For clients in booking center Switzerland only

Finder for structured products

For clients in booking center Switzerland only

Structured Products

Understanding the fundamentals.
Pic1ENG.png

What are structured Products

Structured products tend to be more complex financial instruments by their very nature. They complement direct investments and offer access to numerous asset classes and individual payoff scenarios.
Structured Products derive their name from the fact that they are made up of a combination of different elements. They are always based on an underlying asset, for example equity, bond, index, or commodity such as gold or oil. With the use of one or more derivative instruments, specific payoff scenarios are created.
Buying structured products does not typically entail any obligations beyond paying the purchase price, and investors are entitled to a payoff in accordance with a predefined scenario. Structured products are generally defined by different categories depending on those possible payoff scenarios.

Structured products enable investors, for instance, to gain exposure to an equity index and choose between different degrees of participation in the performance of the underlying index or add capital protection features. Investors can also use structured products to hedge currency and manage other risks.
The value of a structured product depends on how its underlying(s) perform(s), as well as the type and amount of payoff they generate.
Structured products are typically issued by financial institutions and can be issued publicly as well as privately. They can also be fully customized to investors’ needs. For this reason, structured products are marketed with detailed term sheets and fact sheets to help understand them in depth. They are typically considered ‘buy and hold’ products.

Product types

 

Thanks to the wide variety of derivative strategies that can be used, structured products are flexible investment instruments that can be adapted to any market situation and all market expectations of investors. They can also be tailored to personal investment targets and requirements, creating a spectrum of individualized payoff structures tailored to different investor types. Structured products are commonly categorized in four different groups with increasing return potential but also increasing risk:

  • Protection (capital protection products)
  • Optimization (yield enhancement products)
  • Participation (participation products)
  • Leverage (leverage products)


Pic2ENG.png

Protection (Capital protection products)

A capital protection certificate provides investors with the opportunity to benefit from the performance of the underlying up to a certain limit, while protecting their invested capital (except in the case where the issuer defaults). Therefore, investors in capital protection structures aim to gain exposure to an underlying but want to ensure that they at least recover all or part of their invested capital at maturity of the product, irrespective of how the underlying performs, even if it falls. It is important to note that while capital protected products ensure that investors will receive back their invested capital at maturity (or the level they agreed, e.g. 90%), the price of the capital protected product can still drop during its lifetime, but will automatically recover at maturity.

Example

 

Some investors purchase a 100% capital protection certificate on the European stock market:

If the stock market value is up, then investors holding the capital protection certificate would benefit to the same extent from the performance of the stock market as they would had they bought the underlying shares. However, they will not receive any dividends in the case of investing in the capital protection certificate.
So, in the case where the underlying has had positive performance, investors would be slightly better off with investing in the underlying as they could receive dividends. If the underlying pays no dividends, investors would be equally well off with the capital protection certificate.

 

If the stock market value is down 10% when the capital protection certificate reaches maturity, investors will nevertheless receive back the full amount of invested capital.
So, in the case where the underlying has had negative performance, investors would be better off with the capital protection certificate rather than investing in the underlying directly.

Pic3ENG.png

With the possibility to individualize structured products, investors in capital protection products can benefit from tweaking the following features to suit their specific needs or market expectations.

 

Optimization (Yield enhancement products)

Yield enhancement products allow investors to benefit from sideways-trending markets where they are willing to forego full participation in the price increase of the underlying. In return for surrendering full participation in the upward growth potential of the underlying, they are given a coupon (in the case of a reverse convertible), or a discount on purchasing the underlying (in the case of a discount certificate). In addition, yield enhancement products can include conditional downside protection features that add a limited safety net for them in case the price of the underlying falls. However, this downside protection usually only protects investors from smaller declines in the price of the underlying down to a certain barrier level (e.g. 80%). If the underlying declines sharply, they are fully exposed to the negative performance of the underlying and bear losses, as they would with a direct investment in the underlying if the underlying is not recovering until maturity. Yield enhancement products can have multiple underlyings which may impact their coupon as well as barrier level of protection

Example

 

Some investors purchase a barrier reverse convertible on a stock with a barrier of 80% and a coupon of 5%.

If the share price rises significantly, investors will not participate in this performance but receive the coupon.
So, in the case of significant positive performance of the underlying, investors will be better off holding the underlying rather than the barrier reverse convertible. This is why the product is intended for sideways-trending market expectations.

