Principal Protected Notes (PPNs)

Level 1: Beginner | Module 1.3 | Time: 2 hours

🎯 Learning Objectives

By the end of this module, you will:

• Understand principal protection mechanics
• Learn how PPNs combine bonds and options
• Calculate participation rates
• Know when capital protection makes sense
• Understand the trade-offs involved

Prerequisites: Covered Calls

What is a Principal Protected Note?

An investment that guarantees your capital back while giving you upside exposure to an asset.

The Core Promise

"You can't lose your principal, but you can participate in gains"

Think of it as: Safety + Opportunity

The Safety Net Concept

Traditional Dilemma

Option A: Keep $100,000 in cash
- Safe, but earns 0% (loses to inflation)
- No upside potential

Option B: Buy Bitcoin
- Huge upside potential (+50% possible)
- Huge downside risk (-50% possible)
- Can't afford to lose principal

PPN Solution

Principal Protected Note:
- Invest $100,000
- Guaranteed: Get $100,000 back in 1 year (100% protection)
- Potential: Participate in Bitcoin upside (maybe 80% of gains)
- Risk: Only opportunity cost if Bitcoin falls

Perfect for: Conservative investors who want exposure without risk

How It Works: The Component Breakdown

The “magic” is splitting your money into two pieces:

Component 1: Zero-Coupon Bond (The Safety)

What is a Zero-Coupon Bond?

• A bond that pays no interest during its life
• You buy it at a discount
• It matures at face value
• The difference is your return

Example:

Face Value: $100,000 (what you get back)
Current Price: $95,000 (what you pay today)
Time to Maturity: 1 year
Implied Interest Rate: 5.26%

Math: $95,000 × 1.0526 = $100,000 in 1 year

This is your safety net! No matter what happens to Bitcoin, you get $100,000 back.

Component 2: Call Options (The Opportunity)

With the remaining money, buy call options:

You invested: $100,000 total

Allocation:
- Zero-coupon bond: $95,000
- Call options: $5,000

The $5,000 buys you upside exposure to Bitcoin!

Complete PPN Example

Initial Setup

Date: January 1, 2025
Investment: $100,000
Term: 1 year (matures Jan 1, 2026)
Underlying: Bitcoin (currently $50,000)
Interest Rate: 5% (for zero-coupon bond)

Building the PPN

Step 1: Buy Zero-Coupon Bond

Need $100,000 in 1 year
Present value at 5% = $100,000 / 1.05 = $95,238

Spend: $95,238 on zero-coupon bond
Guaranteed: $100,000 in 1 year

Step 2: Buy Call Options

Remaining: $100,000 - $95,238 = $4,762

Buy Bitcoin call options:
- Strike: $50,000 (at-the-money)
- Expiration: 1 year
- Cost per option: ~$8,000
- Number of options: $4,762 / $8,000 = 0.595 contracts

Participation Rate: 59.5%

What does 59.5% participation mean?

• If Bitcoin rises 100% → you get 59.5% × 100% = 59.5% return
• If Bitcoin rises 50% → you get 59.5% × 50% = 29.75% return

Scenarios at Maturity

Scenario A: Bitcoin Rises to $75,000 (+50%)

Bitcoin return: +50% (+$25,000 per BTC)
Your participation: 59.5%
Your gain: 50% × 59.5% = 29.75%

Returns:
- Bond matures: $100,000 ✅
- Option profit: $100,000 × 29.75% = $29,750
- Total: $129,750

Compared to:
- Just holding BTC: $100k → $150k (+$50k) ✅ Better
- PPN: $100k → $129.75k (+$29.75k)
- Cash: $100k → $100k (0%)

Trade-off: Gave up 20.25k upside for capital protection

Scenario B: Bitcoin Rises to $100,000 (+100%)

Bitcoin return: +100%
Your participation: 59.5%
Your gain: 100% × 59.5% = 59.5%

Returns:
- Bond matures: $100,000 ✅
- Option profit: $100,000 × 59.5% = $59,500
- Total: $159,500

Compared to:
- Just holding BTC: $100k → $200k (+$100k) ✅ Better
- PPN: $100k → $159.5k (+$59.5k)
- Cash: $100k → $100k (0%)

Scenario C: Bitcoin Falls to $30,000 (-40%)

Bitcoin return: -40%
Your participation: Doesn't matter (options expire worthless)

Returns:
- Bond matures: $100,000 ✅
- Options: $0 (worthless)
- Total: $100,000

Compared to:
- Just holding BTC: $100k → $60k (-$40k) ❌ Disaster
- PPN: $100k → $100k (0%) ✅ Protected!
- Cash: $100k → $100k (0%)

This is where PPNs shine! Protected from crash.

