Structured Products incorporating Call Spreads May 2009

Call Spreads Content What is a Call Spread? Uncapped vs Capped – a comparison Summary

What is a Call Spread? A call option gives the holder of that option the right to buy an asset at a specified time in the future at a certain price (STRIKE price). But what if at the same time as buying a call option on an asset at a certain STRIKE price, a call option on that same asset is SOLD at a DIFFERENT strike price? For example, let us assume that an investor buys a call option on the FTSE with a strike of 4,500 whilst simultaneously selling a call option on the FTSE with a strike price of 5,500. What are the returns for different market levels on the expiry date of those options compared with the returns of an uncapped call option with strike of 4,500?

What is a Call Spread? Table of possible returns: Index at maturityUncapped call returnCall spread return 6,0001,5001,000 5,7501,2501,000 5,5001,000 5, , ,00000

What is a Call Spread? You can see that for index levels at maturity up to 5,500, there is no difference between the return on the 4,500 call and the return on 4,500 / 5,500 call spread. Therefore, if the investor thinks that the FTSE will not be above 5,500 at maturity he will be equally well off buying the call spread as buying the uncapped call. The benefit to the investor is that the call spread will be cheaper than buying the uncapped call. Let’s use some example figures to see how the investor could enhance his returns by investing in a call spread through a structured product compared with buying an uncapped call within a similar structured product.

Uncapped vs Capped – a comparison GBP1.00 Investor’s Cash Share Price at Issue p Zero-Coupon Bond75.00p Aggregate Costs 1.50p a)Uncapped call price23.50p b)100/150% call price11.75p GBP1.00 Zero-coupon Bond Option Providing Economic Return The option providing the economic return could be a number of things, two of which are an uncapped call or a call spread

Uncapped vs Capped – a comparison The previous diagram can be described using the numbers below: Amount to spend = 100p Zero coupon bond (ZCB) cost = 75p Costs = 1.5p Therefore cash remaining to spend = 100 – 75 – 1.5 = 23.5p Let us assume also that: a) Cost of one FTSE 100% call option = 23.5p b) Cost of one FTSE 100%/150% call spread = 11.75p This means that the investor could buy either: a) 1 x ZCB + 1 x 100% FTSE call, or b) 1 x ZCB + 2 x 100%/150% FTSE call spread

Uncapped vs Capped – a comparison The table below shows a comparison of returns at the maturity for these two structured products for different FTSE Index levels at maturity. FTSE at maturity Uncapped call product payoff Call spread product payoff Difference (Call spread – Uncapped) 50%100% 0% 75%100% 0% 100% 0% 125% 150%25% 150% 200%50% 200% 0% 250% 200%-50%

Uncapped vs Capped – a comparison From the table you can see that the product incorporating the call spread does better than the product incorporating the uncapped call unless the FTSE more than doubles over the term of the trade. If the investor’s view is that the FTSE will not double over the term of the trade, but will show some appreciation, then of the two products he would be better advised to buy the product incorporating the call spread, were the two products available.

Summary There are a number of advantages to buying call spreads compared with buying uncapped calls if you are of a certain investment view: a)Potential to buy GEARED UPSIDE to an asset’s appreciation. b)Width of call spread can be tailored to the investor’s view on the underlying. c)When volatility is high (as it is now) buying uncapped calls is expensive, so structured products investing in uncapped calls do not look as attractive now as they have in the past. Capping the upside via call spreads can mitigate this to some degree.

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