Structured Products? What is that?
When I was selling structured products for Dresdner Kleinwort, I found it difficult to explain to my mom what I was really doing….. So I simplified the concepts and the approach, and I managed to make her almost understand everything! So hopefully my fellow MBA colleagues will also understand easily what I’m talking about….
Aziz Morsly
To explain it simply, structured products are usually bonds or funds wrapped around with options and guarantees. Lets take a simple example:
James is an investor who has 20M$ to invest during 10 years and he wants to be exposed to the S&P500 ‘without’ risking his capital.
James will ask a bank (or a financial institution) to provide him with a solution. The bank will thus package the solution such as:
A zero-coupon bond (that can be issued by the bank itself or by another institution)
and a simple European Call option on S&P500
As you can understand easily, a 10 years zero coupon will cost far less than the 20M$ invested by James, the difference between the 20M$ and the ZC value with thus be equal to the premium of the European Call. Usually the money left doesn’t give the possibility to offer 100% exposure to the S&P500, but a smaller ‘participation’ (let’s say 75%).
So what happens at maturity of the bond? Three cases are possible:
The S&P500 is below it’s initial level (the strike of the option), James will thus receive 100% of it’s investment back (20M$ coming from the ZC) and that’s it…. the option is out of the money and is not exercised (worth 0). James is unhappy because of it’s wrong anticipation, but he gets his capital back.
The S&P500 has boomed and has exactly doubled in 10 years. James is thus really happy, he gets 20M$ (ZC paying the capital) + an extra payment of 15M$ (75% of the performance of the index times the capital invested) = 35M$
The Issuer that James has trusted to provide the guarantee (the ZC) has default…. James is totally depressed, he looses partially his capital (or totality… it depends on the subordination of the debt). The option might still pay something (if the S&P has performed, and if the provider of the option is not the same as the issuer of the ZC…)
As you see really simple stuff.
On what kinds of underlying can a bank package such a solution?
On almost any financial instrument. The underlying could be equity markets (individual or Basket of Indices or stocks), rate markets (specific rate or govies…), credit market (corpo bonds or CDS), commodities markets (indices or other contracts), forex (any exchange rate or basket of fx), real estate (indices, ETFs etc…), funds (trade or not trade, Hedge Funds etc…) and even on hidden assets (Volatility Indices, skew, correlation etc…)
Start to be less simple right?
Lets add some spice: What kind of payments can the investor expect?
Well in addition to the ZC we said earlier that the bank was also selling a European Call to James. But as the human imagination has no limit, payoffs can be much much more complex or lets say tailor-made. For example, James might just want to receive a coupon during the investment life if the S&P500 is above a certain level, in that case the banks will need to package a series of Digital Options to be able to provide the payments.
So any exotic options could be packaged in a structured product and provide with different investment profiles (and expose to different risks). Banks are used to trade light exotic options and thus charge less for these types of products, but some exotic options are less easy to risk-manage (eg. cliquet options) and are thus sold for a higher price, which is translated in a lower participation or a lower coupon).
If James want to sell his bond how does he do that?
In that case James must understand that he has a high probability to lose some capital. Indeed he has bought a ZC that will be worth only 20M$ in 10 years, and an option that is supposed to provide exactly (well minus fees for the bank) the difference. If James wants to sell in 5 years and the S&P has decreased by 50%, there is a big chance that the option will be worth close to zero, and thus James will recover partially his capital (from the ZC). It is important to understand that the option and the ZC are sold in the same package but are priced separately.
James can also want to sell back just a part of his investment, and the bank will provide what we name a secondary market price.
Does James have other choices than buying a bond?
As banks can tailor made payoffs, they can also tailor-made the wrapper. They can offer to James the possibility to buy a bond (called EMTN usually not liquid and secondary market is offered by the bank itself – humhum), a certificate or warrant (liquid and thus easily salable on the market, as there is usually a market maker, the bank itself…), or fund (tradable or not, UCIT or not etc…) or even a special vehicule (called SVT and usually used to put some assets off balance sheet)
Is a structured product always capital guaranteed?
Obviously the answer is no. If James wants to expose some of its capital to gain a greater participation in the underlying performance, the bank will package a solution. Usually the easiest way to implement this, is to create a package such as: a 20M$ Zero Coupon + a European Call – a Put Spread. Thus James will be selling a put spread to bank (let say 100/80%) to gain some participation in the call, but will expose 20% of it’s capital if the underlying performs poorly.
Finally, who is James?
James can be almost any type of investors: an institutional (e.g. insurance company), an asset manager (to package it into a fund / in that case payoff of the option is exchanged against fixed payments into a swap), a private bank (to sell it to their rich clients), a family office, a corporate (to access some markets and diversify their portfolio) and of course individuals (directly buy buying certificate or warrant on the market or indurectly through their insurance contracts)
Well as you can see there is a lot to say on the subject, so if you are interested feel free to ask any question, and I’ll do my best to explain it simply!
Some resources in case you want to read a bit:
– A well documented website where you’ll get the basics: Structured Retail Product Magazine
– A more advanced website with Structured Products news: Risknet for structured products
– To understand everything about options pricing: Wilmott website