In June 1999, Charles Schwab offered investors an Equity-linked Certificate of Deposit (CD).

This product offered:

i. A guaranteed minimum repayment of invested amount plus $200 at the end of 10 years

ii. plus, 75% of the simple appreciation in the S&P500 index over that time (during the 10 years from investment) on the invested amount, should the index appreciate.

In other words, in addition to preserving the principal invested, this product allows the investor to participate in any appreciation of the stock market in the next 10 years, without penalizing her for any market downturn.

a) Break this product down in terms of a portfolio of lending and options. Put another way, identify what kind of (and how many) options are embedded in this product.

b) If the annual rate of return on a comparable CD (simple lending without any option characteristics) is 7%, and if the value of the S&P500 at the time of investment is 975, calculate the value of each option embedded in the Charles Schwab Equity-linked CD product.

Answer rating: 100% (QA)

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