Structured Products – Project Report

Presented by: Structured Products Project Report presented to:

Siqi Li - 213393996 Faisal Habib

Calvin Calce- 213849146 Fhabib@schulich.yorku.ca

Farazi Ahmed- 213827340 Analysis of Structured Products

Mathieu Fortier – 213849039 MFIN 5500

Daniel Monroy - 210919199 Schulich

School of Business

July 15th, 2015

Contents Summary ............................................................................................................................................................................. 3

Leveraged Technologies Structured Note – Product Overview .......................................................................................... 3

Terms of the notes ........................................................................................................................................................... 3

Demand ........................................................................................................................................................................... 3

Attractiveness of the product .......................................................................................................................................... 3

Unattractiveness of the product ....................................................................................................................................... 4

Suitability ........................................................................................................................................................................ 4

Description of Underlying Stocks Included In the Basket .............................................................................................. 5

Composition and Fair Market Value of the Notes .............................................................................................................. 5

Capital Market Assumption - Potential for growth and income ..................................................................................... 6

Black-Scholes Assumptions ............................................................................................................................................ 6

Basket of stocks – Correlation Matrix ............................................................................................................................ 7

Payoff Diagram of the Leveraged Technologies Structured Note .................................................................................. 7

Issuer Hedging Strategy .................................................................................................................................................. 8

Construction Challenges ................................................................................................................................................. 8

Scenario Analysis ................................................................................................................................................................ 9

Fee Structure ....................................................................................................................................................................... 9

Sales Channel (Distribution) ............................................................................................................................................. 10

Through Underwriters ................................................................................................................................................... 10

Through dealers and agents ........................................................................................................................................... 10

Through direct sales channels ....................................................................................................................................... 10

Trading .............................................................................................................................................................................. 10

Alternative Investments .................................................................................................................................................... 10

Risk Management ............................................................................................................................................................. 11

Investor Risk ................................................................................................................................................................. 11

Issuer Risk ..................................................................................................................................................................... 12

Regulatory Implication – Law & Taxation matter ............................................................................................................ 12

Summary STRATTON Investment Bank is an American Bank operating solely in the United States. This is the third issuance of the

Leveraged Technologies Structured Note for the bank given the products past success. The following report is a summary

of the important features such as the in-house pricing of the notes, construction overview, payoff for issuer, note

characteristics, suitability, and risk management. The distribution of $12,750,000 Leveraged Technologies Structured

Notes at $255 (50,000 notes) each will begin on June 2nd 2015 and maturity will be 18 months after the issue date. The

maturity date should be on December 31st 2016. The principal invested in the note is at risk, since it is not protected from

any downside. Additionally, the product provides a leveraged upside exposure to the following technology stocks: Tesla

Motors, LinkedIn and Apple.

Leveraged Technologies Structured Note – Product Overview

Terms of the notes

These notes are products that provide investors with an exposure to three technology stocks (Apple, Tesla Motors &

LinkedIn) regrouped together into one basket. The note provides a 3 to 1 exposure to increases in the value of the basket of

stocks, up to a capped value of a 45% return, and a 1 to 1 downside exposure to a decrease in the value of the basket due to

adverse market conditions. The investment period will last for 18 months. The basket return is measured over the holding

period from the closing level on the issue date to the closing level applicable on the closing valuation date after 18 months.

100% of the invested capital is at risk, with no principal protection.

𝑯𝒐𝒍𝒅𝒊𝒏𝒈 𝑷𝒆𝒓𝒊𝒐𝒅 𝑹𝒆𝒕𝒖𝒓𝒏 = (𝑬𝒏𝒅 𝑽𝒂𝒍𝒖𝒆𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏 𝑫𝒂𝒕𝒆 − 𝑬𝒏𝒅 𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆 𝑫𝒂𝒕𝒆)

𝑬𝒏𝒅 𝑽𝒂𝒍𝒖𝒆𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏 𝑫𝒂𝒕𝒆

⁄

This investment product is designed for investors that anticipate the three stocks included in the basket will grow at a

moderate rate in the next 18 months, and seek an accelerated growth that we offer. These investors will most likely be

looking to diversify their portfolio through exposure to the technology sector.

Demand

Demand will be present from investors who are moderately bullish on the technology industry in the short term, however

are unwilling to undertake substantial downside exposure. Additionally, investors who require some exposure to the

technology industry, either for diversification or speculation, but who are not very bullish on tech, will find this proposition

attractive. Through the use of our proprietary hedging and derivative implementation, our product offers 3 to 1 accelerated

upside returns, while being able to retain the same 1 to 1 risks on the downside, given that the prospective investor is willing

to sacrifice some upside through a capped return, aggressively established at 45%. This product will be sought out as it

provides an investor with the upside enjoyed by a risk-seeking individual, while limiting the downside to that appropriate

for a more risk-averse investor. It provides very attractive short-term bullish exposure to an industry, leveraging returns,

without subsequently increasing downside risk. Finally, these products can be replicated by any wealthy investors with

access to substantial capital, and therefore they are intended for average-income investors that want to have an exposure to

volatile technology stocks with a low investment required. The product’s structure would be relatively easy to replicate

given a substantial amount of capital, but this is simply not feasible for the everyday investor looking to partake in such a

great strategy. Moreover, it provides a specific exposure to a small number of volatile stocks. This product will reach

investors that are interested in investing in technology stocks, and take some risks to increase their returns. The product

provides an opportunity for everyday investors to gain exposure in a lucrative product that may otherwise not be feasible,

which will be discussed thoroughly in the benefits section.

