Alternative Assets – Introduction to Structured Products
Overview of Structured Products

Key characteristics

Basic structures

Partial/leveraged returns

Reasons for investing in structured products
Key Characteristics
A structured product (SP) is an investment that has embedded derivative attributes. The key
characteristics of these products are:
1. Specified maturity: a structured product usually has a stated maturity. Whereas an investment
in an individual equity or ETF has no predetermined horizon, a structured product that mimics
the return on an equity index might have a payout determined at particular times.
2. Automatic cash-settled return: SPs are essentially passive. The redemption value and any
intermediate returns are calculated mechanically based on observations of relevant values.
Payout is generally cash-settled.

Example: payout is generally cash-settled if a SP references equity performance. Then
the investor receives a return in cash, rather than receiving equity securities. This raises
the issue of how such observations need to be taken. Investors must be comfortable
with the methodology used to observe asset levels and calculate the payout.
This automatic generation of return may not be attractive to those who believe that an active
investment manager (e.g., a hedge fund manager) can outperform passive instruments. This has
led to the creation of structured hedge fund products, whereby the return is based on a hedge
fund index.
3. Credit Claim on the SP Issuer: purchasing a SP involves taking on the credit risk that the product
issuer may not be able to fulfill payment obligations. The credit risk of the issuer is distinct from
any risk that is taken on through having returns linked to a particular market.

Example: an investor purchases a structured note, issued by Company A, where the
return is linked to corporate bonds issued by Company B. The investor is thus exposed
to the credit risk of both Company A (as note issuer) and the credit risk of Company B
(as the issuer of underlying bonds). This raises the issue of correlation between the two
default probabilities.
Basic Structures
There are three fundamental SP structures
4. Participation: The simplest aspect of a SP to understand is where the payout is linked to some
form of participation in the performance of an asset. The payout may be expressed through this
formula:
𝑉 = 𝑃 ± [𝑃 × 𝑅
(𝐴𝑚 − 𝐴𝑠 )
]
𝐴𝑠
𝑉 = 𝑅𝑒𝑑𝑒𝑚𝑝𝑡𝑖𝑜𝑛 𝑣𝑎𝑙𝑢𝑒
𝐴𝑚 = 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
𝐴𝑠 = 𝑆𝑡𝑟𝑖𝑘𝑒 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡
𝑃 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑣𝑎𝑙𝑢𝑒
𝑅 = 𝑃𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒
5. Downside Protection: Many SPs incorporate principal protection, whereby the issuer will return
the investor’s full principal, regardless of the performance of the underlying asset. The formula
for the downside protection then becomes:
𝑉 = 𝑀𝑎𝑥 {𝑃, 𝑃 ± [𝑃 × 𝑅
(𝐴𝑚 − 𝐴𝑠 )
]}
𝐴𝑠
6. Capped Upside: if investors are only mildly bullish, they can benefit by selling their upside.
Investor Uses of Structured Products
Structured products are used by investors for several reasons:

Automatic returns: the mechanical calculation of returns removes the need to make judgments
about the investment prowess of particular funds or managers. Similarly, that most SPs are
cash-settled removes any transactional duties / execution risks.

Extending access and exposure: by accessing a diversified range of markets or asset classes, an
investor can use SPs to take exposure in line with internally generated risk/reward profiles.
Buying a structured product may be much more straightforward than attempting to invest
directly in opaque markets.
This will be particularly useful for sophisticated investors who use portfolio optimization
techniques for generating benchmark exposures in different assets. SPs allow investors to
participate in debt, equity, FX, credit and commodity markets, as well as their geographical
subsets. SPs also facilitate tactical asset allocation (TAA) strategies. Example: US or European
investor whose portfolio optimization model suggests exposure to the Indian equity market may
find it easier to purchase a SP rather than investing directly.

Customizing returns: a structured product allows an investor to “fine-tune” an investment
strategy with a more refined approach to the risk/reward tradeoff. Investors can access
different asset classes and increase/decrease the amount of leverage. They can adapt positions
according to particular market outlooks. Instead of merely being “bullish? Or “bearish”,
investors can take more nuanced views.

Different asset classes

Interest rates: simple structured notes, such as capped FRNs or callable bonds,
incorporate straightforward derivative payoffs, but products can be designed where the
payoffs are more complex functions of the shapes of key yield curves, such as those for
swaps or government bonds.

Equities: one of the earliest structured products was an equity related structure in the
UKL known as the guaranteed equity bond (GEB) – a principal protected structure with a
return linked to the performance of an equity market. More complicated equity products
focus on multiple assets; different stocks in a single basket or return linked to different
market indexes.

