I heard that some banks offer you these “safe” investments when you sign up, but what are they really? Essentially, at maturity, it guarantees that you will receive the amount you invested in, plus some non-negative amount depending on how well the market performs. For example if you invest $1000 for one year, you might receive $1050 or $1100, but nothing less than $1000.
But I thought investing was risky?
You might be thinking: How is it possible that both 1) the initial investment is protected, and 2) the bank makes money, at the same time? The short answer is: There is the risk that inflation is eating your investment.
Here’s what this security is actually made up of: The bank buys a zero-coupon bond and some options, and keeps the remainder as commission. The zero-coupon bond guarantees the principle at maturity, while the options provide the chance of additional returns. Zero-coupons will always cost less to purchase than the principle. The remainder of the initial investment is used to buy options or kept by the bank as commission. Notice that this is a fixed-pie, where banks have the incentive to keep more as commission.
Is it worth it?
The returns of this strategy is largely dependent on the current interest rates. A high interest rate means that the zero-coupon bond is less expensive to purchase, which leaves more money available to buy options. However a higher interest rate might reduce returns of the market in the long-term, limiting the potential upsides of this strategy. On the other hand, a lower interest rate increases the cost of the zero-coupon, leaving less money to buy the leveraged options. And don’t forget - the bank will take a cut of your investment as commission! Now you might be thinking, I will just create this strategy by buying bonds and options myself right? Well that might actually cost more in commissions because that requires two transactions. So in most cases it might actually be better choose a different strategy!