Understanding Structured Products

Once upon a time, the retail investment world was a quiet, rather pleasant place where a
small, distinguished cadre of trustees and asset managers devised prudent portfolios for
their well-heeled clients within a narrowly defined range of high-quality debt and equity
instruments. Financial innovation and the rise of the investor class changed all that.
One innovation that has gained traction as an addition to retail and institutional portfolios
is the class of investments broadly known as structured products. This article provides
an introduction to structured products with a particular focus on their applicability in
diversified retail portfolios.
What are structured products?
Structured products are designed to facilitate highly customied risk-return
ob!ectives. This is accomplished by taking a traditional security, such as a conventional
investment-grade bond, and replacing the usual payment features "e.g. periodic coupons
and final principal# with non-traditional payoffs derived not from the issuer$s own cash
flow, but from the performance of one or more underlying assets.
The payoffs from these performance outcomes are contingent in the sense that if the
underlying assets return %&%, then the structured product pays out %y%. This means that
structured products closely relate to traditional models of option pricing, though they may
also contain other derivative types such as swaps, forwards and futures, as well as
embedded features such as leveraged upside participation or downside buffers. "For
related reading, see Understanding Option Pricing.#
Structured products originally became popular in 'urope and have gained currency in
the (.S., where they are frequently offered as S')-registered products, which means
they are accessible to retail investors in the same way that stocks, bonds, e&change-
traded funds "'TFs# and mutual funds are. Their ability to offer customied e&posure,
including to otherwise hard-to-reach asset classes and subclasses, makes structured
products useful as a complement to these other traditional components of diversified
portfolios.
Looking Under the Hood
)onsider the following simple e&ample* a well-known bank issues structured products in
the form of notes, each with a notional face value of +,,---. 'ach note is actually a
package consisting of two components* a ero-coupon bond and a call option on an
underlying equity instrument, such as a common stock or perhaps an e&change traded
fund "'TF# mimicking a popular stock inde& like the S./ 0--. 1aturity is in three
years. Figure , represents what happens between issue and maturity date.
)opyright 2 3--4 5nvestopedia (6)
Figure ,
7lthough the pricing behind this is comple&, the principle is fairly simple. On the issue
date you pay the face amount of +,,---. This note is fully principal-protected, meaning
that you will get your +,,--- back at maturity no matter what happens to the underlying
asset. This is accomplished via the ero-coupon bond accreting from its original issue
discount to face value.
For the performance component, the underlying, priced as a 'uropean call option, will
have intrinsic value at maturity if the underlying asset$s value on that date is higher than
its value when issued. 8ou earn that return on a one-for-one basis. 5f not, the option
e&pires worthless and you get nothing in e&cess of your +,,--- return of principal.
Custom Sizing
5n the e&ample above, one of the key features is principal protection. 5n another
instance, an investor may be willing to trade off some or all of this protection in favor of
more attractive performance features. )onsider another case. 9ere, an investor trades
the principal protection feature for a combination of performance features.
5f the return on the underlying asset "Rasset# is positive - between ero and 4.0: - the
investor will earn double the return "e.g. ,0: if the asset returns 4.0:#. 5f Rasset is
greater than 4.0:, the investor$s return will be capped at ,0:. 5f the asset$s return is
negative, the investor participates one-for-one on the downside "i.e. no negative
leverage#. There is no principal protection. Figure 3 shows the option payoff chart for this
scenario.
)opyright 2 3--4 5nvestopedia (6)
Figure 3
This strategy would be consistent with a mildly bullish investor$s view - one who e&pects
positive but generally weak performance and is looking for an enhanced return above
what he or she thinks the market will produce.
Over the Rainbow
One of the principle attractions of structured products for retail investors is the ability to
customie a variety of assumptions into one instrument. For e&ample a rainbow note is
one that offers e&posure to more than one underlying asset. 7 lookback is another
popular feature. 5n a lookback instrument, the value of the underlying asset is based not
on its final value at e&piration, but on an average of values taken over the note$s term,
for e&ample monthly or quarterly. 5n the options world, this is also called an 7sian option
to distinguish it from the 'uropean or 7merican option. )ombining these types of
features can provide attractive diversification properties.
7 rainbow note could derive performance value from three relatively low-correlated
assets, for e&ample the ;ussell <--- 5nde& of (.S. stocks, the 1S)5 /acific e&-=apan
inde& and the >ow-75? commodity futures inde&. 7ttaching a lookback feature to this
could further lower volatility by %smoothing% returns over time rather than on !ust one
date.
What about i!uidit"?
One common risk associated with structured products is a relative lack of liquidity due to
the highly customied nature of the investment. 1oreover, the full e&tent of returns from
the comple& performance features is often not realied until maturity. @ecause of this,
structured products tend to be more of a buy-and-hold investment decision rather than a
means of getting in and out of a position with speed and efficiency.
7 significant innovation to improve liquidity in certain types of structured products comes
in the form of e&change-traded notes "'TAs#, a product originally introduced by @arclays
@ank. These are structured to resemble 'TFs, which are fungible instruments traded like
regular common stock on a securities e&change. 'TAs are different from 'TFs,
however, as they consist of a debt instrument with cash flows derived from the
performance of an underlying asset - in other words, a structured product. 'TAs can
provide access to hard-to-reach e&posures, such as commodity futures and the 5ndian
stock market. "For more insight, read Exchange Traded Notes - An Alternative To ETFs.#
Other Risks and Considerations
5n addition to liquidity, one risk associated with structured products is the credit quality of
the issuer. 7lthough the cash flows are derived from other sources, the products
themselves are legally considered to be the issuing financial institution$s liabilities. They
are typically not, for e&ample, issued through bankruptcy-remote third party vehicles in
the way that asset-backed securities are. The vast ma!ority of structured products are
from high investment grade issuers only - mostly large global financial institutions such
as @arclays, >eutsche @ank or =/ 1organ )hase.
7nother consideration is pricing transparency. There is no uniform standard for pricing,
making it harder to compare the net-of-pricing attractiveness of alternative structured
products offerings than it is, for instance, to compare the net e&pense ratios of different
mutual funds or commissions among broker-dealers. 1any structured products issuers
work the pricing into their option models so that there no e&plicit fee or other e&pense to
the investor. On the flip side, this means that the investor can$t know for sure what the
implicit costs are.
Concusions
The comple&ity of derivative securities has long kept them out of meaningful
representation in traditional retail "and many institutional# investment
portfolios. Structured products can bring many of the benefits of derivatives to investors
who otherwise would not have access to them. 7s a complement to more traditional
investment vehicles, structured products have a useful role to play in modern portfolio
management.