effect that the pricing of the structured product is fair to the investor. In Canada, PPNs are usually issued in the exempt market and there is no corresponding requirement.


Calculation Agent Sometimes, the bank will also be the calculation agent. The latter calculates, among other things, the return to which investors are entitled on maturity of the PPN. There is a potential conflict of interests when the issuer and the calculation agent are one and the same person. Some PPNs provide that a calculation agent independent of the issuer may be appointed in certain circumstances, such as when the price of the underlying asset needs to be calculated (as opposed to observed on a market) or when the calculation involves the use of material discretion. The appointment of an independent calculation agent reduces the potential for conflicts of interests. Due Diligence Questions The Structurer and Conflicts of Interests

• Who is the product structurer? • Is the product structurer a related party of the issuer? • Who is the calculation agent? • Is the calculation agent a related party of the issuer? • If the calculation agent is related to the issuer, will an independent calculation

agent be appointed if it becomes necessary to use material discretion when making calculations?


IV. EVALUATING PRINCIPAL-PROTECTED NOTES WHEN THE UNDERLYING ASSET IS A FUND So far, PPNs have been looked at from the point of view of the issuer (as a cost-effective way of raising capital) and the product structurer (as a potentially profitable line of business). Sometimes, the initiative for a PPN is taken by a fund manager. The latter will partner up with a structurer (which may also be the issuer) to offer a principal-protected version of its products. The return on the PPN will be linked to the performance of a fund sponsored by the fund manager. Here, the objective is not to raise capital at lower cost for the issuer but to increase the assets under management of the fund manager for which the PPN effectively serves as a distribution channel. In many cases, the underlying asset is a mutual fund. This makes the fund more attractive to conservative investors who want exposure to the mutual fund’s returns but are unwilling to risk their capital. Funds of hedge funds are also used as underlying assets. A hedge fund manager has even more to gain than a mutual fund manager from the use of PPNs as a distribution channel. This is because retail investors are unable to purchase hedge funds and funds of hedge funds directly.19 By wrapping a PPN around a fund of hedge funds, a hedge fund manager gains indirect access to a market which would otherwise be out of reach. From the investor’s perspective, it may be beneficial to have indirect access to investments that would otherwise be inaccessible. For instance, hedge funds have low correlation with stocks and bonds and may, therefore, improve the risk-return trade-off of a portfolio. When the underlying asset is an actively managed fund (as opposed to, say, a single stock or an equity index), the classic option-based protection structure described earlier is generally not used. Instead, the protection structure is generally based on portfolio insurance. Portfolio insurance-based structures potentially provide investors with a greater exposure to the underlying asset. Organization of this Section This section reviews the drawbacks of the option-based protection structures that were presented in section I. It explains how these drawbacks are addressed by portfolio 19 Hedge funds may be purchased by accredited investors. These include (i) an individual who, alone or with a spouse, has net financial assets exceeding $1 million or net assets of at least $5 million, and (ii) an individual whose net income before taxes exceeded $200,000 (or $300,000 when including the spouse’s income) in each of the two most recent calendar years and who expects to exceed that net income level in the current calendar year. Hedge funds may also be purchased in an amount not less than $150,000 by a person who pays in cash at the time of the trade. See National Instrument 45-106 Prospectus and Registration Exemptions.


insurance-based protection structures such as Constant Proportion Portfolio Insurance (CPPI). Finally, it discusses the risks and issues associated with CPPI.

4.1 Drawbacks of Option-based Protection Structures The classic protection structure combines a zero-coupon bond and a call option. This structure has the advantage of simplicity and it is still used in practice. However, it suffers from a couple of drawbacks. The first drawback is its static nature. Once the proceeds of issue of the PPN have been split between the zero-coupon bond and the call option, the split is never adjusted. If the underlying asset performs very well, the value of the call option will rise. Indeed, it may rise to a point where it is more than sufficient to ensure the repayment of the principal.20 If this is the case, there is little point in holding the entire zero-coupon bond, since its relatively low yield will limit the overall performance of the PPN. The second drawback is that, in periods of low interest rates such as experienced in the past few years, the zero-coupon bond ties up a large portion of the proceeds of issue of the PPN. This leaves less money with which to buy the call option and thereby gain exposure to the performance of the underlying asset. To overcome the drawbacks of static structures, dynamic structures have been developed. These structures are based on portfolio insurance techniques, which provide the rules for monitoring the risk of a portfolio and deciding when to switch from more risky to less risky investments to ensure the protection of the principal.

4.2 Constant Proportion Portfolio Insurance The most common dynamic structure is CPPI.21 Under CPPI, the proceeds of issue of the PPN are invested in a basket consisting partly of the underlying asset and partly of low-risk investments such as bonds and money market instruments. This is illustrated in Figure 4.1. How CPPI Works Initially, the basket is fully invested in the underlying asset. The portion of the basket invested in the underlying asset is adjusted over time depending on its performance. This is the reason for which the strategy is said to be dynamic. The adjustment is calculated by comparing the net asset value (NAV) of the basket with a reference curve based on the value of a nominal zero-coupon bond that will repay the principal at maturity. 20 This argument assumes that it is possible to sell the call option or a portion thereof. 21 Other dynamic structures include Variable Proportion Portfolio Insurance (“VPPI”) and Multilevel Portfolio Insurance (“MLPI”). These newer structures will not be discussed here.


The process is illustrated in Figure 4.2. Initially, the basket is 100% exposed to the underlying asset. Thereafter, the exposure depends on the distance between the basket’s NAV and the reference curve. If the underlying asset performs well, the NAV of the basket will go up to, say, point A in Figure 4.2. This increases the distance. A portion of the bonds or money market instruments is sold and reinvested in the underlying asset. Here, the objective is to allow greater participation in the performance of the underlying asset. On the other hand, if the underlying asset experiences negative performance, the NAV of the basket will drop towards the reference curve to, say, point B in Figure 4.2. This decreases the distance. A portion of the underlying asset is sold and the proceeds reinvested in bonds or money market instruments. Here, the objective is to protect the principal. An increase or decrease in the distance does not immediately trigger a reallocation of the assets in the basket. The basket’s NAV is usually allowed to fall by a certain margin before a portion of the underlying asset is sold and reinvested in low-risk investments. When the basket’s NAV is falling, a wider margin provides greater protection to the investor against reduced exposure to the underlying asset. On the other hand, when the NAV is rising, a wider margin constitutes a drag on performance because it slows down the reallocation of the basket’s assets to the underlying investment.


If the NAV of the basket drops within the buffer zone, as indicated in Figure 4.2., it will be dangerously close to the reference curve. At this point, the basket’s entire investment in the underlying asset is sold and reinvested in bonds or money market instruments.

4.3 Risks under CPPI CPPI involves a number of risks:

• Risk of reduced investment exposure (also known as deleveraging); • Risk related to the use of leverage in the basket; and • Interest rate risk.


Risk of Reduced Investment Exposure Under CPPI, principal protection may come at the price of a reduced investment exposure to the underlying asset (also known as deleveraging). This is the most important drawback associated with CPPI. A reduced investment exposure negates some of the benefits of investing in a PPN since exposure to the performance of the underlying asset is one of the main motivations for investing in the product. Exposure to the underlying asset is reduced when the NAV of the basket falls. The structure is particularly vulnerable to weak performance of the underlying asset in the first few months following the date of issue. Once assets have been switched from the underlying asset to low-risk investments, it is difficult to reverse this trend. In fact, further switches in the same direction are likely. If the net asset value of the basket falls within the buffer zone, the entire position in the underlying asset is liquidated and the basket becomes fully invested in bonds or money market instruments. In this case, the basket will no longer have any exposure to the underlying asset. Even if the underlying asset subsequently recovers, the basket will not benefit from the recovery. All that the investor can look forward to is the return of the principal at maturity. CPPI usually provides 100% exposure to the performance of the basket. However, 100% exposure to the basket is not the same as 100% exposure to the underlying asset. Here is an excerpt from the marketing document of a PPN:

“Dynamic Allocation The Notes provide 100% initial exposure to the Target Portfolio with the potential for up to 200% exposure when the Target Portfolio performs well.”

The word “dynamic” is a give-away — it informs us that the protection structure is CPPI or a variant thereof. We are also informed that the initial exposure to the underlying asset is 100%, with the potential for up to 200% exposure through leverage. However, the key word is “initial”. The basket will be 100% exposed to the underlying asset on Day 1. Thereafter, its exposure to the underlying asset may lie anywhere between 0% and 200%. The risk of the investment exposure dropping to zero is an important concern. In order to address this concern, some products guarantee that the percentage of the basket invested in the underlying asset will not fall below a minimum level, say, 10% of the basket’s NAV.22 You should investigate whether the PPN under review includes such a guarantee.

