structured product - aiwmi...structured products •they are also known as market-linked...

Structured ProductCHAPTER 6

Concept of Structured Products

Benefits to Investors

Risks of Structured Products

Types of Structured Products

Special Purpose Vehicle/Entity

Benefits and Risks to Sponsoring Firms

Risk Measures for CDO

Future for Structured Products

Structured Products• Structured products are financial instruments which offer investors a

range of different investment terms and risk profiles much like other mainstream investments.

• Structured products promise to protect some or all of the money invested whilst providing some growth on the investment or a measure of predefined income throughout the life of investment.

• They are fixed-term products which means the investor has to be prepared to “lock in” his money for the term of the investment but this often means that they have the potential to provide “enhanced returns” and can help with the financial planning process.

Structured Products• They are also known as market-linked investments.

• These are pre-designed investment strategies which are based on a single or basket of securities, indices, foreign currencies, debt options, commodities and to a little extent derivatives.

• There is no set strategy for structured products.

• Certain structured products provide a “principal guarantee” function which translates to principal protection if the product is held till maturity.

Structured Products• U.S. Securities and Exchange Commission (SEC) Rule 434 (regarding

certain prospectus deliveries) defines structured securities as "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".

Benefits to Investors• The investors have a thorough understanding of their potential returns

as the costs are calculated up-front when designing the product and are “built in” to the terms offered to potential investors.

• A defined investment term allows potential investors to plan more effectively and gauge their potential returns over the term of the investment.

• Growth plans which offer geared or accelerated returns linked to the performance of an established index.

Benefits to Investors• Income plans are available which offer attractive levels of fixed income

over the term of the investment and also stay fixed despite market volatility or interest rate changes.

• The returns are often linked to the performance of a well-known and publicized index which enables investors to monitor the performance of their investment.

• Some plans incorporate trigger points (linked to the performance of the underlying index) which enable additional features when this pre-set level is breached.

Risks of Structured Products• It can suffer a loss in value due to market movements.

• Option strategies are used which work on leverage and can lead to complete loss in margin payments if market moves in the opposite direction than expected.

• The products which guarantee principal might not be insured by Federal Deposit Insurance Corporation (US) or any other concerned authority of the region and thus might not provide any protection during the time of bankruptcy or liquidity crunch.

Risks of Structured Products• Structured Products do not trade on secondary markets and thus

provide very less liquidity.

• The structure of these products are a little complicated and thus it is difficult to calculate the expected return. Thus, it makes simply owning the assets easier and simpler.

Autocalls

• These are structured products, which can mature prior to their scheduled maturity date, if certain

predetermined market conditions have been met.

Income products

• These are market-linked investments that can provide an enhanced level of income.

Growth Products

• These are market-linked investments, which aim to return a growth payment and initial capital at

maturity of the plan.

Structured deposit plans

• These are cash-based fixed term deposits, like fixed rate bonds, but instead of paying a fixed rate

there is a variable return linked to the performance of an underlying asset.


Auto-Callable Products• It consists of a zero coupon bond with a call or put option on any

underlying asset.

• Auto-calls get automatically matured prior to the scheduled maturity date if a certain predetermined market condition with reference to the underlying asset has been met.

• Some auto-call products also have a conditional capital protection feature.

Auto-Callable Products• The zero coupon bond is bought at a price less than the face value with

the face value being repaid at maturity of the product.

• Option embedded in the product provides the investor with the right (not obligation) to buy (call option) or sell (put option) the underlying asset at a predefined price on a specified date in the future.

• It might also include digital options, they provide a fixed pay out if the value of the underlying asset is equal to or more than a previously agreed upon level. This can lead to an early pay out or ‘kick out’.

Income Products• These are market-linked financial instruments which are expected to

give return well above risk free rate of return and ahead of inflation.

• The income earned on the product can be fixed and is usually paid either annually or monthly depending on the duration of the plan.

• In some of the plans, the income of the product can also depend on the performance of the underlying asset.

• There can be two types of income products: capital protected or capital-at-risk.

Income Products• These products are also structured with zero coupon bonds and an

option.

• The ZCB returns the original capital investment in the product. Sale of put option can increase the capital investment in the product however, it also introduces risk to the initial capital if the underlying asset were to fall significantly below the exercise price.

