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5. Structured Products
Structured products are synthetic investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used as an alternative to a direct investment in stocks or bonds; as part of the asset allocation process to reduce risk exposure of a portfolio; or to utilize the current market trend.
A structured product is generally a pre-packaged investment strategy which is based on derivatives (i.e. options and to a lesser extent, swaps) but which features protection of principal if held to maturity. For example, an investor invests 100 dollars, the issuer simply invests in a risk free bond which has sufficient interest to grow to 100 after the 5 year period. For example, this bond might cost 80 dollars today and after 5 years it will grow to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and transaction volume requirements of many options and swaps are beyond many individual investors.
Interest in structured investments has been growing quickly in recent years. The main reason for this lies in the economic function of derivatives; it enables the transfer of risk, for a fee, from those who do not want to bear it to those who are willing to bear risk. Structured products are also available at the mass retail level with relatively low entry levels.
Typically, investors use structured products to:
Enhance the potential returns from international markets or protect against market price volatility.
Secure returns based on the performance of broad-based benchmark indices or specific custom-made industry sectors.
Reduce transactions costs, capital gains taxes, or management fees associated with buying and selling securities.
Obtain returns from potentially higher yielding and otherwise unavailable investments by combining elements of different asset classes into hybrid instruments.
Limit, reduce, or virtually eliminate downside exposure to price fluctuations in cash investments by using structured derivative products that are linked to similar or identical assets; risk of loss is usually limited to the dollar amount invested in and the creditworthiness of the issuer of the derivative instrument.
Diversify into international markets, reduce exchange rate exposure, defer taxation, or minimize regulatory risks.
Structured products are by nature not homogeneous as a large number of derivatives and underlying securities can be used, and can be classified broadly under the following categories: Interest rate-linked notes, Equity-linked notes, FX and Commodity-linked notes, and Hybrid-linked notes.
Typically, combinations of derivatives and financial instruments create structures that have significant risk/return and/or cost savings profiles that may not be otherwise achievable in the marketplace. Structured products are designed to provide investors with highly targeted investments tied to their specific risk profiles, return requirements and market expectations. These products are created through the process of financial engineering, i.e. by combining shares, bonds, indices or commodities with derivatives. The value of derivative securities, such as options, forwards and swaps is determined by the prices of the underlying securities.
The benefits of structured products for investors thus include: principal protection; tax-efficient access to fully taxable investments; enhanced returns within an investment; and reduced volatility (or risk) within an investment.
Now anyone that understands investing would be skeptical at this point and rightfully ask, “What is the catch?” The catch in enhanced return structured products, for example, is your potential profits are “capped.” Also, the investor will not participate in any dividends provided by the underlying index, since these products are structured through the use of derivatives.
Investors get nervous when the word “derivative” is used, but when used properly they can add value to an investor’s portfolio through hedging, leverage, or both. For example, one type of structured product that usually becomes more attractive during volatile markets is an investment that offers full or some degree of protection on the downside.
The following broad categories of risk are involved in derivatives and structured products for issuers, dealers, and end users. While not unlike risks present in most financial instruments, the management of these risks presents unique challenges due principally to the customized nature of many derivative and structured financial products.
Credit Risk. The risk of loss should a counterparty fail to perform pursuant to the terms of an agreement. The loss is the cost of replacement, which is usually equal to the present value of expected cash flows at the time of default or the notional value of outstanding positions.
Legal Risk. The risk of loss if an agreement is not enforceable due to insufficient documentation, lack of capacity, or unenforceability in bankruptcy or insolvency.
Liquidity Risk. The risk of loss from either the inability to unwind, offset, or hedge a particular transaction (or the inability to do so without adversely affecting the market price) or the inability to meet payment obligations or collateral requirements.
Market Risk. The risk of loss from an instrument resulting from adverse price movements or market conditions that should generally be viewed from the net or residual exposure of the entire portfolio.
Operational Risk. The risk of loss from deficient or inadequate systems, internal controls of management oversight.
Thus, structured products are not without negatives, of which the prominent for investors are the lack of liquidity, capped returns and their market timing aspect (because they are point-to-point investments).
Be sure to fully understand what you are buying before getting into a structured product, since some tend to be difficult to understand and others may be very expensive. If you do your research and deal with someone with expertise in this area, these can be great investments that should be considered as an addition to anyone’s portfolio.
1) John C. Braddock (1997), Derivatives Demystified
2) J. Scott Miller (2007), “Synthesized Portfolios with Structured Products” , Available at: http://www.forbes.com/personalfinance/2007/04/06/structured-products-hedging-pf-ii-in_jsm_0406soapbox_inl.html]
3) Wikipedia, Available at: http://en.wikipedia.org/wiki/Structured_products