Structure Note_ Final with edits

Leveraged Technologies Structured Product

Siqi Li - 213393996

Calvin Calce - 213849146

Farazi Ahmed - 213827340

Mathieu Fortier – 213849039

Daniel Monroy - 210919199

A product offering by Stratton Investment BankJune 30th 2015 meeting

The American economy has been recovering since 2008 US economy is recovering and we predict there is still room for the stock market to go up,

especially technology stocks

Conference Board Consumer Confidence IndexUnited States Department of Labor

Jan-11 Jan-12 Jan-13 Jan-14 Jan-153.00%

4.00%

5.00%

6.00%

7.00%

8.00%

9.00%

10.00%

US Unemployment Rate

Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-150

20

40

60

80

100

120

Consumer Confidence Index

Investment Current Landscape

Sector PerformanceHigh Demand Reasons

Technology industry has the highest return among all industry, except healthcare

Anticipated return for the next 18 months high

Provides an investor with the upside enjoyed by a risk-seeking individual, while limiting the downside

1.90%

12.40%

16.27%

10.35%

-10.92%

20.78%

28.58%

16.13%17.72%

26.92%

3.53%

Top 100 Market Cap Sector Return in the last year

　 DescriptionHPR – last

18 months

Tesla Motor Inc.

-American automotive technology company-Focus on producing electric powered vehicles-Trade on NASDAQ-Dominant positioning in renewal energy powered vehicle

72.65%

Apple Inc.

-American technology company-The world’s second largest technology firm based on global revenues-Trade on NASDAQ and DJIA-Enjoy leading market share with regards to consumer products

58.73%

LinkedIn Corporation

-World most popular business networking social media platform-Rely primarily on ad revenues-Enjoy success as public firm with a vast global reach with subscribers -Elected to go public in 2011

-0.49%

Investment Current Landscape

Structured Note Profile The Note has a maturity of 18 months

Features 3 of the most well-known companies in the industry incorporated in one basket Tesla Motors Inc. (60%)

Apple Inc. (20%)

LinkedIn Corporation (20%)

Leveraged of 3, 3:1 upside on a basket of very volatile and lucrative stocks with a 1:1 downside exposure

No principal protection is offered – Downside effect similar to an equity investment

Redemption payments are calculated based on the Holding Period Return after 18 months.

Return are capped at a value of 45%

Distribution in United States only

Modest gains will be transformed into respectable returns following an accelerated upside structure 3:1!

Leveraged Technologies Structured Notes

Suitability

Target Investors

Bullish or moderately bullish expectation in technology market for short term

Able to accept significant loss if the basket decreases below threshold value

Willing to sacrifice upside potential due to capped return

Willing to accept market risk, liquidity risk, and credit risk

Demand will be present from moderately bullish investors on the technology industry in the short-term

Highly attractive product for diversification or speculation purposes for investor who are not fully bullish on technology stocks

Average investor affordability

Notes provide very-attractive short-term bullish exposure to an industry

Notes position can be easily replicated by wealthy investors with a deep knowledge of derivatives products

Leveraged Technology product like this one are not currently offered on the market and investors are provided with a unique investment opportunity

"This product changed our life!We were able to diversify our portfolio and even though the stocks only gained an average of 5%, we received a 15% return on our principal!”

Bring a unique investment opportunity

Product Strategy Recap

Investments

• 18 Months maturity• 3:1 upside exposure with

capped return at 45%• 1:1 downside exposure,

No principal protection offered to customers

Underlying Stocks

• 60% Invested in Tesla Motors Inc.

• 20% invested in LinkedIn Corporation

• 20% invested in Apple Inc.

Call Options

• 2 Long-Calls options bought at-the-money for each underlying stock

• 2 Short-Calls options bought at a return of 15% for each underlying stock

• All the call are bought at time 0 in the same time then underlying stocks

• The whole position is built at the same time.

