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Preservation of capital or return: an unavoidable choice?

Preservation of capital or return: an unavoidable choice?. May 2006. Justo de Rufino BBVA Mercados Globales y Distribución Director Negocio Crédito. Product description. Structured Products. Investors seek. Products with guaranteed capital. Maximization of the Yield/Volatility Ratio.

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Preservation of capital or return: an unavoidable choice?

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  1. Preservation of capital or return: an unavoidable choice? May 2006 Justo de Rufino BBVA Mercados Globales y Distribución Director Negocio Crédito

  2. Product description Structured Products Investors seek Products with guaranteed capital Maximization of the Yield/Volatility Ratio

  3. Product description Structured Products Structuring ability Maximum flexibility to meet client needs Structured productswith guaranteed capital

  4. Product description Structured Products Structured Products 100% Protected Capital The client receives the yield by means of: + Annual/Quarterly Coupons (Fixed or floating) 100% Dynamic Management

  5. Product description Structured Products Format Flexibility to meet client needs 100% Protected Capital Structured products with guaranteed capital Dynamic Management Institutional Tier I Bonds (PPN) Annual/ Quarterly Coupons Notes with guaranteed capital linked to CDX Dynamic Management of Basket of Funds (CPPI)

  6. Format Structured Products Format Structured products may have the following format: Format: Notes Issued by SPV, Issuer, Deposit, Swap, etc Term: 7/10 years Protected Principal: 100%

  7. Coupons Structured Products Annual/ Quarterly Coupons The product pays coupons annually or quarterly,either guaranteed or subject to the existence of a cushion in the structure: Floating Fixed Benchmarked to some index, etc

  8. Dynamic management of CPPI Structured Products Dynamic Management of Basket of Funds (CPPI) Dynamic management is introduced into the structure, applying theCPPItechnique (see section II for further details) The underlying asset,dynamically managed, will be a basket of funds, chosen by means of a quantitative analysis, seeking to maximise the yield/risk binomial. Research will be carried outwith the aim of obtaining an asset with high yield, accompanied by very low volatility, thanks to the optimization achieved by the study of correlations between the components of the basket By dynamic management,leverage, in addition to guaranteeing the nominal value, allows the share in the rise of the underlying asset to be over 100%

  9. Dynamic Management of CPPI Structured Products Dynamic Management of Basket Of Funds (CPPI) The asset underlying the CPPI willbe a balanced, consistent basket of funds from the yield/risk ratiopoint of view. We need to imagine a basketselected from among the following categories, with a track record showing an excellent level of yield/riskand a study of the basket’s correlation, sensitivity and trade-off which guarantees balance and diversification: Underlying Asset Global Fixed Income US Fixed Income Global Equities Latam Equities

  10. Dynamic Management of CPPI Structured Products • Dynamic Management Simulation :we have carried out1000 Monte Carlo Simulations using the following scenario: • Funding: 1M USD Libor forward. • Maximum Investmentin the Underlying Basket of Funds: 300%. • MaximumMonthly Fall permitted: 10% (Leverage: 10 times the cushion). • Initial Cushion: [15.00]%. • Initial Investment: [150.00]%. • Coupon zerofixed at the outset to protect the capital. • Yield and Volatility of the Basketforcarrying out the Monte Carlo simulations exactly as indicated in the Track Record: • IRR: 12.45%. • Volatility: 4.89%. Dynamic Management of Basket Of Funds (CPPI) Simulations

  11. Dynamic Management of CPPI Structured Products • According to the 1000 Monte Carlo Simulationsthat were carried out and the distribution of probabilitiesof the IRR of the CPPI over the nominal value of the notes, statistically: • The average expected IRR of the CPPI is16.69% • The IRR of the CPPIwill beover10.52%witha 95% probability • The IRRof the CPPIwill beover7.61%with a 98% probability Dynamic Management of Basket Of Funds (CPPI) Simulations

  12. Dynamic Management of CPPI Structured Products Dynamic Management of Basket Of Funds (CPPI) Simulations Distribution of probabilitiesofthe expected CPPI yield, to which must be added the yield received as a result of payment of guaranteed coupons, which in this case are annual coupons at 2.50% Average IRR 16.69% Percentile 95: IRR 10.52% Percentile98: IRR 7.61%

  13. Notes with guaranteed capital linked to CDX Structured Products Notes with guaranteed principal Minimum coupon guaranteed Additional coupon, linked to possible credit events in the 0% - 3% tranche of the CDX index. Final Accumulated Super Coupon, linked to possible credit events in the 0% - 3% tranche of the CDX index. Notes with guaranteed capital linked to CDX Characteristics

