Monday, January 26, 2009

Another Way to Build Your Own Market-Linked GIC

A reader made an interesting observation about last week’s post on building your own market-linked GIC with stock options. Econstudent noted that using call options, you lose out on the stock’s dividends. So, let’s build an investment with principal protection that doesn’t lose out on the dividends.

Recall that our earlier strategy was to invest most of our $100,000 in a 3-year GIC that matured to a value of $100,000, and used the left over money to buy call options on the TSX 60 stock index. This fully protected the initial principal, and gave some upside if the TSX 60 rose over the 3 years.

Another approach is to actually buy the TSX 60 in the form of the exchange-traded fund XIU with most of the $100,000. Then buy long-term put options on XIU, and invest any cash left over in a GIC. The put options provide principal protection in case stocks drop, and you get to collect dividends during the three years you own XIU shares.

The dividend rate on XIU is about 4.8% right now, which is fairly high. In theory, all the prices of call and put options on XIU should take into account dividends. Sure enough, when I tried constructing portfolios with this alternative method that seems to have the advantage of capturing XIU dividends, I couldn’t do any better than I did with the first call option method.

It seems that put option prices are very high right now. For example, XIU closed at $13.04 on Friday, and the cost of a March 2011 put option struck at $12 is $3.15. XIU would have to drop below $8.85 in a little over 2 years for this put option to be profitable. This is more than a 30% drop. With option prices this high, it’s hard to do well building your own market-linked GIC.

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