FX: SPs may also have payouts related to foreign exchange levels. Many products mirror
the development of FX derivatives, incorporating range and barrier structures.

Commodities: SPs can have payouts linked to market levels of precious metals or energy
commodities.

Credit: in tandem with developments in credit derivatives markets, there has been a
dramatic increase in SPs with payouts linked to credit. For example: a simple credit
linked note (CLN) allows an investor to take a view on the creditworthiness of a single
credit or basket or credits.
Customization or Commoditization
The flipside of the customization possibilities inherent in SPs is a reduction in liquidity. SPs are usually
designed to be held to maturity and secondary markets are limited. As a product becomes more
complex, the opportunity for secondary trading in that product diminishes. Valuations of SPs may need
to incorporate sometimes opaque values for volatility, market levels and correlation. Some kind of
secondary market will usually be offered by the financial intermediaries responsible for distributing the
products to investors, but the prices offered to investors looking to liquidate instruments early may well
be lower than anticipated. In addition to the costs of unwinding derivative transactions, there is a sunk
cost in the initial price of an instrument representing distribution and structuring fees.
Where possible, the best valuation model is a competitive quote – the investor will not be concerned
with the particular parameters as long as multiple prices can be obtained. This may well be difficult in
the customized area of SPs, however, particularly in small, non-economic quantities.
Market Development – Origins of the SP Market
Early Days
Originally, the major clients for investment bank's marketing derivatives were debt issuers looking to
transform the nature of their liabilities (for instance, converting fixed rate debt to a floating rate
liability). There was little activity on the asset side–although many investment managers saw potential in
derivatives, it was hard for them to enter into an asset swap. Many contracts would entail the
investment bank taking on significant credit exposure. Most investment managers, however, lacked
sufficient credit standing.
Emergence of Structured Notes/Deposits
In the late 1980s and early 1990s, the structured note/deposit market emerged, with this product, an
investor purchased an investment that had a desired derivative payout, thus eliminating the credit
exposure. As will a vanilla swapped bond, the asset profile could be transformed, so that the issuer was
left with a simple liability.
From Institutional to Retail
Reduced credit exposure increased the potential for structured investments. Initially, SPs tended to be
transactions targeted at sophisticated institutional investors, but there followed a dramatic growth in
retail targeted products aimed especially at high net worth investors. The key difficulty in structures that
are targeted at retail investors Is generating a sufficient critical mass equating to an economic size. It
may be easier to structure on behalf of one large investor with a demand for $10MM, than attempting
to market to 1M investors each with $10M.
More Complex Structures
Many initial SPs had straightforward structures, but there has been a growing sophistication among
investors when identifying acceptable instruments. There has been a symbiotic relationship with the
derivatives markets in the various asset classes; increasingly complex derivative products offer more
sophisticated PSs, while the demand for particular payoffs drives development in the derivatives
markets. Today, not only to SPs cover multiple asset classes, but they also look at basket and multi-asset
structures. The payoffs may mimic a whole variety of exotic options and derivatives, with digital
structures, such as knockouts or range notes, now commonplace.
Products with simple payout structures are not necessarily simple in construction or risk management. A
product with a simple payout equivalent to some percentage of the average performance of an
underlying basket of stock indexes may be easy to understand while at the same time requiring complex
structuring.

Size of the SP Market: precise numbers on the overall size of the SP market are hard to come by,
since SP distribution is largely by way of private transactions. The OECD estimated in 2007 that
the SP market had a global size of approximately USD 3.8TN – with volumes trebling voer the
previous six years.
Lifecycle of a Structured Product
There are three stages in the lifecycle of a structured product:
1. Idea:
a. Idea: There are potentially an infinite number of SPs that can be devised for investors.
Matching a product to investor appetite is a fundamental task. Ideas may be generated
either by investors themselves, or by the intermediaries at the financial institutions who
are advising them. Investors in SPs are both institutional as well as private retail
investors, particularly high net worth individuals (HNWIs). In recent years, private
investors have dominated the SP market, especially in continental Europe and asia.
Traditional distribution channels, such as private banks, wealth managers and
independent financial advisors (IFAs), have become specialists in SP ideas
b. Term Sheets: Unless an individual investor has sufficient appetite, it is more probable
that an idea will be shown by a potential distributor to multiple private investors. Since
SPs are considered more opaque than traditional investments, it is usual (and may be
mandatory in some jurisdictions) for a distributor to show a term sheet to potential
investors, typically containing the following:

