Let's have a look at buffered notes.

Another type of equity linked note.

Buffered notes usually provide investors with 100% participation in the upside performance of an asset or index, while offering limited downside protection in the form of a buffer.

Unlike principle protected notes, buffet notes do not guarantee full capital protection.

While they do offer capital protection for moderate losses beyond a certain threshold, the investor is fully exposed to further declines in value.

Let's consider a two year FSE linked buffered note.

At maturity, the investor will receive their full initial investment plus any positive performance of the FSE index above the initial level on a one for one basis.

This means that for every percentage point, the index rises above the initial level.

The investors return increases by the same percentage amount.

On the downside, losses are only incurred if the index falls below a predefined buffer level here set at 88% of the initial index level.

This means the investor is shielded from the first 12% of losses.

If the index declines but remains above this buffer, the investor still gets back 100% of their initial investment.

To illustrate how this works in practice, let's look at a few possible outcomes at maturity.

If the index rises by 10% at maturity, the investor participates fully in this upside receiving 100% of their initial investment, plus an additional 10% return.

If the index finishes at 90% of the initial level, the investors still gets back 100% of their initial investment as the loss does not exceed the buffer.

If the index falls to 85%, the investor incurs a 3% loss.

Since the first 12% of the decline is absorbed by the buffer, their final payout would be 97% of the initial investment.

If the index drops to 80%, the investor bears the portion of the loss exceeding the 12% buffer.

In this case, they experience an 8% loss receiving 92% of their initial investment.

Looking at the diagram, what does this payoff structure remind you of? It's essentially a short risk reversal position, meaning the investor is long a call option with a strike price of 100% of the initial index level and short a put option with a strike of 88%.

When determining the strike of the put, the structuring desk must balance Risk and cost effectiveness.

The key question is, what is the lowest possible put strike so that the premium received from selling the put combined with the remaining funds after purchasing the zero coupon bond IE, the discounted, which the bond trades below par at issuance after deducting fees is sufficient to purchase call options on an amount equal to a hundred percent of the investor's initial investment.

The buffer level is ultimately determined by the structuring desk based on market conditions and investor demand.

Several key factors influence this. One, interest rates.

Higher rates reduce the cost of the zero coupon bond, freeing up more funds to buy options, which can improve the terms for the investor.

Two call option pricing.

The cost of the 100% strike call option affects how much of the budget remains available, and three, put option pricing.

The strike price of the put is adjusted so that its premium contributes enough to fund the note while keeping the buffer at an attractive level.