Structured products are investment vehicles based on or derived from:
- A Single Security
- A Basket of Securities
- An Index
- A Commodity
- A Debt Issuance and/or a Foreign Currency.
A Structured Investment Product is a legally binding contract between an investor and a bank. The investor lends money to the bank for the life of the product (typically five years). At the end of the product life, the investor receives the product return from the bank.
The product return is based on a formula, sometimes based on the performance of the prices of individual shares, but more typically on a share price index, such as the FTSE 100. Structured products have a fixed maturity date and are designed to offer specific risk-return tradeoffs, with pre-set formulas for both the potential risk and potential return. However, these calculations are often complex.
Some structured products offer protection of the principal – when held to maturity, subject to issuer credit risk, thus offering a lower risk than investing in the underlying asset directly. Others do not guarantee principal, but may provide a partial buffer against loss or offer the potential for enhanced returns.
For example, an investor invests £100, the issuer simply invests in a risk free bond that has sufficient interest to grow to £100 after the five-year period. This bond might cost £80 today and after five years it will grow to £100. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and transaction volume requirements of many options and swaps are beyond many individual investors.
As such, structured products were created to meet specific needs that cannot be met from the standardised financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilise the current market trend.
Below is a brief description of how structured products are manufactured
Combinations of derivatives and financial instruments create structures that have significant risk/return and/or cost savings profiles that may not be otherwise achievable in the marketplace. Structured products are designed to provide investors with highly targeted investments tied to their specific risk profiles, return requirements and market expectations.
These products are created through the process of financial engineering, i.e. by combining underlyings like shares, bonds, indices or commodities with derivatives. The value of derivative securities, such as options, forwards and swaps is determined by the prices of the underlying securities.
Structured investments arose from the needs of companies that wanted to issue debt more cheaply. Traditionally, one of the ways to do this was to issue a convertible bond, that is, debt that under certain circumstances could be converted to equity. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors would accept lower interest rates in the meantime. However this trade-off and its actual worth is debatable, since the movement of the equity value of the company could be unpredictable.
Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection. These extra features were all based around strategies investors themselves could perform using options and other derivatives, except that they were pre-packaged as one product.
The goal was again to give investors more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand the goal for the investment banks was to increase profit margins since the newer products with added features were harder to value, so that it was harder for the banks’ clients to see how much profit the bank was making from it.
Interest in these investments has been growing in recent years and high net worth investors now use structured products as a way of portfolio diversification. Nowadays the product range is very wide, and reverse convertible securities represent the other end of the product spectrum (yield enhancement products). Structured products are also available at the mass retail level – particularly in Europe, where national post offices, and even supermarkets, sell investments on these to their customers.
Benefits of structured products include:
- principal protection (depending on the type of structured product)
- tax-efficient access to fully taxable investments
- enhanced returns within an investment (depending on the type of structured product)
- reduced volatility (or risk) within an investment (depending on the type of structured product)
- the ability to earn a positive return in low yield or flat equity market environments
These types of investments are only open for short periods of time, until the strike date arrives or the fund has reached its complete investment level. Banks and institutions have a continual flow of these products being released, and to find out more about the current offerings please contact us today by calling +44 (0)1245 216030, email firstname.lastname@example.org or go to our Contact Page. We can advise you on how structured products can form an important part of an expat investment portfolio and what the benefits are to you.
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