Wednesday, February 19, 2014

The Double-Up GIC

Canada’s big banks all offer various types of market-linked Guaranteed Investment Certificates (GICs). The idea is that your principal is 100% guaranteed, and if the stock market performs well enough you get higher returns than standard GICs pay. It’s like you can have your cake and eat it too. However, the returns usually have a fairly low cap. I decided to design my own market-linked GIC that I’d be happy to offer to the public if it weren’t for two things1.

My Double-Up GIC would offer the potential for a 100% gain over 5 years. The big banks tend to offer much lower maximum returns. The interest paid would be linked to the Canadian TSX 60 stocks and the U.S. S&P 500 stocks. However, even if stocks crash, investors’ principal would be 100% protected and would be paid back after 5 years.

Here is the detailed calculation of the interest payment. In each of the 60 months we start with that month’s compounded share of the potential 100% gain (1.162%). Then we take the month’s returns of each of the 560 stocks and cap each stock’s return at its compounded share of the month’s maximum return (0.206 basis points) and then compound all the stock returns together. Then we compound together the 60 monthly returns to get your final 5-year return. If this final return is negative we move it up to zero; you never lose principal.

A big advantage of the Double-Up GIC is that it uses compound interest rather than the simple interest calculation many of the big banks use to calculate your market-linked GIC returns. We all know that compound interest grows your money faster than simple interest. Another advantage is that my interest calculation is much simpler than the elaborate calculations some of the big banks use.

Like other market-linked GICs, the Double-Up GIC strikes a balance between the bank’s desire for profits and investors’ desire for the appearance of safe access to stock-like returns.

1 Financial regulations and my ethics.

9 comments:

  1. Michael, I do not get your Double-Up scheme.
    Investing in equities has inherited risk of loss, no calculation will remove it.For somebody to cover this risk investor must pay a fee, often referred to by the financial industry as premium. I do not see any reference to a fee in your explanation, though I can't say I fully understand it.

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    1. @AnatoliN: I'm talking about acting as the bank and offering this investment to others. So, I would be the one who would make up the difference to back the 100% principal protection guarantee. So, this guarantee isn't about how stocks will perform but about making up the difference if they don't perform.

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  2. Hmmm, so each day a stock moves up more than 0.00206%, you keep the excess. Basically you are taking people's money, investing it in the market, and keeping virtually all the market gains daily when the markets go up. Looks like you've set up a virtually interest free loan which you invest in the markets and keep virtually all the gains. Your poor customers can only double their money if all stocks go up exactly 0.00206% every day for 5 years, right? You could lose I suppose, if stocks declined and there was very little variance in daily returns. Not likely would be an understatement.

    Entertaining puzzle, how did I do?

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    1. @Greg: You're close to the mark. In fact, I would probably invest very little customer money in stocks. To minimize my risk, I'd put the bulk of the money in a bond that produces the amount of the principal guarantee at maturity.

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  3. You had to really work hard to create a deal more terrible than the existing market-linked GICs. Sadly, I suspect you've just given them ideas.

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    1. @Potato: Maybe I have a future in designing bank products.

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  4. I get your point that this is a deal that sounds less lousy than it really is, but I'm trying to understand the numbers, and wonder if "compounding" the 1.162% maximum monthly gain across the stocks (i.e. 1.01162^(1/560) - 1) to get the 0.206bp per-stock monthly cap is a meaningful calculation. Is this just bad math to skew the returns in the bank's favour, or is there an application in which compounding works across investments, rather than over time?

    Appreciate your thoughts...

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    1. @Anonymous: There is no good reason to compound returns of different investments. As you say, compounding happens over time. I could have just split the investment across the 560 stocks without making much difference to the final result, but I got the idea to include a pointless claim about using compounding in the come-on for the Double-Up GIC.

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    2. Thanks. Nice job crafting such an "ehhh... I don't get it, so I'll just hope for the best" detailed calculation. I know how much an in-depth explanation improves the impact of a joke, but wasn't sure whether I was missing something.

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