• Other options are purchased to provide either the fixed pay out or the income pay out if the underlying is above a predetermined level.

Growth Product• These are market linked products which return a formulaic growth

along with the initial capital upon maturity of the plan.

• The growth in these products depends upon the performance of the underlying asset.

• The growth in the price of the underlying asset between the closing and opening level of the plan is multiplied by a pre-decided amount which is then paid to the investor.

• These plans usually have a cap on the maximum growth which can be paid.

Growth Product• A growth product also might include a call spread.

• It is created by combination of two call options i.e. buying a call option at a low strike price and selling another call option at a higher strike price.

• The number of call spreads equal the number of times the growth payment pays out on the performance of the underlying.

Structured Deposit Plan• These are cash based fixed term deposits which pay a variable return as

per the performance of the underlying asset.

• These are generally used to complement traditional cash based savings vehicle.

• At the maturity of the product, the full capital is paid out with a variable interest (subject to counterparty risk).

• These plans are ideal for investors who desire a capital security but also wish to earn high return instead of fixed interest provided by traditional cash deposits such as fixed rate bonds.

Structured Deposit Plan• The return from these products is deemed as interest income and thus

the tax treatment is also the same.

• At the beginning of the plan, the initial investment is transferred to a Deposit Taker. It provides the investor with the return specified in the plan brochure in exchange of the interest earned by the deposit.

• The investments are placed in a bare trust and the plan manager is allowed to act on the behalf of the investors.

• The plan manager acts as the trustee of the trust with the investors being the beneficiaries.

Special Purpose Vehicle• It is a legal entity created to fulfill a specific objective.

• It is created as a subsidiary company and thus has a legal identity different from its parent company such that if the parent company goes bankrupt its assets are protected.

• It usually forms the counterparty for swaps or other credit sensitive derivative instruments.

• The presence of accounting loopholes can turn this method into a financially damaging way of hiding debt.

Special Purpose Vehicle• The structure of a SPV can be of trust, corporation, limited liability

partnership, etc.

• The various purposes of creating a SPV includes protection of a project from insolvency problems, independent ownership and management of a company, creating a synthetic lease that is expensed on the entity’s income statement rather than recorded as a liability on the balance sheet.

• It help in reducing the risk exposure of the sponsor by reallocation the risks to interested investors.

Process of Risk Transfer

Uses of SPV• Securitization

• Asset transfer

• Financing

• Risk sharing

• Financial engineering

• Raising capital

Benefits to Sponsoring Firms• Asset Ownership

• Minimal red tape

• Clarity of documentation

• Freedom of jurisdiction

• Tax benefits

• Legal protection

• Isolation of Financial Risk

• Meeting regulatory requirements

Risks to Sponsoring Firms• Lack of Transparency

• Reputational Risk

• Signaling Effect

• Franchise Risk

• Liquidity and Funding Risk

• Equity Risk

• Mark-to-Market Risk

Risk measures for CDO• Collateralized debt obligations is referred to as the securitization of a

pool of assets.

• CDOs issue securities in the form of different tranches with each tranche having a different maturity and credit risk.

• Tranches are divided as senior, mezzanine and subordinate or equity with the credit risk being highest in case of equity.

• The hierarchy of repayment is termed as ‘Cash Flow Waterfall’.

Risk measures for CDO• The credit rating of each trance is reflection of the credit quality of the

collateral and also shows how much credit protection is provided by its subordinate tranche(s).

• The sponsor of the CDO typically holds the subordinate tranche and is thus also referred to as first loss position.

Future of Structured Product• The market for structured products has seen a significant momentum in

the recent years.

• A few years ago, a number of structured products earned a poor reputation as the providers and investors chased high returns, just as markets and interest rates went against them. Exotic products tried to match those aims, but at the expense of severe losses of capital should markets tumble.

• After the dotcom bust, many realized too late that capital protection and sensible targets were essential.

Future of Structured Product• Today’s protected plans are smarter, more transparent with their terms

and charges and generally more investor friendly.

• There are different structured products available for different investment objectives.

• Each product is formed using some complex financial tools to achieve the investment objectives.

“I will tell you how to

become rich. Close the doors.

Be fearful when others are

greedy. Be greedy when

others are fearful.”

– Warren Buffett

THANK YOU

structured product - aiwmi...structured products •they are also known as market-linked...

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