Structured Perspectives part 3: How Autocalls harness the Equity Risk Premium

JJ Baker
Nov 20
8 min read

This is a marketing communication for professional investors only. Capital at risk.

Introduction

In part 2 of our Structured Perspectives series, we looked at how Defensive Autocalls and Buffer ETFs take advantage of the Volatility Risk Premium, to what extent, and the nuances behind the differences in risk premium being harnessed between the two types of investment. In part 3, we will be looking at how Defensive Autocalls harness the Equity Risk Premium.

Structural overview: Equity Risk Premium

What is the Equity Risk Premium?

The Equity Risk Premium is one of the most fundamental concepts in finance and represents the extra return investors demand for holding equities instead of a risk-free asset that forgoes the higher volatility and uncertainty of equity markets.

The Equity Risk Premium varies over time and between markets. There are many factors that influence the Equity Risk Premium, such as macroeconomic uncertainty, corporate profitability and investor risk appetite, etc.

For Defensive Autocalls, the Equity Risk Premium is embedded within the option package through the pricing implied by the equity forward. Before we go further, it is important to remind ourselves what the equity forward is.

Equity Forward

Forward contracts, or “futures”, describe derivative contracts that force a buyer and seller to exchange an asset at a fixed price at a pre-determined time in the future. They are traded on many asset classes and are frequently found in commodity markets where corporates use forwards to hedge their exposure to product inputs. Forwards reflect the market’s fair value, non-arbitrage price of the underlying asset at a specific time in the future. Equity forwards are no different and are a key pricing parameter in options.

In equity markets, the forward price of an asset is calculated using the formula below:

Forward = Spot × (1 + Rates – Dividends)

Where:

The “Spot” price is the current price of the asset.
“Rates” is the prevailing risk-free rate to the expiry date of the forward.
“Dividends” is the expected dividends to be paid by the asset until the expiry date of the forward.

What is the thought process behind this formula?

An Equity forward represents an agreement to buy a stock/index in the future, and therefore, its price should reflect this cost of waiting, which is captured in the interest rate component of the equation. Equities can also provide an economic benefit in the form of dividends, and as such, this also needs to be incorporated into the price of the forward. More simply, the interest rate is the return forgone by investing in a stock/index, and the dividends are the returns you are earning.

Let’s look at an example:

Equity Index Level = 6000 Points

1 Year Rates = 4.50%

Expected Dividends = 1.25%

The 1 Year Forward is calculated as follows:

Spot × (1 + Rates – Dividends) = Forward

6000 × (1 + 4.50% – 1.25%) = 6,195, or 103.25% of initial index level.

Why is this the fair price?

Suppose the forward were mispriced at 105% of the initial index level. In that case, I could sell the forward at 105%, borrow $100 to buy the index at initial level, and hold it for a year. I would earn dividends of $1.25, pay $4.50 in interest, and receive $105 at expiry. The resulting profit would be:

$105 – $100 – $4.50 + $1.25 = $1.75, a clear arbitrage.

Harnessing the Equity Risk Premium

Note that there is no input on future growth expectations in calculating an equity forward. Because markets do tend to grow at more than the risk-free rate over time, because of the equity risk premium, it turns out that the forward price of an equity is often lower than where that equity ends up being at the end of the forward’s term. To demonstrate this, we compared realised index returns to forward levels over both one-year and six-year horizons using daily data since 2008. The results are striking.

Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, 01/01/2008 to 30/06/2024

Past performance does not predict future returns.

Over one-year periods, the equity return exceeded the forward level 74% of the time for the UK Large Cap, 84% for

the US Large Cap, and 68% for the European Large Cap. Over six-year periods, these figures rise significantly to 94%, 100%, and 93%, respectively.

This highlights a key point: the forward is not a forecast. It is a mechanical, no-arbitrage construct. Its consistent

underestimation of long-term equity returns reveals the presence of a “forward” risk premium, which is just like the

equity risk premium, inherent in derivatives pricing. It reveals a structural gap between implied pricing and actual

outcomes, one that investors can take advantage of. The table also shows the benefit of harvesting this premium

over longer time horizons. Over longer periods, drivers of long-term returns, like GDP growth, are more important than over short time periods, when short-term volatility can drown out longer-term equity-growth drivers.

This strengthens the case for using longer-dated equity derivative-based strategies to systematically capture the

forward risk premium as a robust and reliable return source over shorter-term equity derivative strategies.

The graphs below compare the Equity Risk Premium over different time horizons and demonstrate that it is more

apparent in the longer term.

Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, 01/01/2008 to 30/06/2024

Past performance does not predict future returns.

This explains why investors tend to favour time horizons of around 6 years for Defensive Autocall investments. While the relationship between short-dated and long-dated implied volatility is not always consistent, one key observation has been consistent: market drawdowns tend to be shallower and less frequent over 5-to-7-year periods. This tends to align with the length of business and credit cycles, which often revert and recover from recessions and periods of stress over a similar timeframe.

In contrast, shorter investment horizons are more exposed to acute market stress events, such as the COVID-19 Pandemic or the Global Financial Crisis, where volatility and correlation spike, and short-term losses can be severe. Meanwhile, time horizons of longer than six years tend to increase the risk of “double dip” scenarios, where markets recover only to decline again, as seen in various post-crisis or stagflationary environments.

By targeting a 6-year maturity, investors position themselves in the historical sweet spot of the risk/return curve: generally, long enough to benefit from long-term growth drivers, mean reversion and cycle recovery, yet short enough to avoid the compounded risks of multi-phase downturns. This is demonstrated in the maximum drawdowns graph below.

