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Fleece the Fools

By

Go fleece yourself, cowboy!

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John,

In recent months, I've been receiving regular offerings of the type listed below.

_____

We are pleased to announce a new issue equity-linked note investment opportunity for Members which provides:

HIGH COUPON INCOME: 8.50%
STRONG ISSUER CREDIT: Aa1/AA
SHORT MATURITY: August 31, 2006 (approx. 1 year term)
SECONDARY MARKET LIQUIDITY: Yes
TAX BENEFITS: Yes. (Please see the Tax Considerations section in the prospectus.)

The enclosed equity-linked note may be appropriate for Members that seek high coupon income and are comfortable receiving at maturity, either a) principal at 100% of the purchased face amount of the note or b) shares of Merck & Co. Inc. based on the face amount of the note purchased divided by the closing price of shares of Merck & Co. Inc. on the Initial Pricing Date.

SUMMARY OF TERMS:
UNDERLYING STOCK: Merck & Co. Inc. (NYSE: MRK)
SECURITY: Equity-Linked Note
RATING: Aa1/AA (Moody's/S&P)
PROPOSED COUPON: 8.50% per annum, payable monthly. Coupon shall be paid to holder regardless of the stock price movement of Merck & Co. Inc. Next coupon payment is September 30, 2005.
EST. MATURITY DATE: August 31, 2006 (approx. 1 year term)
EST. YIELD TO MATURITY: 8.50% (Assumes "principal" payment of 100% of the purchased face amount at Maturity. See section Payment at Maturity.)
EST. NEW ISSUE PRICE: Par (100) ($1,000 per Note)
EST. INITIAL PRICING DATE: Friday, August 26, 2005
MIN. ORDER: $10,000 face amount (10 Notes at $1000 per Note)
MIN. TRADING AMOUNT: 5 Notes for "taxable" accounts, 2 Notes for "retirement" accounts

PAYMENT AT MATURITY:
i. If the stock price of Merck & Co. Inc. does not close below 80% of the Initial Pricing Date's closing price on any day prior to Maturity, then holder receives principal at 100% of the purchased face amount at Maturity.

-or-

ii. If the stock price of Merck & Co. Inc. does close below 80% of the Initial Pricing Date's closing price on any day prior to Maturity, and the stock price is below the Initial Pricing Date's closing price at Maturity, then at Maturity, holder receives shares of Merck & Co. Inc. based on the face amount of the note purchased divided by the closing price of shares of Merck & Co. Inc. on the Initial Pricing Date (the "Exchange Ratio").

-or-

iii. If the stock price of Merck & Co. Inc.does close below 80% of the Initial Pricing Date's closing price on any day prior to Maturity, and is at or above the Initial Pricing Date's closing price at Maturity, then holder receives principal at 100% of the purchased face amount at Maturity.
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While I'm hardly a derivatives expert, it appears to me that what's going on is that somebody is trying to offload much of their downside volatility to me and retain all the upside, in exchange for a regular coupon. Not sure how, or if it fits into your overall observations about the regular selling of volatility, but thought it might make for an interesting "case study" of how this stuff works and who is trying to benefit. (Being a small guy, I'm pretty sure that the primary beneficiary is somebody other than me.)

Not seeking advice. My decision not to invest in unusual vehicles peddled over the internet is unwavering.

Minyan Michael-

Thank you Michael, for providing a real world example of how Wall Street makes money off retail investors by "structuring" notes such as this.

What this firm is doing is trying to buy a very cheap option from the investor. Essentially the investor is short an at-the-money put if the stock closes at or below 80% of the stock price at the day of pricing. This is called a "down and in put," an at-the-money put that gets "activated" if certain conditions occur. In this case the condition is that the stock price closes for only one day at 80% of the current stock price.

The really disingenuous part is that the firm describes this as "20% protection" for the investor. This is hilariously inaccurate and misleading, for once the stock trades at 80% the investor has absolutely no protection except for the "income" generated. This income is the only protection the investor has from a falling stock price, so the amount of that income is all important. As I will show, this comes woefully short.

The so-called coupon, or interest earned, is generated from the fact as explained above that the investor is short an option (the investor is exposed to the downside of the stock 100% as long as the stock closes just one day down 20%). I won't bore you with the details, but if you do the math the investor is selling the option at 4% of the notional stock price. We have that option worth at least 7.8% based on market implied volatilities.

Let me repeat that: the investor is selling an option at 4% that is worth 7.8%.

Professor Succo

John-

Thanks, it's been a long time since I did options pricing of any kind, and that was so long ago it was really a different world.

I had no doubt that the promotional stuff they sent out was misleading. As I said before, I am well aware of where I am in the hierarchy of investors, and when somebody is pushing such "great opportunities" as these guys always have, I usually find it extremely suspect that they need to come to me in order to sell it.

During the dotcom boom, I used to hang out at a bar in Menlo Park with guys who mostly worked up on Sand Hill Road. We used to go over the "private placement offers" this outfit would send me for "pre IPO companies" and laugh. Sadly, many individual investors who got hooked by them found that it wasn't so much fun having an illiquid investment in a company with no real exit potential.

I figured these offers were just another round in the same game of "fleece the fools," as was their own "private placement offering" to me some time back.

Look forward to seeing your analysis and to meeting you in person next week at MIM2.

Minyan Michael



No positions in stocks mentioned.

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