22 Under a protection structure known as Option on a Dynamic Basket (ODB), the principal protection is provided by a zero-coupon bond and the variable return is provided by a call option on a dynamic basket allocated between the underlying fund (often a fund of hedge funds) and low-risk investments. Unlike under CPPI, the reference curve is not established by reference to a zero-coupon bond but is calculated with an algorithm. With ODB, it is possible to guarantee that the exposure to the underlying fund will not drop below a minimum level.


Risk Related to the Use of Leverage in the Basket Leverage may be used to increase the basket’s exposure to the underlying asset. If the return on the underlying asset is higher than the cost of borrowing, this will increase the gain to the investor. The reverse will be true if the cost of borrowing exceeds the return on the underlying asset. The borrowing is usually provided by an entity related to the structurer. The terms of the borrowing are sometimes disclosed in the information statement. The information statement of an actual product states that:

“Interest on the Loan Amount will accrue daily at an annual rate equal to the one-month Bankers’ Acceptance Rate plus 0.25%, reset daily and paid monthly.”

When the terms are not disclosed, appropriate inquiries should be made. Evaluate whether the terms and conditions of the borrowing, including the interest rate, reflect normal market conditions. Ensure that the borrowings are non recourse. Also make sure that you are comfortable with the maximum leverage allowed. A good investment strategy should be able to generate reasonable returns without excessive leverage. Interest Rate Risk The risk of loss as the result of a movement in the interest rate is known as interest rate risk. The basket’s exposure to the underlying asset depends on the distance between the NAV of the basket and a reference curve based on the value of a nominal zero-coupon bond. Because there is an inverse relationship between the interest rate and the value of a zero-coupon bond, an increase in the interest rate will cause the reference curve to swing downwards in a counter clockwise direction.23 This will increase the distance between the basket’s NAV and the reference curve even though the value of the basket has not changed. A greater portion of the basket can now be invested in the underlying asset. Conversely, if the interest rate drops, this will cause the reference curve to swing upwards in a clockwise direction. This will reduce the distance and will cause money to be moved from the underlying asset to bonds or money market instruments. The investor is thus exposed not only to the investment risk of the underlying asset (of which he is presumably aware) but also to interest rate risk (of which he may not be aware).

23 See Figure 1.1 in Appendix I for an illustration of this.


4.4 Other Issues with CPPI If you choose to recommend a PPN that uses CPPI, be sure that your client understands the following issues:

• The consequences of path-dependency may be counterintuitive; and • The timing of buy and sell transactions impacts performance.

The Consequences of Path-Dependency May Be Counterintuitive With CPPI, the final return is path-dependent, i.e., it depends on the history of prices of the underlying asset throughout the term of the PPN. It was noted above that, once the basket becomes fully invested in bonds or money market instruments, it ceases to have any exposure to the underlying asset. Even if the underlying asset subsequently recovers, the basket will not benefit from the recovery. There is thus a possibility of the investor getting no return even though the price of the underlying asset at maturity is higher than its price on the date of issue. Are you comfortable with the prospect of having to explain this to your client? The Timing of Buy and Sell Transactions Impacts Performance CPPI involves buying more of the underlying asset after a period of strong performance, i.e., when it has become expensive. It also involves selling some or all of the underlying asset after a period of weak performance, in other words when it has become cheap. This will have an impact on the investment performance. Due Diligence Questions CPPI Issues

• By what percentage is the basket’s NAV allowed to change without triggering a reallocation of assets in the basket?

• Is the basket guaranteed to have a minimum exposure to the underlying fund? • Is leverage allowed in the basket? • If so, what are the terms and conditions of the borrowings? • Do the terms and conditions reflect normal market conditions? • Is the leverage non recourse? • What is the maximum leverage?


V. EVALUATING THE PRODUCT FEATURES OF PRINCIPAL-PROTECTED NOTES PPNs are not standardized products. There is a broad diversity of PPNs, each with its own features. As a result, product comparison is difficult. Organization of this Section This section provides a structured approach to the analysis of a PPN’s product features. It also addresses the question whether the principal protection may be redundant in some cases. Product Features The main features through which product structurers try to distinguish their products from those of competitors are:

• The underlying asset; and • The manner in which the final variable return on the PPN is linked to the

performance of the underlying asset. Other product features are:

• Minimum return at maturity; • Coupon; • Term; • Liquidity; and • Fees.

Liquidity is considered separately in section VI and fees in section VII.

5.1 Underlying Asset There is a wide diversity of underlying assets. These may be divided into two broad categories:

• Unmanaged investments such as baskets of stocks, equity indices and commodities; and

• Actively managed funds such as mutual funds and funds of hedge funds. The underlying asset exposes the investor to investment risk, subject to the principal protection. Investment risk is the risk that the investor will get no return because of a poor performance of the underlying asset. Consequently, you should subject the


underlying asset to the same kind of analysis that you would perform before recommending an investment generally. Factors to be considered include:

• The factors influencing the performance of the investment (what is the investment thesis?);

• Risk factors relevant to the investment; • Historical returns; • Historical volatility; and • Historical correlation with other assets or asset classes.

Mutual Funds as Underlying Asset If the underlying asset is a mutual fund, you should also consider factors such as:

• The record and reputation of the manager; • The investment objective of the fund; • The management style; • The length of time for which the fund has existed; • The size of the fund; • The fund’s quartile ranking; and • The rating (e.g., number of stars) assigned to the fund by Morningstar or similar

organizations.

Funds of Hedge Funds as Underlying Asset Funds of hedge funds invest in stand-alone hedge funds, which are themselves advised by a number of different advisers. A variant involves managed accounts. When this system is used, the fund allocates its assets among a number of accounts at a prime broker. Each of the managed accounts is advised by a different adviser. Managed accounts provide greater transparency than funds of hedge funds and potentially enable better risk management. Hedge fund returns exhibit low correlation with those of traditional asset classes such as stocks and bonds. By adding hedge funds to a traditional portfolio, it is possible to improve the efficiency of the portfolio, i.e., obtain the same expected return with less risk. Hedge funds are less regulated than mutual funds and hedge fund managers have much more discretion than mutual fund managers. If you choose to recommend a PPN whose underlying asset is a fund of hedge funds, you should be aware of the issues related to hedge funds generally — lack of transparency, concerns about fund valuation, conflicts of interests, etc.24

24 These issues are discussed in André Fok Kam, A Canadian Framework for Hedge Fund Regulation in Task Force to Modernize Securities Legislation in Canada, Canada Steps Up, Vol. 3, October 2006.


When the underlying asset is a fund of hedge funds, additional factors must be considered. The Manager You must be absolutely comfortable with the fund manager. Some important questions to address are:

• What is the manager’s reputation for integrity? • For how long has it been in business? • What is its size as measured, say, by its capital or its assets under management? • Does it have the investment, risk management, compliance and administrative

capabilities required to run a fund management business? • To what regulations is it subject? Is it registered with a regulatory authority?

Custodian Make sure that you are comfortable with the quality of the custodian because it is responsible for safeguarding the assets. The custodian should be an independent party.25 The importance of a credible, independent custodian cannot be sufficiently emphasized. Leverage Make sure that you are comfortable with the maximum permitted leverage of the fund. Diversification Funds of hedge funds may be single-strategy or multi-strategy. Multi-strategy funds are exposed to a broad range of investment strategies (relative value, event-driven and opportunistic) and provide diversification by strategy as well as by adviser. Single-strategy funds concentrate on a single investment strategy. They reduce adviser risk but do not provide diversification by strategy. Track Record Hedge funds sometimes publish back-tested or pro forma performance data.26 Such data should be ignored. The analysis of historical performance should be based only on actual data.

25 Note that, in the case of hedge funds, there is no regulatory impediment to the fund manager (or a related party) being the custodian. Contrast this with mutual funds where the custodian is required to be a bank, a trust company or a subsidiary of a bank or trust company. See National Instrument 81-102 Mutual Funds. 26 By way of comparison, mutual funds are not allowed to publish such data. See National Instrument 81-102 Mutual Funds.


Maximum Drawdown Absolute-return investments such as hedge funds should be less vulnerable than equities to difficult market conditions. Insight can be gained into the fund’s ability to weather such conditions by looking at its maximum drawdown, i.e., the maximum percentage decline in the unit price of the fund from peak to trough. The maximum drawdown is a commonly used risk measure among hedge funds. Downside Risk Some investment strategies are more exposed than others to strongly negative returns. A convenient way to gain insight into downside risk is to analyze a graph showing the return distribution of the fund. If the graph exhibits a fat tail on the downside, this means that strongly negative returns are relatively frequent. Market Exposure The adviser’s remuneration includes a share of the fund’s profits. This reflects the fact that hedge fund returns are claimed to be dependent upon the adviser’s skills rather than on market conditions. Ensure that the fund’s return is indeed due to adviser skill rather than straightforward exposure to the market. This can be done by analyzing the fund’s beta, which measures the responsiveness of a security’s returns to changes in the market return. For instance, an index fund will have a beta close to 1, meaning that it tracks the market closely. A hedge fund should have a low beta. Regulatory Jurisdiction If the fund is an offshore fund, are you comfortable with the quality of the regulatory regime in the relevant jurisdiction?