Name and description of ultimate borrower

Terms and conditions of the product

Details of how the redemption and any intermediate payments will be
calculated and made

Risk disclosures and/or scenario analysis

Taxation concerns
2. Issuance: the following are the main parties involved in the issue of a SP:
a. Issuer: as the investor in a SP is taking credit risk on the ultimate borrower, this risk must
be acceptable. Where the ultimate borrower is a large financial institution, it is common
for the institution to distribute SPs with investors either purchasing notes or placing
funds on deposit (where the interest is paid on a structured basis). In addition, there are
many entities that are happy to issue SPs in medium term note (MTN) form. The ultimate
issuer could be a financial institution, corporate, sovereign, or supranational entity.
The issuer will rarely have any interest in the particular asset profile desired by an
investor – the issuer’s liability profile will typically be transformed from the structured
payoff.
b. Derivatives House: By transforming asset payouts into simpler liabilities, derivative
intermediaries play a critical role. It is the derivatives house that takes on the risk
management task such that the payout can be generated in the required format.
Historically, many of the profits involved in distributing structured notes were built into
the prices of the component derivative pieces and SP distribution was largely by way of
the sales channels of the derivative houses.
Institutions with good sales channels can, however, now choose between competing
derivative providers. There is no necessary linkage between the availability to structure
and the ability to distribute. Profits are no longer simply made on the derivative side, but
distributors make simpler intermediation profits and commissions. With multiple
derivatives houses competing for the structuring and risk management business, it is
now common for a financial institution with no particular in-house derivatives expertise
to be the distribution channel.
c. Rating Agencies: While more sophisticated investors will often analyze credit themselves,
retail investors may find it difficult to analyze credit, particularly for unfamiliar names,
and will gain some comfort if a specialized agency assigns a credit rating to a security.
d. Some investors are prohibited from buying securities where there are no ratings or
where the ratings fall beneath a particular threshold (e.g., investment grade)
e. Different agencies have different methodologies and, if multiple agencies are employed
to rate securities, the securities may have a split rating where two or more different
agencies assign different rankings.
Remark: as instruments become more complex, losses in portfolios are not simply a function of
credit. A structured note might well be rated AAA because the credit risk is minimal, but the
market risk might be extremely high. Example: a structured note issued by an AAA rated
institutions where the payments (including principal redemption) are some function of changes
in the level of a stock market. An investor might lose money even though there had been no
credit issues, as the market risk greatly exceeds the credit risk.
3. Maturity: Once products are in the market, the issuer’s role is largely done, except at maturity,
when investors must be repaid. In the meantime, the derivative provider must manage the
inherent risks, which may require numerous transactions in the underlying asset and options
markets.
As reference assets change in price, an investor may ask for updates on the value of the
structured product. These will only ever be indicative and there may be a temptation for
valuations to be inflated (e.g., disputes over derivatives valuations where a major contributing
factor in the case between Bankers Trust and P&G in the 1990s).
If the investor chooses to unwind early and crystallize any valuation (either to gain or loss), then
the investor may not receive the price expected. When an investor unwinds a product early, the
issuer will rarely wish to extinguish the liabilities. Thus a third party must be found that is willing
to take on the issuer’s credit risk. The third party may not, however, want a structured payout,
in which case the derivative transactions must be unwound. This typically results in a lower
unwind price being offered to the original investor.
Key Product Considerations for Investors
There are a number of key aspects of structured products that investors should consider before
choosing to invest in a SP:
1. Baskets: many Sps have returns based on multiple asset prices. This may take the form of a
basket of imilar assets (e.g., collection of equities or equity indexes), or may involve a basket of
different assets. For example: the payout may be linked to equity, FX and commodity prices.
Where multiple assets are involved, the payout may be based on the average performance, or
perhaps the best or worst performer in the basket of assets. The composition of the basket may
also change over the life of the SP according to preset rules. Investors in SPs that reference
baskets must also consider the additional risk of correlation between the returns on the
constituent assets.
2. Notes or Deposits: Investors may be indifferent to whether borrowing takes the form of a
security (bond or note) or a structured deposit. The credit risk may be identical and the limited
secondary market may give no real liquidity advantage to the security. There may, however, be
legal reasons to why one form or another may be preferable. Example: some structured
deposits in the US may be eligible for FDIC insurance (limited at $250M).
3. Income or Capital: a key decision for a SP investor is between income or capital appreciation.
This is analogous to selling or buying options.
A structured note might offer income with total returns capped at a certain point, which would
be analogous to selling a call on an underlying asset.
Where an investor seeks principal protection is akin to buying an option. The cost of this option