This type of structured product, consisting of a basket featuring stocks solely in the technology industry, is not currently

offered on this market. This type of product provides many new investors with the opportunity to gain exposure in this

sector, however with more attractive risk reward incentives than would usually be feasible by the average investor. Many

investors who may not have initially invested in the technology industry directly can turn to a product such as ours, which

carries 3 well known and established booming stocks that are well known worldwide, all at a reduced cost.

Attractiveness of the product

One of the major attractions of this note is the fact that average investors will now be able to afford purchase a participation

in the structured product to facilitate an exposure to technology stocks such as Tesla, Apple and LinkedIn. These stocks are

currently selling for relatively high prices, especially Tesla at close to $300. For an investor to replicate the type of exposure

we are providing here, let’s examine first the structure of purchasing call options. For simplicity, let’s assume the investor

would like to replicate this structure without imposing a cap. An at the money call option for Tesla is currently selling for

approximately $65, which will subsequently translate into $6,500 following the purchase of the necessary minimum of 100

contracts, or 100 call options. To sustain a leverage ratio of 3 to 1, 2 call options are required for every 1 underlying share,

and so 50 shares of Tesla are required for an overall position of 3:1. For simplicity, assuming Tesla was trading for a round

$300 per share figure, this would equate to an additional $15,000 investment. Ultimately, solely replicating a 3 to 1 uncapped

upside with a 1 to 1 upside would cost an investor $21,500. Now, assuming this average investor had such a substantial

margin that he was able to short 100 options, at the cap rate, and assuming a price of $50 each option, this would equate to

a premium received of $5000. If this investor did have this substantial margin, he would still sustain a $16,500 cost to

replicate this position we offer. Let’s remember, this is before transaction costs and that this only represents one stock,

whereas our product includes 3. However, our Leveraged Technologies Structured Note provides investors an exposure to

these assets given this type of structure at an affordable price of only $255. This is because the investors are actually

purchasing a piece of our entire basket of weighted equity. They are then able to choose the amount of exposure to these

stocks that they desire and subsequently can enjoy this leveraged exposure without the substantial capital required, as

demonstrated above. Due to their affordability, they will be easily accessible to the middle-income and average investors

who are looking for some exposure in the technology sector, whether it is for diversification needs or solely speculation.

Our product provides the average investor the ability to enjoy accelerated upside potential in equities that may not have

otherwise been affordable. Given the accelerated returns, even a relatively small exposure through our product can prove to

be beneficial and attractive for those who would otherwise find this type of market exposure financially unfeasible. This is

the only leveraged basket in the market currently which focuses solely on the technology industry, and we believe immense

popularity will be given to it.

Even if the notes do not provide downside-protection, investors should be attracted to the upside potential and the exposure

given to this specific asset class and position’s overall risk reward proposition. After all, the downside exposure is equivalent

to that of a direct investment, and not the usual downside associated with being so highly leveraged. Due to the feature of

leverage, as soon as the underlying basket of assets generates positive returns, those returns are tripled up to a certain limit.

A return of 5% from the basket of assets, which would usually be considered a poor return for these types of equities, would

produce a return of 15% through the use of our product. By directly investing in the market, investors would still have the

same downside, but their upside would be limited to the return of the market, which in this case would be 5%. This is the

primary reason why this product is attractive to investors who are ready to accept sensible downside risk and that have

moderately bullish expectations on the technology industry. Without the use of our product, an investor with only

moderately bullish expectations of the technology sector may not decide to gain the exposure as they are accepting

substantial volatility without much expectation of an upside, but the same potential for a poor downside. Our product allows

these same investors to enjoy 3 times the upside potential while maintaining the same initial downside exposure, all the

while, mitigating the costs a structure like this would usually entail.

Unattractiveness of the product

As opposed to many notes available on the market, our notes do not offer downside protection. Holders of the notes are

exposed to 100% of the fall in price of the underlying assets within the basket. Essentially, the downside exposure is

equivalent to that experienced if the investor had directly invested in these equities. It is commonly known that markets

are more volatile when interest rates are low. In the current market, a surge in stock prices could be experienced, but a

decline could also come to fruition, like the price correction experienced in October and November 2014. However, this is

solely a tradeoff to the accelerated upside these investors will now be able to enjoy. Those looking to add technology to

their portfolio for whatever reason will be more inclined to do so through the use of our product than a direct investment,

given only moderately bullish expectations as explained. Additionally, the investor may choose to hedge his exposure

however they see fit, which can easily be implemented to mitigate some of the downside potential.

Additionally, no secondary market will be provided to investors, and they should be prepared to hold the note until maturity

when investing. As such, solely an 18 month investment horizon should be sought out when our product is utilized. Actually,

this lack of liquidity is an issue investors will need to consider when investing in a structured note in general. Notes are not

listed on any securities exchange as the issued volume is usually very low, with only 50,000 notes being offered in our case.

We anticipate the trading volume to be low and mostly non-existent. Our bank is the only provider of a daily secondary

market, but we are in no way obligated to do so and requests will be dealt with on an individual basis.