5.2 Final Variable Return The final variable return may be linked to the performance of the underlying asset in a number of ways. The Classic Case – Final Value In the classic case, the return is equal to the percentage increase in the price of the underlying asset between the issue date and the maturity date. This approach makes sense because, in the long run, markets usually trend upwards. However, the approach involves timing risk. The investor’s return depends on the price of the underlying asset at only one point in time – the maturity date. If the price of the underlying asset rises steadily over the term of the PPN, then drops sharply just before maturity, the return will be adversely affected.


Average Value In lieu of the price of the underlying asset at maturity, it is possible to use the average of prices at the end of each period. For example, the final variable return of an actual PPN is computed by reference to the average value of the underlying asset, calculated monthly over the life of the PPN. As the PPN has a four-year term, this involves 48 data points. The use of an average is less risky than that of a final value. The timing risk is significantly reduced. With this approach, the investor is not penalized in the event of a sharp drop in the price of the underlying asset immediately prior to maturity. However, if the price of the underlying asset rises steadily throughout the term of the PPN, this approach will yield a lower return than in the classic case. When an average value is used, the final return is path-dependent, i.e., it depends on the path taken by the price of the underlying asset over the term of the note. It was noted in section 4.4 that the final return is path-dependent under CPPI. Path-dependency also applies to option-based structures where the final return is based on the average value of the underlying asset. Path-dependency sometimes yields results, which may be counterintuitive to the investor. Suppose that the underlying asset price remains steadily below the initial price throughout most of the term, and then rises sharply above the initial price just before maturity. Since the average reflects all the lower prices, the return may be nil even though the final price is higher than the initial price. If you choose to recommend a PPN whose return is path-dependent, you should be prepared to explain this kind of result to your client. Lock-in of Gains Some PPNs lock-in the gains on the underlying asset at specified dates. For example, the underlying asset of an actual PPN consists of a notional basket of eight securities. The PPN has a four-year term. Every six months, the return from the best performing security is locked-in and the security removed from the basket. At maturity, the final variable return is calculated as the average of the eight locked-in returns, subject to a floor of 0%. Look Back “Look back” strategies may also be used to reduce the timing risk. One approach is to look back over, say, the six months prior to maturity and pick the highest price which prevailed over that period to serve as the final price. An alternative is to look back over, say, the six months following the date of issue and pick the lowest price over that period to serve as the initial price.


Price Return versus Total Return The variable return may be based on the price return of the underlying asset (i.e., excluding dividends) or the total return (i.e., including dividends). When the variable return includes dividends, some other desirable product feature may need to be sacrificed. For instance, it may be necessary to accept a lower participation rate or a lengthier term. Participation Rate Most PPNs feature a participation rate of 100%, although participation rates of less than 100% are not unknown. Note that the expression “participation rate” is rarely used in information statements. The participation rate can be determined by analyzing the formula used for calculating the final variable return. Here are some relevant excerpts from an information statement: “Calculation of Variable Return … “Variable Return” payable on a Note will be an amount (if any), not less than zero, calculated based on the following formula:

Variable Return = ($100 Principal Amount x Percentage Change) … Calculation of Percentage Change “Percentage Change” will be a number, expressed as a percentage … determined as follows:

Percentage Change = (Settlement Level – Base Level) Base Level

where: “Base Level” is … the [value of the underlying asset] on the first Exchange Day after the Issue Date”; and “Settlement Level” is the [value of the underlying asset] on the third Exchange Day immediately prior to the Maturity Date.” The above formula effectively states that the variable return will be equal to 100% of the percentage increase in the value of the underlying asset between the issue date and the maturity date. This represents a participation rate of 100%. In the case of PPNs whose protection structure is CPPI, note than even if investors participate in 100% of the return on the basket, this does not mean that they participate in 100% of the return on the underlying asset. The exposure of the basket to the underlying


asset can range from 0% to more than 100%, depending, among other factors, on the performance of the underlying asset and the permitted leverage, and it cannot be determined in advance. Cap on the Return Some PPNs feature a cap on the final variable return. The rationale for a cap is explained in section 1. Call Feature Some PPNs have a call feature, which allows the issuer to repurchase the note at specified prices on specific dates prior to maturity. The call option is for the benefit of the issuer and it will be exercised if it is beneficial to the issuer to do so. A call feature places a cap on the PPN’s return. Impact of Extraordinary Events on the Variable Return An extraordinary event is generally one that has a material adverse impact on the ability of the issuer to perform its obligations under the PPN or to hedge its obligation to pay the variable return. If the assets in the basket drop to an uneconomically low level as a result of redemptions of the PPN or of losses sustained by the basket, this may also be considered to be an extraordinary event. On the occurrence of an extraordinary event, the issuer has a number of rights. For instance, it may decide to terminate the PPN’s exposure to the underlying asset, crystallize the amount of the variable return and, if positive, pay the amount net of extraordinary hedging costs before maturity. Extraordinary hedging costs are generally the costs of unwinding any hedging arrangements the issuer may have entered into in order to hedge its obligations under the PPN. Notwithstanding an extraordinary event, the principal amount is itself usually repayable at maturity. It is important to ascertain what constitutes an extraordinary event under the terms of the PPN and what actions the issuer is entitled to take in such an event.

5.3 Minimum Return at Maturity All PPNs are at least 100% principal-protected. This is necessary in order to benefit from the regulatory exemptions. Some PPNs protect more than 100% of the principal. This is effectively a promise of a minimum return on the PPN at maturity. An actual PPN has an issue price of $10 and an eight-year term. The PPN promises that, at maturity, the investor will receive the higher of $11.265 and an amount calculated by reference to the


performance of the underlying asset. This is equivalent to a minimum compound annual return of 1.5%. In the same way as the repayment of the principal amount, the payment of the minimum return is an obligation of the issuer and is subject to credit risk. Also bear in mind that there is no such thing as a free lunch. For instance, in order to offer a minimum return at maturity, the product structurer may have reduced the participation rate or increased the term of the PPN.

5.4 Coupon Certain products pay a periodic coupon, which may be fixed or variable. For instance, there is a PPN whose underlying asset is a portfolio of dividend-paying stocks and which pays monthly coupons equal to the dividends paid by the stocks. Again, bear in mind that the coupon may have come at the price of a lower participation rate, a longer term or some other undesirable characteristic. Coupons may be paid out as interest or return of capital. The latter is more tax-efficient. Note that returns of capital reduce the principal amount payable at maturity.

5.5 Term The term is usually four to eight years, although there has been a note with a term of 13.5 years. Products whose final variable return depends on the average value of the underlying asset usually have shorter terms than those whose return depends on the final value. The term is influenced by the level of interest rates. When interest rates are low, as has been the case in the past few years, a longer term is necessary to provide the principal protection and exposure to the underlying asset. From the issuer’s perspective, long maturities are beneficial. They enhance the stability of its balance sheet and reduce refinancing risk. Long maturities also have beneficial properties from the point of view of the product structurer. A longer term provides scope to the structurer to increase the participation rate, offer a minimum return at maturity or add a coupon or some other feature which investors will find attractive. From the point of view of the investor, an overly lengthy term has drawbacks:

• The investor depends entirely on the creditworthiness of the issuer (or the guarantor, if there is one) for the repayment of the principal and the payment of


the return. The longer the term, the more exposed the investor will be to a deterioration in the creditworthiness of the issuer.

• During the term, the investor will not be able to monetize the PPN and reinvest the proceeds in other investment opportunities. There is an opportunity cost in holding a PPN. A longer term increases the opportunity cost. Of course, the investor may redeem the note, if redemption opportunities are available, or sell it on the secondary market. However, the investor will then lose the benefit of principal protection which was one of the main justifications for investing in a PPN in the first place.

• A longer term increases the uncertainty associated with the final variable return because the latter is not known until maturity.