must be priced into the SP structure. This may be achieved by increasing the effective strike
before an investor gains, capping the amount that can be gained, or by changing the level of
participation (or a combination of the preceding). An investor can boost returns by having some
capital at risk (e.g., protecting only part of a structure). Flexibility is a double-edged sword, as it
is sometimes difficult to keep track of fair pricing.
4. Investor View: the simplest SPs involve having a directional view on the market; returns are
linked to gains or losses. The directional view is fine-tuned, however, so there may be a
maximum payout or the participation level may incorporate leverage or limited performance.
As well as a directional view, a SP investor is often taking a position in market volatility. If there
is a maximum payout, then an increase in volatility will increase the number of scenarios where
there is no increase in value for the product, despite a rise in value of the simple payout
formula. This exposure to volatility can be particularly important if an investor is looking to
unwind the position before maturity. A product with maximum payout effectively involves
selling an option at the level that produces the first payout. If volatility rises, so does the value
of the sold option – this will reduce the value of the structured package.
5. Path Dependency: many SPs have payments linked to the performance of the asset price over
the life of the product. Example: the range / range accrual note has a payout that varies
depending on whether the price of the reference asset is above and/or below particular barriers
over the life of the product. When the asset price lies outside the barrier, then payments cease
(or begin, depending on the structure).
Other forms of path dependency include returns based on average observed prices (e.g., Asian
style returns)_ rather than one single price, and various forms of barrier-linked returns;
payments may kick-in or knock-out depending on intermediate price observations.
Path dependent options and barriers introduce complexity into the calculation of whether more
or less volatility is desired. Perhaps the structure is one where payments are made if a price rises
above a particular level, but this payment is extinguished if prices rise beyond an even higher
level. One the one hand, an investor might want increased volatility to improve the chances of
the price rising above the first level, but would not want volatility be so high that the chances of
the options being extinguished also increase.
Product Construction
Low exercise price option (LEPO)
The simplest form of SP is a basic participation note, where an investor gains or loses according to price
movements in some underlying assets. Effectively, the returns are the same as a forward transaction of
the asset. Where direct access is difficult, many structures use LEPs. These options, first introduced in
AUS, now trade on many major exchanges and are simply equity call options with a nominal strike, such
that the option will always be in the money and exercised at expiry. They will be purchased at the
forward price of the equity and are basically equivalent to forward contracts. In some cases, the
contract can even be cash settled, eliminating any transaction risk.
Option plus zero-coupon bond
The simplest way of creating a principal protected structure is through a combination of a zero-coupon
bond and an associated option. The zero coupon bond has the same maturity and face value principal as
the structured note, ensuring that the principal amount of the note is redeemed at maturity. This
amount will be below par; the discount is a function of interest rates – the higher the rates, the greater
the discount. If the SP is then sold at par, the surplus cash can be used to purchase an option. These
monies can be used to fund the purchase of both an option and a virtually riskless instrument.
Risks – Delta & Gamma
Delta represents the market risk of an instrument – the sensitivity of a security to movements in the
price of the underlying asset. For an individual option, delta is usually expressed as a percentage. A
simple participation note would be a one-delta instrument – the value of the instrument would rise and
fall in step with the underlying price. This differs from a principal-protected note, where, if the
underlying price were already below the protection level, further falls may not affect the value of the
instrument.
Gamma is the rate of change of an instrument’s delta. If an instrument is deeply in/out of the money,
such that the optionality is no longer a feature, the delta will approach one or zero, and the gamma will
approach zero.
Risks – Vega
Vega represents the sensitivity of an instrument to changes in implied volatility, and hence the market
price of the underlying options. It is not always obvious whether a structure is positively or negatively
exposed to changes in volatility, particularly if there are barrier options in the structure.
Risks – Theta
An option is a wasting asset; the right to purchase an instrument at a price of 100, when the current
price is 120, might be worth a lot of it option lasts for 10 years. If the option expires in two minutes,
however, it might well be worthless. Theta represents change in an option value due to the passage of
time.
Dynamic Risk Assessments and Other Factors
For both investors and derivatives houses, the interplay of various factors driving the value of SPs means
that it is important to continuously assess changes in risk. For a derivatives house looking to hedge the
various exposures, it may be necessary to 0065ecute transactions in the market on a regular basis.
Furthermore, as products incorporate complex features such as path dependency or correlation,
evaluation and hedging models become increasingly opaque. As well as the more basic Greeks, risk
factors are introduced through correlation-type relationships between relevant assets, volatility and
yield curves, etc. obtaining stable, agreed, values for these factors may well be virtually impossible.