  14. Notes with guaranteed capital linked to CDX Structured Products Standard and liquid credit index (CDS) Consisting of 125 references of US Investment Grade Wide diversification by sector 0 – 3% Tranche: Equity Tranche of the CDX Index Absorbs the first losses up to a limit of 3% of the portfolio (CDX) CDX Index 0 – 3% Tranche

  15. Super Coupon At term the investor receives: + K Guaranteed + Super Coupon (linked to defaults in 0% - 3% CDX) Investment in CDX 0-3% 100% Capital Credit exposure Risk-free Asset Investment in risk-free asset Throughout the life of the Note the Investor receives: + Guaranteed Coupon + Variable Coupon (linked to defaults in the 0% - 3% tranche of CDX) Notes with guaranteed capital linked to CDX Structured Products Structure

  16. Notes with guaranteed capital linked to CDX Structured Products During 10 years the investor receives: A minimum guaranteed coupon A credit-linked coupon At term he receives: 100% of his guaranteed investment. A FinalSuper Coupon, also credit-linked. Flow structure Note at 10 years Credit-linked Coupon Guaranteed Coupon Final Super Coupon Guaranteed Principal 10 years

  17. Notes with guaranteed capital linked to CDX Structured Products Term : 10 years Currency:USD Minimum guaranteed coupon: 2.43% Fixed coupon linked to CDX 0-3% : 3.94% Final Premium Coupon linked to CDX 0-3% : 39.05% IRR (in case of no defaults): 9.11% Flow Structure Example Number of defaults Guaranteed Coupon C.Linked Coupon Premium Coupon 0 2.43% 3.94% 39.05% 1 2.43% 3.41% 33.84% 2 2.43% 2.89% 28.64% 3 2.43% 2.36% 23.43% 4 2.43% 1.84% 18.22% 5 2.43% 1.31% 13.02% 6 2.43% 0.79% 7.81% 7 2.43% 0.26% 2.60% 8 2.43% 0.00% 0.00% Estimated Recovery Rate: 50%

  18. Dynamic Management of Principal Protected Note (PPN) Structured Products Dynamic Management Institutional Tier 1 Bonds (PPN) Format: Notes (PPN) issued by SPV Dynamic Management:initial exposure of 250%of the nominal value issued in a bond portfolio made up of Institutional Tier 1 securities A system of Triggers is set up, in other words, exposure and cushion limits that force disinvestment if the cushion descends to the level below. If it returns to the upper level, reinvestment takes place but never exceeding an exposure of 250% on the basket

  19. Dynamic Management of Principal Protected Note (PPN) Structured Products Dynamic Management Institutional Tier 1 Bonds (PPN) The underlying bond portfolio may have the following characteristics Portfolio Institutional Tier I securities Basket made up of 20 references Each bond in Asset Swap until the first Call date Issuers with a credit rating between AAA y A+

  20. Dynamic Management of Principal Protected Note (PPN) Structured Products Dynamic Management Institutional Tier 1 Bonds (PPN) In case of the call being exercised on any bond by the issuer, or the rating of the issuer itself falling below Investment Grade, BBVA shall be able to substitute the bond(s) in question within the portfolio to protect the structure. In such a case, the substituting bond shall be similar to the one being substituted and come from an issuer of the same rating or higher than that originally held by the issuer of the substituted bond in the structure. Substitution Event

  21. Dynamic Management of Principal Protected Note (PPN) Structured Products • Dynamic Management Simulation: • Funding:1M Euribor forward • Maximum Investment(Equal to the Initial Investment): 250% • Initial Cushion:[30.93]% • Open Coupon Zero • Quarterly Coupons:Euribor 3m + 20pb • Scenario presented: • At current market levels,the carry of the underlying bond portfolio is: • Euribor 1M + 65.00pb • Carry(net of fees) of the leveraged underlying bond portfolio: • Euribor 1M + 112.50pb Dynamic Management Institutional Tier 1 Bonds (PPN) Simulations

  22. Dynamic Management of Principal Protected Note (PPN) Structured Products • Result of the simulation: • IRR: 5.61%(quarterly coupons of de Euribor 3m + 20pb included in the calculation and net of fees) Dynamic Management Institutional Tier 1 Bonds (PPN) Simulations • This IRR would improve if: • There were a rise in interest rates, because the return received by the client is at a floating rate and this would also make the product more consistent, avoiding the likelihood of a partial or total Trigger Event. • There were an improvement in the price of the bonds in the underlying portfolio.

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