I was reading about EIUL (Equity Index Universal Life) Insurance policies. They seem to be constructed to track the Dow or S&P500 with a floor at 0% gain and a ceiling at say 16% say per year. I was thinking how do they actually construct such a trade? I can see buying the index and putting on a 1 year put option at the strike price you bought the index at. That would work in most situations, but how are they making money if your ceiling is so high 15%? Most years the S&P might not go up above 15% so then the company is not keeping much of a gain and is passing you everything. Also they have to pay for the cost of the put. Anyone know how they run that business? Maybe it is done not as a Stock purchase + put, but some other way? I wonder because I am trying to construct a similar trade. I am bullish on EEM and think in the next 12 months it will increase by 10% or more. Investment horizon: 10 - 12 months Gain Sought: 10% - 15% Risk Tolerance: 5% or less Trade idea: Buy 100 EEM @ 39.90 Buy 1 SEP 2010 38 PUT @ 3.40 Total Cost of 100 Shares: 39.95 + 3.40 = 43.35 To reach 10% increase on account, need EEM to hit 47.69 (increase of 19% on current price). Max Loss is: 1.95 a share (4.88%) How could I better construct such a trade if I am very conservative with the money but bullish on an index? This money would be used as down payment for a house in about 12 months time or so.
The basis for any capital guarantee trade is very simple. Buy a zero coupon bond that matures on the required date and invest the amount that would produce your intial capital on maturity. Whatever is left is your risk capital that you can invest any way your like (the catch is that you cannot lose more than this amount). For example, say you sart with $100K. The current interest rate on a 1-year risk free zero coupon bond or any similar instrument is 3% (I'm making up the numbers). To have 100K in 1-year's time you need to invest 97,090 today(97,090*1.03). The remaining 2,910 is your risk capital. So if you are bullish then you would buy call options. If the market goes up then you make money on your calls, if it doesn't then you lose 2,910 and you are left with your intial 100K. Longer time horizon and/or higher interest rate gives you more risk capital.
Some important things to look for in such policies are: 1) A stable, reliable insurance company 2) An acceptable growth cap 3) A 100% participation rate (percentage of index credit you receive)