Suitability

The product is intended for investors who hold a short-term and moderately bullish view on the technology industry, and

so those seeking long-term exposure are not targeted. The product is not suitable for any individuals who are looking to sell

the product before maturity, as it is intended to be held for the entirety of the investment horizon. The product does not

provide any ownership in the equity of the underlying stocks, and so any investors seeking this type of ownership are not

targeted. Although the upside and downside proposition is attractive, this product does not target any investors looking to

hedge their downside risk as this position introduces the same downside risk as a direct investment in the equity. Investor’s

looking for a diversified industry outlook are not targeted as the leveraged basket is made up of solely 3 securities, with the

main priority of generating accelerated upside gains while adding a modest exposure to the technology industry. Investors

seeking guaranteed returns should look elsewhere, as these products are not principal protected and returns carry no

guarantees. The product offers accelerated, but capped returns, and so investors seeking returns in excess of 45% are not

targeted.

The following is a list of investors targeted by this notes and for which the exposure would be suitable;

Investor’s anticipation of the market is that it will increase over the next 18 months, moderate or drastic, from the

Starting Value to the Ending Value.

Investors can accept that their investment will result in a loss, which could be significant, if the basket value

decreases at maturity relative to its value at issuance.

Investors are willing to accept that a secondary market is not expected to develop for the notes, and understand that

the market prices for the notes may be less than the amount originally invested if they decide to liquidate prior to

maturity.

Investors are ready to assume our credit risk for all payments related to the ownership of the notes.

Investors that are not suitable for this leveraged basket structured product are included in the following list;

Investors believe that the market will decrease from its Starting Value level in the next 18 months or that it will not

increase sufficiently over the term of the notes to provide a desired return for the risk it represents.

Investors seek 100% principal protection or to be protected up to a certain percentage of their losses. This note does

not provide any downside risk protection and therefore their principal is entirely at risk.

This note, even if derived from a basket of stocks, does not provide direct exposure to technology stocks.

Investors seek an investment for which there will be a liquid secondary market.

Investors are unwilling or are unable to sustain the market risk or our credit risk inherent in the notes

Description of Underlying Stocks Included In the Basket

Tesla is an American automotive technology company which primarily focuses on producing electric powered vehicles.

Tesla’s stock trades on the NASDAQ and is unarguably one of the most interesting stocks in today’s technology industry.

Following Tesla’s initial public offering in 2010, they generated their first profits in 2013 and have been surging since. They

have enjoyed the advantage of being first to market in offering a premium electric vehicle. Following the introduction of

their newly developed entry level vehicle, the Model X, paired with the integration of their autopilot programming, we

believe Tesla is a great aggressive investment.

Apple is an American technology company and the world’s second largest technology firm based on global revenues. Its

stock trades on the NASDAQ and was added to the Dow Jones Industrial Average earlier this year in 2015. Apple has

enjoyed leading market share with regards to consumer products such as smartphones and tablets. As Apple has experienced

top line growth following the release of their new smart watch, the iWatch, we believe Apple’s stock will be a greater

performer in the near future and will prove to beneficial over the next 18 months.

LinkedIn is the world’s most popular business networking social media platform with a business model relying primarily

on ad revenues, similar to Google. It enjoyed much success as public firm with a vast global reach with subscribers and

elected to go public in 2011. It listed on the NYSE and grew an astonishing 170%. It has since generated great returns for

its investors and is one of the more watched and known stocks in the industry, given its growing popularity in business

networking. LinkedIn’s recent acquisition of Lynda was well received by the market and we believe their stock will continue

to appreciate along with its growing market penetration.

Composition and Fair Market Value of the Notes This product offers the customer a 3 to 1 capped upside exposure, while at the same time being able to maintain a 1 to 1

downside risk, similar to a direct investment without the downside effects of leverage. As such, we have replicated this

portfolio through a combination of the underlying assets and various derivatives. Firstly, we purchase the underlying assets.

These provide a 1 to 1 upside, and a 1 to 1 downside. Now, in order to leverage the upside on a 3 to 1 basis, we have

purchased 2 long call options on this underlying asset, both with strike prices set at the price we paid for the underlying

asset; essentially, these are at-the-money call options. At this point, we have replicated a 3 to 1 upside and a 1 to 1 upside

for the underlying asset. To introduce the capped return of 45%, we have sold 2 call options, with strike prices equal to a

45% capital appreciation on the underlying asset. Only 2 call options were needed to be sold here as opposed to 3, as the

customer is liable for any decrease of the underlying asset on a 1 to 1 basis. The application of this derivative strategy

ensures as perfect of a hedge possible for the bank. All of the options utilized in the strategy will carry a maturity of 18

months to match the maturity of our product. Of course, this structure has to be repeated for each of the three underlying

assets. This clearly translates into a very costly structure that an average investor would have difficulty trying to replicate,

given the substantial liquidity required. Because of the call options and the long position in the underlying stocks, we are

able to provide a 300% participation in the return of the basket up to a capped amount.

Now, in order to create the price path simulations for each stock contained in the underlying basket of assets (Apple, Tesla

& LinkedIn) we used the Cholesky Matrix and the generation of 3 random numbers from Marsaglia-Bray. We then

multiplied the Cholesky matrix with the vector of random numbers from Marsaglia-Bray, summing the products together

for three continuously changing random numbers. This is done to account for the correlations existing between the stocks.