Tesla Motors IncNASDAQ: TSLA

Produces High Quality Electric Vehicles

Increase in Revenue (59% in 2014)

In 2015, Tesla announced the Powerwall

a battery product for home use

Began construction of a gigafactory:

to support production of a mass-market affordable vehicle

to produce battery packs intended for use in stationary storage

to improve robustness of the electrical grid

to reduce energy costs for businesses and residences

to provide a backup supply of power

LinkedIn CorpNYSE: LNKD

Business-oriented Social Networking Service

In March 2015, more than 364 million users in more than 200 countries and territories

Increase in Revenue (2014: +45%) with a market capitalization of $27bn

Forward P/E Ratio of 64.94

Filed for an initial public offering in January 2011

Latest acquire: Lynda.com (an e-learning website) for 1.5 bn (April 9th 2015)

Lynda.com helps users to understand business, technology, software, and creative skills through videos

Apple Inc.NASDAQ:AAPL Produces consumer electronics, computer software, online services, and personal computers

Moderate increase in Revenue (2014: 7%)

Market Advantage & Brand Power

Well-known hardware products:

Mac line of computers

iPod media player

iPhone smartphone

iPad tablet computer

Apple Watch smartwatch

On the way to be the first company to reach a $ 1 Trillion Market Capitalization

Latest Release: Apple Music (June 30th 2015)

A music streaming service with the Internet radio station Beats 1

Capital Market Assumption – Pricing Model

Tesla Motors Apple LinkedIn

Inception Price (S) $268.26 $125.43 $206.63

Strike Price (K) $268.26 $125.43 $206.63

Strike Price at the Cap $308.2 $144.2 $237.6

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

Volatility 49.85% 22.62% 41.01%

Dividend yield 0% 0% 0%

Investment Period (T) 18 months 18

months18

monthsWeighted

Stocks 60% 20% 20%

Risk-free rate (0.6%) All 3 stocks of our underlying 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 from the Federal Reserve.

Stock price follow random walk and are log normally distributed

Dividends (0%)

Variance: For each stock in the basket, we first averaged and then

annualized their historical volatility in the last 2 years. Assuming respective variance would be constant with their

last 2 years average over the next 18 months investment period.

Option Long position in At-the-money European Call Option Short position in European Call Option At the Cap Rate

Structured Note Implementation-Step 1

1. Breakdown of components Purchase of the underlying assets: Tesla Motors Inc., Apple Inc. and LinkedIn Corporation

Purchase of two long call options at-the-money for each underlying assets purchased

Sell (short) of two call options at a return of 15% for each underlying assets purchased to hedge risk and be able to repay customer

Implementation Steps

Tesla Motors

Stock Price: $268.26

At-the-Money Call

Short Call at the Cap:

LinkedIn


At-the-Money Call

Short Call at the Cap

Apple


At-the-Money Call

Short Call at the Cap


2. Allocation of weights Weights were allocated based on stocks volatility

Highest volatile stock was allocated 60% of the weight in order to maximize note’s volatility, Tesla Motors Inc. (60%)

Minimum weight of 20% allocated to the least volatile stock, Apple Inc. (20%)

The remaining stock was allocated 20% of the weight, LinkedIn (20%)

Weights allocated to the stocks will maximize the likelihood of significant upward movements.


Apple

20%

LinkedIn

20%

Tesla

60%


3. Calculation of Correlations between stocks Co-movement were calculated based on the correlation of the daily log-normal returns of Tesla

Motors Inc., Apple Inc. and LinkedIn Corporation for the past 2 years


Correlation Matrix

Tesla Apple LinkedIn

Tesla 1 0.16306 0.29877

Apple 0.16306 1 0.08986

LinkedIn 0.29877 0.08962 1

7/1/2013 7/1/20140

50

100

150

200

250

300

350

Tesla Motors Apple LinkedIn

Sto

ck P

rice

s


4. Cholesky Decomposition Correlation matrix decomposed to get a lower-

triangular L matrix. Cholesky Decomposition is the decomposition of a positive-definite matrix into a lower triangular matrix. A = LL* . L is the lower triangle and L* is the transpose.


Cholesky Decomposition


Tesla 1 0.00 0.00

Apple 0.16306 1 0.00

LinkedIn 0.29877 0.08962 1

Correlation Matrix


Tesla 1 0.16306 0.29877

Apple 0.16306 1 0.08986

LinkedIn 0.29877 0.08962 1


5. Marsaglia-Bray Calculation Create a vector of 3 Gaussian randomly changing normally inversed variables

Multiply the vector by the Cholesky matrix and add the results


Cholesky Decomposition


Tesla 1 0.00 0.00

Apple 0.16306 1 0.00

LinkedIn 0.29877 0.08962 1

Gaussian Random #

0.20964

0.56770

-1.08948

Summation

0.20964

0.59428

-0.95241

= NORMSINV(RAND())


6. Brownian Motion Implementation Once the three numbers are created using the Marsaglia-Bray, they are

implemented into the Geometric Brownian Motion to create the shock

This is implemented into each individual stock in the leveraged structured product


