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How Market-Linked GICs Work

September 30th, 2013

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This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Have your cake and eat it too: Is it possible to enjoy the safety of bonds AND make money when stocks go up?

Suppose you're a conservative investor. You hate the thought of losing money, and that's why you gravitate towards bonds and GICs.

However, recently, bonds haven't been doing so hot.

At the same time, you're looking over enviously at stock market investors, who are enjoying much better returns. But still, that risk averse side of you is afraid to take the plunge into the stock market.

If only you could have it both ways. If only you could get the safety of bonds, and enjoy the stock market's rise.

"Well," the banks said. "We have good news for you. You CAN have it both ways."

You can buy a product called a 'Market-Linked GIC'.

What Does The Market-Linked GIC Promise?

Specifically, market -linked GICs promise two things.

One, it promises safety of your original investment up to a certain amount. Oftentimes, they actually promise 100% of the original amount. In other words, if you put $100,000 in, you're guaranteed to receive at least $100,000 at the end of the term.

Sometimes though, the guarenteed amount is lower - say 90% of your investment. So if you put in $100,000, you're only guaranteed to get back $90,000 at the end of your term. In exchange though, as we'll see, a lower guaranteed amount will let you enjoy more of the stock market's rise.

Two, market-linked GICs promise higher returns when stock markets go higher. This does NOT mean that you'll receive a 20% return when the stock market returns 20%.

If the stock market goes up by 20%, you may receive something like 5%. If the market goes up by 5%, you may receive 1%, and so on. In other words, you only get a partial benefit if the stock market goes up.

Notice that there's a catch - once you invest, you won't see your money until the end of the term. This term is usually around 3 to 5 years.

How To Replicate A Market-Linked GIC

Some of you might wonder how it's even possible to guarantee both safety and returns correlated with the stock market. Savvy readers like you know that there's never any 'free lunch' - you only generate returns when you take on risk. If there's no risk, how can it generate return?

To answer this question, let me tell you how to replicate a market-linked GIC. That's right - you can replicate this from home!

To cook up a market-linked GIC, you need two ingredients - A Canadian government bond, and a call option.

Most people know what a government bond is (if you don't, read our free book), so let me explain what a call option is.

A call option is a right (but not the obligation) to buy a stock at a pre-determined price. For example, as of the time of this writing, I can buy the option to buy the TSX 60 ETF (XIU.TO) for $19 at anytime between now and March 2016. This option costs around $1.4 as of this moment.

Now, suppose you bought this call option at $1.4. What would happen?

If XIU.TO rises to $22 in March 2016, you can exercise your option to buy XIU.TO at $19, and sell it in the market for $22. You'll have profited $3 in the process. When you account for the cost of buying the option, you'll have earned $3 - $1.4 = $1.6 overall.

If XIU.TO goes down to $16 in March 2016, you won't exercise your option. I mean, why would you buy XIU.TO for $19 when you can buy it for $16 in the open market? In this case, you'll have just lost the amount you paid for the option, which is $1.4.

In other words, if you buy the option, you can only lose $1.4, but gain a lot if the stock market goes up.

Before we continue, a warning: I don't recommend investing in options.

Studies have shown that investors who dabble in options lose even more money than investors who dabble in stocks. I don't want to get side tracked and explain why that is, but trust me, there are good reasons for it. I'll explain this in detail in a future post.

4 Steps To Create Your Own Market-Linked GIC

Now that we have the ingredients, let's start cooking. This involves just four steps.

Step 1) Decide on your term. Do you want to replicate a 2-year market-linked GIC? Or perhaps you want to go 3 years?

Your term will decide the maturities of the bonds and options you buy. In other words, if you set a term of 2 years, you'll buy a government bond that matures in 2 years, as well as an option that expires in 2 years.

Unfortunately, right now, the XIU.TO option that expires furthest into the future expires two and a half years from now. XIC.TO (the TSX Composite ETF) options don't even go that far. So unfortunately, until the markets start offering longer term options, you have to choose a term of two and a half years or less.

Step 2) Decide how much you want to guarantee. Do you want to guarantee 100% of your principal? Or 90%? As I've said, a lower guarantee will let you participate more in the stock market's rise, and vice versa. You can choose any number between 0 and 100%.

Step 3) Buy bonds. How much you should buy depends on the following formula.

[Investment amount] * [Guarantee %] / (1 + [interest rate])^[term]

For example, let's say you have a $100,000. You set a term of 2 years, and you want to guarantee 90% of the amount. Then, since 2 year bonds have interest rates of 1.2% per year right now, you have

$100,000 * 0.9 / (1 + 0.012)^(2) = $87,878

Therefore, you invest $87878 into government bonds that yield 1.2% per year for 2 years. At the end of 2 years when the government bond matures, this $87,878 will earn interest so that you'll receive $90,000.

Step 4) Invest the rest of the money in call options. Taking the previous example, take the remaining $12,122 and buy call options.

For the options, the maturity should match the term (i.e. 2 years from now in our example). For the 'strike' of the option, I would choose the one closest to today's price. For example, if XIU.TO is trading at $18.2, choose $18 as strike. This way, you make money if the stock market goes up from today's level.

And wallah! You have yourself a custom built market-linked GIC.

If the stock market goes down at the end of 2 years, you'll lose the $12,122, but gain interest on your $87,878 and end up with $90,000.

If the stock market goes up, so that the $12,122 worth of options becomes $20,000, then you have $90,000 + $20,000 = $110,000. In other words, you gained 10% over 2 years on your initial $100,000 investment.

Calculator For Replicating Market Linked GICs?

Now that you know how market-linked GICs work, you may now wonder if they're good investments. I'll address that question in the near future, so stay tuned.

I might create a calculator that calculates how many bonds and options you should buy to replicate a market linked GIC. But I'll only do so if you, the readers, show interest. If you're interested, please share this page using the share buttons.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.