On 16 April 1998, a commodity-linked bond was launched in Italy, the first in Europe. The bond pays a single coupon at maturity linked to the performance of a basket of three commodities, one of which is silver. The commodities that make up the basket were chosen specifically for their strong economic demand potential and because they provide a hedge against inflation.

In this five-year, ITL100 billion deal, the investor pays lire and receives at maturity the greater of 16% or 120% of the average growth of the commodity basket for the first three years of the bond's life only.

Structured notes such as these are selling briskly. They are targeted at investors looking to diversify their asset classes and play different markets. Commodities, including gold and silver, can provide important protection for portfolios because they tend to perform well when financial markets go awry.

Where 'Basket Growth' represents any appreciation in the basket of commodities between the monthly average for the first three years only and the price on the payment date.

If, for example, the growth in the basket were 20% over the three- year period then the redemption would be the greater of 16% or 30% (i.e., 120% x 20%.)

Demand for this product came principally from two insurance companies, but banks were quick to follow. Italian investors have seen a dramatic decline in lire interest rates during the past three years; they have reached levels many investors no longer find attractive. How to increase yields, yet keep a guaranteed minimum rate of return? With shrinking silver stocks and a surge in industrial demand, this deal provides investors with the opportunity to participate in rising silver prices with very limited downside risk.

How is it priced?

The fund manager receives lire, swaps part of the interest income over the life of the bond for an up-front payment and uses this to purchase out-of-the-money call options on the commodities that make up the basket.