Structured Products

Structured products are complex synthetic products designed to give exposure to assets or investment strategies via a single instrument. Structured products are generally listed and tend to be issued through private placements to professional investors or via public offering to general investors subject to local regulation. Structured products often span different asset classes and often embed derivatives.

Structured products have at least one of four characteristics :

• Access provision the structure gives investors exposure to assets they might otherwise find impractical to trade. Let us consider a retail investor who would like to invest in a particular fund of hedge funds. h e fund has a minimum investment of $250,000, but the retail investor only has $50,000 available, so the retail investor has no direct access to the fund. However, it may be possible to get access via a structured product that offers identical performance to the fund. To achieve this, the structurer invests a large sum in the fund on wholesale terms and repackages it into units small enough to allow the retail investor to buy.
• Principal protection or loss limitation the product provides directional exposure to an underlying asset in one direction only. A simple example would be a note linked to an equity index, which, at maturity, pays back at least the initial investment, and also a large fraction of the performance of the equity index if positive. h is can be achieved in a number of ways, but a simple way would be to buy a zero coupon bond that pays 100% of the principal at maturity at a discount. The remainder is then invested in a call option on the equity index struck at todays price. Whatever happens, the bond matures to pay back the original investment. If the index rises, the call option also pays out the performance of the equity index. h e actual exposure depends on the relative costs of zero coupon bonds and options on the underlying and is commonly called the participation rate.
• Leverage the structure provides leveraged access to an underlying asset, that is, it pays a multiple of the return on the underlying asset. Structures with leverage usually embed a mechanism to limit losses to the amount of principal invested.
• Algorithmic trading rule products structures that invest in assets according to a specified rule set. There may be one or many underlyings, and the algorithm could define the constituents of an index forming the underlying asset depending on prevailing market conditions, or it could define buy or sell points of underlying assets according to the trading rules.

Systemic Risk

Nowadays, structured products are usually carefully constructed with market impact as well as risk control in mind. However, historically they have set up unexpected feedback loops in the underlying market. An early structured product, the portfolio insurance note, is now widely believed to have contributed to the 1987 stock market crash.

In mid-October 1987, 2%3% of the market capitalization of the Standard & Poors 500 (S&P) was covered by portfolio insurance. Portfolio insurance is an algorithm, which calls for selling of the underlying asset if it falls to a predefined level and repurchase it if it subsequently rises. As the market started falling on Thursday, October 15, 1987, a few sell orders were generated as a result of portfolio insurance.

On Friday, the S&P fell further, triggering many more sell orders and the futures market closed with a large backlog of sell orders. h e 20.4% drop in the S&P on Monday was inevitable. Market participants had failed to fully analyze the mechanism, size, and uniformity of portfolio insurance.

The crash of 1987 was an especially severe case, and serves as a lesson in proper construction of structured products, not a blanket warning against the use of structured products. The basic lesson, not to allow the market to become too concentrated in one risk or another, is now well understood in the context of structured products. Nowadays, structurers usually consider market impact as part of internal risk assessment while creating structured products.

Common Examples

Because they are customized solutions, the possible variety of structured products is almost endless. However, some common examples include:

• Delta-one notes a note that provides the same returns as an underlying product. These are pure access products.
• Principal protected note (PPN) protects the initial investment while giving some level of participation in the upside returns of a risky asset. A PPN may comprise a zero coupon bond and a call option on the risky asset, giving constant participation in the upside of the risky asset regardless of its subsequent path. A PPN may also take the form of a portfolio insurance strategy that starts with full (or higher) participation in the underlying, and reduces participation should the underlying fall. In other words, participation and eventual pay of is path dependent. h e expected outcome of these two PPN variants is the same if initial conditions are the same and leverage is not allowed. If leverage is allowed, the expected outcome of portfolio insurance-based PPNs is generally better than that of option-based PPNs because in portfolio insurance strategies leverage is only employed if the path of the underlying is upward. h e cost of leverage is not incurred when the underlying performs badly.
• Autocallable note allows investors to profit from a range-bound underlying, paying a coupon provided the underlying remains below a specified threshold level. However, should the underlying trade down to a predetermined, the holder only receives the actual performance of the underlying.
• Reverse convertible note protects the investors principal and pays a high coupon as long as the underlying remains below a predetermined level. However, if the product falls to a lower predetermined level, the coupons fall and could become negative. h is is equivalent to being long a zero coupon bond and short a down-and-in put.
• Airbag protects the investor from a small crash in markets, but not a large one. Airbags are equivalent to a long at-the-money put and short more than one out-of-the-money puts.