5.6 Is the Principal Protection Redundant? The longer the period of time for which an investment is held, the lower the risk of loss. The lengthy term to maturity of most PPNs is, in itself, a form of protection against the loss of principal. If so, is it worth paying for the protection? The question acquires particular significance under CPPI. The type of investment in which the underlying fund may invest is subject to the approval of the product structurer. This is normal because the latter must compensate the issuer if there are insufficient assets at maturity to repay the principal. In order to minimize its exposure, the product structurer will insist on relatively low-risk investments. It will also insist on relatively liquid investments in order to facilitate the switch to bonds or money market instruments if necessary. This may not be what investors want. Since they have a promise of principal protection, they will probably want the fund to be invested in riskier, less liquid assets with a higher return potential. Thus, there is a conflict of interests between the structurer and the investors. There are PPNs whose underlying asset is a mutual fund which has never lost money over the period of time corresponding to the term of the PPN. Ask yourself if the principal protection is worth paying for. Your client might be better off investing directly in the underlying mutual fund. Due Diligence Questions The Underlying Asset

• What is the underlying asset? • What are the factors influencing the performance of the underlying asset? What is

the investment thesis? • What are the risk factors? • What are the historical returns? • What is the historical volatility?


• What is the historical correlation with other assets or asset classes? More Points when the Underlying Asset Is a Mutual Fund

• Who is the manager? • What are the record and reputation of the manager? • What is the investment objective of the fund? • What is the management style? • For how long has the fund been in existence? • What is the size of the fund? • What is the fund’s quartile ranking? • What is the rating (e.g., number of stars) assigned to the fund by Morningstar or

similar organizations? Even More points when the Underlying Asset Is a Fund of Hedge Funds

• Does the fund invest in stand-alone funds or in managed accounts? • For how long has the manager been in business? • What is its size as measured, say, by its capital or its assets under management? • Does it have the investment, risk management, compliance and administrative

capabilities required to run a fund management business? • To what regulations is it subject? Is it registered with a regulatory authority? • Who is the custodian? • Is the custodian independent? • What is the maximum permitted leverage of the underlying fund of hedge funds? • Is the fund single-strategy or multi-strategy? • Does the performance record include back-tested or pro forma data? • What is the maximum drawdown? • What is the downside risk? • What is the fund’s beta? • Where is the fund’s regulatory jurisdiction? • If the fund is located offshore, what is the quality of regulation in the relevant

jurisdiction? Final Variable Return

• Does the final variable return depend on the final value or the average value of the underlying asset?

• Are gains locked-in? • Does the product include look-back features? • Is the final variable return related to the price return or the total return of the

underlying asset? • What is the participation rate? • Is there a cap on the return? • If so, what is the cap?


• Is the PPN callable by the issuer? • If so, when and at what price? • What constitutes an extraordinary event? • What are the issuer’s rights on the occurrence of an extraordinary event?

Minimum Return at Maturity

• Is there a minimum return at maturity? • If so, what is the minimum return?

Coupon

• Is there a coupon? • If so, at what frequency is it paid? • How is it calculated? • Is it paid as interest or return of capital?

Term

• What is the term of the PPN? Principal Protection

• Is the principal protection worth paying for?


VI. EVALUATING THE LIQUIDITY OF A PRINCIPAL-PROTECTED NOTE PPNs are long-term investments. In order to benefit from the principal protection, the investment must be held until maturity. However, there may be cases when investors wish to monetize their investment prior to maturity. An unforeseen event may have occurred that requires them to access their money. Alternatively, they may have fundamentally changed their views on the likely performance of the underlying asset. The holder of a PPN faces liquidity risk, which is the risk of loss from the inability to monetize the PPN at a fair price prior to maturity. Organization of this Section This section reviews the potential sources of liquidity and identifies the issues associated with redemption rights and dealer-maintained secondary markets.

6.1 Exchange Listing Some PPNs are listed for trading on an exchange such as the TSX. However, an exchange listing is the exception rather than the rule. When a PPN is listed on an exchange, this may provide the required liquidity. However, even exchange-listed investments can suffer from thin trading and wide bid-ask spreads.27 In the absence of an exchange listing, the investor may monetize the investment by:

• Redeeming it (if the terms of the PPN provide for redemption rights); or • Selling it on a dealer-maintained secondary market.

6.2 Redemption Rights The information statement will disclose whether there are redemption rights and, if so, which conditions apply. The investor loses the benefit of the principal protection when redeeming the note. The redemption price will usually be equal to the NAV of the PPN and may be less than the amount of the original investment. When they exist, redemption rights normally apply only at certain times, say, once a week. The issuer may reserve the right to suspend the redemption right in certain circumstances.

27 The bid-ask spread is the difference between the buying price and the selling price of a security on a market.


Advance notice of an intention to redeem is usually required. If the required notice period is very long, this will complicate the redemption process. The issuer may reserve the right to limit total redemptions on a redemption date to a maximum amount equal to, say, a certain percentage of the outstanding notes. If so, enquire what happens if redemption requests in excess of this amount are received. Are redemptions then processed on a pro-rata or a first come, first served basis? Are any unfulfilled requests automatically carried forward to the next redemption date? Ensure that the redemption proceeds are payable to the investor within a reasonable period after the redemption date. Redemption fees may apply if the PPNs were purchased with deferred charges and they are redeemed within a certain number of years of the date of issue. Enquire about the redemption fee schedule. In addition, there may be an early redemption charge if the PPNs are redeemed shortly (say, within a few months) after the date of issue. Early redemption charges usually apply to PPNs purchased with initial as well as deferred sales charges. Enquire if an early redemption charge applies. NAV The NAV is important because, when redemption rights exist, the PPN is normally redeemable at the NAV. The manner of calculating NAV depends on the protection structure used – option-based or CPPI. NAV under an Option-based Structure Under an option-based protection structure, the calculation of the NAV consists in valuing the two components of the PPN, i.e., the zero-coupon bond and the call option.

• The value of the zero-coupon bond is obtained by calculating the present value of the principal amount receivable at maturity; and

• The value of the option is calculated using an option pricing model. The value of the zero-coupon bond will be mainly affected by changes in the interest rate. Thus, the investor is exposed to interest rate risk. 28 The interest rate may change because of general economic conditions or because of a change in the issuer’s credit rating. Other things being equal, the interest rate will fall and the value of the zero-coupon bond will rise if the issuer’s credit rating improves. The reverse will be true if the issuer’s credit rating deteriorates. 28 It is possible for the structurer to hedge this risk by means of a derivative known as a Bermudan Accreting Swaption.


The price of the call option is affected by a number of variables, including the price of the underlying asset.29 If the price of the underlying asset rises, the price of the option will increase. Thus, under an option-based structure, an investor bears the following risks when redeeming PPNs:

• The interest rate risk on the zero-coupon bond; and • The market risk on the option.

NAV under CPPI Under CPPI, the proceeds of issue of the PPN are invested in a basket, which is itself invested partly in the underlying asset (usually, an actively managed fund) and partly in bonds and money market instruments. Leverage may be used. Thus, the NAV of the note will consist of:

• The market value of the underlying asset in the basket; plus • The market value of the bonds and money market instruments in the basket; less • The amount of any borrowings.

6.3 Dealer-maintained Secondary Market In most cases, the product structurer or a related entity will maintain a secondary market in the product. However, it will usually reserve the right not to do so. This is in order to protect itself in the event of market disruption. Enquire if the secondary market will be maintained for the entire period between the issue and maturity dates. It is possible that the secondary market will only be started some time after the issue date. A dealer-maintained secondary market may be less liquid than an exchange and bid-ask spreads may be wider. The bid-ask spread constitutes the dealer’s profit from maintaining the secondary market. The dealer may commit itself to a maximum spread. For example, the information statement of an actual PPN discloses that the maximum bid-ask spread will be 1% of the principal amount, excluding commissions. Note that this only represents a commitment as regards the size of the bid-ask spread, not as regards the level of prices in the secondary market. The price of a PPN in the secondary market is determined by demand and supply forces and will bear some relationship to NAV.

29 See Appendix I for a discussion of the variables affecting the price of an option.


When selling a PPN on the secondary market, the principal protection does not apply. It is possible for the price of the PPN to be lower than the issue price. The dealer will attempt to find a buyer for the PPNs that are sold to it on the secondary market. If this is not possible in the short term, it may maintain a stock. However, if the stock becomes too high, the dealer usually has a right to require the issuer to redeem the notes. This may cause the amount of the notes outstanding to drop to an economically low level and trigger an extraordinary event.30 In order to maintain a secondary market, it may be necessary for the dealer to commit its capital. Enquire whether the dealer has the resources to do so. When the dealer is part of a financial group with a solid credit rating, this will usually not be a problem. Due Diligence Questions

Exchange Listing

• Will the PPN be listed for trading on an exchange such as the TSX? Redemption Rights

• Are there redemption rights? • If so, how is the redemption price determined? • If the redemption is at NAV, how is NAV calculated? • How frequently may the redemption rights be exercised? • Under which circumstances may the redemption rights be suspended? • How much notice of redemption must be given? • Is there a ceiling on the amount of total redemptions on a redemption date? • If so, how are redemption requests fulfilled if the amount of redemption requests

exceeds the ceiling? • How long after the redemption date will the redemption proceeds be paid to the

investor? • Are there redemption fees? • If so, what is the redemption fee schedule? • Is there an early redemption charge? • If so, how is it calculated?