If the stock only declines slightly during the lifetime of the product, e.g. by 15% and does not breach the barrier, then investors holding the barrier reverse convertible benefit from the conditional downside protection and receive their invested capital back at maturity as well as the coupon.

So, in the case of a flat or slightly negative performance of the underlying, they will be better off investing in the barrier reverse convertible based on the conditional downside protection and coupon that it provides.

If the stock drops 30% during the lifetime of the product and the barrier has been breached, the conditional downside protection would be lost. As a result, investors will be fully exposed to this negative performance and only receive back, at maturity, the price of the underlying or the predefined number of shares, unless the underlying fully recovers. However, they will receive the coupon which is usually more than any dividends that the underlying would have paid.
So, in the case of a significant negative performance of the underlying, investors would be better off with the barrier reverse convertible compared to holding the underlying directly due of the coupon paid by the note.

Pic7ENG.png

With the possibility to tailor structured products to each individual, investors in yield enhancement products can benefit from tweaking the following features to their specific needs or market expectations:

 

Participation (Participation products)

In principle, participation products allow investors to fully benefit in the price movements of the underlying. Some products directly participate in the underlying’s performance 1:1 (e.g. tracker certificates) and are an easy way for them to get access to markets or investment areas which are difficult or impossible to access directly (e.g. raw materials). Other products actually participate more than 100% so that investors benefit disproportionately on the upside, up to a certain level called the strike (e.g. outperformance certificate). Alternatively, a participation product may also add a conditional protection to limit participation on the downside in case the price of the underlying decreases during the lifetime of the product, at least as long as the underlying does not fall below a specific barrier level.
Additionally, investors may be keen to achieve a minimum performance even if markets trend sideways without giving up protection on the downside or the unlimited upside potential, as they would in the case of a yield enhancement product. They can do so by adding a specific payout amount (‘bonus’) which is guaranteed as long as the underlying does not drop below a certain level during the lifetime of the product.
It must be highlighted that, in exchange for participating in the price movements of the underlying as well as any additional features, investors forgo any dividends of the underlying.

Example

 

Some investors purchase a bonus certificate on an equity index with a bonus level of 105% (=strike) and a protection barrier of 70%:

If the index rises significantly, investors will fully participate in this performance.
So, in the case of significant performance of the underlying, investors will be slightly better off holding the underlying rather than the bonus certificate as the holder of the bonus certificate does not benefit from the dividends of the index, and the bonus will not be paid as the performance is higher than the bonus level.

If the index only declines slightly during the lifetime of the product, e.g. by 10%, then investors holding the bonus certificate benefits from the conditional downside protection and the additional bonus, receiving their invested capital back at maturity as well as the 5% bonus payoff.

So, in the case of a flat or slightly negative performance of the underlying, investors will be better off investing in the bonus certificate based on the conditional downside protection and bonus payoff it provides.

If the index drops 35% during the lifetime of the product, the barrier is breached and the conditional downside protection is therefore lost. As a result, investors will be fully exposed to this negative performance and participate 1:1 in the price of the underlying. Because the certificate has dropped below the barrier, they will also not receive the 5% bonus payout anymore.
So the in case of a significant negative performance of the underlying, investors will be worse off with the bonus certificate compared to investing in the underlying directly, as they in the underlying at least receives dividend payments from the index components.

Pic8ENG.png

With the possibility to tailor structured products to each individual, investors in participation products can benefit from tweaking the following features to their specific needs or market expectations:

 

Leverage (Leverage products)

Structured products in this category provide investors with potentially above-average participation in price changes in the underlying asset beyond the simple performance they would achieve if they invested in the underlying directly. As the performance participation of more than 100% also extends to the downside, these structured products tend to require a high risk appetite and sufficient experience. For the purposes of this material, they are beyond the scope.




Risks of investing in structured products

Investors must understand the risks associated with the structured product in which they intend to invest and should only reach an investment decision after careful consideration with their legal, tax, financial and other advisors. The following is a summary of the most significant risks. Product specific risks are documented in the respective product documentation (e.g. term sheets and product description forms).

Risks include, but are not limited to, the following:

Market risk (performance of the underlying)

Issuer default risk

The value of a structured product depends greatly on how the underlying performs. Depending on the specific payoff structure, its value may suffer if the underlying does not fare as initially expected. This is especially true in the case of conditional protection features which do not provide any protection for investors once the relevant barrier has been breached.

Issuer default risk

If the structured product performs adequately but the issuer fails, there is a chance of large or total capital loss for investors, without recourse to the local regulator or government for investor protection.

