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A structured product, also known as a market-linked investment, is a pre-packaged
structured finance Structured finance is a sector of finance — specifically financial law — that manages Leverage (finance), leverage and Financial risk, risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of ...
investment Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...
strategy based on a single
security Security is protection from, or resilience against, potential harm (or other unwanted coercion). Beneficiaries (technically referents) of security may be persons and social groups, objects and institutions, ecosystems, or any other entity or ...
, a basket of securities, options, indices,
commodities In economics, a commodity is an economic good, usually a resource, that specifically has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. Th ...
, debt issuance or foreign
currencies A currency is a standardization of money in any form, in use or currency in circulation, circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a ''system of money'' in common use wi ...
, and to a lesser extent, derivatives. Structured products are not homogeneous — there are numerous varieties of derivatives and underlying assets — but they can be classified under the aside categories. Typically, a
desk A desk or bureau is a piece of furniture with a flat table (furniture), table-style work surface used in a school, office, home or the like for academic, professional or domestic activities such as reading (activity), reading, writing, or using ...
will employ a specialized "
structurer In investment banking, a structurer Joris Luyendijk (2012)Interview: Head of Structuring equity-derivatives ''theguardian.com'' is the finance professional responsible for designing structured products. Their solution will typically deliver ...
" to design and manage its structured-product offering.


Formal definitions

U.S. Securities and Exchange Commission The United States Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street crash of 1929. Its primary purpose is to enforce laws against market m ...
(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".


Utility

From the
investor An investor is a person who allocates financial capital with the expectation of a future Return on capital, return (profit) or to gain an advantage (interest). Through this allocated capital the investor usually purchases some species of pr ...
's point of view, the concept of structuring means customizing a specified return stream; structured products can be used as an alternative to a direct investment, as part of the
asset allocation Asset allocation is the implementation of an investment strategy that attempts to balance risk versus reward by adjusting the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investm ...
process to reduce risk exposure of a
portfolio Portfolio may refer to: Objects * Portfolio (briefcase), a type of briefcase Collections * Portfolio (finance), a collection of assets held by an institution or a private individual * Artist's portfolio, a sample of an artist's work or a ...
, or to utilize the current market trend. From the issuer's point of view, structuring means that a number of existing financial products are combined to achieve the client's desired return function. Theoretically an investor can do this themselves, but the cost and transaction volume requirements of many options and swaps are beyond many individual investors. As such, structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. The more outlandish the idea and with less time to play out, the cheaper pricing will naturally be (see
moneyness In finance, moneyness is the relative position of the current price (or future price) of an underlying asset (e.g., a stock) with respect to the strike price of a derivative, most commonly a call option or a put option. Moneyness is firstly a th ...
). Two typical
use case In both software and systems engineering, a use case is a structured description of a system’s behavior as it responds to requests from external actors, aiming to achieve a specific goal. It is used to define and validate functional requireme ...
s: * An investor dislikes a specific stock and does not want to hold it in their portfolio, but knows how much regret a 20 percent rise in the stock would cause. Therefore, the investor chooses to purchase a structured product on the stock instead: an agreement ('contract', 'certificate', '
note Note, notes, or NOTE may refer to: Music and entertainment * Musical note, a pitched sound (or a symbol for a sound) in music * ''Notes'' (album), a 1987 album by Paul Bley and Paul Motian * ''Notes'', a common (yet unofficial) shortened versi ...
') with another entity (e.g. a bank) that pays out the full return on the given stock, but only if the stock surpasses a specified threshold, such as this 20%, over a specified time period. This product is known as a market-linked note. Numerous combinations of conditions and assets are available to construct this, see below, and the pricing is then based on past likelihoods and actual occurrences, and current market expectations of such returns happening over such timespans given the agreed constraints. * A feature of some structured products is a principal guarantee function, which offers protection of principal if held to maturity. For example, an investor invests $100, the issuer simply invests in a
risk-free bond A risk-free bond is a theoretical bond that repays interest and principal with absolute certainty. The rate of return would be the risk-free interest rate. It is primary security, which pays off 1 unit no matter state of economy is realized at t ...
that has sufficient interest to grow to $100 after the five-year period. This bond might cost $80 today and after five years it will grow to $100. With the remaining funds, the issuer purchases the options and swaps needed to perform whatever the investment strategy calls for. See
structured note A structured note is an over the counter derivative with hybrid security features which combine payoffs from multiple ordinary securities, typically a stock or bond plus a derivative. When the product depends on a credit payoff, it is calle ...
.