Dealer-maintained Secondary Market

• Will the PPN be traded in a dealer-maintained secondary market? • On which factors, if any, is the dealer’s commitment to maintain a market

conditional?

30 See section 5.2 for a discussion of the implications of an extraordinary event.


• Will the secondary market be maintained throughout the period from issue date to maturity date?

• Is there a commitment to a maximum bid-ask spread? • Does the dealer have the resources to maintain a secondary market?


VII. FEES AND EXPENSES The investor incurs fees and expenses when buying, holding and redeeming a PPN. Some of these are explicit whereas others are embedded in the price of the product. The fees and expenses may be analyzed as follows:

• Hedging profit embedded in the price of the product; • Sales charges; and • Annual fees and expenses.

7.1 Costs Embedded in the Price of the Product Section I explains how a hedging profit may be embedded in the price of the product.

7.2 Sales Charges Initial Selling Commission The dealer is remunerated at the time of the initial sale by means of a selling commission. The commission may be paid by the investor (in the case of an initial sales charge) or by the issuer (in the case of a deferred sales charge). In the latter case, the issuer will recoup the commission from the investor through annual management fees or redemption fees. Only one of the two options (initial or deferred sales charge) may be available in any given case. Sometimes, a reduced deferred sales charge (or low load) may be available. This is a variant of the deferred sales charge. Redemption Fees When PPNs have been purchased with a deferred sales charge, redemption fees will be charged to the investor if the latter redeems the notes with a certain number of years of purchase. In some cases, redemption fees are also charged when the notes are sold on the secondary market. Early Redemption Charge An early redemption charge may be charged to the investor if the notes are redeemed shortly (e.g., within a few months) after purchase.


When an early redemption charge exists, it applies whether the PPN was purchased with an initial or deferred sales charge.

7.3 Annual Fees and Expenses When the underlying asset is an actively managed fund (as opposed to a passive investment), annual fees are usually charged to the note. These are variously called management fees or portfolio fees and are usually computed as a percentage of assets under management. There may or may not be an annual trailer fee to the dealer. When the underlying asset is a passive investment and there is no management fee, there is usually no trailer. When trailer fees are paid, a portion is sometimes charged to the note.

7.4 Annual Fees and Expenses when the Underlying Asset Is a Fund of Hedge Funds Fees and expenses can get very complicated when the underlying asset is a fund of hedge funds. Advisers of stand-alone hedge funds normally charge an annual advisory fee of 2% of assets under management together with an incentive fee of 20% of profits. At the fund of funds level, the adviser charges an additional set of fees normally comprising an annual advisory fee of 1% of assets under management together with an incentive fee of 10% of profits. When incentive fees exist, the following questions should be asked:

• On what periodic results will the incentive fee be based? If it is based, say, on monthly or quarterly results, it is possible for an adviser to be paid an incentive fee even if it loses money over a full year.

• Is there a hurdle rate? A hurdle rate is a minimum rate of return that must be achieved for an adviser to be eligible to charge incentive fees.

• Is there a high-water mark? A fund’s high-water mark is the highest unit value previously reached by the fund. A high-water mark is designed to prevent the adviser from earning incentive fees twice on the same profits. For instance, if the fund’s unit value reaches a peak, then falls, no incentive fee is earned as the fund climbs its way back towards the previous peak or high-water mark. New incentive fees will be earned only after the unit value exceeds the high-water mark.

• If there is a high-water mark, is it permanent or reset at periodic intervals? A high-water mark that is reset too frequently may not be of much value.

Note that incentive fees are based on each adviser’s performance. It is, therefore, possible for the advisers of certain stand-alone funds to receive incentive fees even if the fund of funds as a whole loses money.


If the compensation of the adviser of the fund of hedge funds includes incentive fees, ensure that they are based on the performance of the fund of funds as a whole and not of each stand-alone fund. Each stand-alone fund and the fund of funds will also have expenses, including interest on borrowings where applicable. The remuneration of the advisers and the expenses are deducted from the assets of the stand-alone hedge funds and the fund of hedge funds. They are therefore embedded in the NAV of the fund of hedge funds. Additional annual fees such as administrative fees and swap agreement fees are sometimes charged directly to the note. These fees are usually based on assets.

7.5 Break-even Gross Return The various fees and expenses are summarized in Table 7.1 whose objective is to help calculate the break-even gross return. This is the gross return that needs to be earned before a return starts accruing to the investor. It is equal to the total of annualized fees and expenses, both explicit and embedded, deducted from the gross return. Assumptions For the purpose of this exercise, it may be assumed that the PPN will be held till maturity. When CPPI is used, it may be assumed that leverage will not be used. It is understood that some of the numbers will be estimates. Please note that, if incentive fees are involved, a number of iterations may be required. Due Diligence Questions Sales Charges

• Is an initial sales charge available? • If so, what is the maximum commission chargeable to the investor? • Is a deferred sales charge available? • If so, what is the commission payable by the issuer? • Is a reduced deferred sales charge available? • If so, what is the commission payable by the issuer? • Is a trailer fee payable? • If so, what is its size? • By whom is it payable?


Annual Fees and Expenses

• Will incentive fees, if any, be based on monthly, quarterly or annual results? • What is the hurdle rate, if any? • What is the high-water mark, if any? • Is the high-water mark permanent or reset periodically? • If reset periodically, at what interval? • Are the incentive fees of the fund of hedge funds’ adviser based on the

performance of the fund of funds as a whole or of each stand-alone fund? • What is the break-even gross return? (Complete the grid in Table 7.1.)


Table 7.1 Calculation of Break-even Gross Return % of Assets under Management A. One-time fees Costs embedded in the price of the product Initial sales charge Other Total one-time fees Annual equivalent (Total one-time fees / Term of PPN in years) B. Annual fees and expenses (i) Charged to the note Management or portfolio fees Trailer fees Administrative fees Swap agreement fees Other fees and expenses (ii) Charged to the fund of funds Advisory fees Incentive fees Expenses (iii) Charged to the stand-alone funds (average) Advisory fees Incentive fees Expenses Total of annualized fees and expenses (= Break-even gross return)


VIII. TAX CONSIDERATIONS Most, but not all, information statements provide a summary of the Canadian federal income tax considerations applicable to individual Canadian-resident investors who purchase the PPN. PPNs may usually be held in registered accounts such as Registered Retirement Savings Plans. When PPNs are held outside a registered account, you should be aware of the tax consequences. Here is a non-exhaustive list of factors to be considered:

• Will the notes qualify as capital property in the hands of the client? • How will the coupons, if any, be taxed? Distinguish between coupons which

constitute interest and those which constitute return of capital. • How will the minimum return, if any, be taxed? • In what circumstances will interest accrual on a “prescribed debt obligation”, as

defined for purposes of the Income Tax Act (Canada), apply? • If redemption rights exist, how will a profit or loss on redemption be taxed? • How will a profit or loss on the disposal of a PPN on a secondary market prior to

maturity be taxed? • Is the answer different if the disposal takes place shortly before maturity? • How will the variable return at maturity be taxed?

Tax Uncertainty Most information statements state that when an investor disposes of a PPN on a secondary market prior to maturity profits will be treated as capital gains, and losses as capital losses for tax purposes. This statement is invariably qualified by another statement to the effect that “the matter is not free from doubt”. Caveat emptor. The uncertainty regarding the tax treatment is all the greater when the PPN is disposed of shortly prior to maturity. Information statements usually recommend that, in such cases, investors should consult their own tax advisers with respect to their particular circumstances. Once again, caveat emptor. Tax Treatment of PPN versus Underlying Asset The client should understand that the tax implications of holding a PPN are not the same as those of holding the underlying asset directly. Consider the case of a PPN whose underlying asset is a portfolio consisting of dividend-paying stocks. Suppose that the PPN pays monthly coupons equal to some percentage of the dividends paid by the stocks in the portfolio. Depending on whether the monthly coupons constitute interest or return of capital, they will be taxed in the hands of the investor as interest or decrease the


adjusted cost base of the investment. If the investor had invested directly in the stocks, the receipts would have been taxed as dividends. Due Diligence Questions Eligibility for Registered Accounts

• Is the product eligible for inclusion in registered accounts? Tax Issues

• Will the notes qualify as capital property in the hands of the client? • How will coupons constituting interest, if any, be taxed? • How will coupons which constitute return of capital, if any, be taxed? • How will the minimum return, if any, be taxed? • In what circumstances will interest accrual on a prescribed debt obligation apply? • If redemption rights exist, how will a profit or loss on redemption be taxed? • How will a profit or loss on the disposal of a PPN on a secondary market prior to



IX. INVESTORS AND PRINCIPAL-PROTECTED NOTES In this final section, the threads developed in earlier sections are pulled together and PPNs are examined from the perspective of the investor.

