Q&A Structured Products

 

Structured Products are taking an increasingly important role in the changing landscape for investing. More and more investors are adding Structured Products to their portfolios, as consistent record increases in new issuance in the U.S. indicate the following:

   -  Structured Products are becoming an asset class of their own.  

   -  Structured Products have numerous potential benefits for investors:  including diversification, yield, and principal protection.

   -  Structured Products can be customized to meet investors’ objectives in current and expected market conditions. 

  • 1.

    What is a Structured Product?

    Structured Products provide investors with exposure to an Underlying Asset in a form that typically cannot be achieved through direct investment in the Underlying Asset

    Components: The payoff formula of a Structured Product typically has 3 components:

    The Underlying Asset

    Stocks, Indices, Commodities, Baskets of Assets, etc.

    The Performance Component

    Access to the performance of the Underlying Asset. This access comes in various forms.

    The Protection Component

    A level of principal protection at maturity which also comes in various forms.

    Investors should read and understand the offering document for a particular Structured Product before investing. The offering document includes important information, including the description of the: 

    • Underlying Asset 
    • Payoff formula 
    • Level of principal protection 
    • Performance component

    Some Protection & Performance Components

    Protection Components

    Performance Components

    Full Principal Protection:

    A Principal Protected Note offers 100% principal protection at maturity

    Enhanced Performance:

    Receive a multiple of any positive performance of theUnderlying Asset at maturity

    Partial / Conditional Principal Protection:

    Downside Protection providing partial (less than 100%) or conditional principal protection at maturity

    Capped Performance:

    Potential returns are subject to a maximum amount.  This feature is usually paired with either Enhanced Performance or some amount of Principal Protection

    No Principal Protection:

    Certain Structured Products offer no principal protection at maturity.  100% of your investment is at risk.  

    “Absolute Value” Performance:

    An opportunity for positive returns at maturity, even if the performance of the Underlying Asset is negative (down to a set level).

    Basic Example

    5-Year Principal Protected Notes Linked to the S&P 500® Index

    • What does that mean?

    At maturity, investors will receive their initial principal back plus a percentage of the upside performance of the S&P 500® Index, if any, during the life of the Notes.

    • How is it built? 

     A Principal Protected Note on the S&P 500® Index essentially replicates 2 components:

     A Zero-Coupon Bond: A debt instrument sold at a discount from par (100%) and which pays par (100%) at maturity.

     A Call Option on the S&P 500® Index: Paying some amount of any positive performance of the S&P 500® Index.


    RESULT: In this example, the investor would get a 5 Year Principal Protected Structured Product with the following payoff formula:
    100% of initial Principal invested

    A Percentage of the 5-Year Positive Performance of the S&P 500® Index (if any) 

    If the S&P 500® Index has a negative performance at the end of 5 years, investors will only receive their initial principal at maturity. 

    Indicative Structured Product Payoff in Detail

    Example: 

    • 5-Year Product 
    • 100% Principal Protection at Maturity 
    • Linked to the Positive Performance of the S&P 500® Index

    Société Générale buys the Protection Component:

    • Purchase of a zero-coupon bond
    • 5 Year US Swap rate:  4.68% (hypothetical value for illustration purposes only)
    • Cost of a zero coupon bond which will pay 100% at maturity: 100% / ((1 + 4.68%)^5) = 80%  

    Calculate the Amount Available for Société Générale to purchase the Performance Component:

    • Equal to investor’s initial investment minus the cost of the  zero-coupon bond: 100% - 80% = 20%

    Société Générale buys the Performance Component: A Call Option on the S&P 500® Index

    • Cost of a 5-Y Call Option on the S&P 500® Index = 25%
    • The level of participation Investors will have in the   performance of the S&P 500® Index is calculated as follows: 
    • 20% / 25% = 80%
    • The Structured Product will pay 80% of any positive performance of the S&P 500® Index

    RESULT: A Structured Product with the following redemption formula at maturity:
    100% of initial Principal invested

    80% of the 5-Year Performance of the S&P 500® Index

    *This example is for illustration purposes only 

  • 2.

    What are the benefits of Structured Products?

    Broad Flexibility and Tailored Solutions to Manage Investment Needs:

    Flexibility and a tailored approach to investing are the key advantages of Structured Products. These vehicles can enable investors:

    • To meet diverse individual goals and financial preferences.
    • To adapt their portfolio to specific market conditions.

