TYPES OF
Structured products fall into broad categories and the terms used may vary slightly from one issuer to the next. The categorization explored here is for guidance only.
The classes of structured products investors are most likely to come across are:
It is generally considered that capital protection products carry the least risk of the three and participation products carry the most risk with yield enhanced products sitting in between. The reality is that any instrument, regardless of product class, can be constructed with various features. Instruments should be assessed according to their specific terms and not by general product grouping.
STRUCTURED PRODUCTS OFFER EXPOSURE TO A DIVERSE RANGE OF MARKETS AND UNDERLYING ASSETS
CAPITAL PROTECTED
Varying degrees of capital protection can be built in to an instrument. Some structured products offer 100% protection of the initial investment and others offer partial capital protection. At maturity, investors will receive the capital they have invested in the case of a 100% capital protection instrument even if the market has moved against their expectations.
Some instruments offer conditional capital protection commonly linked to the performance of the underlying asset. If specific conditions are met, for example if the price of the underlying asset falls below an agreed threshold during the investment period, the capital protection disappears and the investor may incur a loss at maturity.
YIELD ENHANCED
These products offer no protection for the initial investment and sometimes with a capped upside potential. The aim is to generate a return higher than that of other investment options generally considered less risky such as a bond.
Although yield enhanced instruments may appear bond-like, paying a coupon and often issued at par or at discount, their risk profile is very different to that of classical fixed income instruments. It is important to understand that these coupon paying instruments are not directly comparable to bonds.
FEATURES
Yield enhanced products can have features such as a barrier or multiple barriers, fixed or relative to a predetermined factor, causing certain features to take effect if specific conditions are met during the investment period.
A BARRIER CAUSES A CERTAIN FEATURE OF AN INSTRUMENT TO COME INTO EFFECT ONCE A PREDETERMINED CONDITION IS MET. THIS COULD BE BASED ON THE PRICE MOVEMENT OF THE UNDERLYING ASSET
PARTICIPATION
These instruments commonly features leveraged upside potential or downside protection with no or only partial and conditional capital protection. Generally, no coupon is paid on these instruments and they are not issued at discount.
There are many variations of this type of instrument. They are commonly known as certificates and are often equity based, but can be based on any underlying asset. Some instruments incorporate a return at maturity which is calculated by multiplying the performance of the underlying asset by a fixed percentage, called the participation rate.
FOR EXAMPLE
If the participation rate of an instrument tracking the FTSE 100 is 60%, then 60% of the index’s performance will be used to calculate payout at maturity. Participation rates can apply downside as well as upside.
PARTICIPATION RATE IS THE PERCENTAGE OF THE PERFORMANCE OF THE UNDERLYING ASSET WHICH WILL BE USED TO CALCULATE THE RETURN WHEN A PRODUCT REACHES ITS MATURITY
CONSIDER THE COUNTERPARTY RISK
Investors should consider the counterparty risk before investing. In the event of the issuing bank being declared bankrupt or being unable to meet its liabilities, investors may lose part or all of their original capital investment.
LEVERAGE
As the structured products market evolves, more innovative products are available with ever increasing variations in terms and structure. Some instruments will fall into more than one of the broad categories we have discussed. Investors should understand the terms, payouts and risk profile of any instrument before investing.