9.1 Benefits to the Investor Some investors may benefit from including PPNs in their portfolio. PPNs offer two main benefits:

• Access to a wider variety of risk-reward profiles; and • Access to investment products that would otherwise be unavailable.

A Wider Variety of Risk-Reward Profiles Perhaps the greatest benefit of PPNs to the investor relates to their flexibility. This flexibility enables the investor to enjoy risk-return characteristics which are not possible with other investments. For instance, an equity investment provides a possibility of high returns but there is no principal protection. A GIC provides principal protection but the return is low. A PPN allows investors to participate in the return of the underlying asset while at the same time benefiting from principal protection. The return profile of PPNs can be varied within very broad limits – the variable return can be based on the final or average price of the underlying asset, the participation rate can be varied, there may or may not be a cap on the return, the PPN may or may not be callable, there may or may not be a minimum return, the coupon, if any, may be fixed or variable and may be paid as interest or return of capital. There are enough variations in practice to satisfy the tastes of most investors. Access to More Products PPNs provide investors with access to products that would otherwise be inaccessible for regulatory or other reasons, e.g., hedge funds and commodities. Hedge fund returns exhibit low correlation with those of traditional asset classes such as stocks and bonds. By adding hedge funds to a traditional portfolio, it is possible to improve the efficiency of the portfolio, i.e., obtain the same expected return with less risk. Retail investors can obtain indirect exposure to hedge funds by purchasing a PPN whose return is linked to that of a fund of hedge funds. Prior to the elimination of the foreign-property rule in 2005, it was possible to use PPNs to achieve foreign market exposure beyond the 30% ceiling allowed by the rule. This was because PPNs held in registered accounts qualified as Canadian content even when the underlying asset was clearly foreign.


9.2 Risks to the Investor In order to enjoy these benefits, the investor must shoulder a number of risks. These risks were discussed in earlier sections and are summarized here for convenience. Some of these risks (e.g., inflation risk, credit risk, interest rate risk) are common to most debt instruments. Other risks (e.g., investment risk) are common to all equity investments. The risks specific to PPNs are those which derive from the nature of the product or the protection structure. Inflation Risk The principal protection applies only to the nominal value, and not the real value, of the principal. Investors are exposed to an erosion of the purchasing power of their investment over the term of the PPN in the event that the return is lower than the rate of inflation. Credit Risk Credit risk is the risk of loss if the issuer fails to perform its obligations. The investor is solely dependent on the creditworthiness of the issuer (or the guarantor, if there is one) for the repayment of the principal and the payment of the return. The investor has no preferential access to the assets in the protection structure. Credit risk can be managed by evaluating the credit quality of the issuer, as evidenced by its credit rating. The credit rating of an issuer evolves over time. PPNs have lengthy terms to maturity. The lengthier the term, the more likely it is that the credit quality of the issuer will change, perhaps unfavourably, prior to maturity. Hedge Counterparty Risk This is the risk of loss if the hedge or swap counterparty fails to perform its obligations. This risk is usually borne by the issuer, but it is occasionally transferred to the investor. Investment Risk The investor is exposed to investment risk, subject to the principal protection. Investment risk is the risk that the investor will get no return because of poor performance of the underlying asset. When the underlying asset is a fund of hedge funds, issues related to hedge funds generally become relevant — lack of transparency, concerns about fund valuation, conflicts of interest, etc.


Timing Risk Under option-based protection structures, the final variable return on the PPN is often equal to the percentage increase in the price of the underlying asset between the issue date and the maturity date. Timing risk is the risk that the PPN will mature precisely at a time when the underlying asset is suffering from a bout of weakness. Risk of Reduced Investment Exposure Under CPPI, if the underlying asset performs badly or if there is a drop in the interest rate, the basket’s assets are reallocated from the underlying asset to low-risk investments. Since exposure to the performance of the underlying asset is one of the main motivations for investing in a PPN, the risk of reduced investment exposure is an important concern. In an extreme case, the entire position in the underlying asset may be liquidated such that the basket becomes fully invested in bonds or money market instruments. All that the investor can now look forward to is the return of the principal at maturity. Claims of 100% exposure to the performance of the underlying asset may only be true on Day 1. Thereafter, exposure may range from 0% to more than 100%, depending on the performance of the underlying asset, the permitted leverage and the interest rate. Risk Related to the Use of Leverage in the Basket Under CPPI, leverage may be used to increase the basket’s exposure to the underlying asset. If the return on the underlying asset turns out to be lower than the cost of borrowing, the use of leverage will work against the investor. Interest Rate Risk Interest rate risk is the risk of loss as the result of a movement in the interest rate. Under option-based structures, the investor is exposed to interest rate risk if the PPN is redeemed or sold on a secondary market prior to maturity. Under CPPI, the investor is exposed to interest rate risk throughout the life of the note. Liquidity Risk Liquidity risk is the risk of loss from the inability to monetize the PPN at a fair price prior to maturity. While some PPNs are listed for trading on an exchange, this is the exception rather than the rule. A dealer-maintained secondary market may be less liquid than an exchange and bid-ask spreads may be wider. The principal protection does not apply when selling a PPN on a secondary market.


9.3 Other Issues There are a number of other issues that the client should understand when buying a PPN: Lack of Transparency of Pricing The pricing of a PPN is not always transparent. Unlike publicly distributed investment funds such as mutual funds, some of the costs of a PPN are not charged for separately but embedded in the price of the product. Conflicts of Interests There may be conflicts of interests arising from the multiple roles of the product structurer. The structurer may also be the issuer, the calculation agent, etc. Path-dependency of Returns Under certain protection structures, the final return on the PPN is path-dependent, i.e., it depends on the history of prices of the underlying asset throughout the term of the note. This may give results which the investor may find counterintuitive. Possible Redundancy of Principal Protection The lengthy term to maturity of most PPNs is itself a form of principal protection. In addition, the underlying asset itself may be a relatively safe investment. Opportunity Cost During the term, the investor will not be able to monetize the PPN and reinvest the proceeds in other investment opportunities. There is an opportunity cost in holding a PPN. Of course, investors may redeem the note, if redemption opportunities are available, or sell it on the secondary market. However, they will then lose the benefit of principal protection which was one of the main justifications for investing in a PPN in the first place. Fees and Expenses PPNs carry fees and expenses, some of which are embedded in the price of the product. When the underlying asset is a fund of hedge funds, there are multiple layers of fees and expenses. In some information statements, the fees and expenses are not clearly disclosed. Tax Uncertainty There is uncertainty as regards the tax treatment of certain aspects of PPNs.


9.4 Suitability Considerations As for any other investment, the suitability of a PPN will depend on the investor’s investment objectives, investment horizon and other relevant circumstances. PPNs are most likely to be suitable for investors who:

• Are risk-averse; • Would like some exposure to the underlying asset without exposing their

principal; and • Have a long investment horizon.

Investment Objectives PPNs may be appropriate to meet the following investment objectives:

• Capital protection; • Regular income in the form of a coupon; • Some exposure to equity markets; • Diversification (access to alternative investments); • Access to leverage; and • Tax efficiency.

Investment Horizon One of the main justifications for investing in a PPN is the principal protection. The principal protection is available only if the PPN is held until maturity. If it is likely that the investor will need access to his or her money prior to maturity, a PPN is probably not a suitable investment. Fixed Expected Return The return on a PPN depends on the performance of the underlying asset and may turn out to be nil. A PPN is unlikely to be suitable for investors who expect a fixed return on their investment. Margin Accounts When investors purchase PPNs on margin, ensure that the firm has procedures in place to monitor the loan value of these products for margin purposes.


9.5 Overall Evaluation After performing the procedures explained in this guide, you will have:

• Evaluated the return potential of the PPN under review; • Identified and assessed the risks and issues associated with the PPN; • Identified and quantified the costs associated with buying and holding the PPN;

and • Identified the type of client for whom the PPN may be suitable.

