Barrier Reverse Convertible
The barrier reverse convertible (BRC) is a special variant of the classic reverse convertible. The holder of a barrier reverse convertible gives up the potential upside exposure to the underlying asset in exchange for an enhanced coupon. The holder of the product is not exposed to the downside exposure, unless the underlying asset breaks through a predefined barrier set at the inception of the product.
The enhanced coupon of the BRC is paid in any case. The coupon may be paid quarterly, semi-annually or annually. Because of this, the product will always outperform its underlying asset on the downside. The product will also outperform if the asset doesn't rise by more than the coupon. Hence, the ideal market scenario for BRC is the prospect of a sideways trending market. All else remaining equal, a BRC pays a lower coupon than a reverse convertible without barrier, because of the conditional capital protection (sometimes called contingent protection feature) provided by the barrier.
The BRC is constructed by means of a short down&in put and a money-market placement. In most cases, the strike is placed at-the-money. More conservative products have an out-of-the-money strike. The barrier is set far below the spot price, usually ranging between 80% and 50% of spot. The lower the strike, the lower the coupon. The lower the barrier, the lower the coupon. The payoff diagram on the right shows an at-the-money strike with a 50% barrier.
As long as the underlying asset does not cross the barrier, the BRC remains capital protected. Once a barrier breach (often called a barrier event) occurs, the capital protection is lost, and the BRC transforms itself in a classic reverse convertible (dotted line).
For example, if the underlying asset was a stock, say IBM, and the product would pay an 8% coupon for a maturity of six months, and the strike would be placed at-the-money (100% of the stock's spot price at the time of the issue) and the barrier at 70% of spot, then there would be 3 scenarios at maturity:
- IBM's price never crossed the barrier during the lifetime of the product: the product is redeemed in cash amounting to 100% of the invested nominal.
- IBM's price is lower than at issue and has crossed the barrier at least once within the lifetime of the product: the product is redeemed in IBM shares and the holder incurs a loss if the stock has lost more than the height of the coupon (which amounts to 8% in this case).
- IBM's price crossed the barrier anytime during the product's lifetime, but finishes above the strike level at maturity: the product is redeemed in cash amounting to 100% of the invested nominal.
- The coupon is paid in any case.
- Invest in a BRC if the prospect is for sideways trending markets and the volatility is high or expected to fall.
- Consider a classic reverse convertible with a lower strike, no barrier, same coupon and maturity versus a BRC with at-the-money strike and low barrier. Although the barrier of the BRC will be lower than the strike of the reverse convertible, it may be wiser to select the classic reverse convertible in terms of worst-case scenario.
- Do consider using a European Style barrier, which can be "knocked-in" only at maturity. Albeit the product will have a lower coupon, the contingent protection can be lost only at maturity.
- Don't invest in a BRC if you forecast "that the underlying asset may still fall a little bit but rebound afterwards". Falling assets have usually rising volatilities and you will be better off investing when the asset is effectively lower (assuming you were right).
- Don't choose a BRC if you forecast a rising market that may amount to more than twice the level of the coupon. Other instruments without a cap to the upside may be more adequate in such scenarios.
Main influence factors
- Volatility: the higher the volatility of the underlying asset, the higher the level of the coupon.
- Interest rate and dividend yield (for stocks): the higher either of the factors, the higher the coupon
- Skew (or Smile): the higher the skew of the underlying asset's options, the lower the barrier can be set.
There exists dozens of BRC variants. Here's the most common:
- Worst-of barrier reverse convertible
- Callable barrier reverse convertible
- Trigger barrier reverse convertible
- Multichance barrier reverse convertible
- Window barrier reverse convertible
- Lookback barrier reverse convertible
BRC's often look like very safe investments, because of the optically very low barrier protecting the capital. However, you should know that the chance of a barrier breach is actually much higher than it might appear at first glance. This is often reflected in the level of the coupon. Imagine a one-year BRC on a single stock with a 10% coupon and a 50% barrier. The stock is a blue-chip, a heavyweight in your country's main stock index. Suppose the current risk-free rate is at 2%; then the BRC pays 5 times that risk-free rate! Since nobody (especially not banks) will give away money for free, there must be a catch somewhere. As a matter of fact, the delta of the product at inception normally gives a good hint of the knock-in chances. In this case, even with a 50% barrier, the delta would probably be around 40%, implying that the product has a ~40% chance of being "knocked-in" if the coupon is 5 times the risk-free rate. Ask ithese informations to your representative before taking a decision, and be certain that you can bear the worst-case scenario, which can amount to nearly the total loss of your capital.