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CliCK on CirCleS For inTeraCTive FeaTureS

investors are exposed to risk from the
russell 2000s implied volatility and the
skew structure of that volatility, as well as
from the shape of the forward curve for
the index and the
credit risk of uBS.
understanding
this digital coupon
notes performance
and pricing requires
understanding
volatility skew. The
term means volatility
(as implied by option
prices) is higher at
lower strike levels
compared with
at-the-money contracts, for a given con-
tract maturity.
This phenomenon leads to rising
volatility when markets fall and falling
volatility when they rise. Thats because
traders attach a higher probability to a
large downward move (making the op-
tions more expensive) than an equiva-
lent gain on the upside. volatility skew
manifested itself after the october 1987
market crash, when demand surged for
low-strike puts, driving up their price and
implied volatility. after that event, skew
became important in valuing digital op-
tions and other exotic products.
a digital option payoff can be approxi-
mated by a call spread strategy, where an
investor buys a low-strike option and sells
a high-strike one. The more volatility skew
there is, the higher the value of the option.
Pricing a digital option using an assump-
tion of flat volatility, and not accounting for
skew, would make the contract cheaper
than its true value.
The upside performance of the uBS
note resembles a combination of a digital
call and a bullish call spread strategy. The
downside simulates a short knock-in put
option. This is dangerous; a significant
portion of principal could be lost.
Credit (issuer default): The spread over
risk-free rates for two-year debt for uBS
ag was 125 basis points on the pricing
date. Z-spreads for similar-maturity debt
for others ranged from 38.2 basis points
for royal Bank of Canada to 244.8 for
Morgan Stanley.
Chandra Khandrika has valued structured notes
for Bloomberg clients.
Contingent return optimization securi-
ties combine the attractiveness of a
minimum coupon with some participation
in gains of the underlying. They are con-
sidered yield enhancement notes.
on aug. 28, uBS ag issued $11.8 million
of two-year securities linked to the russell
2000 index. They pay 10 percent as long
as the benchmark doesnt fall more than
30 percent by maturity. investors also
receive any rise in the index, beyond 10
percent, up to a cap of 26.25 percent. on
the downside, if the russell 2000 drops
50 percent, breaching the trigger level, the
loss is 50 percent.
The notes advantages include a yield of
up to 26.25 percent in a low interest-rate
environment, a minimum coupon of 10
percent even if the russell 2000 declines
moderately, and a threshold barrier of 70
percent (the index hasnt closed below
that level since nov. 4, 2009). Disadvan-
tages include the principal being fully at
risk if the barrier is crossed.
The note payoff can be replicated using
european-style options and a zero cou-
pon bond.
on the upside:
long on one digital
call option at 570
that pays $1.
long on one call
option at 895.71, to
provide performance
above the minimum
coupon.
Short on one call
option at 1,028.03,
to cap the upside.
on the downside:
Short on one unit of a knock-in put
option that has a strike of 814.28 and a
barrier of 570.
return of capital is replicated by a hypo-
thetical zero coupon bond issued by uBS.
UBS digital Note features minimum Coupon, Some Participation in gains
deCoNSTrUCTiNg THe deal analySiS By CHanDra KHanDriKa, DerivaTiveS PriCing SPeCialiST
-60
-40
-20
0
20
40
60
400 500 600 700 800 900 1000 1100 1200
R
e
t
u
r
n

(
%
)

Underlying (Russell 2000)
Note
Identical returns
UBS Note Pays at Least 10 Percent Unless Index Tumbles
Source: UBS prospectus
Interactive features
not viewable on IOS
devices.
THe noTe
Bloomberg iD: Cv5033161
asset class: equity
Principal protected: no
issuer: uBS Financial Services inc
underlying: russell 2000 index
Maturity: 2 years
Contingent return: 10%
upside participation: 100% (26.25% cap)
Downside participation: 100% (30% barrier)
Trade Date: august 28, 2012
value of the notes
daTe 8/28/12 9/28/12 10/31/12 11/30/12 12/31/12
Embedded Derivative Value -$0.03 $0.24 $0.21 $0.38 $0.59
Model Price $9.97 $10.24 $10.21 $10.38 $10.59
Model Price (Credit Adjusted) $9.68 $10.02 $10.02 $10.21 $10.46
External Price (UBS London) $10.02 $9.94 $10.14 $10.39
01.31.13 www.bloombergbriefs.com Bloomberg Brief | Structured Notes 6
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