A Modeling Approach of Return and Volatility of Structured Investment Products with Caps and Floors

TL;DR

This paper models the return and risk of Puerto Rico stock market IRAs with caps and floors, revealing they underperform compared to direct stock investments but offer principal protection for risk-averse investors.

Contribution

It introduces a parametric modeling approach to analyze structured investment products like PRIRAs, comparing their statistical properties before and after tax.

Findings

PRIRAs underperform compared to direct stock market investments.

PRIRA1 has slightly higher expected return than U.S. bonds but with double the risk.

PRIRA2 has lower risk than PRIRA1, maintaining principal protection.

Abstract

Popular investment structured products in Puerto Rico are stock market tied Individual Retirement Accounts (IRA), which offer some stock market growth while protecting the principal. The performance of these retirement strategies has not been studied. This work examines the expected return and risk of Puerto Rico stock market IRA (PRIRAs) and compares their statistical properties with other investment instruments before and after tax. We propose a parametric modeling approach for structured products and apply it to PRIRAs. Our method first estimates the conditional expected return (and variance) of PRIRA assets from which we extract marginal moments through the Law of Iterated Expectation. Our results indicate that PRIRAs underperform against investing directly in the stock market while still carrying substantial risk. The expected return of the stock market IRA from Popular Bank (PRIRA1) after tax is slightly greater than that of investing in U.S. bonds, while PRIRA1 has almost two times the risk. The stock market IRA from Universal (PRIRA2) performs similarly to PRIRA1, while PRIRA2 has a lower risk than PRIRA1. PRIRAs may be reasonable for some risk-averse investors due to their principal protection and tax deferral.