Scenario D: Bitcoin Stays at $50,000 (0%)

Bitcoin return: 0%
Your participation: 0% of 0% = 0%

Returns:
- Bond matures: $100,000 ✅
- Options: $0 (ATM, worthless)
- Total: $100,000

Compared to:
- Just holding BTC: $100k → $100k (0%)
- PPN: $100k → $100k (0%)
- Cash: $100k → $100k (0%)

Opportunity cost of missing bond yield elsewhere

Participation Rate Mechanics

The participation rate depends on several factors:

Factor 1: Interest Rates (Higher = Better Participation)

Scenario A: 5% Interest Rate
- Bond cost: $95,238
- Money for options: $4,762
- Participation: ~59.5%

Scenario B: 10% Interest Rate
- Bond cost: $90,909
- Money for options: $9,091
- Participation: ~113% (FULL participation + extra!)

Why? Higher rates → cheaper bond → more money for options

Factor 2: Option Premiums (Lower = Better Participation)

Scenario A: High Volatility (Expensive Options)
- Option cost: $8,000
- Budget: $4,762
- Participation: 59.5%

Scenario B: Low Volatility (Cheap Options)
- Option cost: $4,000
- Budget: $4,762
- Participation: 119% (MORE than full participation!)

Why? Cheaper options → buy more → higher participation

Factor 3: Time to Maturity (Longer = Lower Participation)

Scenario A: 1 Year PPN
- Bond cost: $95,238 (only 1 year of discounting)
- Participation: 59.5%

Scenario B: 3 Year PPN
- Bond cost: $86,384 (3 years of discounting)
- Participation: 170% (way more options can be bought!)

Why? Longer time → deeper bond discount → more option budget

BUT: Longer time → more expensive options (trade-off)

Formula for Participation Rate

Participation Rate = (Money for Options) / (Cost of ATM Call)

Example:
Money for options: $4,762
ATM call cost: $8,000

Participation = $4,762 / $8,000 = 59.5%

When Capital Protection Makes Sense

✅ Use PPNs When:

1. You Can’t Afford Losses

Scenario:
- Retirement funds
- College savings (kid goes to school in 1 year)
- Down payment for house (buying soon)

Solution: PPN gives upside shot without risking principal

2. Very Uncertain About Direction

Scenario:
- Bitcoin could go to $100k or $20k
- No strong conviction
- Want exposure without risk

Solution: PPN = free lottery ticket on upside

3. Regulatory / Mandate Constraints

Scenario:
- Pension fund MUST preserve capital
- Can't take equity risk directly
- Need creative solutions

Solution: PPN counts as "protected" for regulatory purposes

4. Psychological / Behavioral

Scenario:
- Can't handle volatility emotionally
- Would panic sell at bottom
- Need to sleep at night

Solution: PPN = peace of mind, stay invested

❌ Don’t Use PPNs When:

1. Strongly Bullish

Problem: Participation rate caps your upside
Better: Just buy the asset directly

2. High Interest Rate Environment

Problem: Bonds yield 8%, PPN yields 0% if flat
Better: Buy bonds, get guaranteed 8%

3. Need Liquidity

Problem: PPNs lock up capital until maturity
Better: Keep funds liquid

4. Short Time Horizon + Low Vol

Problem: Little time + low vol = tiny option budget
Better: Other strategies might work better

Trade-Offs: The Hidden Costs

Trade-Off 1: Opportunity Cost

If you buy PPN, you give up:
- Bond yield (could have earned 5% risk-free)
- Full upside (participation < 100% usually)
- Liquidity (locked up for term)

You gain:
- Downside protection (worth it in crashes)
- Upside exposure (better than cash)
- Peace of mind

Trade-Off 2: Participation vs Protection

High Participation (90%):
- Great upside capture
- But likely shorter protection or less protection

Low Participation (50%):
- Lower upside
- But 100% principal protected

You can't have both perfect protection AND full upside!

Trade-Off 3: Time Lock-Up

Standard PPN: Locked for 1+ years

If Bitcoin moons in month 2:
- Can't sell and take profits
- Stuck until maturity
- Opportunity cost of redeploying capital

Advanced PPN Variations

1. Multiple Participation Levels

Structure:
- 100% of first 20% gains
- 50% of next 30% gains
- 0% above 50% gains

Example: Bitcoin +60%
- First 20%: 100% × 20% = 20%
- Next 30%: 50% × 30% = 15%
- Last 10%: 0% × 10% = 0%
- Total: 35% return

Benefit: Better participation on moderate gains

2. Partial Protection (90% Principal Protected)

Structure:
- Protect only $90,000 of $100,000
- Use extra $5,000 for more options
- Participation increases to ~120%

Trade-off:
- Higher upside participation
- Accept 10% potential loss

3. Barrier Features

Structure:
- 100% protected IF Bitcoin doesn't touch $25,000
- 150% participation
- If barrier hit → protection void

High risk / high reward version

Real-World Case Study: 2020 COVID Crash

Background

Investor: Pension Fund
Amount: $50 million
Date: Jan 2020
Goal: Equity exposure without risking beneficiary capital

