A Probabilistic Analysis of Autocallable Optimization Securities

TL;DR

This paper provides a probabilistic analysis of autocallable optimization securities, revealing that their complex structure often led to substantial losses for investors and highlighting issues with financial adviser's understanding and fiduciary responsibilities.

Contribution

It introduces a probabilistic framework for analyzing reverse convertible notes, clarifies their payment procedures, and assesses the risks faced by note-holders under various market scenarios.

Findings

Note-holders likely suffered substantial losses in many scenarios.

Financial advisers generally lacked the necessary expertise to understand the notes.

The notes were designed to protect financial institutions at the expense of investors.

Abstract

We consider in this paper some structured financial products, known as reverse convertible notes, that resulted in substantial losses to certain buyers of these notes in recent years. We shall focus on specific reverse convertible notes known as "Autocallable Optimization Securities with Contingent Protection Linked to the S\&P 500 Financial Index," because these notes are representative of the broad spectrum of reverse convertibles notes. Therefore, the analysis provided in this paper is applicable to many other reverse convertible notes. We begin by describing the notes in detail and identifying potential areas of confusion in the pricing supplement to the prospectus for the notes. We deduce two possible interpretations of the payment procedure for the notes and apply the Law of Total Expectation to develop a probabilistic analysis for each interpretation. We also determine the corresponding expected net payments to note-holders under various scenarios for the financial markets and show that, under a broad range of scenarios, note-holders were likely to suffer substantial losses. As a consequence, we infer that the prospectus is sufficiently complex that financial advisers generally lacked the mathematical knowledge and expertise to understand the prospectus completely. Therefore, financial advisers who recommended purchases of the notes did not have the knowledge and expertise that is required by a fiduciary relationship, hence were unable to exercise fiduciary duty, and ultimately misguided their clients. We conclude that these reverse convertibles notes were designed by financial institutions to insure themselves, against significant declines in the equities markets, at the expense of note-holders.