Summation

0.20964

0.59428

-0.95241

𝑆𝑡+Ϫ 𝑡=𝑆𝑡∗𝑒𝑥𝑝((µ𝑖− 12𝜎 𝑖

2)Ϫ 𝑡+𝜎 𝑖√Ϫ 𝑡𝜙 𝑖))Stock Starting

Stock PricesSimulated

Stock Prices

Tesla $268.26 $255.14

LinkedIn $206.63 $207.42

Apple $125.43 $96


7. Payoff for Call Options Now that the three stock Prices have been simulated, start working on the

payoffs in order the price the options through Monte Carlo Simulation

Price both the two Calls at the money and the two short calls out of the money for each of the three stocks.

In order to price individual options, we look at the payoffs from each of the stock prices. For example:

Repeat Step, for the other two stocks


Stock Starting Stock Prices

Simulated Stock Prices

LinkedIn $206.63 $207.42

¿𝑃𝑎𝑦𝑜𝑓𝑓 𝐿𝑖𝑛𝑘𝑒𝑑𝐼𝑛=MAX ($207.42−$206.63 ,0)=$ 0.79

Strike At-the- money Strike at the Cap rate (15%)

$206.63 $237.62

¿𝑃𝑎𝑦𝑜𝑓𝑓 𝐿𝑖𝑛𝑘𝑒𝑑𝐼𝑛=𝑀𝐼𝑁 ($237.62−$207.42 ,0 )=$0


8. Assign the number of simulations () Repeat steps 5 -7 in order to have number of observations for stock prices, and

therefore payoffs for both long call options and short call options.

Once number if simulations have been ran, the structure cost can be calculated

Structure Value Using Monte Carlo:

$250.72


𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒𝑉𝑎𝑙𝑢𝑒=∑ 𝐴𝑠𝑠𝑒𝑡𝑃𝑟𝑖𝑐𝑒𝑖+(𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗(𝑆𝑢𝑚𝑜𝑓𝐿𝐶𝑃𝑎𝑦𝑜𝑓𝑓 𝑖𝑁 )−𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗( 𝑆𝑢𝑚𝑜𝑓𝑆𝐶𝑃𝑎𝑦𝑜𝑓𝑓 𝑖𝑁 ))∗ h𝑤𝑒𝑖𝑔 𝑡𝑖

Structured Note Using Closed Form

Use Black-Scholes to Price Options Once the options are priced using the Black-Scholes model, the model

becomes really easy to price

The formula below is used for this pricing

$250.77


𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒𝑉𝑎𝑙𝑢𝑒=∑ 𝐴𝑠𝑠𝑒𝑡𝑃𝑟𝑖𝑐𝑒𝑖+ (𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗𝐿𝐶𝑂𝑝𝑡𝑖𝑜𝑛−𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒∗𝑆𝐶𝑂𝑝𝑡𝑖𝑜𝑛 )∗ h𝑤𝑒𝑖𝑔 𝑡 𝑖Company Tesla LinkedIn Apple

Stock Price $268.26 $206.63 $125.43

2 Call Options (ATM)

130.52 83.44 28.65

2 Short Calls (Cap) (103.24) (61.69) (15.25)

Total Cost 295.54 228.38 138.83

Weight 60% 20% 20%

Structured Note Fair Market Value

Use the closed form solution From the closed form solution, we add a markup to the price of around 2%,

for a total final structure price of:

$250.77 + $4.23

Total Price = $255

Why was Monte Carlo implemented, if we used Closed form?

The structure of the Monte Carlo simulation was used for the risk management department in order to arrive at an expected payoff

Fair Market Value

Payoff ProfileStructure

Initial starting value: $255 -weighting of the underlying stocks

Terminal value calculated using same weights at T (18 months)

Redemption values calculated based upon these weighted baskets

Positive returns: times a factor of 3

-capped return at 45%

Negative returns: on a 1-to-1 basis - principal amount returned to the investor; No principal protection

105114123132141150159168177186195204213222231240249258267276285294303312321330339348357366375384393402411420429438

($150)

($100)

($50)

$0

$50

$100

$150

$200

$250

Investor Payoff

Investor Payoff Stock Price at T

Share Price

Pay

off

𝑯 𝑷𝑹=(𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆¿¿𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏𝑫𝒂𝒕𝒆−𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆)

𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆

¿

Leveraged Basket Product PricingPricing the Product

Capped Return = 45% of $255 = $115Capped Rate = 15%

Below $255 ~> Stock Price

Above $255 ~> 2 Long Calls

Share Price > $ 2553X Return (1 Stock & 2 Call Options)

Capped Rate of 15% ~> 2 Short Calls

After Cap Rate: Effect of 1 Share & 2 Long Calls = Effect of 2 Short Calls

Price of Product = $255𝑯 𝑷𝑹=

(𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆¿¿𝑽𝒂𝒍𝒖𝒂𝒕𝒊𝒐𝒏𝑫𝒂𝒕𝒆−𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆)𝑬𝒏𝒅𝑽𝒂𝒍𝒖𝒆𝑰𝒔𝒔𝒖𝒆𝑫𝒂𝒕𝒆

¿

105119133147161175189203217231245259273287301315329343357371385399413427441455469483497

($150)

($100)

($50)

$0

$50

$100

$150

$200

$250

$300 Pricing the Product

Investor Payoff Stock Price at T 2 Long Calls + Share

Share Prices

Payoff

Basket Return: -9%

You Receive: -9%1-to-1 Downside

Scenario Analysis 1 - Downside

L = -7.5%A = +3.7%

0.0 0.3 0.6 0.9 1.2 1.5$0

$50

$100

$150

$200

$250

$300

$350

Tesla Linkedin Apple

Time in Years

Share

Pri

ce T = -

13.7%

A = +12%

T = +25%

L = -17%

Basket Return: 14%

You Receive: +42%3-to-1 UPSIDE

Scenario Analysis 2 – Upside (below cap)

0.0 0.3 0.6 0.9 1.2 1.5$0

$50

$100

$150

$200

$250

$300

$350

$400


Time in Years

Share

Pri

ce

T = +52%

A = -25%

Basket Return: 28%

You Receive: +45%Capped Return

L = +11%

Scenario Analysis 3 – above cap

0.0 0.3 0.6 0.9 1.2 1.5$0

$100

$200

$300

$400

$500

$600


Time in Years

Share

Pri

ce

Fee Structure

A total selling concession fee of 1.5% Underwriting Fee and Marketing Fee (0.5%)

Total amount invested to market the notes

Lower amount than usually required due to the simplicity of the product and relative ease of building the position

Broker Fee (1%) Distribution of the notes through usual market and known network

Notes are only made available on the American Market, and purchased by US Citizens

The fee structure was determined based on the special feature of the product and benchmark on what the bank usually charges

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

Trading

Not listed on any exchange market

No secondary market

May receive less than invested if

liquidate before maturity

Notes will be redeemed after 18 months

Plan of Distribution

2. Resell the securities

1. Able to buy structured notes on their own accounts

To Underwriters

To Agents

& Dealers

Direct Sales

Retail Investors

Suitability

3. Give additional underwriting fees

1. Dealers and agents buy the structured notes at principal

Institutional Investors

Pension Plan

Endowment

Insurance Companies

Risk Profile

2. Resell the structured notes

to the public

3. At variable prices to be determined

Legal Structures

US laws are applicable for the design and the distribution of this structured product

A U.S. Holder will recognize gain or loss upon the sale, exchange or maturity of its notes

The amount should be recognized at maturity.

Long-term capital gain or loss because the note is an 18-month product, longer than one year.

An interest charge would apply

The tax rates applicable is dependent on the state of residence of note’s holder

“The structured note is considered as open transaction that is no debt instrument for US federal income tax purposes.”

“The note could be treated as constructive ownership transaction”.

US Federal Income TaxImplications & Requirements

Internal Revenue Code“Section 1260”

Hedging Strategy In order to provide investors with the required return at maturity date

Purchased 2 long calls at-the-money for each underlying assets

Short 2 calls at a 15% return for each underlying assets

No perfect hedge strategy since we are hedging against a basket by hedging the assets individually

Main reason why competitors offers leveraged return based on Indexes

-100 100 300 500 700 900 1100

Stratton Investment Bank Note Histogram Payoffs

Return

Fre

quency

Monte Carlo Simulation Results

Simulation # 10,000

Average $6.10

Back Testing

Stocks Returns

Tesla Motors Inc. (60%)

72.65%


-0.49%

Apple Inc. (20%) 58.73%

Total Weighted Return

53.08%

Leveraged Portfolio Return

45%

Investment Return if you had invested in the last 18 months – From Jan.1st 2014 to June 30th 2015

All past return data were retrieved from Yahoo Finance

Based on the returns and the model, the bank would have secured a return of $15.09 per issuance, generating an 8.9% return

Back Testing

Stocks Returns

Tesla Motors Inc. (60%)

23.76%


11.97%

Apple Inc. (20%) 66.13%

Total Weighted Return

29.87%

Leveraged Portfolio Return

45%

But what if you would have invested in the company from May 19th 2011 to November 19th 2012

All past return data were retrieved from Yahoo Finance

Based on the returns and the model, the bank would have secured a return of $13.31 per issuance, generating an 11% return.

