Chapter 10 notes 2012 08 02

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Chapter 10 notes 2012 08 02

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 10Basics of Structured ProductsMay 2012
  2. 2. Chapter summary and outlineThis chapter provides an introduction to structured products,including components, types of structured products, similaritiesand differences between the product categories, uses ofstructured products and the suitability of structured products forinvestors.Chapter outline:• What is a structured product?• Components of a structured product• Different types of structured products• Similarities and differences between the product categories• Uses of structured products• Suitability of structured products to investorsfinlogIQ 2
  3. 3. What is a structured product?• A financial product that allows risk-returns customization through a combination of two or more underlying financial instruments• Used to package investment strategies, designed to achieve a pre- determined performance based on a certain investment strategy Value of derivative component = $35 Value of derivative Value of Zero- component = $20 Coupon Bond = $100 Value of Zero- Coupon Bond = $80 Issue Date Maturity DatefinlogIQ 3
  4. 4. Components of a structured product - 1Principal component• Usually a fixed income component – bonds (government/corporate) or bank deposits• Used to provide capital preservation (partial or full) at product maturity• Higher capital preservation => lower risk => lower potential returns• Principal could also be used as collateral against credit default swaps, which increases the return of the product, but also increases the risksReturn component• Comprises of other financial instruments such as securities, indices, debt, or derivatives (equities, fixed income, FX, commodities etc), or a combination• Return profile could be tailored for a pre-defined conditional return (ie coupons), or a growth element with unlimited upside potentialfinlogIQ 4
  5. 5. Components of a structured product - 2Wrapper• Legal form in which products are sold• Structured notes, structured funds and structured investment-linked insurance policiesPrincipal risk• Comprises of the credit risk of the issuer as well as the principal component of the structured product.• Includes bankruptcy or default of structured product issuer or underlying fixed income componentReturn risk• Comprises market risk, currency risk, default risk and liquidity risk of the underlying providing the return in the structured productfinlogIQ 5
  6. 6. Components of a structured product - 3Trade off between return/income and risk• The return and risk of a structured product can be tailored according to requirements and depends on its allocation and choice of the principal and return component• Higher allocation to principal component => Lower allocation to return component => Lower potential returns• The risk profile can also be varied within the two components• In general, for the principal component, higher investment rating for principal component => Lower risk => Lower yield => Lower amount to be spent on return component• For the risk component, using a derivative generally enables higher leverage to the performance of an underlying as compared to buying the underlying directly. However, the derivative component could also expire worthless if certain conditions are not fulfilled, as opposed to owning the underlying directly.finlogIQ 6
  7. 7. Different types of structured products - 1Structured notes• Debt instruments which incorporates potential coupon payments or maturity payouts linked to the performance of other underlying financial instruments• Possible underlyings include: – Interest rates – Equities – Indices – Credits – Commodities – Combinations of the above• The structured note would usually contain simple options, or more complex derivative strategies• The return of the structured note will be linked to its underlying debt obligation as well as the derivative component embedded in itfinlogIQ 7
  8. 8. Different types of structured products - 2Structured funds• Funds which combine financial instruments to achieve specific risk/return and/or cost/savings profiles that may not be otherwise achievable• Typically comprise a combinations of securities (ie bonds) and derivatives, or could invest purely in derivatives• Structured funds can provide some level of capital preservation by investing in fixed income instruments, together with derivatives (options, futures or swaps) to provide a return• Exchange Traded Funds (ETFs) are funds that are traded in real-time like shares, and managed to achieve a return linked to a reference asset. The ETF could offer tracking (either directly or with leverage), short exposures, or with other derivative strategies.finlogIQ 8
  9. 9. Different types of structured products - 3Structured investment-linked policies• Insurance products which combine insurance coverage and structured investment returns• Investor pays premiums which are used to buy life insurance coverage and invest in a managed fund which contains structured products• Single premiums (premiums payable in one lump sum) vs regular premium ILPs (ongoing premiums are payable)• Do not usually provide guaranteed cash values, value of the ILP upon redemption depends on the performance of the underlying assets of the structured fund• ILPs provide insurance coverage in the event of death (additional coverage could include total and permanent disability, accidental death, critical illness and hospitalization charges).finlogIQ 9