Once the correlated random numbers were created, we used the stock simulation model and implemented the correlation

random numbers to create three different stock prices. A Monte Carlo simulation for the aforementioned process was run

10,000 times, in order to calculate the various options on the three stocks, and subsequently, the total cost of building this

position and price for the consumer.

Weights were determined based on the volatility of the different stocks. In order to maximize volatility while still ensuring

diversity, we capped the weight for the highest volatile stock at 60% and put a minimum weight of 20% representation

within the basket. Tesla Motors, being the most volatile stock of the basket, represents a weight of 60% of the basket. Apple,

because it has the lowest variance, has a weight of 20% of the basket and LinkedIn weight is 20%. This focus on volatility

was implemented in efforts to maximize the likelihood of significant upward movements and subsequently greater returns

for the investors. However, the remaining two stocks have equal weights to ensure some level of diversification was present.

Ultimately, we ended up with a FMV of $250.77 to build the entire position at the time of issuance, including both the

underlying assets and their accompanying derivatives. We will be selling the product with a margin equal to approximately

2% at a round figure of $255 to cover the 1.5% of fees attached to our product and still keep an extra earning for each note,

which will be really small.

Capital Market Assumption - Potential for growth and income

The American economy has been recovering from the 2008 recession and economic data has showed lingering effects ever

since. The Consumer Confidence Index has been continually increasing in the last 18 months, demonstrating that faith in

economy is being restored. May 2015’s unemployment rate of 5.5% is at an all-time low since the economic crisis1. Large

American companies have been stockpiling cash derived from their operations in order to avoid the lack of credit sustained

throughout the crisis. Apple is a great example of a company sitting on a substantial sum of cash and we believe this cash

flow will be used to finance large acquisitions or will be used internally to finance large projects and development2. As

previously stated in the Black-Scholes assumptions, we assume that an interest rate forecast of 0.6% is logical given the US

T-Bills rates currently sit below this. We suggest that even if the Federal Reserve increases the rates in the fourth quarter of

2015, we would anticipate a maximum hike of a quarter of a percent3. As such, we believe we have chosen an accurate rate.

We are also comfortable with the historical volatility of the stocks included in the basket.

Black-Scholes Assumptions

The Black-Scholes assumptions taken to price the call and the price path of the underlying assets will be crucial in the

overall pricing of our structured notes. We do our best to match the maturity of our product with the historical age of our

data. Seeing as it is an 18-month maturity, we tend to utilize 2-year historical data. Here are the major assumptions that we

made on key variables;

1. Risk-free rate: All 3 stocks of our underlying basket are US stocks traded on the NASDAQ or the S&P 500 and will be

distributed by our American Bank, STRATTON Investment Bank. They are sensitive to the American economy and

therefore US interest rates will be used. A 0.6% risk-free rate corresponds to the rate on a horizon of 2 years of past data

from the Federal Reserve. This is not perfectly matching with our investment horizon of 18 months, but we believe this

to be an accurate enough proxy.

2. Stock price: It was assumed they follow a random walk and the prices are log normally distributed.

1 http://data.bls.gov/timeseries/LNS14000000, United States Department of Labor: Bureau of Labor Statistics, retrieved June 29th 2 Apple 2014 Annual Report 3 U.S Department of Treasury, Treasury Bill Rates, http://www.treasury.gov/resource-center/data-chart-center/interest-

rates/Pages/TextView.aspx?data=billraterates/Pages/TextView.aspx?data=billrates, retrieved on June 29th 2015

3. Variance: For each stock in the basket, we first averaged and then annualized their historical volatility in the last 2 years.

We assumed their variance over the past 2 years would be consistent with what will be experienced during the 18 month

horizon of the product.

4. Dividends: Neither the product nor the stocks pay any dividends. Apple has been paying quarterly dividends in the last 4

quarters. However, by analyzing their financials and dividend policy, it was noticed that they don’t have any dividends

policy in place and could cease to pay a dividend whenever they want. For this reason, we considered Apple dividend

yield equaled to 0%, as we believe including their discretionary dividends would be inaccurate.

5. Embedded options in the product are European. They are to be exercised solely at the 18-month mark, and not to be traded

or otherwise altered in any way.

6. No transactions costs have been included within our simulations.

Apple Inc. Tesla Motors Inc. LinkedIn Inception Price (S) $125.43 $268.26 $206.63

Strike Price (K) $125.43 $268.26 $206.63

Risk-Free Rate (RF) 0.6% 0.6% 0.6%

Volatility 22.62% 49.85% 41.01%

Dividend yield 0% 0% 0%

Horizon 18 months 18 months 18 months

Weighted of Stocks 20% 60% 20%

Basket of stocks – Correlation Matrix

Our in-house valuation of the Leveraged Technologies Structured Note takes into consideration the co-movement between

the underlying assets which compose our basket. Co-movement was

calculated based on the correlation of the daily log-normal returns of Tesla

Motors, Apple, and LinkedIn for the past 2 years. A multivariate normal was

generated to account for the correlations between stocks. The table below

shows the correlation among the assets and their Cholesky decomposition.