    Excellent portfolio enhancement tools which can provide for:

    Diversification

    • Access hard-to-reach Underlying Assets (e.g. indices and commodities): Gain or hedge exposure using specific asset classes that might not be accessible with traditional investment vehicles.
    • Access to different investment strategies
    • Gain greater diversification of existing portfolio exposure and positions

    Yield Enhancement

    • Potentially enhance an investor’s portfolio returns
    • Potentially improve an investor’s risk/reward profile

    Wealth Preservation

    • The diversification and yield enhancement features can be combined with an element of principal protection typically not available with direct investment in an underlying asset.

    High Level of Transparency:

    All Structured Products have the following features in common:

    • Defined Maturity and Underlyings
    • A Level of Princopal Protection (ranging from 100% to 0%)
    • A Payoff Formula at Maturity

    Even the simplest Structured Product can achieve a Combination of the following Objectives in a Single Structure:

    • Full or partial principal protection
    • Exposure to the performance of a specific Underlying Asset
    • Regular coupon income

    Structured Products can be designed to perform across a wide range of Market Conditions by choosing the appropriate Performance Component,  for example:

    • A Bearish Performance Component: provides for performance if the Underlying asset/market decreases in value
    • A Bullish Performance Component: provides for performance if the Underlying asset/market increases in value
  • 3.

    What are the basic types of Structured Products?

  • 4.

    Which underlying assets are Structured Products linked to?

    Currently, the first structured products were on single stocks or equity indices. 
    Structured Products allow investors to access the performance of a broad range of Underlying Assets, including:

      Equities

    Structures based on single stocks or baskets of stocks.

    Indices

    Ranging from broad-based U.S. and international indices (S&P 500, Dow Jones Industrial Average, Nikkei 225, Dow Jones Euro STOXX, etc.) to specific indices featuring particular investment themes (commodities, industries etc.) or proprietary indices (developed using the quantitative capabilities of creators)

    Commodities

    Energy, industrial metals, precious metals, agriculture, etc.

      Baskets:

    A more targeted approach than index investing. Selection of specific combinations of multiple stocks, indices or commodities.

      Multi-Asset Classes:

    Combinations of different asset classes.

      Hedge Funds: 

    Access to hedge fund performance for qualified purchasers.

  • 5.

    What should be considered with your financial advisor before investing in a Structured Product?

    Some points to be considered with your financial advisor prior to investing in a Structured Product

    Market Conditions:

    Analyze the current and expected market environment

    Are current markets stable, bullish, bearish or uncertain? Is it likely that they will continue in the same trend?

    Market Views:

    Select a Structured Product mechanism that is aligned with these views on the markets (bullish, bearish, moderately bullish, moderately bearish, stable, uncertain, neutral, etc.)

    Product Features:

    Assess the variety of Structured Products available

    • Wealth preservation?
    • Minimum guaranteed return?
    • A chance for returns no matter what the market does? 

    These points are not intended as investment advice and do not address all of the factors to be considered before investing in any Structured Product

    Structured Products can be precisely tailored to meet your unique needs and we recommend consulting with an investment advisor to develop the optimal Structured Products solution

  • 6.

    What are some of the risks of Structured Products?

    • Unless Structured Products provide a principal protection component or a minimum return feature, investors may lose their entire investment.
    • There may not be any secondary market for structured products.
    • Investors' yield may be lower than the yield on a standard debt security of comparable maturity.
    • Price or other movements in the underlying assert or instruments comprising the underlying asset are unpredictable.
    • The historical performance of the underlying asset (or any instrument comprising the underlying asset) is not an indication of future performance.
    • Tax treatment of certain Structured Products is unclear, depending on the types of investors.
    • The ability of the issuers to pay their obligations under any structured products is dependent on a number of factors, including their creditworthiness, financial conditions and results of operations.
  • 7.

    What are the common concerns about Structured Products?

    Concern 1:
    "Structured Products are not transparent”

    • Typically, Structured Products have a payoff formula which is set and disclosed to investors before the Structured Product is issued. Regardless of the complexity of a Structured Product, the payoff will depend on 3 factors:
      • The performance of the Underlying Asset
      • The structure of the Performance Component
      • The level of principal protection (if any)
    • Secondary Market Available: The issuer may have (or may not have) a dedicated secondary market team to provide and explain the value of the Structured Product over its life (in some case as frequently as daily). The secondary market team, if any, will provide product valuation for a given structured product and explain the factors affecting such valuation over the life of the product.

