Risk analysis of Equity Accumulators

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Yes. This is the infamous equity structured product that wiped out the wealth of a lot of Asian High Net Worth individuals in 2007-2008. The product is also dubbed as "I kill you later" because what it did. The buyer of an accumulator contract agrees to buy a fixed number of stocks on each observation date, at a given strike price which is usually at around 10% discount to the prevailing price of the underlying in the market, till expiry or early termination date. The contracts terminates early [i.e. knocks out] when the underlying breaches prespecified high barrier called autocall barrier.

The buyer benefits the most in a moderately bullish market when the underlying price (=S0) is close to but still less than the autocall barrier price. In this situation, the contract keeps on accumulating stocks at a discount. If the underlying breaches the autocall barrier, the contract terminates yielding a payoff of (S0-K0) on each unit accumulated till the autocall date. However, if the market collapses the trade keeps on accumulating shares (now at a premium = [K0-S0]). We see that the upside potential of the contract is limited while is the downside is unlimited, hence these contracts are deemed dangerous for naiive investors.

We are however going to evaluate here the risks of the accumulator contract from the seller's point of view. Lets assume that we have sold a contract that accumulates x stocks of company A for the investor everyday till maturity at price K0 unless the stock breaches a high barrier Kh. If the stock does breach Kh some day before maturity the contract terminates. If we look closely, we will notice that the contract could be structured by selling a series of put options with Strike K0 and buying a series of binary options paying Kh - K0 with knock out barrier = Kh expiring in 1D, 2D, 3D so on and so forth till expiry. In effect the seller finances the binary options from the premium received from selling the puts.

Having split the payoff into vanilla components, it becomes straight forward to analyse the risks of the structure now. Because the seller is long the puts with strike K0 and short the binary option with knock out at Kh, the seller is short delta, long vega and long gamma on the overall structure.

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