Aug 21, 2023|Decoding Risks in Structured Products- 4 min
The previous article discussed:
Traditional approaches to active management focusing on finding a high-potential investment, and
Financial engineering techniques that aim to generate returns using solutions like structured products.
This article discusses the benefits and pitfalls of structured products in more detail.
Structured Products: A simple example
Structured products come in infinite varieties. Some try to achieve the best of both worlds, like allowing you to participate in the success of a technology company without risking your capital by combining a low-yield instrument, such as a bond, with one or more derivatives (e.g., options, futures, swaps).
For example, an investor who believes that technology stocks will boom in the next three years due to advances in artificial intelligence (AI) and other emerging technologies such as quantum computing, can invest in a portfolio of technology stocks. But if the market falls, so will the value of the portfolio.
A structured product can be designed to allow investors to participate in the growth of the technology sector without investing in it directly by combining a zero-coupon bond and a call option that gives the holder the right, but not the obligation, to purchase technology shares at a defined price (the so-called “strike price” is usually above the prevailing market price at the time).
For example, say you invest $1,000 as follows: $850 in a $1,000 face value, zero-coupon, three-year bond and $150 in a call option to buy 30 shares in a technology-focused fund at a strike price of $25 per share when the prevailing market price is $20 per share.
If the share price of the technology fund stays at or below the $25 strike price, you would allow your call option to expire and would just get $1,000 from the bond at maturity, recovering your investment. But if the share price grows to, say, $30, you would exercise your call option to buy 30 shares for $25 per share, making an additional profit of $150 ($5 per share x 30 shares).
The above is a simplified example of how a structured product can provide potential returns from a high-growth sector without the risk of investing in it directly.
But the reality is more complex. The complexity of structured products can make them opaque, hiding potential fees charged by the investment bank for creating the product and other risks.
The need for caution
The main benefit of structured products is the indefinite flexibility for customization, not “risk-free return.” Risk simply cannot be “engineered away” completely with the right design. Many retail and institutional investors during the Great Financial Crisis of 2008-9 discovered suddenly that their so-called principal-protected structured products had no value.
Regulators have since attempted to address many issues that led to this disconnect by ensuring that banks have more capital and are clearer about what can and cannot be guaranteed.
The hidden risks
The ultimate value of structured products depends on three broad factors which add varying layers of risk.
The Market (Market Risk): Economic conditions (e.g., inflation, recession) and geo-political events (e.g., armed conflict, public emergencies) can affect security prices drastically which impacts the value of the derivative linked to the affected security.
The Counterparties (Credit Risk): Agreements rely ultimately on the involved parties doing what they promised to do. If the borrower in the previous example defaults on the bond, or the seller of the option cannot honor a call, investors will lose money regardless of the written agreement.
The Issuer (Issuer Risk): Even if the market and counterparties behave as expected, the company that sells the structured product may experience difficulties that impair their ability to pay the investor.
The sheer variety of structured products requires each one to be assessed separately. That does not make them a wrong choice per se. Simplistic solutions may not achieve the required returns in a challenging environment, which necessitates some complexity.
But the sheer number of moving parts in structured products means that issues can arise anywhere in the chain and affect the product as a whole.
Structured products may serve a purpose in a well-considered investment strategy, but they are not a “safe” route to higher returns and their opaque nature can hide many inherent risks.