You now have all the information you need to decide whether you should recommend the product to your clients. There is no magic formula with which to weigh the various factors when making the decision. This final step requires professional judgment. Not all factors have equal weight. You should decide which factors are particularly important in the product under review. In some cases, a single factor, say, the credit quality of the issuer or the costs associated with the product, may be more important than all other factors taken together. Consider other available products. Are there competing products on the market which may meet the same objectives with lower risk or at lower cost? Based on your quantitative and qualitative evaluation of the product, and your knowledge and experience of competing products on the market, you should be able to decide whether the product should be placed on the list of approved products. Due Diligence Questions Overall Evaluation

• Which factors are particularly significant in the product? • Are there competing products on the market which may meet the same objectives

with lower risk or at lower cost? • Based on your quantitative and qualitative evaluation of the product, and your

knowledge and experience of competing products on the market, should the product be placed on the list of approved products?


APPENDIX I – BUILDING BLOCKS OF A PRINCIPAL-PROTECTED NOTE The building blocks of a PPN are:

• A zero-coupon bond; and • A call option, which is a type of derivative instrument.

1.1 Zero-coupon Bonds By using a zero-coupon bond as a component of a PPN, it is possible to protect the principal at maturity. A zero-coupon bond is a debt instrument that does not pay periodic interest. Instead, it pays a lump sum, which is equal to its face value, at maturity. Prior to maturity, it trades at a discount to its face value. A zero-coupon bond enables the purchaser to avoid reinvestment risk, which is the risk that cash flows received prior to maturity may need to be reinvested at a lower interest rate than the current rate. There is no reinvestment risk because, by definition, a zero-coupon bond pays no coupon. Reinvestment risk is particularly relevant when interest rates are trending downwards. The price of a zero-coupon bond depends on the time remaining until maturity and on the interest rate required by investors. The latter will itself depend on a number of factors, including the issuer’s credit risk. The issuer’s debt rating provides a good indication of its credit risk. Table 1.1 Relationship between the Price of a Zero-coupon Bond, the Time to Maturity and the Interest Rate (Assuming a face value of $1,000) Interest rate Time to Maturity 7 years 8 years 6% $665 $627 7% $623 $582


Table 1.1 illustrates the relationship between the price of a zero-coupon bond, the time to maturity and the interest rate. Assume that the bond has a face value of $1,000, that there are seven years until maturity and that the annual rate of interest is 6%. Table 1.1 shows that the price of the bond is $665. This is the amount that, when invested at a compound annual interest rate of 6%, gives $1,000 in seven years’ time. Interest Rate Risk There is an inverse relationship between the rate of interest and the price of a bond. For instance, if the interest rate rises, this will cause a drop in the price of the bond. The risk of loss as the result of a movement in the interest rate is known as interest rate risk. By way of example, if the annual rate of interest is increased to 7% while the time to maturity is maintained at seven years, the price of the bond will drop to $623, compared with $665 in the original case. This can be seen by reading down the “7 years” column in Table 1.1. All this is shown graphically in Figure 1.1. The solid curve shows the original path of the bond price over time. For a given interest rate, the price of the bond increases over time as it gets closer to maturity. At maturity (indicated by the point M), the price is equal to the face value. Now suppose the interest rate rises after one year (at time 1). The path will rotate around point M in a counter clockwise direction to the new position shown by the dotted curve. The price of the bond will drop at time 1 by the vertical distance between the two curves. Note that a change in the interest rate has an impact on the price of the bond only prior to maturity. At maturity, the zero-coupon bond will always be worth its face value, provided there is no default on the part of the issuer. The Time to Maturity and the Price of a Zero-coupon Bond The longer the time to maturity, the lower the price of the bond will be. This can be seen by reading across the “6%” row of Table 1.1. If the time to maturity is lengthened to eight years while the annual rate of interest is maintained at 6%, the price of the bond will decline to $627, compared with $665 in the original case.


1.2 Options An option is a derivative, i.e., a financial instrument whose value is derived from that of an asset or variable known as the underlying asset.31 Examples of underlying assets are:

• Individual stocks or bonds; • Baskets of stocks or bonds; • Indices, e.g., stock market indices; • Commodities; • Interest rates; • Inflation rates; • Currencies; • Mutual funds; and • Funds of hedge funds.

31 For a useful introduction to options in a Canadian context, see Montréal Exchange, Equity Options Reference Manual, March 2004.


By using an option as a component of a PPN, it is possible to link the return on the PPN to the performance of the underlying asset. An option may be a call option or a put option. Call Options A call option gives the buyer (also known as the holder) the right, but not the obligation, to buy an asset (known as the underlying asset) at a specified or determinable price (known as the exercise price or strike price) at the end of or during a period of time (known as the term of the option). An option, which may be exercised only at the end of the term, is known as a European option whereas an option, which may be exercised at any time during the term, is known as an American option. The price for which an option may be bought or sold is known as the premium. When the price of the underlying asset is equal to the exercise price, a call option is said to be at-the-money. In this situation, it makes no difference to the holder whether the option is exercised or not. When the price of the underlying asset is higher than the exercise price, a call option is said to be in-the-money. In this situation, it is worth exercising the option. Assume the underlying asset is a stock whose price is $50. Assume also that the exercise price is $40. On exercising the option, the holder will pay the exercise price of $40 to acquire the stock. The latter can be immediately re-sold on the market for $50, thereby leaving a $10 profit before taking the cost of the premium into account. In the case of call options, the positive difference between the price of the underlying asset and the exercise price is known as the intrinsic value of the option. When the price of the underlying asset is lower than the exercise price, a call option is said to be out-of-the-money. It will not be worth exercising the option. Suppose the price of the underlying stock is $30. There would be no point in paying the exercise price of $40. If the investor wants the stock, the latter can be bought on the market at the cheaper price of $30. Put Options A put option gives the holder the right, but not the obligation, to sell the underlying asset at the exercise price at the end of the term (in the case of European options) or during the term (in the case of American options). When the price of the underlying asset is equal to the exercise price, a put option is said to be at-the-money. There is no profit or loss to be made from exercising the option. A put option is in-the-money when the price of the underlying asset is lower than the exercise price. The holder will then make a profit from exercising the option. Assume the price of the underlying stock is $30 and the exercise price is $40. On exercising the


option, the holder will sell the stock for the exercise price of $40. The stock can be immediately re-purchased on the market for $30, thereby leaving a $10 profit before taking the cost of the premium into account. In the case of put options, the intrinsic value is the positive difference between the exercise price and the price of the underlying asset. A put option is out-of-the-money when the price of the underlying asset is higher than the exercise price. In that situation, it will not be worth exercising the option. Assume that the price of the underlying stock is $50. There would be no point in exercising the option and receiving the exercise price of $40 when the holder can sell the stock on the market for $50. Risks and Rewards to the Holder of an Option The buyer of an option knows in advance the maximum amount of the potential loss. The loss cannot be greater than the premium paid. Consider a call option. If the price of the underlying asset remains below the exercise price throughout the term, the holder will simply let the option expire unexercised. The loss will be equal to the premium paid to acquire the option. Now, assume the price of the underlying asset rises above the exercise price. In this case, the holder can realize a profit by exercising the option. Since there is no limit to how high the price of an asset can rise, the potential profit to the option holder is unlimited. In the case of a put option, if the price of the underlying asset remains above the exercise price throughout the term, the holder will simply let the option expire unexercised. The loss will be equal to the premium paid to buy the option. Now, assume the price of the underlying asset drops below the exercise price. In this case, the holder can realize a profit by exercising the option. Since the price of an asset usually does not drop below zero, the potential profit to the option holder is limited to the exercise price less the cost of the premium. Exchange-traded Options versus Over-the-Counter Options Options may be purchased on an exchange. Such options are standardized as to contract size, maturity date, exercise price, etc. Exchange-traded options are issued and their settlement guaranteed by a clearinghouse. This effectively eliminates counterparty risk, which is the risk that the counterparty does not perform its obligations. When a party has specific requirements which cannot be met by exchange-traded options, it may purchase an option over-the-counter. In this case, the terms of the option are tailored to meet the exact requirements of the parties involved. In over-the-counter transactions, there is no clearinghouse to guarantee settlement. Hence, the parties are exposed to counterparty risk. This risk is managed by dealing only with counterparties with proven creditworthiness.


Pricing of Options Table 1.2 shows the factors which affect the price of an option and the nature of the relationship (direct or inverse) between the factor and the option price. Table 1.2 Option Pricing Factors Factor Price of a Price of a call option put option Exercise price - + Price of the underlying asset + - Time to expiry of option + + Volatility in price of underlying asset + + Dividend yield on underlying asset - + Interest rate + - A ‘+’ denotes a direct relationship between the factor and the option price A ‘-’ denotes an inverse relationship between the factor and the option price Most of the factors are self-explanatory. However, volatility deserves some explanation. Volatility is a measure of the expected variability of the returns on the underlying asset over the life of the option. It is the factor whose value is the most difficult to establish. It is not directly observable and must, therefore, be calculated. When an option is traded on an exchange, its price is known. It is then possible to work backwards and calculate the implied volatility of the underlying asset.32 Factors and Option Prices Consider a call option. The price of a call option varies directly with all the variables above except the exercise price and the dividend yield on the underlying asset. For instance, the longer the time to expiry, the higher the price of the call option will be. This is because the longer the time to expiry, the more likely it is that the current price will rise above the exercise price. On the other hand, the price of a call option varies inversely with the exercise price. Thus, the higher the exercise price, the lower the price of the call option will be. This is because the higher the exercise price, the less likely it is that the price of the underlying asset will rise above the exercise price.

