Structured Product - Origin

Origin

Structured investments arose from the needs of companies that wanted to issue debt more cheaply. Traditionally, one of the ways to do this was to issue a convertible bond, that is, debt that under certain circumstances could be converted to equity. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors would accept lower interest rates in the meantime. However this trade-off and its actual worth is debatable, since the movement of the equity value of the company could be unpredictable. Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection. These extra features were all based around strategies investors themselves could perform using options and other derivatives, except that they were prepackaged as one product. The goal was again to give investors more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand the goal for the investment banks was to increase profit margins since the newer products with added features were harder to value, so that it was harder for the banks' clients to see how much profit the bank was making from it.

Interest in these investments has been growing in recent years and high net worth investors now use structured products as way of portfolio diversification. Nowadays the product range is very wide, and reverse convertible securities represent the other end of the product spectrum (yield enhancement products). Structured products are also available at the mass retail level - particularly in Europe, where national post offices, and even supermarkets, sell investments on these to their customers.

Below is a brief description of how structured products are manufactured.

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 underlyings like shares, bonds, indices or commodities with derivatives. The value of derivative securities, such as options, forwards and swaps is determined by (respectively, derives from) the prices of the underlying securities.

The market for derivative securities has grown 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.

Benefits of structured products may include:

• principal protection (depending on the type of structured product)
• tax-efficient access to fully taxable investments
• enhanced returns within an investment (depending on the type of structured product)
• reduced volatility (or risk) within an investment (depending on the type of structured product)
• the ability to earn a positive return in low yield or flat equity market environments

Disadvantages of structured products may include: .

• credit risk - structured products are unsecured debt from investment banks
• lack of liquidity - structured products rarely trade after issuance and anyone looking to sell a structured product before maturity should expect to sell it at a significant discount
• no daily pricing - structured products are priced on a matrix, not net-asset-value. Matrix pricing is essentially a best-guess approach
• highly complex - the complexity of the return calculations means few truly understand how the structured product will perform relative to simply owning the underlying asset

Structured products are by nature not homogeneous - as a large number of derivatives and underlying can be used - but can however be classified under the following categories

• Interest rate-linked notes and deposits
• Equity-linked notes and deposits
• FX and commodity-linked notes and deposits
• Hybrid linked notes and deposits
• Credit-linked notes and deposits
• Constant proportion debt obligations (CPDOs)
• Constant Proportion Portfolio Insurance (CPPI)
• Market-linked notes and deposits