Historical Maximum Drawdowns

Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, US Large Cap: Solactive US Large Cap Index 01/01/1984 – 30/06/2024, European Large Cap: Solactive Euro 50 Index 01/01/1987 to 30/06/2024.

Another useful way to demonstrate the historical sweet spot of risk and return is by looking at the frequency of 20% and larger drawdowns throughout history. The graph below shows that frequency is significantly reduced around the 6-year mark, with increased frequency in both the shorter and longer term.

Frequency of 20%+ Drawdowns

Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, US Large Cap: Solactive US Large Cap Index 01/01/1984 to 30/06/2024, European Large Cap: Solactive Euro 50 Index 01/01/1987 to 30/06/2024.

So not only do Defensive Autocalls take advantage of what has historically been a rich source of volatility risk premium via longer dated volatility selling as we discussed in our previous note, but the 6-year tenor also allows Defensive Autocalls to capture the equity risk premium through the forward more effectively than do shorter-dated investments.

What does this mean for returns?

To quantify the impact of this premium in terms of return potential, we can perform the same exercise as that performed in Part 2 of this series. Firstly, we took the terms of a Defensive Autocall typical of our Defined Returns Fund, a UK/Europe underlying combination yielding a return of 8.60% per annum, and a UK/US variation yielding 8.40%.

Common Terms:

Annual Autocall Barrier Levels: 100% / 95% / 90% / 85% / 80% / 69%
Conditional Capital Protection Barrier: 64% (i.e. capital protected up to a 36% fall)

We then calculated the average outperformance of the underlying indices relative to their forwards between 2008 and now, and illustrated the results in the table below:

	1 Year	6 Year	6 Year Annualised
UK Large Cap	5.82%	25.73%	3.89%
US Large Cap	11.48%	90.26%	11.32%
EU Large Cap	6.71%	35.13%	5.15%

Source: Atlantic House, Solactive. UK Large Cap: Solactive United Kingdom Large Cap ex Investment Trust Index, 01/01/2008 to 30/06/2024

Past performance does not predict future returns.

Taking one of the numbers in this table, it shows that, on average, the UK Large Cap market outperformed its forward

by an annualised 3.89% since 2008.

We then wanted to use these outperformance numbers to somehow quantify the value of the forward risk premium on autocall pricing.

We therefore decided to take a conservative approach and shift the forward of each index up by the lowest of the 6-year annualised outperformance figures across the 3 indices (3.89%) to be conservative and reprice the autocalls with this higher forward. We found that respective UK/Europe and UK/US defensive autocall pricing would have been significantly lower, as the table below shows:

Index pair	"Normal" pricing	"Adjusted Forward" pricing	Difference
UK/Europe	8.60%	5.80%	2.80%
UK/US	8.40%	5.50%	2.90%

Source: Atlantic House, 25/06/2025

Using this method, we can estimate that the forward risk premium is worth almost 3% in this type of investment.

Conclusion

Whilst both Buffer ETFs and Defensive Autocall strategies take advantage of the Equity Risk Premium, longer dated autocalls benefit to a greater extent. This is due to both the overall drift in markets as well as the nature of equity market declines being shallower and less common over longer time periods than when compared to shorter tenors. This Equity Risk Premium is the main driver of autocall returns above the equivalent bond return, and when combined with the Volatility Risk Premium, largely explains the excess returns of a Defensive Autocall. In our final part, we will have a look at what this means for defined outcome strategies in general and what this can mean for client outcomes.

Important information

This is a marketing communication issued by Atlantic House Investments Limited and does not constitute or form part of any offer or invitation to buy or sell shares. It should be read in conjunction with the Fund’s Prospectus, key investor information document (“KIID”) or offering memorandum. Atlantic House Investments Limited is authorised and regulated by the Financial Conduct Authority FRN 931264. Atlantic House Investments Limited is a Private Limited Company registered in England and Wales, registered number 11962808. Registered Office: One Eleven Edmund Street, Birmingham. B3 2HJ.

The contents of this article are based upon sources of information believed to be reliable. Atlantic House Investments Limited has taken reasonable care to ensure the information stated is accurate. However, Atlantic House Investments Limited make no representation, guarantee or warranty that it is wholly accurate and complete.

This material may not be disclosed or referred to any third party or distributed, reproduced or used for any other purposes without the prior written consent of Atlantic House, any data provider and any other third party whose data is included herein and must be returned on request to Atlantic House and any copies thereof in whatever form destroyed.

A decision may be taken at any time to terminate the arrangements for the marketing of the Fund in any jurisdiction in which it is currently being marketed. Shareholders in affected EEA Member State will be notified of any decision to terminate marketing arrangements in advance and will be provided the opportunity to redeem their shareholding in the Company free of any charges or deductions for at least 30 working days from the date of such notification.

GemCap Investment Funds (Ireland) plc is authorised in Ireland by the Central Bank of Ireland pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations 2011 (S.I. No. 352 of 2011) (the “UCITS Regulations”), as amended.

Gemini Capital Management (Ireland) Limited, trading as GemCap, is a limited liability company registered under the registered number 579677 under Irish law pursuant to the Companies Act 2014 which is regulated by the Central Bank of Ireland. Its principal office is at Suites 22-26 Morrison Chambers, 32 Nassau Street, Dublin 2, D02 X598 and its registered office is at 7th Floor, Block A, One Park Place, Upper Hatch Street, Dublin 2, D02E762. GemCap acts as both management company and global distributor to GemCap Investment Funds (Ireland) plc.