    Concern 2:
    "Structured Products are Complicated”

    • Structured Products vary in complexity to accommodate investors’ market expectations, investment objectives and risk appetite.
    • Payoffs are typically disclosed before any Structured Product is issued and investors should read and understand the payoff formula before investing in any Structured Products
    • Structured Products are created based on innovative financial concepts:
      Investors must have a basic understanding of the components of Structured Products and their likely performance across various market scenarios before investing. It is important to first consult with a financial advisor before investing in a structured product and then select the structured product that you fully understand and where you can see (after consultation of the financial advisor) the application to your portfolio.

    Concern 3:
    "Structured Products Cannot be Redeemed Before Maturity”

    • Structured products are typically designed to be held to maturity, and investors may only receive the full benefit of the Payoff formula (including principal protection) at maturity.
    • However, certain Structured Product issuers may make a secondary market available for the products they issue.
    • Liquidity on secondary markets enables the early redemption based on the product valuation at the time of exit: if a secondary market is available for your specific product, you may be able to sell all or part of your investment in such secondary market before maturity on the basis of the product valuation at the exit time.
    • Please note that prices in the secondary market that you may receive may be lower than the initial price of the product depending on market conditions, and that issuers are typically not obligated to make a secondary market for any structured products.
  • 8.

    What goes behind the scenes?

    Clients will typically interact the most with the Sales and Engineering Teams at a Structured Products house

    The Sales Team

    Dedicated Relationship Managers

    • In charge of assessing investors’ unique needs and tailoring the full range of potential Structured Products solutions available
    • The Sales Team will coordinate with all of the other teams involved to ensure that the consideration for the client’s needs is paramount throughout the structuring process

    The Financial Engineering Team

    Responsible for building the Structured Product

    • Engineering will define all of the financial characteristics of the Structured Product, taking into account market conditions as well as the internal risk guidelines of the issuer
    • To design an optimal solution, Engineers must take into consideration important factors such as:
      • The results of financial and pricing analysis provided by the Traders (see below);
      • Legal and regulatory considerations; and
      • Accounting and tax consideration

    Behind the scenes, two additional teams are critical in the design of any Structured Product

    The Traders

    Methodology of prescribing levels of the performance and protection components of a structured product.

    • Trading teams analyze a variety of risk factors in order to price a structured product.
    • Traders will also run ‘stress tests’ on the structured product to determine both (i) the risk to the Structured Products House of issuing a particular product and (ii) the likelihood of the product to perform
    • Pricing is then provided to the Financial Engineers

    The Research Team

    Construction of a Representative Underlying Asset

    • For Structured Products that have more than one Underlying Asset it is important to analyze the relationship between the Underlying Assets to ensure that the basket will have the potential for optimal performance.
    • Similarly, for Structured Products that aim to track the performance a particular asset universe, research is required to ensure that the assets selected are representative of that universe.

    The quality of after-sales services is as important as the design and structuring of the Structured Product itself

    The Secondary Market Team

    Providing secondary market liquidity (subject to certain terms and conditions, not guaranteed)

    • The Secondary Market team intends to provide a product valuation and liquidity for each product issued (in some cases as frequently as daily)
    • The price quoted by the Secondary Market team will take standard factors into account that include but are not limited to: Interest rates, Value and Volatility of the Underlying Asset(s), and Correlation between the Underlying Asset(s) and interest rates.

    The Traders

    Management of a Structured Product after it is issued

    Over the life of a Structured Product, the Trading Team will have 2 roles:

    • Managers:
      • Of the financial characteristics of the Structured Product
      • Of the hedging positions that issuers take to mitigate any exposure created by issuing the Structured Product
    • Calculation Agent:
      • Managing any adjustments that might be necessary. Adjustments and extraordinary events are precisely defined in advance in the legal documentation for the product.
  • 9.

    What is the typical organization for a Structured Products provider?

  • 10.

    How do Structured Product providers manage risk?

    • Hedging: A primary way to reduce Issuer’s risk associated with a Structured Products platform is through hedging.
      • Hedging involves taking a specific position in an Underlying Asset that is opposite to the Issuer’s obligation on a Structured Product linked to that Underlying Asset.
    • Mass is important:
      • Issuers with a sizeable platform and a high volume of Structured Products issuances will have a very large ‘book’ of outstanding issued products and positions.
      • The larger the "book" the more risk offset potential there is:
        Many of the issuer’s risks can simply never be fully hedged. Traders can, however, achieve a hedge by offsetting a given risk using another internal position.

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