Origin

Structured investments arose from the needs of companies that want to issue
debt Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...
more cheaply. This could have been done by issuing a
convertible bond In finance, a convertible bond, convertible note, or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock in ...
—i.e., debt that could be converted to equity under certain circumstances. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors would accept lower interest rates in the meantime. However, the worth of this tradeoff is debatable, as the movement of the company's equity value could be unpredictable.
Investment bank Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...
s then decided to add features to the basic convertible bond, such as increased income in exchange for limits on the
convertibility Convertibility is the quality that allows money or other financial instruments to be converted into other liquid stores of value. Convertibility is an important factor in international trade, where instruments valued in different currencies must ...
of the
stock Stocks (also capital stock, or sometimes interchangeably, shares) consist of all the Share (finance), shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporatio ...
, or principal protection. These extra features were all strategies investors could perform themselves using options and other derivatives, except that they were prepackaged as one product. The goal was again to give investors more reasons to accept a lower
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...
on debt in exchange for certain features. On the other hand, the goal for investment banks was to increase profit margins since the newer products with added features were harder to value, and thus harder to gauge bank profits. 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 A reverse convertible security is a type of convertible security where a bond or short-term note can be converted to cash, debt or equity at a set date by the issuer based on an underlying stock. In effect it is a type of option on the maturity d ...
represent the other end of the product spectrum ( yield enhancement products). Structured products are also available at the mass
retail Retail is the sale of goods and services to consumers, in contrast to wholesaling, which is the sale to business or institutional customers. A retailer purchases goods in large quantities from manufacturers, directly or through a wholes ...
level—particularly in
Europe Europe is a continent located entirely in the Northern Hemisphere and mostly in the Eastern Hemisphere. It is bordered by the Arctic Ocean to the north, the Atlantic Ocean to the west, the Mediterranean Sea to the south, and Asia to the east ...
, where national
post offices Post, POST, or posting may refer to: Postal services * Mail, the postal system, especially in Commonwealth of Nations countries ** An Post, the Irish national postal service ** Canada Post, Canadian postal service ** Deutsche Post, German posta ...
, and even
supermarkets A supermarket is a self-service Retail#Types of outlets, shop offering a wide variety of food, Drink, beverages and Household goods, household products, organized into sections. Strictly speaking, a supermarket is larger and has a wider selecti ...
, sell investments on these to their customers; these are referred to as
PRIIPs Packaged retail investment and insurance products (PRIIPs) is European Union regulatory term to encompass a range of investment products that banks or other financial institutions offer to consumers. It was first used in regulation (EU) No 1286/ ...
. Structured product business, as a key part of customer-driven derivatives business, has changed dramatically in recent years. Its modern setup requires a comprehensive understanding of: * Prevailing regulatory environment, specifically existing and forthcoming regulations including
MiFID II Markets in Financial Instruments Directive 20142014/65/EU commonly known as MiFID 2), is a directive of the European Union (EU). Together with Regulation No 600/2014 it provides a legal framework for securities markets, investment intermediari ...
, KYC
PRIIPs-KIDs
etc. * Principles of risk-based capital/liquidity requirements specified by
Basel III Basel III is the third of three Basel Accords, a framework that sets international standards and minimums for bank capital requirements, Stress test (financial), stress tests, liquidity regulations, and Leverage (finance), leverage, with the goa ...
,
FRTB The Fundamental Review of the Trading Book (FRTB), is a set of proposals by the Basel Committee on Banking Supervision for a new market risk-related capital requirement for banks. Background The reform, which is part of Basel III, is one of th ...
, etc. * Real-life quantitative pricing models able to handle multi-curve environments, volatility smile/skew, etc. * Structured product payoff features and their risk characteristics, as above * Structured product manufacture process, and the "derivatives business" value chain - i.e. linking trading, structuring, quantitative modelling and risk management * Structured product distribution channels, product wrappers, impact of e-platforms