32 The implied volatility of a number of underlying assets may be found on Bloomberg.


Option Pricing Models The values of the factors are input into computer models, which are often proprietary, to generate option prices.33 The most commonly used option pricing models are:

• The Black-Scholes option pricing model; • The binomial option pricing model; and • Monte Carlo methods.

Black-Scholes is the original option pricing model. It may be used to price European options where the dividend is a known proportion of the price of the underlying asset. The binomial model is based on similar assumptions to Black-Scholes and uses binomial trees to calculate the option price. It may be used to price a wider range of options than Black-Scholes, e.g., European options where the dividend is a known absolute number (rather than a proportion of the price of the underlying asset), American options and Bermudan options.34 Monte Carlo methods use simulation to price options with complex features, e.g., Asian options.35 Simulation requires a lot of computer resources and is not generally used when simpler methods are adequate. Intrinsic Value and Time Value of an Option The price of an option may be broken down into its intrinsic value and its time value. As already explained, the intrinsic value of an option is the amount by which it is in-the-money. The time value is the difference between the option price and the intrinsic value. When options are at-the-money or out-of-the-money, they have no intrinsic value. However, they have time value because there is always a possibility that, prior to expiry, the price of the underlying asset will move in a favourable direction. Time value declines over the life of an option and reaches zero on the expiry date. Consequently, the option price on the expiry date consists solely of the intrinsic value, if any. For instance, the price of a call option will be equal to the positive difference, if any, between the price of the underlying asset and the exercise price.

33 One such model may be found on Bloomberg. 34 Bermudan options are options which may be exercised at certain predetermined times during the term of the option. 35 An Asian option is one whose payoff depends on the average price of the underlying asset over a specified period of time rather than on its price on the exercise date.


APPENDIX II – DUE DILIGENCE QUESTIONNAIRE Quality of Disclosure

• How complete and of what quality is the product disclosure? Regulatory Risk

• Does the product satisfy the requirements of the exemption under which it is distributed?

The Issuer and Credit Risk

• Who is the issuer? • What is the rating of the issuer’s debt instruments? (You should refer to debt

instruments which are comparable with the PPN in terms of rank, maturity, etc.) • As a minimum, does the rating indicate that the debt instruments are of

investment grade? • Is the credit trend negative? • Is the rating under review with negative implications? • Are there factors to suggest that there might be a significant deterioration of the

rating prior to the maturity of the PPN? Hedge Counterparty Risk

• Is the investor exposed to hedge counterparty risk? The Structurer and Conflicts of Interests

• Who is the product structurer? • Is the product structurer a related party of the issuer? • Who is the calculation agent? • Is the calculation agent a related party of the issuer? • If the calculation agent is related to the issuer, will an independent calculation

agent be appointed if it becomes necessary to use material discretion when making calculations?

CPPI Issues

• By what percentage is the basket’s NAV allowed to change without triggering a reallocation of assets in the basket?

• Is the basket guaranteed to have a minimum exposure to the underlying fund? • Is leverage allowed in the basket? • If so, what are the terms and conditions of the borrowings?


• Do the terms and conditions reflect normal market conditions? • Is the leverage non recourse? • What is the maximum leverage?

The Underlying Asset

• What is the underlying asset? • What are the factors influencing the performance of the underlying asset? What is

the investment thesis? • What are the risk factors? • What are the historical returns? • What is the historical volatility? • What is the historical correlation with other assets or asset classes?

More Points when the Underlying Asset Is a Mutual Fund

• Who is the manager? • What are the record and reputation of the manager? • What is the investment objective of the fund? • What is the management style? • For how long has the fund been in existence? • What is the size of the fund? • What is the fund’s quartile ranking? • What is the rating (e.g., number of stars) assigned to the fund by Morningstar or

similar organizations? Even More points when the Underlying Asset Is a Fund of Hedge Funds

• Does the fund invest in stand-alone funds or in managed accounts? • For how long has the manager been in business? • What is its size as measured, say, by its capital or its assets under management? • Does it have the investment, risk management, compliance and administrative

capabilities required to run a fund management business? • To what regulations is it subject? Is it registered with a regulatory authority? • Who is the custodian? • Is the custodian independent? • What is the maximum permitted leverage of the underlying fund of hedge funds? • Is the fund single-strategy or multi-strategy? • Does the performance record include back-tested or pro forma data? • What is the maximum drawdown? • What is the downside risk? • What is the fund’s beta? • Where is the fund’s regulatory jurisdiction?


• If the fund is located offshore, what is the quality of regulation in the relevant jurisdiction?

Final Variable Return

• Does the final variable return depend on the final value or the average value of the underlying asset?

• Are gains locked-in? • Does the product include look-back features? • Is the final variable return related to the price return or the total return of the

underlying asset? • What is the participation rate? • Is there a cap on the return? • If so, what is the cap? • Is the PPN callable by the issuer? • If so, when and at what price? • What constitutes an extraordinary event? • What are the issuer’s rights on the occurrence of an extraordinary event?

Minimum Return at Maturity

• Is there a minimum return at maturity? • If so, what is the minimum return?

Coupon

• Is there a coupon? • If so, at what frequency is it paid? • How is it calculated? • Is it paid as interest or return of capital?

Term

• What is the term of the PPN? Principal Protection

• Is the principal protection worth paying for? Exchange Listing

• Will the PPN be listed for trading on an exchange such as the TSX?


Redemption Rights

• Are there redemption rights? • If so, how is the redemption price determined? • If the redemption is at NAV, how is NAV calculated? • How frequently may the redemption rights be exercised? • Under which circumstances may the redemption rights be suspended? • How much notice of redemption must be given? • Is there a ceiling on the amount of total redemptions on a redemption date? • If so, how are redemption requests fulfilled if the amount of redemption requests

exceeds the ceiling? • How long after the redemption date will the redemption proceeds be paid to the

investor? • Are there redemption fees? • If so, what is the redemption fee schedule? • Is there an early redemption charge? • If so, how is it calculated?

Dealer-maintained Secondary Market

• Will the PPN be traded in a dealer-maintained secondary market? • On which factors, if any, is the dealer’s commitment to maintain a market

conditional? • Will the secondary market be maintained throughout the period from issue date to

maturity date? • Is there a commitment to a maximum bid-ask spread? • Does the dealer have the resources to maintain a secondary market?

Sales Charges

• Is an initial sales charge available? • If so, what is the maximum commission chargeable to the investor? • Is a deferred sales charge available? • If so, what is the commission payable by the issuer? • Is a reduced deferred sales charge available? • If so, what is the commission payable by the issuer? • Is a trailer fee payable? • If so, what is its size? • By whom is it payable?

Annual Fees and Expenses

• What is the size of the costs, if any, embedded in the price of the product? • Will incentive fees, if any, be based on monthly, quarterly or annual results? • What is the hurdle rate, if any?


• What is the high-water mark, if any? • Is the high-water mark permanent or reset periodically? • If reset periodically, at what interval? • Are the incentive fees of the fund of hedge funds’ adviser based on the

performance of the fund of funds as a whole or of each stand-alone fund? • What is the break-even gross return? (Complete the grid in Table 7.1.)

Eligibility for Registered Accounts

• Is the product eligible for inclusion in registered accounts? Tax Issues

• Will the notes qualify as capital property in the hands of the client? • How will coupons constituting interest, if any, be taxed? • How will coupons which constitute return of capital, if any, be taxed? • How will the minimum return, if any, be taxed? • In what circumstances will interest accrual on a prescribed debt obligation apply? • If redemption rights exist, how will a profit or loss on redemption be taxed? • How will a profit or loss on the disposal of a PPN on a secondary market prior to


Overall Evaluation

• Which factors are particularly significant in the product? • Are there competing products on the market which may meet the same objectives

with lower risk or at lower cost? • Based on your quantitative and qualitative evaluation of the product, and your

knowledge and experience of competing products on the market, should the product be placed on the list of approved products?

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Documents

ue Diligence Guidelines on Principal-protected Notes · Due Diligence Guidelines on Principal-protected Notes 5 I. WHAT IS A PRINCIPAL-PROTECTED NOTE? A principal-protected note (“PPN”)