Structured Products
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Structured products are designed and created to meet the specific needs of investors that cannot be met by traditional financial instruments. These customized products are also called market linked products and can be used as an alternative to direct investment or as part of the asset allocation process to reduce risk exposure. Structured products are generally fixed maturity products issued by investment banks and their affiliates.[br]
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Need for and Origin of Structured Products
The need for the development of structured products arose with the desire to issue debt more cheaply. Convertible bonds were the earliest form of structured products that included an option for conversion into equity under certain circumstances. Over the years, investment banks have added new features, such as principal protection or increased income, in exchange for limits on convertibility of stock to issue structured products. These additional features attracted investors to accept lower interest rates on debt products, while enabling the issuing investment banks to hide the profits they were earning on such issuance.
Composition and Risks of Structured Products
A product of financial engineering, structured products are created by a combination of financial instruments and derivatives and have two components: a note and a derivative. While the note provides for periodic interest payments to the investor at a predetermined rate, the derivative component provides for the payment of the maturity amount. The derivative portion can include a call or a put option.
Many market linked or structured products carry the risk of loss of the principal, just like options. In the case of ‘Principal Protected’ products, the insurance may be given by the issuer and the Federal Deposit Insurance Corporation. In such cases, liquidity or a solvency crisis faced by the issuer is a cause of concern and indicates potential loss of the principal.[br]
Disadvantages of Structured Products
Although structured products offer enhanced returns, their unsecured nature makes them quite risky. It is very difficult to sell a structured product after its issuance and, in most cases, it has to be sold at hefty discounts. The absence of a uniform pricing procedure for structured products makes it difficult for investors to compare the various available options. These products are also quite complex and thus difficult to understand.