Product design and manufacture

Structured products aspire to provide investors with highly targeted investments tied to their specific
risk profiles Risk equalization is a way of equalizing the risk profiles of insurance members to avoid loading risk premium, premiums on the insured to some predetermined extent. In health insurance, it enables private health insurance to operate in some countri ...
, return requirements and market expectations. Benefits of structured products may include: * Principal protection,
as above ''As Above...'' is an album released in 1982 by Þeyr, an Icelandic new wave and rock group. It was issued through the Shout record label on a 12" vinyl record. Consisting of 12 tracks, ''As above...'' contained English versions of the band' ...
(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) * Ability to earn a positive return in low-yield or flat equity market environments * Ability to minimize issuer risk by using collateral secured instruments (COSIs) backed with collateral in the form of securities or cash deposits Historically, this aspiration is met with an ad hoc approach: the structure of the product is postulated in a way that seems appropriate for the client. Within this approach it can be difficult to articulate the precise problem the product is designed to solve, let alone to claim the product as optimal for the client. Nevertheless, this approach is still widely used in practice. A more advanced mathematical approach to product design has been proposed. It allows the structure of
financial products Financial services are economic services tied to finance provided by financial institutions. Financial services encompass a broad range of service sector activities, especially as concerns financial management and consumer finance. The financ ...
to be derived as a mathematically optimal solution to the clients' needs. This approach demands higher proficiency from both the
structurer In investment banking, a structurer Joris Luyendijk (2012)Interview: Head of Structuring equity-derivatives ''theguardian.com'' is the finance professional responsible for designing structured products. Their solution will typically deliver ...
who designs the product, and the client who needs to understand the proposal. Once the product is designed, it is manufactured through the process of
financial engineering Financial engineering is a multidisciplinary field involving financial theory, methods of engineering, tools of mathematics and the practice of programming. It has also been defined as the application of technical methods, especially from mathe ...
. This involves replicating the product through a trading strategy involving
underlying In finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements: # an item (the "underlier") that can or must be bou ...
instruments such as bonds,
shares In financial markets, a share (sometimes referred to as stock or equity) is a unit of equity ownership in the capital stock of a corporation. It can refer to units of mutual funds, limited partnerships, and real estate investment trusts. Sha ...
, indices,
commodities In economics, a commodity is an economic good, usually a resource, that specifically has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. Th ...
as well as simple derivatives like vanilla options, swaps and
forward contract In finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument.John C Hu ...
s.


Risks

The market for derivatives has grown quickly in recent years because,
as above ''As Above...'' is an album released in 1982 by Þeyr, an Icelandic new wave and rock group. It was issued through the Shout record label on a 12" vinyl record. Consisting of 12 tracks, ''As above...'' contained English versions of the band' ...
, they perform an economic function by enabling the risk averse to transfer risk to those who are willing to bear it for a fee. At the same time, there are several risks associated with many structured products, especially those that present risks of loss of principal due to market movements, are similar to risks involved with options. Disadvantages of structured products may include: *
Credit risk Credit risk is the chance that a borrower does not repay a loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay ...
– structured products are
unsecured debt In finance, unsecured debt refers to any type of debt or general obligation that is not protected by a guarantor, or collateralized by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the te ...
from investment banks * Lack of liquidity – structured products are primarily traded over the counter and issuers are not obligated to provide a bid * Highly complex – the complexity of the return calculations means that it is difficult to determine how the structured product would perform versus simply owning the
underlying asset In finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements: # an item (the "underlier") that can or must be bou ...
*
Intuition Intuition is the ability to acquire knowledge without recourse to conscious reasoning or needing an explanation. Different fields use the word "intuition" in very different ways, including but not limited to: direct access to unconscious knowledg ...
-based methods of product design often produce trades that are mathematically equivalent to
gambling Gambling (also known as betting or gaming) is the wagering of something of Value (economics), value ("the stakes") on a Event (probability theory), random event with the intent of winning something else of value, where instances of strategy (ga ...
. ( the above "Quantitative Structuring approach" can be used to eliminate this problem) * Lack of clarity on what exact problem the product is actually solving (does not apply to products built through the Quantitative Structuring approach). * Lack of transparency on pricing - the investment bank fees are hidden in the product pricing and difficult for the customer to discern More generally, the serious risks in options trading are well-established and customers must be explicitly approved for options trading. The U.S.
Financial Industry Regulatory Authority The Financial Industry Regulatory Authority (FINRA) is a private American corporation that acts as a self-regulatory organization (SRO) that regulates member brokerage firms and exchange markets. FINRA is the successor to the National Associati ...
(FINRA) suggests that firms "consider" whether purchasers of some or all structured products should be required to go through a similar approval process, so that only accounts approved for options trading would also be approved for some or all structured products. Further, "principal-protected" products are not always insured by the
Federal Deposit Insurance Corporation The Federal Deposit Insurance Corporation (FDIC) is a State-owned enterprises of the United States, United States government corporation supplying deposit insurance to depositors in American commercial banks and savings banks. The FDIC was cr ...
in the United States; they may only be insured by the issuer, and thus could potentially lose the principal if there is a
liquidity crisis In financial economics, a liquidity crisis is an acute shortage of ''liquidity''. Liquidity may refer to market liquidity (the ease with which an asset can be converted into a liquid medium, e.g. cash), funding liquidity (the ease with which borrow ...
or
bankruptcy Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...
. Some firms attempted to create a new market for structured products that are no longer trading; some have traded in
secondary market The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold. The initial sale of ...
s for as low as pennies on the dollar. The regulatory framework for structured products is hazy and they may fall in legal grey areas. In
India India, officially the Republic of India, is a country in South Asia. It is the List of countries and dependencies by area, seventh-largest country by area; the List of countries by population (United Nations), most populous country since ...
, equity-related structured products may violate the Securities Contract Regulation Act, which prohibits issuing and trading equity derivatives that do not trade on a nationally recognized exchange. A Quantitative framework in order to assess the risk-reward profile of structured products based on probability theory was developed by Marcello Minenna.


