CMFAS Module 9A Key Notes 1
Structured products are among the fastest growing investment classes in global finance. The name “structured products” comes from the fact that such products are created by combining traditional investments (usually a fixed income instrument such as bond or note) with financial derivatives (usually an option).
These pre-packaged investments that normally include assets linked to interest plus one or more derivatives. They are generally tied to an index or basket of securities, and are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security such as a conventional investment-grade bond and replacing the usual payment features—periodic coupons and final principal—with non-traditional payoffs derived from the performance of one or more underlying assets rather than the issuer’s own cash flow.
The choice of wrapper depends on a number of factors, including:
- regulatory restriction on issuers
- the desired investment freedom
- desired level of transparency
- the targeted level of returns
- tax consideration in a particular jurisdiction.
The most common wrappers are:
(a) Structured Deposits
(b) Structured Notes
(c) Structured Funds
(d) Structured Investment-linked Life Insurance Policies (ILPs)
Structured Deposits have lower administrative
cost as the bank structuring the product also performs the distribution and the bank usually guarantees return of capital.
While Structured Funds have A wide and ready
distribution network through existing fund distribution channels but their administrative cost is higher due to operating cost of the fund and their product design may be
affected by investment restrictions due to regulatory requirements designed to protect customers.
- They have a wide and ready distribution network through existing insurance distribution channels.
- Insurance coverage being provided, albeit typically very small.
- Insurers typically outsource the structuring, which adds an additional layer of cost.
- Similar to funds, investment restrictions may apply.
Because structured products can be used as an alternative to a direct investment in traditional asset classes, especially in markets where direct access is restricted.
They can also offer access to exotic asset classes typically
out of reach for individual investors. They are extremely versatile, and can be tailor-made to deliver specific risk / return profile to suit the investor’s needs, such as leveraged returns, guaranteed return of capital, or conditional capital protection.
The main challenge would be the difficulty with pricing; as the markets for instruments used to construct structured products may not be liquid enough to achieve meaningful mark-to-market values. The lack of transparency on the hedging and transaction costs implicit in the structure also contributes to the difficulty in getting the price right.
There are two components in every investment transaction, namely the principal invested, and the investment return generated. The purpose of investment is to maximise return, while safeguarding principal.
The return of principal is achieved through a fixed income instrument, which provides periodic interest payments and the return of principal on maturity.
Structured products can be classified into the categories as described below.
- Interest Rate-linked
- FX (Foreign Exchange) and Commodity-linked
Structured products are versatile in the sense that they can be linked to single or multiple securities, in any or a combination of asset classes, of short or long durations, denominated in any currencies, providing full or no return of capital.
Structured products based on their investment objectives, which correspond to their risk levels:
(a) products designed to protect capital;
(b) yield enhancement products; and
(c) performance participation products.
A structured product delivers return to investors only when the:
(a) anticipated market view is correct;
(b) strategy or structure to capture the market view is appropriate; and
(c) pricing on the structure is reasonable.
- Structured deposits;
- Equity or credit-linked notes, to the extent that the fixed income component of the product is structured to provide the return of capital; and
- Capital guaranteed funds.
In terms of structure, a reverse convertible bond consists of:
- a bond, providing the periodic interest payments (if any) and par value at maturity; and
- a written put option (i.e. the investor is selling a put option), providing the shares in lieu of par value at maturity if the kick-in level is breached.
The reason for its creation is to give investors access to investments otherwise not possible or not economically feasible, such as a tailored-made index.
They are designed to give the downside protection only to the level of the barrier. So long as the price of the underlying asset does not drop below the barrier, the payoff to the investor at maturity is no lower than an agreed amount (the “bonus”).
An airbag certificate was created to reduce the impact of knock-out, extending the downside protection up to a pre-determined airbag level. Airbag certificates can be designed to have different airbag level to suit an investor’s particular risk tolerance.
Listed structured funds come under the generic umbrella of
Exchange-Traded Funds (ETFs). Keep in mind that not all ETFs are structured funds. Although majority of ETFs are tracker funds, some ETFs make direct investments, while others use derivatives, to replicate the underlying index.
Investors have three basic investment objectives, namely safety of principal, stability of investment income, and potential for capital appreciation. In addition, the investor wants to be able to convert his investments into cash at a reasonable price, when the need arises.
Factors such as interest rates, inflation, exchange rate, commodity prices, and others can cause prices to fluctuate, as they directly affect profitability.
Yes, the risk drivers for the derivatives component are linked to the underlying assets of the derivatives contracts, as the price movement of the derivatives contracts follows the price movement of the underlying assets, be it an equity index, or a specific commodity, or a basket of stocks or currencies.
The counterparty’s inability to meet contractual obligation is called “default”. The word “default” encompasses a range of failure to meet obligations, such as paying interest when due, making futures delivery, repayment of loan, etc.
There are many possible causes of defaults, ranging from shortterm liquidity crunch due to temporary business or operational tribulation, to more permanent changes in financial position leading to loss of funding facilities. Regulatory action or prohibition may also prevent a counterparty from meeting his commitments
When an institution is exposed to liquidity risk, its financial position and resulting credit standing are inevitably affected, leading to a possible downgrade in its securities and loss of values to their investors.
Liquidity from investor’s perspective refers to the ease of converting his investments into cash. Publicly traded products tend to have greater liquidity over products traded OTC, because there is a ready market. However, just because a product is listed on an exchange, it does not guarantee liquidity, as the investor may be unable to sell his investments for a reasonable price due to lack of demand.
Investors in structured products are exposed to FX risk in two ways.
First, if the investor’s investments are denominated in a foreign currency, he may suffer a loss on principal when he converts the maturity payment (made in foreign currency) back into local currency.
The second source of FX risk relates to investment performance. If the underlying assets are denominated in foreign currency, the investment return is dependent on the FX rate as applied to the performance measurement.
Most derivative contracts are leveraged, or geared, by design. Consequently, a structured product is leveraged if it
uses leveraged derivatives. The price volatility of leveraged products can be significantly greater than direct investments. Some leveraged transactions may result in losses in excess of the amount invested, as is the case in futures contracts.
No, diversification is not just within an asset class, but across asset classes via asset allocation, namely a mix of cash, equities, fixed income, and risk-tolerance permitting, alternative investments such as derivatives, commodities and structured products.