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.