Structure: 1-Year PPN on S&P 500

Components:
- $47.5M in treasury bonds (maturing at $50M)
- $2.5M in S&P 500 call options
- Strike: 3,200 (then-current level)
- Participation: ~55%

Timeline

February 2020: COVID Crash Begins

S&P 500 falls from 3,200 to 2,200 (-31%)

Without PPN:
- $50M → $34.5M (-$15.5M loss) ❌

With PPN:
- Bond still worth ~$47.5M
- Options worthless BUT protection active
- No realized loss yet, still on track for $50M

March 2020: Panic Selling

S&P 500 at 2,200

Competitors:
- Many funds panic sold at bottom
- Locked in 30% losses
- Missed recovery

PPN Fund:
- Can't panic sell (locked structure)
- Protection provides confidence
- Stay the course ✅

January 2021: Maturity

S&P 500 at 3,750 (+17% from start)

Results:
- Bond: $50M ✅
- Option profit: 17% × 55% = 9.35%
- Total: $50M × 1.0935 = $54.675M

Final:
- Protected through crash
- Captured recovery
- Beat cash and bonds
- Met obligations ✅

Lesson: PPNs work brilliantly in volatile, uncertain environments.

Designing Your Own PPN

Step-by-Step Process

Step 1: Determine Your Parameters

Investment: $______
Time Horizon: __ years
Underlying: Bitcoin / Ethereum / Stock
Protection Level: 100% / 90% / 80%

Step 2: Find Current Interest Rate

Risk-free rate: ____%
(Use treasury yield for your time horizon)

Step 3: Calculate Bond Cost

Formula:
Bond Cost = Principal / (1 + r)^n

Example: $100k, 5%, 1 year
Bond Cost = $100,000 / 1.05 = $95,238

Step 4: Calculate Option Budget

Option Budget = Investment - Bond Cost

Example:
$100,000 - $95,238 = $4,762

Step 5: Price ATM Call Option

Use Black-Scholes or market prices
Example: 1-year ATM BTC call = $8,000

Step 6: Calculate Participation

Participation = Option Budget / Call Price

Example:
$4,762 / $8,000 = 59.5%

Practice Exercise: Design a PPN

Your Scenario

You have: $50,000 to invest
Time: 2 years
Underlying: Ethereum (current price $3,000)
Risk-free rate: 4%
ATM call option (2-year): $1,200 per ETH

Design a PPN:
1. How much goes to bond?
2. How much to options?
3. What's your participation rate?
4. What's your return if ETH doubles?

Step 1: Bond Cost
PV = $50,000 / (1.04)^2 = $50,000 / 1.0816 = $46,225

Step 2: Option Budget
$50,000 - $46,225 = $3,775

Step 3: Participation Rate
Each call costs: $1,200
Number of calls: $3,775 / $1,200 = 3.146 options
Per ETH basis: 3.146 / 1 = 3.146 (but we need to normalize)

Actually: Participation = (Option Budget / Call Cost) for 1 unit exposure
If we want participation per $50k:
- 1 ETH = $3,000
- To match $50k exposure: $50k / $3k = 16.67 ETH
- Cost of 16.67 calls: 16.67 × $1,200 = $20,004

Since we only have $3,775:
Participation = $3,775 / $20,004 = 18.87%

Step 4: Return if ETH Doubles ($3,000 → $6,000)
ETH return: +100%
Your return: 100% × 18.87% = 18.87%
Total value: $50,000 × 1.1887 = $59,435

Alternative: Lower your protected amount to increase participation!

Key Takeaways

1. PPNs = Zero-Coupon Bond + Call Options

• Bond protects capital
• Options provide upside
• Split creates safety + opportunity

2. Participation rate is the critical variable

• Higher rates → better bond discount → more option budget
• Lower volatility → cheaper options → higher participation
• Can range from 30% to 150%+

3. Perfect for capital preservation + upside exposure

• Retirement funds
• Conservative investors
• Regulatory constraints

4. Trade-offs are real

• Give up full upside participation
• Locked up for term
• Opportunity cost vs bonds

5. Shine in volatile / uncertain markets

• Protection prevents panic selling
• Capture recovery without risking capital

What’s Next?

You’ve mastered Principal Protected Notes! You now understand:

• ✅ How capital protection works
• ✅ Component decomposition (bond + options)
• ✅ Participation rate mechanics
• ✅ When to use PPNs
• ✅ Design process

Ready for advanced income strategies?

Continue to: Range Accruals →

Learn how to earn yield when markets trade sideways.

Tools & Resources

Build Your Own:

• Structure Tool - Design PPNs with live pricing
• Participation Calculator - Calculate rates
• Bond Pricer - Price zero-coupon bonds

Further Reading:

• Black-Scholes Model - Option pricing
• Interest Rates Impact - How rates affect structures
• Case Studies - Real PPN examples

Next Module: Range Accruals →

Related Topics:

• Volatility - Affects option prices and participation
• Monte Carlo - Price complex PPNs
• Multi-Asset Structures - PPNs on baskets