Barrier Reverse Convertibles: How they work
Barrier Reverse Convertibles (BRCs) are the classics among structured products. They belong to the yield optimization category and are characterized by a predetermined coupon and a certain safety buffer. BRCs are interesting due to their attractive coupons and in markets that are trending sideways.
How a Barrier Reverse Convertible works
Barrier Reverse Convertibles (BRCs) are investment products that belong to the yield optimization category. BRCs are among the most popular structured products.
The key features of the product include the coupon and the barrier. BRCs also have a fixed maturity. The coupon is fixed in advance. Payment of the coupon is independent of the performance of the underlying asset. The barrier serves as a safety buffer. While the product is protected against price setbacks of the underlying up to the barrier, the potential return is limited to the coupon.
In principle, the lower the barrier (i.e. the protection against price setbacks of the underlying), the lower the coupon. The barrier is specified in relation to the price of the underlying at the time of initial fixing. During the term, it is observed whether the price of the underlying touches or falls below the barrier.
A barrier reverse convertible consists of at least one underlying, usually a share, but indices are also possible as underlyings. The price performance of the underlying is decisive for the repayment of the BRC at maturity. There are three possible redemption scenarios.
Scenarios
Scenario 1: The price of the underlying is at or above the strike price at maturity
In this scenario, it does not matter whether the barrier is touched or breached during the term. If the price of the underlying is at or above the strike price at the end of the term, the nominal value is repaid in full and the coupon is paid.
Scenario 2: The price of the underlying is below the strike price at maturity without touching the barrier
In this scenario, the price of the underlying is below the strike price at maturity, but the barrier has not been touched or undercut during the term. At maturity, the full nominal value is repaid plus the coupon payment.
Scenario 3: The price of the underlying asset has touched the barrier during the term and is below the strike price at maturity
In this scenario, the price of the underlying has touched or fallen below the barrier and the price of the underlying is below the strike price at maturity. The regular coupon payment and a physical delivery of the underlying or a cash settlement are made. The physical delivery or cash settlement is based on the specified number of underlyings (e.g. shares).
It should also be noted that investors bear the issuer risk in all scenarios.
Product variants
The classic BRC can be supplemented with different properties and additional features. The most important variants are mentioned below.
Single or Multi BRC
BRCs consist of at least one underlying. Multiple underlyings can also be used for one product. The product scenarios are similar, except that multiple underlyings are observed with regard to barrier and strike price. As the risk of touching or falling below the barrier is increased, the coupon is generally greater.
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In the case of Multi BRCs, the type and amount of repayment is determined depending on the performance of the underlying with the worst price performance (which is why these products are often labeled “Worst-Of”). Even if all underlyings as a whole or individual underlyings perform positively, only the underlying with the worst performance is used to determine the repayment.
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Barrier type: American or European
Barrier monitoring is generally carried out in two ways: continuously (American) or at maturity (European).
With the American barrier, the barrier is monitored continuously. This means that the price of an underlying asset is constantly monitored to see whether it touches or falls below the barrier. With the European barrier, it is only checked at maturity (at final fixing) whether an underlying touches or falls below the barrier. If the only difference between the two products is the type of barrier monitoring, the coupon will be higher for the product with American barrier monitoring.
Early repayment: Issuercallable and autocallable
Some BRCs offer the option of early redemption before maturity. In the event of early redemption, the nominal value is repaid in full together with a portion of the coupon depending on the term that has already elapsed.
In the case of an issuer-callable BRC, the issuer has the option of redeeming a product early on certain dates (observation dates).
In the case of an “autocallable” BRC, early redemption depends on the performance of the underlying securities. On the observation dates, the system checks whether the underlying is at or above a certain price level (call level). If this is the case, the product is redeemed early.
If there is no early redemption, the products are continued until the regular maturity date.
Products with the option of early redemption have higher coupons and / or lower barriers than products without the option of early redemption. With the option of early redemption, the exact maturity of the product is uncertain. The resulting reinvestment risk is rewarded with better product conditions.
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Advantages and Risks
Advantages
- Fixed, predetermined coupon payments
- Product takes effect when the underlying asset moves sideways
- Lower risk of loss than with a direct investment
- Safety buffer due to barrier
Risks
- Market risk of the underlying asset and risk of loss
- Limited earnings potential in the amount of the coupon
- No entitlement to dividend payments from the underlying
- Issuer risk
FAQ
What factors influence the value of the product in the secondary market?
BRCs can be purchased on both the primary and secondary markets. In the primary market, a product is “in subscription”. Once this phase is over, a product can be traded on the secondary market via the stock exchange.
The value of a BRC is significantly influenced by four factors: the price of the underlying, the remaining term, implied volatility and the risk-free interest rate.
If the price of the underlying rises, the value of the BRC also rises and vice versa. If the time to maturity decreases, the value of the BRC increases. The implied volatility describes the range of fluctuation of the underlying currently expected on the market. Lower implied volatility causes the value of a BRC to fall and vice versa. Finally, a higher risk-free interest rate leads to a lower value of a BRC and vice versa. A risk-free interest rate is the interest rate on first-class government bonds.
The price of a BRC is given as a percentage. How should this be interpreted?
A BRC is quoted as a percentage of the nominal value of the product. If a BRC is quoted at 102 percent and the nominal value is 1,000 Swiss francs, this corresponds to an equivalent value of 1,020 Swiss francs.
If a BRC is purchased at less than 100 percent and provided that no barrier event occurs before maturity, an additional price gain is realized due to the redemption at par value. In addition to the coupon, this price gain increases the maximum return.
What do the “Clean” and “Dirty” price positions mean?
The pricing concerns the treatment of accrued interest. If the accrued interest is already included in the product price, the pricing is “Dirty”. If the accrued interest is not included in the product price, the pricing is “Clean”. In this case, the accrued interest is listed separately.
When purchasing a product with a “Clean” pricing, the buyer is charged the accrued interest in addition to the product price. In the case of a sale, the seller receives the accrued interest in addition to the product price.