DEFINITION of 'Globally Capped Contract '

A globally capped contract is a structured financial instrument with a cap on total returns. It offers a guaranteed payout with some possible bonus from excess investment returns. This type of option guarantees a minimum return but puts a cap on profits. The cap on returns helps the issuer pay for the promised floor.

BREAKING DOWN 'Globally Capped Contract '

A globally capped contract differs from a locally capped contract in that the cap is on the life of the contract rather than quarterly or other intermediate returns. This difference gives globally capped contracts the perception of more stability than locally capped contracts. Globally capped products don’t pay dividends and are usually based on a market index that does not include dividends. Globally capped contracts have become very popular among investors who are interested in structured investment products that are less volatile than straight options.

Although both globally and locally capped contracts are very popular, many academics have questioned why the latter is more in demand than the former. According to standard finance theory, the simpler globally capped contracts should be preferred to more complex path-dependent contracts like those that are locally capped. A 2008 presentation by a professor at the University of Waterloo concluded that most investors should prefer locally capped contracts, though that is not the case. The presentation posited the following explanations for this disparity:

  • Risk aversion: Highly risk-averse investors prefer globally capped contracts, even when volatility is low.
  • Retail investors are persuaded by high-pressure salespeople working on commission.
  • The complexity of locally capped contracts confuses investors.

The reason they are not, some academics contend, is due to unrealistic expectations. Others believe that sellers of retail financial products deliberately design them to be complex, to confuse consumers.

Local Cap, Global Floor

A locally capped, globally floored contract is a structured financial product that combines a guaranteed payoff with a bonus based on periodic returns of an index, with a cap. The bonus depends on the price movements of an index. This structure allows investors to partially benefit from favorable stock market performance while limiting downside risk. Negative returns count fully, while positive returns are capped before they are summed or compounded, thus making the valuation of these contracts problematic.

The guarantee is a global floor because it covers the entire life of the contract, while the cap is a local cap because it applies to the returns of each period.

The most straightforward version of this contract has only one period and can be viewed as a portfolio consisting of a zero-coupon bond position in two call options on the underlying index. More complex features may include return caps applied to each month or quarter, interest payments and call provisions, etc.

  1. Capped Fund

    A capped fund is a fund with specified maximum limitations included ...
  2. Cap

    A cap is an interest rate limit on a variable rate credit product. ...
  3. Capped Rate

    A capped rate is an interest rate that is allowed to fluctuate, ...
  4. Expense Limit

    An expense limit is a limit placed on the operating expenses ...
  5. Lifetime Cap

    The lifetime cap is the maximum interest rate that is allowed ...
  6. Interest Rate Cap Structure

    Interest rate cap structure refers to the provisions governing ...
Related Articles
  1. Investing

    An Introduction To Small Cap Stocks

    Get an introduction to small cap stocks, and learn why when it comes to a company's size, bigger isn't always better for investors.
  2. Investing

    1Q Small Cap Earnings Preview: The Tide Has Turned

    Earnings growth for small caps should trail large caps badly in the first quarter.
  3. Investing

    Small-cap, mid-cap, and large-cap stocks: A 2016 comparison

    Find out what to happened with small-cap, mid-cap, and large-cap stocks in 2016 – and learn why it is important to diversify between all three.
  4. Insights

    Understanding Small- And Big-Cap Stocks

    If you don't realize how big small-cap stocks can be, you'll miss some good investment opportunities.
  5. Investing

    What's a Small Cap Stock?

    The “cap” in small cap stocks refers to a company’s capitalization as determined by the total market value of its publicly traded shares. Small cap stocks are generally defined as the stock of ...
  6. Trading

    Small Caps Are Just Too Risky At These Levels

    With the rise in the markets over the past few weeks many traders are starting to wonder if now is the time to buy small caps. These 3 charts suggest that it may be best to wait.
  7. Investing

    Small Caps Boast Big Advantages

    Find out why little companies have the greatest potential for growth.
  8. Insights

    Bank of America Turns Bearish on Small-Cap Stocks

    Bank of America dumps small caps as the Russell 2000 can't keep up with the big boys.
  9. Investing

    Why Small Cap Stocks Are Poised for Major Gains

    The Russell 2000 small cap stock index may outperform this year after rising nearly 20% in 2016
  10. Investing

    Valuing Large-Cap Stocks

    Investors seeking to preserve capital in volatile markets might want to consider large-cap stocks.
  1. Is there such a thing as a nano cap or micro cap index?

    While there are indexes that track micro cap stocks, there are few indexes tracking nano caps. Although definitions vary, ... Read Answer >>
  2. What is the difference between market capitalization and shares outstanding?

    Understand the relationship between shares outstanding and market capitalization and how market cap is interpreted to establish ... Read Answer >>
Trading Center