Investors Risk

• Investors’ returns on the notes may be less than what they would have been if they had directly invested in the underlying stocks.

• The increase in the value of one of the basket stock may be moderated and offset the return of other assets

Investment Risk

• The investment is directly linked to stock’s performance traded on the market and may result in a loss.

• Investors are exposed to market movement for 18 months. • Investors are exposed to volatile technology stocks and to their

respective price movements.

Market Risk

• Return on Investment is directly link to the correlation and return of the basket of stocks.

• If the correlation were to increase it would have a direct impact on the return of an investor.

Correlation Risk

• Ending payments owed on the Structured Note are subject to the credit risk of the issuing bank Stratton Investment Bank. Bank’s credit ratings could deteriorates in the next 18 months, leading to insolvency and an inability to meet obligations.

Issuer Credit Risk

• No secondary market will be provided. • If an investor wants to sell his note before maturity, it might be

impossible to do, or he would have to sell at a price lower than the actual price.

Illiquidity Risk

Issuer Risk

• Subject to a mispricing risk when issuing these notes• A mispricing of the cost required to build the position internally would

potentially affect the profit return the bank gets from selling the note Mispricing Risk

• Stocks chosen and put in the basket, with their respective weights, have high variances and low correlations among each other.

• Potential lowering effect on profit if correlations were to decrease• Margin of profit would be declining.

Correlation Risk

Stocks and Positions Total Cost

1 long call contract at-the-money to buy Tesla Motors for a maturity of 1.5 year (100 contract min)

$65.26 * 100 = $6,526

50 Shares of Tesla Motors $268.26 * 50 = $13,413

1 long call contract at-the-money to buy LinkedIn for a maturity of 1.5 years (100 contract min)

$41.72 * 100 = $4,172

50 shares of LinkedIn $206.63 * 50 = $10,332

1 long call contract at-the-money to buy Apple Inc. for a maturity of 1.5 years (100 contract min)

$14.32 * 100 = $1,432

50 shares of Apple Inc. $125.43 * 50 = $6272

2 short call options (per stock=6) – (100 contract min = 600 contracts)

$9008 (skipped steps for simplicity)

TOTAL COST OF REPLICATION $33,139

Cost as of June 30th 2015 required by clients to build this position

With Stratton, clients are only required an investment of $255 to have the same exposure

Benefit of the Structured Note

Benefits and Drawbacks

Leveraged Technologies Structured Note Benefits

• Small investment required to get a 3:1 leveraged exposure• Note affordability. Replication would require a massive investment• Average Investors have the ability to enjoy accelerated upside potential in equities• Basket leverage feature• Investors enjoy a 3:1 leverage return capped at 45% and still maintain the same initial

downside exposure of 1:1

Leveraged Technologies Structured Note Drawbacks

• As opposed to many notes available on the market, this note does not offer downside protection to investors

• The downside exposure is equivalent to an investment in a stock• Lack of liquidity as no secondary market will be provided to investors, and they should be

ready to hold notes until maturity when investing• Wealthy investors can replicate this position by their selves

Alternative Investments

Direct investment in a basket of stocks

Investors will have to invest in the same proportion and the same stocks.

Downside exposure will be the same, but upside will be 1 to 1 without being capped

Investors will not be able to replicate the exposure without substantial investment

Investors, by investing in only one security, would increase their risk and reduce diversification.

• Investors will not be able to find a unique exposure to a basket of technology stocks like our note does. However they could invest in similar equity alternative investments.

Conclusion

Stratton Investment Bank clientele is given a massive opportunity to invest in three technology stocks for which they could earn a return of 45% in 18 months.

Technology industry has been performing well in the last year

Highly volatile stocks included in the basket

Affordable product for averaged-income investors looking for an exposure to technology stocks.

Take the plunge, get into technology today!

Documents

Structure Note_ Final with edits