This document is being provided for the exclusive use of CHANDRA KHANDRIKA at PRICEWATERHOUSECOOPERS LLP

10.18.12 www.bloombergbriefs.com Bloomberg Brief | Structured Notes

Deconstructing The Deal

Analysis by Chandra Khandrika, derivatives pricing specialist

Dual Directional Notes Pay in Good Times or Bad, Unless Barrier Is Breached
Dual directional structured notes, which pay positive returns whether a Dual-Directional Notes Gain in Rising or Falling Market linked asset rises or falls (within a cer60 tain range), have become increasingly For technical common. From November 2011 through breakdown of note, 40 the end of April, banks including JPMormouse over circles, starting here: gan Chase & Co. and Citigroup Inc. sold about $350 million of the securities, ac20 cording to data compiled by Bloomberg. On June 20, Morgan Stanley priced $7 million of two-year dual directional 0 Trigger PLUS notes tied to the value of $800 $1,000 $1,200 $1,400 $1,600 $1,800 $2,000 $2,200 gold. They pay 1.5 times the gains in the -20 precious metal, up to a cap of 23 percent. Interactive features The dual directional feature enables the Underlying (gold) not viewable on IOS investor to profit if gold drops by no more -40 Note devices. than 25 percent. Each percentage point Identical returns of decline pays a corresponding positive -60 yield: A 10 percent decrease equals a 10 percent return. A 50 percent decline that Source: Morgan Stanley prospectus breaches the trigger level, though, results in a 50 percent loss. The notes should appeal to investors On the downside: volatility and the skew structure on that who have a moderately bullish or bearish Long on one put option at $1,601. volatility, the shape of the forward curve view on the underlying. Short on two knock-in put options at for gold contracts, and the issuers credit. Advantages include upside returns of $1,601 and at the barrier of $1,200.75. Credit risk is implied from the value as much as 23 percent in a low interest The return of capital is replicated by of the issuers unsecured bonds using rate environment, with a hypothetical z-spreads over risk-free rates. The THE NOTE a threshold barrier at zero coupon z-spread for 24-month debt for MorBloomberg ID: RD1749657 75 percent (gold has bond issued by gan Stanley & Co. LLC was 363 basis Asset class: Commodity not fallen below $1,200 Morgan Stanley. points on the pricing date. Z-spreads for Principal protected: No an ounce, the level of Upside similar-maturity debt for other issuers Issuer: Morgan Stanley the barrier, since 2010). performance ranged from 61.9 basis points for Royal Underlying: Gold Disadvantages include resembles a Bank of Canada to 363 basis points for Maturity: 2 years the entire note principal straddle with Morgan Stanley & Co. LLC. Higher zUpside participation: 150% (23% cap) being at risk. cap strategy. On spreads imply higher risk of default and Downside participation: 100% (25% barrier) Trade Date: June 20, 2012 The note payoff can be the downside, lower the market value of the note. replicated using Europethe investors The value of each $1,000 note, at issuan style options and a zero coupon bond. one-to-one participation beyond the ance and on monthly dates since then, On the upside: barrier simulates a short put option. This is broken down in the table below, using Long on 1.5 call options at $1,601. is dangerous; a significant portion of Bloomberg analytics. Short on 1.5 call options at $1,846.59, to principal could be lost. Chandra Khandrika (ckhandrika@bloomberg.net) simulate the cap. values structured notes for Bloomberg clients. Investors are exposed to risk from gold

Value of the Notes

Date Spot Price Embedded Derivative Value Model Price Model Price (Credit Adjusted) External Price Source (FTID) 6/20/12 $1,601.00 $16.41 $1,016.41 $938.14 6/29/12 $1,598.83 $23.64 $1,023.64 $949.32 7/31/12 $1,613.65 $33.23 $1,033.23 $975.89 8/31/12 $1,692.15 $68.85 $1,068.85 $1,019.86 $1,026.10 9/28/12 $1,773.60 $98.01 $1,098.01 $1,060.35 $1,070.90

Value of derivatives indicates the fair market value of the embedded derivatives. Model price reflects the value of the derivatives, and credit-adjusted model price adds credit risk. External levels are prices provided by other sources.

Return (%)

1234567891011