In our last few posts we have talked a lot about simple derivatives with their detailed structure and the different approaches, they have towards market. Going onward, we will be discussing another complex form of derivatives known as structured derivative products. We will take up these products one by one separately in detail, within our new series of posts “School-To-College”.
In today`s post, we would be discussing what structured derivatives are all about, Emergence of these product with what importance they have in market?
Meaning Of Structured Derivatives: In finance, a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, commodities, debt issuance and/or foreign currencies, and to a lesser extent, swaps.
Definition: Structured derivatives are financial products whose returns are linked to underlying stocks, interest rates, commodities or indices. They are used as flexible alternative to traditional investments, and designed to provide investors with targeted investments tied to their specific risk profiles, return requirements and market expectations. Also,
- Structured securities are securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor’s investment return and the issuer’s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows: US Securities and Exchange Commission (SEC).
- Structured products are products that are derived from and/or based on a single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign currency, among other things” and include “index and equity linked notes, term notes and units generally consisting of a contract to purchase equity and/or debt securities at a specific time: The Pacific Stock Exchange.
Structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. The goal was 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.
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 underlying like 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. 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.
Structured Derivatives can 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
Important Feature: A feature of some structured products is a “principal guarantee” function, which offers protection of principal if held to maturity.
Economic Function:- 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:
- 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:
- Structured products are unsecured debt from investment banks
- 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
- Structured products are priced on a matrix, not net-asset-value.
- The complexity of the return calculations means few truly understand how the structured product will perform relative to simply owning the underlying asset
Summary: Structured products originally became popular in Europe and have gained currency in the U.S., where they are frequently offered as SEC-registered products, which means they are accessible to retail investors in the same way that stocks, bonds, exchange-traded funds (ETFs) and mutual funds are. Their ability to offer customized exposure, 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.