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Introduction to Structured Products

The financial landscape is continuously evolving and with these changes come new investment opportunities. From conservative to aggressive, Structured Products can complement diversified portfolios by providing efficient market exposure and risk/return profiles formerly available only to institutions and high net worth investors. Structured Products give investors the opportunity to take advantage of individual market views and capitalize on perceived market trends to achieve desired economic benefits.

What are Structured Products and where did they come from? This paper sets the foundation for understanding Structured Products. It begins with a brief history of Structured Products and then presents our definition. It provides highlevel structured product characteristics. Then this paper presents an overview of the investment objectives that drive the various structures used to form Structure Products and the asset classes that support them. It also presents an overview of the Structured Products secondary market.


Objectives


  • Explain the background of structured products.
  • Define structured products.
  • Describe the characteristics of structured products.
  • Define investment objectives structured products help fulfill.


Background

Derivative-based financial transactions are not new. Financial products with returns derived from the performance of another asset have existed for centuries. Thirteenth century shipping merchants bought and sold option contracts to protect the value of their cargos. Confederate states issued bonds with interest payments based on cotton prices during the U.S. Civil War. Investors began trading American Deposit Receipts on U.S. securities exchanges in the 1920’s.

However, in the 1970s and 1980s, computer-based options pricing, standardized option contracts and new types of futures contracts helped structured product development grow. Black-Scholes and Merton developed their option-pricing model in the 1970s. This model revolutionized investment product design by enabling analysts to create and test new financial structures in simulated and dynamic financial markets. Experts refer to the new product structuring process as financial engineering.


Structured Products Today

Today, Structured products designers use sophisticated software programs to quickly create and price new structured products. The computer programs enable analysts to evaluate the impact of price volatility, correlation and interest rates on structured product prices. They also help designers validate exotic payoff structures too sophisticated for traditional analyses. Structured Products can play a key role in an investor’s diversified asset allocation strategy. With a record $50 billion issued in 2005 alone, structured products may just be Wall Street’s best kept secret. Structured Products are a rapidly growing sector of the US financial landscape. Historically, Structured Products were primarily offered to institutions. That is no longer the case. Issuers as well as investors recognize the potential benefits for these investments.


Definition

So what are structured products? They are innovative financial instruments that derive their payoff from the performance of some underlying asset or group of assets.

The derived payoffs respond to three investment goals:


  • Principal protection
  • Enhanced yield or income
  • Leveraged returns

Underlying assets consist of individual or combinations of the following asset classes:


  • Equities/Indexes
  • Credit/Ratings
  • Commodities
  • Foreign Exchanges


Characteristics

What makes structured products unique? Structured products have three important characteristics.

Each product has:


  • An underlying asset or combination of assets
  • A payout structure (derived value) that responds to an investor's investment goals
  • One or more pre-defined return dates on which the structure payout occurs

Structured products’ greatest value lies in their flexibility. We can tailor a product’s payout structure to meet almost any investor’s unique investment risk/ reward tolerance. Payout structure complexity can range from the simple, “plain vanilla” zero-coupon bond with an option structure to the complex, exotic, Constant Proportion Portfolio Insurance (CPPI) structure.

Structured Products respond to investors’ desire for higher financial rewards. However, market forces dictate that investors can only get higher rewards if they accept higher risk. Structured Products foster the transfer of investment risk from risk-averse investors to investors with a higher risk tolerance. Structured Products balance a security’s risk/reward relationship in order to create a payout structure that provides investors increased rewards without a proportionate increase in risk. Investors can use Structured Products to capitalize on risk and income scenarios not typically available through traditional investments as well as assist in helping minimize overall portfolio volatility.

Continuous market fluctuations have forced many US investors to reexamine their investment strategies. What is the level of risk they are willing to accept? Structured Products enable investors to push their acceptable risk level as high as possible and pursue their highest possible investment reward. However, there are several questions investors need to answer in order to identify the structured product design that is best for them. For instance:


  • Is an investor willing to risk some return in order to receive higher reward?
  • What are the investor's prioritized risk/reward expectations?
  • Is preserving of principal or principal growth or regular income the most important?
  • How much principal is an investor willing to lose in exchange for the opportunity to receive a leveraged or enhanced return?


Investment Objectives

Issuers can structure financial products to meet a wide variety of investment objectives. However, there are three broad categories that cover most investment objectives for Structured Products. These are:


  • Principal Protection – The investor desires 100% or some pre-agreed upon percentage of the principal returned at maturity. In addition, the product pays a supplemental return that is based on the performance of an underlying asset. The investor trades a fixed bond coupon for the possibility of receiving a return higher than prevailing market rates.