The correlation matrix was decomposed so we could get the lower-triangular

L matrix and it is transposed so that you can see in the Cholesky

Decomposition table. A Cholesky Decomposition is only the decomposition

of a positive-definite matrix into a lower triangular matrix. Decomposition of the form of A = LL* where L is the lower

triangular matrix and L* is the transpose. In order to create the stock price simulation, the Cholesky matrix shown above

was used as already outlined in the “Fair Market Value” section to account for the correlations of the different stocks

included in the basket. When stocks are highly correlated amongst each other and they are put in the same basket, their

correlation reduces the variance of the entire portfolio. The goal of this product is to provide customers with exposure to

the most known and volatile technology stocks without exposing them to the downsides of a substantial variance. Our

customers will enjoy this volatility solely in terms of their upside exposure. After several simulations, we were able to

identify 3 large technology stocks well-known by the general public which also demonstrate low correlations amongst each

other, subsequently benefitting the overall variance of the basket and ultimately the potential gain for our customers.

Payoff Diagram of the Leveraged Technologies Structured Note

Investors have a 1 to 1 exposure for all downside returns, as if they had directly invested in these assets. For the upside, the

leverage is 3 to 1 and returns are capped at 45%. This means that as long as the basket has a return of 15% or more, the

investor will receive a return on its investment of 45%. When the underlying basket demonstrates an average appreciation

between 15% and 45%, the holder of this structured note will receive a capped 45% return. As they have reached the capped

rate, the leverage will not be follow a 3 to 1 structure, but will remain fixed at a 45% return. However, at any total return

from our product which is below 45%, the investor is still better off with the returns we provide. Obviously, if the underlying

asset experiences capital gains of greater than 45% in 18 months, our product’s return will be below that of a direct

investment. Clearly, this is unlikely and on average an investor will be better off through the use of our product, helping to

explain the substantial popularity with this type of note. This represents a very attractive proposition as a 45% appreciation

in 18 months is highly unlikely, and the risk reward balance is unarguably more advantageous with our product versus a

direct investment in the equity.

TESLA Apple LinkedIn

TESLA 1.000000 0.163068 0.298778

Apple 0.163068 1.000000 0.089862

LinkedIn 0.298778 0.089862 1.000000

TESLA Apple LinkedIn

TESLA 1 0.000000 0.000000

Apple 0.163068 1 0.000000

LinkedIn 0.298778 0.041699 1

Correlation Matrix

Cholesky Decomposition

In case of an increase or a decrease in stock

prices, our investors receive the gains and

sustain the losses. The bank will

conservatively reap profits from about a 2%

margin to be included in the overall price of

this product. Our hedging strategy ensures

the bank will always have enough liquidity

to meet the needs of the customers. We

believe this margin will be more than fair

given the ease of exposure we will be

providing our investors with compared to

the substantial capital required to create

such a scenario. When taking into account

the cost associated with purchasing call

options (given the necessity to purchase

100 contracts on the market), we are

providing the average investor with the opportunity to participate in such a great structure at a subsidized cost.

Issuer Hedging Strategy

The product we are issuing has a 3 to 1 leverage for investors with returns capped at 45%. When stock returns rise, but

remains below 15%, investors are earning three times the return of the underlying stocks and issuers are earning no profit,

other than the markup. When stock prices increase even further, where returns increase by more than 15%, investors are

still earning a maximum 45% return, however the issuer may retain the excess returns over the cap. STRATTON Investment

Bank hedges its liquidity risk by buying two long calls and a position in each underlying stocks, creating the 3 to 1 leverage

position. The long-call and stock positions protect us against this 3 to 1 upside potential owed to the investors. Additionally,

we short two calls on each of the underlying stocks included in the portfolio, each with a strike price equal to a 15% capital

appreciation level to create the cap. These short calls are sold at the same time the long positions are taken. All of these

positions are entered at time 0 and will mature in exactly 18 months. As explained earlier, a perfect hedge is not feasible as

we are hedging against a basket by hedging the assets individually, but this is the closest hedge we could attain. This is one

of the main reasons why our competitors usually offer leveraged product over indices; it is easier for them to perfectly hedge

a position on the index. Additionally, we add an approximately 2% mark up to our cost when selling to cover our fees.

Following our Monte Carlo analysis which can be seen in our excel model, we are averaging a $6 profit per $255 issue,

including both our mark up and subsequent fees. Clearly, Greek hedging is not required as we will not be trading our options

as they will be held for the entirety of the investment horizon. The options that we will used can almost be considered

European since their maturity is the exact maturity of the structured notes we sell.

Back-Testing: Following our Monte Carlo Simulations, the bank was able to determine that on average, even given the

concerns above, the average internal profit of this position was more than $6 per note. This hedging difficulty is inherent to

the structure of the product in having to hedge all of the underlying assets, but returns are calculated on a basket of stocks

that cannot be perfectly hedged. In order to appropriately test our note, we applied and simulated the performance of our

note based on historical returns. It was found out that in a growing environment like 2011 to 2015, this note will produce

positive returns to the bank. STRATTON Investment Bank expectation for technology stocks in the next 18 months is that

they will continue increasing rapidly in value. For example, from Jan 1st 2014 until June 30th 2015, returns from the basket

have been higher than 45% and the bank would have had earned a return of $15.09 above the costs required for each notes,

and just over $13 generated from May of 2011 through November of 2012. Obviously we were limited in our historical data

given the relatively recent issuing of LinkedIn and Tesla; however, we are justified in having proved historical success.

