An autocall (automatic early redemption note) is a structured note that pays an above-market coupon and redeems early if an underlying equity or basket of equities stays above a predefined level on a series of observation dates. If the underlying falls sharply and breaches a capital protection barrier, the investor loses principal in proportion to the fall. The combination of attractive income and conditional capital risk makes autocalls one of the most commercially successful structured products in private banking.
The Basic Mechanics
Consider a five-year autocall note on the FTSE 100, with the following terms:
- Autocall barrier: 100% of initial level (strikes at inception)
- Autocall coupon: 8% per annum
- Observation dates: annually, starting year one
- Capital protection barrier: 60% of initial level (European, observed only at maturity)
- Notional: £100,000
At each annual observation date, the FTSE 100 level is compared to the initial level. If it is at or above 100%, the note automatically redeems: the investor receives back their £100,000 principal plus 8% × the number of years elapsed. If the note reaches year five without autocalling and the FTSE 100 is at or above 60% of its initial level, the investor receives £100,000 (full capital return, no coupon at maturity). If the FTSE 100 is below 60% at maturity, the investor receives £100,000 × (final FTSE level / initial FTSE level) — a loss proportional to the index's fall below the barrier.
Worst-of Autocalls
The most common variation globally is the worst-of autocall, which references a basket of three to five stocks rather than a single index. The autocall and barrier are triggered by the worst performer in the basket — the stock that has fallen furthest from its initial level. If any stock in the basket breaches the barrier at maturity, the investor receives shares in the worst-performing stock (or an equivalent cash amount reflecting its fall).
Worst-of structures are more attractive to clients because they offer higher coupons — sometimes 10–15% per annum — in exchange for the additional correlation risk. The coupon is higher because the bank can sell more correlation risk when it writes a worst-of product: the bank is short correlation (it profits when stocks move together less than implied), and the client bears the risk of one stock diverging badly downward while others hold up.
Reverse Convertibles and Capital-at-Risk Notes
A reverse convertible is a simpler variant: it pays a high fixed coupon unconditionally, but the principal is at risk if the underlying falls below a barrier at maturity. Unlike an autocall, there is no early redemption feature. The investor receives the coupon regardless of performance, but receives either par value (if the stock stays above the barrier) or a proportion of par based on the stock price fall (if it breaches).
The economics are the same as a bond plus a short put option: the high coupon is funded by the premium received from selling the embedded put. The investor has effectively sold insurance against a large equity fall, and receives the option premium as enhanced income.
How the Bank Hedges an Autocall
When the bank issues an autocall note to a client, it takes on a complex, multi-dimensional derivatives position that must be hedged:
Delta risk: The bank is net short the underlying equity (because if the equity rises, the note autocalls and the bank must return principal at par — a loss relative to the rising market). The delta changes as the equity moves relative to the barrier, and especially as observation dates approach. The bank delta-hedges daily using equity futures or the physical shares.
Vega risk: The autocall embeds short optionality — the bank has sold the investor the right to receive a high coupon. The bank is net short volatility: if volatility rises, the probability of a barrier breach increases and the note is worth less to the bank. The bank hedges vega by buying listed options on the index or single stocks.
Correlation risk (for worst-of notes): The worst-of feature means the bank is short correlation: the lower the correlation between stocks in the basket, the more likely one will diverge dramatically downward. The bank hedges this by buying correlation swaps or variance dispersion trades — complex instruments that pay if individual stock volatilities exceed index volatility.
Dividend risk: Dividends reduce the forward price of equities and affect the probability of autocall. The bank hedges dividend risk using dividend swaps or dividend futures.
Client Suitability
Autocall notes carry several risks that must be clearly disclosed: capital is at risk if barriers are breached; early redemption is uncertain, making the investment term unpredictable; secondary market liquidity is limited and may involve a wide bid/offer spread; and the issuer credit risk (the investor is lending money to the bank that issued the note). Regulators in the UK (FCA), EU (under PRIIPs), and elsewhere require a Key Information Document (KID) disclosing risk, costs, and scenarios. These products are generally suitable for sophisticated retail or professional investors with a clear understanding of the conditional payoff.