Structured Notes Linked to Equity Baskets
Structured Notes Linked to Equity Baskets
Basket-linked structured notes provide exposure to multiple underlying assets within a single investment. These products can offer diversification, enhanced yields, or tailored risk profiles by embedding options on custom baskets of stocks, indices, or other assets. Understanding basket mechanics and correlation effects is essential for evaluating these structures.
Definition and Key Concepts
Basket Types
| Basket Type | Description | Use Case |
|---|---|---|
| Equal-weighted | Same weight to each component | Simple diversification |
| Market-cap weighted | Weight by market value | Index replication |
| Custom weighted | Specific allocations | Thematic exposure |
| Best-of | Pays based on best performer | Upside capture |
| Worst-of | Pays based on worst performer | Yield enhancement |
| Average-of | Pays based on average performance | Moderate exposure |
Key Mechanics
| Term | Definition |
|---|---|
| Basket return | Weighted average of component returns |
| Correlation | How components move together |
| Dispersion | Spread of individual returns around average |
| Participation rate | Percentage of basket return investor receives |
| Buffer/barrier | Protection level as % of basket |
Correlation Impact
| Correlation Level | Basket Volatility | Worst-of Risk |
|---|---|---|
| High (0.8+) | Near component avg | Lower |
| Medium (0.4-0.8) | Below component avg | Moderate |
| Low (<0.4) | Significantly lower | Higher |
Key insight: Lower correlation increases diversification benefit for basket options but increases risk for worst-of structures.
How It Works in Practice
Equal-Weight Basket Note
Structure:
- Underlying: 5 stocks (AAPL, MSFT, AMZN, GOOGL, META)
- Basket: Equal weighted (20% each)
- Tenor: 3 years
- Return: 100% participation in basket return
- Buffer: First 10% decline protected
Year-end performance:
| Stock | Return | Weight | Contribution |
|---|---|---|---|
| AAPL | +25% | 20% | +5.0% |
| MSFT | +15% | 20% | +3.0% |
| AMZN | +30% | 20% | +6.0% |
| GOOGL | -5% | 20% | -1.0% |
| META | +20% | 20% | +4.0% |
| Basket | +17.0% |
Investor return: +17.0% (100% participation)
Worst-of Basket Note
Structure:
- Underlying: Same 5 stocks
- Tenor: 18 months
- Coupon: 12% p.a.
- Barrier: 70% of initial (worst-of)
- Principal: At risk if any stock below barrier
Scenario 1: All above barrier
| Stock | Final Level |
|---|---|
| AAPL | 95% |
| MSFT | 105% |
| AMZN | 88% |
| GOOGL | 92% |
| META | 110% |
| Worst | 88% (AMZN) |
Return: Principal + 18% coupon = 118%
Scenario 2: One below barrier
| Stock | Final Level |
|---|---|
| AAPL | 95% |
| MSFT | 105% |
| AMZN | 65% ← Below 70% barrier |
| GOOGL | 92% |
| META | 110% |
| Worst | 65% (AMZN) |
Return: 65% of principal + 18% coupon = 83% Loss: 17% despite 4 of 5 stocks performing well
Worked Example
Rainbow Option Note
Structure:
- Underlying: 3 indices (S&P 500, Euro Stoxx 50, Nikkei 225)
- Tenor: 5 years
- Return: Best-of final performance, capped at 60%
- Principal: 100% protected at maturity
Final performance:
| Index | Final vs. Initial |
|---|---|
| S&P 500 | +45% |
| Euro Stoxx 50 | +25% |
| Nikkei 225 | +55% |
Payoff: Best performer = Nikkei at +55% Investor return: Principal + 55% = 155% (below 60% cap)
Alternative scenario (extreme outperformance):
| Index | Final vs. Initial |
|---|---|
| S&P 500 | +30% |
| Euro Stoxx 50 | +20% |
| Nikkei 225 | +85% |
Payoff: Capped at 60% Investor return: 160%
Pricing Components
Decomposition of basket note:
| Component | Value | Description |
|---|---|---|
| Zero-coupon bond | $85 | Principal at maturity |
| Basket call option | $12 | Participation in upside |
| Cap (short call) | -$3 | Reduces cost, caps upside |
| Issuer margin | $6 | Issuer profit |
| Total | $100 | Note price |
Correlation Sensitivity
Worst-of note pricing:
| Correlation | Barrier | Coupon Offered |
|---|---|---|
| 0.8 (high) | 70% | 8% |
| 0.5 (medium) | 70% | 12% |
| 0.2 (low) | 70% | 18% |
Lower correlation = higher risk = higher coupon
Risks, Limitations, and Tradeoffs
Basket-Specific Risks
| Risk | Description | Impact |
|---|---|---|
| Concentration | Few components dominate | Reduced diversification |
| Correlation breakdown | Correlations shift in stress | Unexpected losses |
| Single-stock risk | One component can drive worst-of | Asymmetric loss |
| Rebalancing | Basket may not rebalance | Drift from intended exposure |
Structural Risks
| Risk | Description |
|---|---|
| Issuer credit | Note is unsecured debt of issuer |
| Liquidity | Secondary market often illiquid |
| Complexity | Hard to value and understand |
| Fees | Embedded costs reduce returns |
Best-of vs. Worst-of
| Feature | Best-of | Worst-of |
|---|---|---|
| Return driver | Highest performer | Lowest performer |
| Investor view | At least one will rally | None will crash |
| Premium | Investor pays | Investor receives |
| Risk profile | Defined upside | Unlimited downside |
| Correlation preference | Low (want dispersion) | High (want co-movement) |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Ignoring correlation | Assuming diversification always helps | Analyze for worst-of |
| Single-stock exposure | One weak link breaks worst-of | Review fundamentals |
| Cap unawareness | Missing upside cap | Read terms carefully |
| Tax complexity | Different treatment by jurisdiction | Consult tax advisor |
| Comparison errors | Comparing to wrong benchmarks | Use proper benchmark |
Advanced Basket Structures
Himalaya Option
Structure:
- Multiple observation dates
- Best performer each date "locked in"
- Removed from basket for remaining observations
- Final payoff: Average of locked-in returns
Example (5 stocks, 5 annual observations):
| Year | Best Performer | Locked Return |
|---|---|---|
| 1 | Stock A | +25% |
| 2 | Stock C | +30% |
| 3 | Stock E | +15% |
| 4 | Stock B | +20% |
| 5 | Stock D | +10% |
Final return: (25% + 30% + 15% + 20% + 10%) / 5 = 20%
Atlas Option
Structure:
- At maturity, remove best and worst performers
- Calculate return on remaining basket
Use case: Reduce impact of outliers
Altiplano Option
Structure:
- Digital coupon if basket above barrier at observation
- Otherwise, zero coupon
- Principal linked to basket performance
Checklist and Next Steps
Pre-investment checklist:
- Identify basket components
- Understand weighting methodology
- Assess correlation among components
- Identify worst-of or best-of structure
- Review barrier and protection levels
- Calculate maximum possible loss
Due diligence checklist:
- Analyze each component fundamentally
- Review historical correlations
- Stress test for correlation breakdown
- Verify issuer credit quality
- Understand all fees and costs
- Read full offering document
Monitoring checklist:
- Track individual component performance
- Monitor distance to barriers
- Watch for correlation changes
- Note observation date outcomes
- Assess secondary market pricing
Related articles:
- For auto-callables, see Auto-Callable Notes and Yield Enhancers
- For correlation trading, see Correlation Trading and Basket Options