Construction Challenges

In building this structured product, two major challenges were encountered and are related to the core characteristics of the

product itself. The first major challenge is related to the basket of options. The correlations between stocks in a basket

decrease the value of the options because they decreased the basket variance. The first step to mitigate problems is to

calculate the covariance and correlations that exist between stocks. From there, the Cholesky decomposition can be

calculated and implemented into the Geometric Brownian motion calculation, taking into account the correlation that exists

($150)

($100)

($50)

$0

$50

$100

$150

$200

$250

$300

$105 $155 $205 $255 $305 $355 $405 $455

Pa

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Share Prices

Payoff and Composition

Investor Payoff Stock Price at T

2 Long Calls + Share 2 Short Calls at Cap

between stocks in the leveraged basket. By doing so, we simulated the underlying price paths and we were able to calculate

an average final payoff and to discount it with a Monte Carlo Simulation. Although this process was also done through a

closed form solution, since the structure of this note is not path dependent; we created the different probable stock prices in

order to create a sensible observation of the bank’s ability to cover the promised return under certain market conditions.

The second major challenge was to accurately implement the leverage into the product. This structured note offers an

accelerated return on a 3 to 1 basis, although capped. As such, we needed to find a way to leverage up the returns of each

of the stocks and did it through the use of call options. The call options were embedded in the pricing option after the

simulated returns. Each of the three stocks also have 2 accompanying call options, which along with the underlying asset

themselves creates a 3 to 1 upside for us. Although this is not a perfect method of leveraging the basket as a whole, leveraging

each underlying asset on a standalone basis provides us with the necessary upside exposure to provide our clients their

promised returns.

Lastly, we must address the hedging difficulty inherent in hedging against a basket of assets. The hedge structure covers

most of the costs that will have to be paid by the bank once customers will be claiming back their returns at the end of the

18 months holding period. However, these positions are not perfectly hedged and we were unable to construct an affordable

and full-proof strategy. In an attempt to provide a unique structure, our basket features three different technology stocks. In

terms of hedging, applying these options individually on each stock to hedge against a cumulative basket is simply not

providing a perfect hedge. As such, we expose ourselves to some risk inherent in the overall structure of the product.

Additionally, this hedging strategy is very costly. Purchasing calls at the money carries very heavy premiums, which we are

partially able to cover through the writing of the call options further out of the money. As such, this is a risky proposition

for the bank which is inherent in products of this type. We believe the ancillary revenue generated by offering such an

attractive product will more than compensate for the potential loss resulting from not covering the cost of the hedging

strategy. Finally, although the hedging strategy is costly, we understand this risk and our Monte Carlo simulations suggest

that we should be able to cover these costs on average. Our back testing has supported the success of the aforementioned

strategy using real world data.

Scenario Analysis We generated three scenarios; the first with a negative return,

the second with a positive return under 15% (under the cap), and

lastly a positive return over 15% (above the capped amount).

For the first scenario, the customer loses the same percentage of

-16.6% as the basket. For the second scenario, the customer hits

the leverage factor and benefits from triple the return of +4.5%.

On the final scenario, the return of 22% went above the capped

rate of 15% so the customer will get the maximum return of

three times the capped rate, i.e. 45%.

Fee Structure Our fee structure includes underwriting and marketing fees as well as fees that the bank has to spend for brokers that sell

the product through specific distribution channels. These provisional fees are associated with the issuance of the structured

notes. In total, a selling concession of 1.5% will need to be paid by our bank for various fixed costs. Fees are assumed by

the bank and decrease our proceeds. In this case, the selling price to the public will be $255 and will be reduced by 1.5%

for a net proceed of $251.18 to STRATTON Investment Bank.

t=0 Tesla Linkedin Apple

Stock Price 268.26$ 206.63$ 125.43$

Risk free ( r) 0.60% 0.60% 0.60%

Time (t) 1.5 1.5 1.5

Sigma 49.85% 41.01% 22.62%

Weights 60% 20% 20%

Stock Prices Tesla Linkedin Apple Total Tesla Linkedin Apple Total Tesla Linkedin Apple Total

Monte Carlo Prices 216.60$ 161.50$ 136.33$ 279.91$ 234.79$ 113.74$ 369.07$ 142.06$ 144.61$

Annual Return -19.26% -21.84% 8.69% 4.34% 13.63% -9.32% 37.58% -31.25% 15.29%

Starting Basket 227.37$ 227.37$ 227.37$

Ending Basket 189.53$ 237.65$ 278.78$

Holding Period Return -16.64% 4.52% 22.61%

Customer gets back 212.56$ 289.60$ 369.75$

Customer Invested 255.00$ 255.00$ 255.00$

Total Return -16.64% 13.57% 45.00%

Scenario 3

Capped Amount of 45%

=$268*60%+$206*20%+$125*20%

=$280*60%+$235*20%+$114*20%

= + 4.52% * 3 times =

=$268*60%+$206*20%+$125*20%

=$370*60%+$142*20%+$144*20%

= Cap. Ret of 15% * 3 times =

=$268*60%+$206*20%+$125*20%

=$216*60%+$161*20%+$136*20%

= -16.64% * 1 time =

Scenario 1 Scenario 2

Underwriting, marketing and product development fees will correspond to 0.5% of the initial offering. This 0.5%

represents the total amount that will be invested to market our notes to the general public and to underwrite this

offering. This amount is reasonable as we anticipate significant demand and the underwriter should be able to

liquidate their position with relative ease.