Structural Process


Securitization

Securitization Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans, or credit card debt obligations (or other non-debt assets which generate receivables) and sellin ...
in relation to structured products is the undertaking and pooling of bundles of debt which may include commercial mortgages, residential mortgages, and other debt obligations such as credit cards. It is under the branch of
structured finance Structured finance is a sector of finance — specifically financial law — that manages Leverage (finance), leverage and Financial risk, risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of ...
which relates to the management of leverage and the risk and serves as a very large source of financing across economies around the world. Securitized products such as Mortgage-backed securities allow investors to get paid from principal and interest cash flows which are usually collected from underlying debt and collateral and then paid back based upon the capital structure of the security, whether it be in relation to mortgages and real estate, or any other debt products that can be financed in this way. Securitized products also provide a huge source of financing in economies and funds more than 50% of US household debt. The securitization process follows a waterfall model which is divided into tranches and pays investors based upon the level of riskiness their investments hold. Securities with lower risk are usually paid first and are considered investment grade investors which invest in bonds that usually have a “AAA rating” with subprime securities having lower credit ratings such as “BBB”. In order to originate and structure these products, the securitization process employs a
special purpose vehicle A special-purpose entity (SPE), also called a special-purpose vehicle (SPV) or a financial vehicle corporation (FVC), is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, speci ...
technique so that a separate company is created in which the securitized debt in formed as a limited liability venture, so it can carry large mortgages with varying levels of riskiness without having to deploy this capital on their own balance sheets.


COVID-19 Implications

In light of the COVID-19 pandemic, structured products saw a major increase in their prices including products such as Commercial Mortgage-backed securities, Residential Mortgage-backed securities, Collateralized loan obligations, and other esoteric asset backed securities due to the federal reserve significantly lowering interest rates. More significantly, bonds and the credit market react this way due to being contra-cyclical with interest rate decreases having the opposite effect on bond prices. In recent times however, in order to control extremely high levels of inflation, the fed has raised interest rates leading to the price of the bond market and structured notes falling significantly, as well as the formulation of a much higher rate o
yield
to investors like asset managers, hedge funds, and investment banks who buy these products.


See also

* Accumulator *
Credit derivative In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the ''credit risk''"The Economist ''Passing on the risks'' 2 November 1996 or the risk of an event of default of a corp ...
*
Derivative (finance) In finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements: # an item (the "underlier") that can or must be bou ...
*
Exotic derivatives An exotic derivative, in finance, is a derivative (finance), derivative which is more complex than commonly traded "vanilla" products. This complexity usually relates to determination of payoff; see option style. The category may also include de ...
*
Structured finance Structured finance is a sector of finance — specifically financial law — that manages Leverage (finance), leverage and Financial risk, risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of ...
*
Structured note A structured note is an over the counter derivative with hybrid security features which combine payoffs from multiple ordinary securities, typically a stock or bond plus a derivative. When the product depends on a credit payoff, it is calle ...
**
Equity-linked note An equity-linked note (ELN) is a debt instrument, usually a bond issued by a financial institution such as an investment bank or a subsidiary of a commercial bank. ELNs are liabilities of the issuer, but the final payout to the investor is based o ...
**
Floating rate note Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like SOFR or federal funds rate, plus a quoted spread (also known as quoted margin). The spread is a rate that remains constant. Almost a ...
**
Inverse floating rate note An inverse floating rate note, or simply an inverse floater, is a type of bond or other type of debt instrument used in finance whose coupon rate has an inverse relationship to short-term interest rates (or its reference rate). With an inverse f ...
**
Credit-linked note A credit-linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repa ...
**
Market-linked note A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, an ...
*
Structurer In investment banking, a structurer Joris Luyendijk (2012)Interview: Head of Structuring equity-derivatives ''theguardian.com'' is the finance professional responsible for designing structured products. Their solution will typically deliver ...


References


External links


Structured Product Guides and Education

Investopedia - Understanding Structured Products

Structured Products Association (US)

Structured Products magazine

Structured Products Information for the UK market

UK Structured Products Association

European Structured Products Association

Structured Retail Products Ltd
Euromoney Institutional Investor Group {{Authority control Structured finance Management cybernetics