Reference no: EM133110767

CITIBANK EQUITY LINKED CD

In the attached newspaper page advertising Citibank's "Stock Index Insured Account", the bank promises "Stock Market Returns. Zero Risk to Principal." In describing how it works, the advertisement explains that: The bank calculates the month-end average of the S&P 500 index average over the next five years, i.e. the average of 60 month-end S&P 500 index values. The bank takes the difference of the month-end average S&P 500 price and the value of the S&P 500 at the time of the deposit. If the difference is positive, i.e. the S&P has appreciated; the investor receives double the amount of the appreciation. If the difference is negative, i.e. the S&P has depreciated; the investor gets back the initial amount invested.

To make things simpler, assume that the bank simply offers to give the difference between the S&P 500 value at the end of five years and the initial index value if the S&P 500 appreciates (i.e. no averaging or doubling). If the S&P 500 depreciates, the investor gets back the initial principal.

a. Draw a picture representing the payoffs to the investor.

b. What is the cost to the investor for buying this product? For example, consider what the investor loses in comparison to a regular CD? Similarly, what does the investor lose in comparison to an investment in the S&P 500 Index Fund?

c. Explain why an investor might be interested in this product. Why would Citibank offer such a product?

d. What is the risk exposure to the bank from offering this product? How might the bank hedge this risk exposure?

e. Discuss the difference the option that truly underlies the CD and the simplified version of the option that I you have analyzed.

Please only answer question e.

More information as following:

TRANSFER OR ROLLOVER YOUR IRA OR KEOGH TO CITIBANK's NEW FDIC INSURED ACCOUNT If you want to make the most of your retirement plan, move your IRA or Keough to Citibank now. Why? Because Citibank's new Stock Index Insured Account gives you the potential for stock market growth, without risk to principal.

CITIBANK'S NEW STOCK INDEX INSURED ACCOUNT: With this unique account, your IRA or Keough deposit actually earns two times the average percentage increase in the Standard & Poors 500 Index over a five year term. There's no risk of losing your principal even if the market goes down. Your principal is FDIC insured.

HERE'S HOW IT WORKS: The Stock Index Insured Account (SIIA) is a five year deposit. So its the perfect way to let your IRA or Keough money take advantage of long term market trends. The return for this account is calculated by averaging the month-end values of the S&P 500 Index over the term, comparing the average to the index on the day your account was opened and doubling the percentage gain. So in a rising market, you enjoy stock market growth. But even in a declining market your principal is safe. Because the return is based on stock market movement over a full five years, there are severe principal penalties for early withdrawal.

EXAMPLE Example A: If you had deposited $10,000 on 12/31/86 and held it until 12/31/91 your total return would be $16,332 (Original investment plus $6,332 interest). Because your return is based on the average of the month-end values of the S&P 500 Index over the five-year term, you would have received a return even though the period included the 1987 market downturn. Example B: If you had deposited $10,000 on 12/31/87 and held it until 12/31/92 your total return would be $17,933 (Original investment plus $7,993 interest)