Broker’s fees with regards to our distribution channels correspond to 1% of the initial offering. Broker’s fees include

the distribution of the notes to the market through our known network. Notes will only be made available on the

American market and therefore purchased by US citizens.

The fee structure was determined based on the investments required to market and sell the notes through STRATTON’s

Investment Bank network. The fee structure (especially broker fees) also corresponds to what is usually charged by our

company when issuing a derivate product and it is benchmarked on the fee structure of the competition and market as a

whole. No discount will be provided to investors who purchase a substantial amount of notes in a single transaction. The

public offering, as well as the fee structure, will remain consistent and the note will sell for $255.

Sales Channel (Distribution) The product will be distributed through underwriters, dealers, agents, and directly to retail purchasers and institutional

investors across the USA. The marketed prices will be determined at fixed prices, market prices prevailing at the time of

sale, or negotiated prices based on type of transactions. Underwriters, dealers, and agents who participate in the distribution

of the securities may be underwriters as defined in the Securities Act. Any discounts or commissions that we pay them and

any profit they receive when they resell the securities will be treated as underwriting discounts and commissions under the

Act, and this will subsequently reduce STRATTON Investment Bank’s net proceeds. We will distribute the product directly

to smaller institutional investors, such as small commercial banks and insurance firms, and the rest will be distributed

through brokers. A total of 1% of the proceeds will be allocated to the brokers.

Through Underwriters

Underwriters are able to purchase the structured notes for their own account at the marketed price and resell the securities

in one or more transactions, at any time for any price. We anticipate substantial demand and the low underwriting fees

associated with this product accordingly reflect this fact.

Through dealers and agents

The structured notes are sold to dealers and agents as principals, which we have referred to as brokers throughout the report.

The dealers and agents may then resell the securities to the public at varying prices to be determined internally by their

departments. Broker channel will be the same the bank usually uses. On the first day of the issuance, brokers will have to

sell the notes at their issuing price of $255. Brokers are charging fees of 1%.

Through direct sales channels

Part of the distribution plan includes direct sales to retail and institutional investors. The institutional investors that will be

targeted by this offering are small commercial banks and insurance firms. We want to market to those small retailers so they

can offer the chance to less worthy clients to participate in this offering. Retail purchasers bear the most risk and could

pursue these products with the purpose of hedging, investing, or speculating. In terms of direct sales to retail investors, we

will be focusing on the types of investors outlined in the suitability section but do not intend to extensively be the distributor

of this offering.

Trading STRATTON Investment Bank will not provide a secondary market for these notes, primarily due to the complexity of

pricing and mainly due to the term of the note. These notes are intended to be held for the entirety of the maturity. A note

holder will not receive the principal amount prior to the Maturity Date and the notes will not be listed on any exchange. If

the note holder decides to liquidate prior to maturity he will personally have to find a buyer, and there is no guaranteed

liquid market to sell and therefore, the holder may receive substantially less than the amount he/she previously invested.

Our bank is responsible for the issuance of the notes on July 16th 2015. The issuance will be made directly by the bank and

by its network of brokers. The notes will not be listed on any exchange market and no secondary market will exist.

Alternative Investments Our Leveraged Technologies Structured Notes provide investors with a unique exposure to a basket of technology stocks,

while being able to enjoy an accelerated return. Due to this unique feature, we are confident investors will not be able to

find a substitute to our product, especially when the amount of cost mitigation taking place is assessed

Investors could directly invest in the underlying stocks that make up the composition of our basket. If they want to replicate

the payoff, they would have to invest in the same proportion and the same stocks. Even if they invest this way, their

investment will not demonstrate the same behavior as the product we are offering. Their downside exposure will be the

same, but their upside will be 1 to 1 without being capped. Our product offers a 3 to 1 upside leverage up to a 45% maximum

limit. It has to be noted that by investing this way, the investor will be building a basket of products that requires superior

knowledge of investments. It would be time consuming and the fee structure would be high, as already mentioned.

Another alternative investment investors could seek is to invest in a leveraged ETF. iShares, Vanguard, Horizons, and

Direxion Daily Technology Bull 3X (TECL) all provide leveraged technology ETFs. ETF’s primarily provide exposure to

index, in this case to the S&P Technology Select Sector Index. It could be 3 times bear or bull. In times of positive returns,

the ETF will exhibit similar behavior to the upside of our Leveraged Technologies Structured Note, but would not be capped.

However, it is important to note that although the upside exposure may be competitive with our product, the downside

exposure is much worse, and this is where our product excels. Due to the leverage of 3 to 1, both upside and downside are

accelerated with the ETF. Investors in a 3 times bull spread will lose approximately 30% of the money invested if the index

decline by 10%, at minimum. It is no secret that in times of declining returns, these leveraged ETFs experience compounded

losses and sometimes become more volatile and with greater losses than advertised by their leverage factors, especially if

held for an 18 month period like our product. Our Leveraged Technologies Note provides an accelerated upside, but

maintains a 1 to 1 downside, identical to a direct investment in the underlying without any added leverage. The only tradeoff

is that we cap the returns, although we are sure to do so at an attractive 45% figure, which represents a great 18-month HPR.

