Structured Products

Structured products in Finance refer to a set of two or more assets or securities with a combination of an interest rate and single or multiple derivatives. These pre-packaged investments may include traditional financial instruments, such as equities, options, investment-grade bonds, indices, commodities, mutual funds, exchange-traded funds, or currency pairs, with non-traditional payoffs.

Retail investors invest small in one or more underlying assets, earning fixed or variable profit from price movements. However, they may be exposed to high liquidity, market and counterparty risks, and transaction costs on or before product maturity while achieving a significant return. A third party like a bank or financial institution issues these customizable market-linked investments which trade on a stock exchange.

• Structured products are a collection of customizable investment products linked to a bond, single or multiple underlying assets, and financial instruments like securities, options, derivatives, commodities, indices, bonds, interest rates, or currency pairs linked to these assets.
• These market-linked investments tend to generate significant returns from underlying asset price movements. However, it comes at the expense of increased high liquidity, market and counterparty risks, and transaction costs on or before maturity.
• Structured products have built-in leverage, stop-loss, pre-defined payoff and maturity, protect principal capital if held to maturity, and their price depends on the performance of underlying assets. 
• Structured deposits, guaranteed capital, and capital at-risk are the three categories of structured products.

Structured products definition describes them as a group of customizable investment products that allow individual consumers to invest for a set amount of time while still receiving protection on their initial deposits. The combination of one or more underlying assets or securities typically includes stocks, bonds, options, indices, commodities, currency pairs, and interest rates. Investors benefit from the market performance of these derivatives that come with pre-specified features, such as maturity and payoff.

Banks and financial institutions introduced them as part of their efforts to issue cheaper debts and to fulfill needs unmet by traditional financial instruments. Investors consider structured products investments to be a reliable source of income despite the risks and high costs associated with them. On the other hand, issuers earn by allowing investors to mix and personalize their existing financial products for maximum yields inclined to market shifts.

These market-linked investments, often known as investment or savings products, have three components - a bond, single or multiple underlying assets, and financial products linked to these assets. Structured products finance opens up a slew of new revenue streams previously unavailable to investors by tailoring their needs. After learning about an investor's financial goals, income, and expectations, issuers recommend appropriate structured products.

Besides customization and better returns, structured products have many characteristics, such as:

1. Retail investors can access them
2. A substitute for a direct investment
3. Linked to a single or a basket of securities
4. Pre-defined payoff and maturity
5. Assist in achieving highly personalized risk-return goals
6. Have built-in leverage, built-in stop-loss, and expiration dates
7. Return dependent on the underlying asset's performance
8. Eligible for physical or cash-settlement
9. Normally, issuers pay returns after the maturity date
10. Closely resembles options, swaps, forwards, and futures
11. The product's price depends on the total value and type of the underlying instruments
12. Ensure protection of principal investments if held until maturity
13. Allow investors to modify the type of underlying assets, risks, maturity, and profitability
14. Minimize the risk of loss - the only loss could be the initial investment
15. Assist high-net-worth investors with portfolio diversification

Let us look at the following structured products examples to understand the concept better:

Example #1

Sienna makes a $10,000 investment in a 40-month pre-packaged structured product. And $8,000 goes into an investment-grade bond, which yields a 7-8% annual return. The remaining $2,000 goes into the stock indices.

She might earn approx $2,000 in interest on underlying assets (i.e., bonds) for 40 months. In the due period, indices will have doubled, and $2,000 will have become $4,000. Therefore, her $10,000 will be worth $14,000 at the end of the maturity, providing her around 40% absolute return. As a result, Sienna may rest assured that her $10,000 investment is safe.

On the other hand, if the indices price decline by half, her investment of $2,000 would become $1,000, resulting in a return of 11,000. This strategy protects her capital at all times and ensures that she will receive $10,000 at the end of 40 months.

Example #2

While market-linked investments can help issuers increase profits by allowing investors to receive returns on their investments in underlying assets, this is not always the case. For instance, Investec Bank PLC declared in February 2021 that it would no longer provide structured products in the Great Britain retail market. According to the company, the main reason behind this decision was increasing hedging costs on some derivatives linked to them.

Structured products can be divided into three categories depending on the risk level at maturity:

1. Structured Deposits

An investor buys an underlying asset based on the foreign exchange projection, setting up a timeframe and a markup. It functions similarly to a deposit account, except the earnings are reliant on the market performance of the asset. As a result, the interest rate fluctuates, but the returns remain constant.

2. Structured Capital Products (Protected)

These are the ones that guarantee the return of the principal capital at the time of maturity. It, thus, protects the initial investment. They are often structured as loans from financial institutions and banks that remain solvent until the product matures. However, investors may lose their principal capital if the issuer declares bankruptcy in a rare occurrence.

3. Structured Capital At Risk Products

These are investment instruments that offer the highest rate of return but do not guarantee the repayment of principal at maturity. An investor may lose money in extreme market situations. In addition, the rate of return is affected by the performance of the underlying assets. Though there is a reward for the investor for taking more risk, their priority will be to protect their money.

This has been a guide to Structured Products and the definition. Here we discuss how do structured products work, along with features, types, and examples. You can learn more from the following articles –

• Structured Notes
• Structured Finance Jobs
• Best Structured Finance Books