Liquidity risk

Early redemption (call) risk / Reinvestment risk

Even though structured products can often be sold back to the issuer at any time, investors should be prepared to hold most products until maturity to avoid incurring additional costs or losses.

This is for two reasons:

  • Issuers are not obliged to make secondary markets in structured products, although they will generally try to as the existence of a secondary market will generally make the structured product more attractive to investors in the first place.
  • Depending on the structured product, the bid-ask spread can be quite wide compared to other products. This is generally because the issuer has the expense of unwinding the risk hedge embedded in the structured product in case the customer wants to redeem early.



Early redemption (call) risk / Reinvestment risk

Some products have the possibility of being bought back early or ‘called’ by the issuer. The capacity for the issuer to do this would be clearly stated in the associated term sheets, fact sheets and product information documents. Such products generally reward investors for this potential risk via improved product terms but will likely be exercised when it is not favorable for them. They then need to find a new investment opportunity under potentially less favorable market conditions.


Complexity

Transparency

Each structured product has a risk profile that investors need to understand. This profile must be considered in terms of their risk tolerance, market expectations and time horizon. Not every product is suitable for all investors and the risk profile of different structured products can vary significantly.

Transparency

It can be difficult to understand precisely how a product behaves over its term. Those with more complex structures require a high level of financial knowledge.

 

Factors influencing the price of a structured product during its lifetime

The specific payoff structures inherent in individual structured products summarize the possible outcomes of the product at maturity. However, during its lifetime, structured products are influenced by a variety of different factors which can have both positive and negative impact on its price. As a result, the price of a structured product during its lifetime usually deviates from the payoff diagram which was described at the initiation of the trade to illustrate the situation at maturity.

With the exception of the price of the underlying asset, all factors listed below will no longer have any effect at maturity (and possibly before). Here, it is important to bear in mind that the explanation for the factor in question only applies on the assumption that the rest of the parameters remain unchanged. As this is rarely the case in reality, it is important to understand that the price movement of a structured product can be rather complex due to the combination of a variety of factors that may impact the product in different ways at the same time.

Price of the underlying asset

Changing volatility

The price development of the underlying asset plays a central role when it comes to the price development of the structured product during its lifetime. However, it must always be considered relative to any reference points that are relevant for the respective structured product, such as a downside protection barrier or a participation cap. In addition, there are structured products which benefit from positive performance of the underlying as well as those benefiting from negative performance of the underlying. As a result, the impact of the performance of the underlying must always be looked at in connection to the relevant product.

Changing volatility

With structured products, the volatility of the underlying is a key aspect to consider. The extent to which volatility impacts the price of a certificate depends on the structure and type of product. Rising volatility can therefore have both a positive as well as negative impact on the price of the product. As expected, increased volatility will have a negative implication on the price development of the structured product if this results in a higher risk of loss, and vice versa. Depending on the type of product, volatility can, however, have a positive impact on price development.

Changing refinancing costs

Residual term to maturity

Money market investments are an important element of securitized structured products usually sold to private investors in addition to the combination of options that determine the individual payoff structure. As a result, the impact of a change in interest rates (i.e. refinancing costs) has a similar effect on structured products as it does on bonds. If interest rates rise, the value of the structured product will drop whereas if interest rates fall, the price of the structured product will increase.

Residual term to maturity

The term remaining until the final fixing date can impact the value of a structured product in a variety of ways. Strictly speaking, this factor must be examined in connection with other factors, in particular the price of the underlying asset. The residual term can also have both a positive or negative impact on the price development of the structured product. The likelihood of sustaining losses during the residual term is of decisive importance here. Generally speaking, however, structured products tend to approach their most likely payoff scenario the closer they get to maturity. If the likely payoff scenario is unclear (e.g. the price of the underlying is close to breaching the conditional downside protection barrier), even small movements in the price of the underlying can lead to substantial fluctuations in the price of the structured product.

 

Investing in structured products

There are many situations where investors would find structured products useful and a better alternative than direct investments in the underlying. In fact, structured products can also be effective risk management solutions if integrated strategically in a diversified portfolio.
Given the inherent complexity that structured products have and their wide variations, it is essential for investors to always study the relevant product documentation in detail before investing in a structured product. They need to have a clear understanding of the payoff scenarios of the relevant product and align them with their expectations of the underlying. For that, they should be familiar with the underlying. Equally important, investors must also consider their risk tolerance level in case the final payoff scenario is not as expected.
Finally, they should only invest in structured products if they intend to hold them to maturity.

If you are…