  10. 10. Similarities and differences - 1Sales restrictions• Exist because structured products considered a complex investment product due to the use of derivatives, as compared to other investment products• Retail investors may not be able to – Appreciate the rationale in combinings several underlying instruments – Understand the risks of the product when derivatives are involved• Sales restrictions on structured products include: – Sale can only proceed after advice from qualified representatives. If investors choose to purchase without advice, they have to acknowledge in writing that they are waiving their rights to receive advice – Financial representatives offering structured products must have undergone adequate training and have the necessary competenciesfinlogIQ 10
  11. 11. Similarities and differences - 2Key risks• The complex risk profile of structured products are due to : – Risk due to each instrument and the combination of instruments in structured products – Non-transparency of components within structured products• Eg, in a First-to-default (FTD) note, although the investors is exposed to the risk of a basket of bonds, his/her liability is not limited to fraction of each bond held, rather the liability is the full notional of the note due to the way the note is structured.• Issuer risk is a key risk. Buyers of structured products can only assert their rights against the issuer of the structured product and not the underlying financial instruments. Bankruptcy or issuer default will mean investors have no claim over the underlying instruments as their ownership is not direct but only through the issuer of the structured productfinlogIQ 11
  12. 12. Similarities and differences - 3Independent oversight• Independent oversight functions are put in place by issuers to give investors the assurance that its products are managed with care• Ie an independent trustee is appointed to hold the assets and underlying financial instruments purchased in the structured product• Independent financial auditors are also engaged to – Ascertain that the structured products financial statements are true and fair – Ensure fair valuation of the structured product and underlying instruments• Exchanges also provide some oversight for listed products as the issuer will need to comply with exchange rules, regulations and requirements including – Provision of semi-annual and annual reports to update investors on their investments – Disclosure of information which is likely to materially affect the value of investmentsfinlogIQ 12
  13. 13. Similarities and differences - 4Principal redemption• Independent oversight functions are put in place by issuers to give investors the assurance that its products are managed with care• Ie an independent trustee is appointed to hold the assets and underlying financial instruments purchased in the structured product• Independent financial auditors are also engaged to – Ascertain that the structured products financial statements are true and fair – Ensure fair valuation of the structured product and underlying instruments• Exchanges also provide some oversight for listed products as the issuer will need to comply with exchange rules, regulations and requirements including – Provision of semi-annual and annual reports to update investors on their investments – Disclosure of information which is likely to materially affect the value of investmentsfinlogIQ 13
  14. 14. Similarities and differences - 5Liquidity and market access• Liquidity and market access for structured products are generally considered to be low due to their bespoke nature• Liquidity may be provided by the issuer, but usually for small amounts only• As such, investors have to be prepared to hold these products until their maturity dates to maximize the full value of the investmentRestrictions on underlying access• These are put in by issuers of structured funds to govern the management of fund assets• Could include portfolio diversification rules related to asset quality (invst grade vs non-invst grade), type of instruments (equitives vs fixed income), investment limits, issuer limits and liquidity limitsfinlogIQ 14
  15. 15. Uses of structured products• Meets a specific need that cannot be met from the standard financial instruments available in the market (ie capital preservation with upside)• Alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio• To profit from a market trend• To provide a tailored risk-return profile and increase the efficiency of a portfoliofinlogIQ 15
  16. 16. Suitability of structured products to investorsThe suitability of a structured product is driven in part by the understanding ofthe product by the investor. This then needs to be compared to his/herrequirements, namely:• Risk appetite – ie the ability and willingness to take risk• Liquidity needs – preparedness to hold the investment to maturity• Risks of the product – scenarios that can result in a loss within the product• Returns of the product – to understand how returns are generated and the return scenarios under different market conditions• Time horizon – how time affects the value of an investment throughout its life, some have a value which is only realized at maturity vs others which expire worthless on its expiry datefinlogIQ 16

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