Explain what principal protected notes (PPNs) are and what must be in place to create them.

FRM® Part I · Financial Markets and Products · Trading Strategies · FRM1.FM.14.b

The idea

A principal protected note returns at least the invested principal at maturity and adds a payoff linked to a risky underlying such as an equity index. The standard construction is a zero-coupon bond maturing on the note date with face value equal to the principal, plus a call option on the underlying bought with the money the bond leaves over. What the bond leaves over is the option budget, the money available for the call. Option budget = face value − bond price. The participation rate is the share of the underlying's gain the investor receives. Participation rate = option budget ÷ cost of the call per unit of notional. Other things equal, higher rates and lower volatility raise it. Low rates or high volatility push it below 100%, or force a cap through a sold higher-strike call. Three things must be in place: the bond, the option, and a creditworthy issuer, because the protection is an unsecured claim on that issuer. On the exam, remember that a note held to maturity loses principal only if the issuer defaults, not if the underlying falls.

Formulas

Option budget of a principal protected note

option budget = F − B

F: the face value of the zero-coupon bond, equal to the principal protected
B: the price today of that zero-coupon bond

Discount the bond with the zero rate and compounding the question gives. Lower rates raise B and shrink the budget.

Participation rate of a principal protected note

participation rate = option budget ÷ call cost

option budget: the money left after buying the zero-coupon bond
call cost: the cost of the call per the same unit of notional

Higher rates and lower volatility raise it. Below 100% the investor gets only part of the gain; a sold higher-strike call can lift it at the price of a cap.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which combination of instruments is the standard construction of a principal protected note?

A zero-coupon bond with face value equal to the principal, plus a put option on the underlyingWhy not: A put pays when the underlying falls, so it gives no participation in a rise; the note's upside comes from a call.
An equity position in the underlying plus a short put optionWhy not: A short put leaves the investor exposed to losses in a fall, so there is no principal protection.
A zero-coupon bond with face value equal to the principal, plus a call option on the underlying - correct
A coupon bond plus a short call option on the underlyingWhy not: Selling a call gives away upside rather than buying participation; the investor needs to hold a long call.

The bond grows to the principal at maturity, which provides the guarantee, and the long call bought with the remaining funds provides participation in the underlying's rise.

A harder one

A bank structures a 3-year principal protected note with 1000 of face value per note. The 3-year zero-coupon rate is 4% with annual compounding. The amount per note left over to buy options after funding the principal guarantee is closest to:

USD 120.00Why not: Treats the 4% as simple interest earned on 1000 for three years instead of discounting the face value at 4% a year.
USD 40.00Why not: Uses a single year of interest and ignores the three years over which the bond accretes.
USD 889.00Why not: This is the cost of the zero-coupon bond, not the money left over after buying it.
USD 111.00 - correct

Bond price = 1000 / 1.04³ = 889.00. Option budget = 1000 - 889.00 = 111.00.

The hardest tier

An issuer prices a 4-year principal protected note with 100% principal protection on an equity index, per 1000 of notional. An at-the-money call on the index costs 150 per 1000 of notional. The 4-year zero-coupon rate (annual compounding) has fallen from 5% to 3% before launch. The participation rate the issuer can now offer is closest to:

118.2%Why not: Uses the old 5% rate, so the budget is too large; the fall in rates leaves less money after funding the bond.
80.0%Why not: Treats 3% as simple interest for four years rather than discounting 1000 at 3% a year.
74.3% - correct
134.5%Why not: Divides the option cost by the budget instead of the budget by the option cost.

Bond cost = 1000/1.03^4 = 888.49; budget = 111.51. Participation = 111.51 / 150 = 74.3%, down from 118.2% at 5%.

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