This is a major reason why our unique product is appealing. Technology stocks are volatile and investors do not bear the

risk of leveraged downside losses if the technology industry was to behave negatively in the next 18 months, regardless of

the fact that the upside is so highly levered. This would not be a feature enjoyed through the use of leveraged ETFs.

Moreover, our Leveraged Technologies Structured Note provides a unique exposure to a precise basket of three stocks. An

average investor looking to gain exposure in the technology industry will feel confident employing their capital towards

industry leading companies, as opposed to some of the more obscure investments available in the technology sector. Usually,

ETFs will not allow the investors to invest in a small selection of stocks, but rather will invest in a whole index. As such,

the upside potential is not as lucrative as can be experienced with our product.

Risk Management

Investor Risk

Market Risk: This is the prominent risk for investors, as it differs from that of a bond and other fixed coupon products,

relying on the performance of the basket of underlying stocks. The investment may result in a loss and there is no guaranteed

return of principal with this note. The investment horizon is short, being only 18 months, and this means that investors are

exposed to market movements for this period of time. Investors’ returns on the notes may be less than what they would have

been if they had directly invested in the market and bought the underlying stocks in the basket given that this note limits the

return based on a Capped Value. This would only happen if the return of underlying assets has a weighted return greater

than our cap of 45%. In all other cases, the holder of this note will have a leverage replication of the risk of the underlying

if return is positive, and will have the same exposure as investing in the market if the return is negative.

Although our product does not provide investors with a direct exposure to the underlying equities, its return is derived from

the prices of these underlying assets, and so some market risk needs to be accepted by the investors. The bank has no control

on the stocks or their price movements and there is a probability that the technology market will not perform well in the

next 18 months.

Correlation Risk: Returns on the investment are directly linked to the correlation and return of the stocks included in the

basket. We have selected volatile stocks with low correlations between each other. However, if the correlation were to

increase, it would have a direct impact on the return of an investor.

Issuer Credit Risk: Leveraged Technologies Structured Notes are unsecured debt that are owed by our bank. Ending

payments owed on the Structured Notes are also subject to the credit risk of the issuing bank STRATTON Investment

Bank. However, this is a standard risk associated with most products of this nature.

Illiquidity Risk: The bank does not provide a secondary market; therefore, if an investor wants to sell a note in the

secondary market, the price he would receive for the notes, if he is able to sell it, will be less than the price he bought

them at.

Other risks that investors could be exposed to include;

Exchange rate movements, political, and economic events can affect the return on the notes and their value.

In calculating the final level of the basket, the increase in the value of one of the basket stock may be moderated,

or more than offset, by the decline in the value of another stock. There can be no assurance that the final basket

level will be higher than the initial basket level.

Issuer Risk

Mispricing Risk: STRATTON is subject to mispricing risk when issuing these notes. Pricing is determined by averaging

all of the costs the bank has to incur to create the position. From the internal costs, the bank adds a modest premium and

design the price at which it will sell the notes to institutional and retail investors. The premium includes the fees we have to

incur, total fees reduce our internal proceeds, to underwrite and market the notes and a small profit that we want to extract

from the notes for STRATTON investment bank. If we have mispriced the notes, or the correlations among the assets

decrease, the internal cost of creating this product would increase and would potentially affect the profit return we generate

from these notes.

Market Risk: Given the aforementioned hedging strategy, we will also be at risk market wise. This risk however, is not

different than what our bank allows traders to take. For the bank, this product is highly dependent on volatility. We proved

through simulation and back-testing that even if the structured notes present inherent risk, it is a risk that the bank will be

able to sustain.

Correlation Risk: The stocks which make up our basket, with their respective weights, have high variances and low

correlations among each other. It is widely known that the correlations in a basket of underlying decrease the variance of

the portfolio as a whole. This portfolio is currently set up so stocks show small correlations among each other. However,

they still present some positive correlations and this is explained by their operations in the same industry. If the correlation

were to decrease and almost be inexistent it would have a negative effect on the pricing (it would increase) and the margin

of profit of the bank would decline.

Regulatory Implication – Law & Taxation matter The structured note is considered as an “open transaction” that is not a debt instrument for US federal income tax purposes.

Under such category, a U.S. holder should generally recognize gain or loss upon the sale, exchange or maturity of its notes,

in an amount equal to the difference between the amount realized at such time and the U.S. Holder’s tax basis in its notes

(generally the amount paid for the notes). Because the bank does not provide any secondary market, the amount should be

recognized at maturity. Such gain or loss generally should be long-term capital gain or loss because the note is an 18-month

product and longer than one year. The note could be treated as “constructive ownership transaction” within the meaning of

Section 1260 of the Internal Revenue Code of 1986, amended (the “Code”). If and to the extent that section applied, any

gain recognized in respect of the notes that would otherwise be long-term capital gain and that was in excess of the “net

underlying long-term capital gain” (as defined in Section 1260), would be treated as ordinary income, and an interest charge

would apply as if that income had accrued for tax purposes at a constant yield over the notes’ term. The tax rates applicable

are dependent on the state of residence of notes holder and is charged on their income.