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I was looking at principal protected notes (PPN) at a bank (link: CIBC Principal Protected Notes). It says:

  • The return of your CIBC PPN depends on the performance of the underlying assets. (It is possible that no interest may be payable)
  • Regardless of performance, your full principal amount will be repaid at maturity
  • Terms range from 3 to 8 years

Suppose I want a PPN. My question is: why should I buy one from a bank? What advantage do bank PPNs have over one that I create for myself?

As far as I am aware, I can create a PPN by:

  • Buying a high quality bond (e.g. government bond).
  • Using an amount equal to or less than the future coupon(s) from the bond to buy an at-the-money call option (e.g. LEAPS) on an index ETF.

With this arrangement, I cut out the middleman (i.e. the bank), I don't have to worry about the credit risk of the bank, and should I choose to, I will be able to liquidate the PPN at any time without having to wait for the "maturity".

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    But you have to do all that work yourself, rather than letting the bank do it. Basically the same reason many people buy mutual funds rather than trading individual stocks.
    – jamesqf
    May 27 '20 at 16:42
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You are correct. Doing the PPN yourself eliminates the direct and indirect fees as well as avoiding the credit worthiness risk of the issuer and you control the time period of the 'investment'. One thing that you have to look out for with a CIBC PPN would be:

  • Some CIBC PPNs may also have caps, participation rates and/or other limiting features That's where the issuer really takes your money (The participation rate what percent of the gain in the underlying asset, index or benchmark will be earned).

FWIW, I got interested in Structured Index Annuities two years ago. For this product, the insurance company offered about a 10% cap per year along with 10% of downside protection on major indexes. Shortly thereafter I determined that I could replicate the product using options but by doing it myself, I could obtain closer to 20% downside protection for that same cap (a 1:2 ratio). The cap and DP ratio can be shifted by varying the strike price of the options chosen. I have been employing this strategy for the past two years but on a 3-5 month basis rather than one year out because the numbers annualize higher. Even more so now because option premiums are greatly inflated due to higher implied volatility levels.

This last point about higher premiums due to higher implied volatility levels would be a detriment to your strategy because the option component costs more now and with rates down, you'd be receiving less on your bond component.

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Are you sure that when you Long Call and Long Bond, your principal is Guaranteed?

Suppose your principal is $100, and you bought a 2-year ATM Call Option for $14, and a Bond for $86.

2 years later the stock did not move and you lost time value. The Call Option is not worth $14 anymore. Your principal is no longer $100.

On the other hand, your bank could guarantee that your principal is never below $100 (at the expense of capped gains of course).

Furthermore, LEAPS are usually up to 3 years only, far from 8 years.

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    Note that I am not saying that principal protected products are better. These products have obscure pricing and return, and enormous hidden fees. Sub-par on a risk-adjusted basis.
    – base64
    Apr 27 '20 at 6:42
  • Did you miss that the call amount is "equal to or less than the future coupon(s) from the bond"? For this to hold in your scenario, the $86 bond would have to pay a guaranteed $14 in interest, which would make up for the loss of option premium. More realistic if you made it $96 and $4.
    – nanoman
    Apr 27 '20 at 7:11
  • I would be very interested if such free lunch opportunity exists. I used real life Dec 2022 prices.
    – base64
    Apr 27 '20 at 7:15
  • As nanoman stated, you did not include the $14 gain on the bond and that $14 covers the cost of the call. At the end of two years, the bond is worth $100. As for LEAPs that expire in 2+ years, this process would be repeated for the duration. Also, longer term arrangements can be made OTC if there are willing counter parties. Apr 27 '20 at 12:45
  • @BobBaerker Take SPY as an example, can you demonstrate that the strategy in the Question works? I understand that you have been synthetically creating similar positions, but this is not 10-20% downside protection. This is 60-95% downside protection using purely Long Call Long Bond.
    – base64
    Apr 27 '20 at 14:51

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