  • Enhance Yield or Income – The investor desires a guaranteed coupon payment. The product usually pays a coupon rate that is higher than the prevailing market. However, the investor is willing to trade the bond’s principal for a specific number of shares of the underlying asset at maturity.

  • Leveraged Returns – The investor desires a leveraged return that is a multiple (commonly 2 or 3 times) the upside performance of the underlying asset. At the same time, the investor will accept a one-for-one downside participation in the underlying asset’s performance. The investor trades a fixed bond coupon and principal for the possibility of receiving a return that is leveraged higher than prevailing market rates.

Investors must be fully aware of investment risks associate with structured products prior to investing. They must also evaluate whether structured products fit within their individual financial parameters. In addition, investors should carefully weigh the following considerations, among others, prior to investing in structured financial products.


  • What is the investment time horizon?
  • What is the investor's risk tolerance?
  • What are the investor's income requirements?
  • What is the investor's market view (Bullish, Bearish, Neutral)?


Underlying Asset Classes

Issuers can use nearly any asset class for the underlying portion of structured products. Here are some of the more commonly used asset classes:


  • Equity/Index – An equity is a security that represents an ownership interest in an enterprise. Typically, equity refers to a company’s stock. An index is typically a hypothetical security portfolio that represents an entire market or a portion of a market. It usually represents a statistical measure of a market’s change related to a baseline value. An index’s percentage change is the value normally used by structured products.

  • Rates/Credit - Measures that track the weighted averages of prices in collections of consumer goods and services. The consumer price index (CPI) is one such measure. Another example is the Constantg Maturity Treasury (CMT) Indexes that are the weekly or monthly average yields on US Treasury securities adjusted to constant maturities.

  • Commodity - A commodity is a good used in commerce to produce goods and services. Commodities are oftentimes natural resources that do not differ between producers. Copper, oil and lumber are examples of commodities.

  • Foreign Exchange – A foreign exchange is the price an investor pays for one currency in terms of another currency. Businesses can trade one currency for another at the exchange rate.


Secondary Market

A secondary market for Structured Products is not always available. Issuers and broker/dealers may maintain a secondary market. Typically, they state in the prospectus whether they intend to maintain a secondary market for the Structured Product offering. However, issuers are not required to maintain a secondary market. They can discontinue any market-making activities at any time without notice, and at their sole discretion. The issuer may even state that they do not expect a secondary market to develop.

Investors may be unable to sell their Structured Products before the stated maturity date. Therefore, they should not expect to sell products or withdraw deposits for any benefits, such as:


  • Achieving trading profits
  • Limiting trading or other losses
  • Realizing income prior to maturity
  • Accessing proceeds prior to maturity

Issuers take into account a number of factors when they establish a Structure Product’s initial price. They usually account for these same factors in the secondary market. If an investor sells a product prior to the stated maturity date, the secondary market price may compensate for the issuer’s costs to develop, underwrite, hedge and distribute the product. These factors may cause the investor to receive significantly less than the initial principal amount invested per unit. Likewise, if there is no movement in the price of the underlying asset and/or no change in market conditions since the product pricing date, the investor should expect the products price to be lower than the original issue price.

Issuers may base a Structured Product’s secondary market price on additional factors, such as:


  • Interest and yield rate movements
  • Volatility of the underlying asset or market index
  • Time remaining until the stated maturity date
  • Issuer creditworthiness
  • Dividend rates on the reference shares
  • Economic, financial, political and regulatory or judicial events that affect the reference shares or stock markets generally and that may affect the price of the reference shares.
  • Sales mark-up or mark-down
  • Handling fees

Investors who choose to sell a Structured Product in the secondary market may receive substantially less in sale proceeds than the principal amount. It is unlikely that the secondary market value of Structure Products will correlate closely with the underlying asset’s market value. If an investor sells a product prior to its stated maturity date and when the underlying asset differs from the starting level, the sale price may be less than the product’s price at maturity.


Ratings

Structured Products carry the rating of the issuing underwriter. They typically represent an unsecured debt obligation of the issuer. As a result, the credit rating only addresses the creditworthiness of the issuer. It corresponds to the issuer’s ability to meet its financial obligations. The rating does not affect or enhance the likely performance of the underlying asset or market index used in a Structured Product.


Portfolio

A portfolio that consists of both stocks and bonds will provide higher returns for a given risk level. Typically, the portfolios that comprise the efficient frontier are the ones that are most highly diversified. Structured Products are an efficient way to diversify a portfolio in order to improve its risk/return ration. For this reason, investors should maintain a portfolio of structured Products.


Summary

Structured Products are not new. However, enhanced computer-based modeling and pricing algorithms make it economical to produce Structured Products today. Structured Products are innovative financial instruments that derive their payoff from the performance of some underlying asset or group of assets.

Prudent investors understand the importance of a well-balanced, diversified portfolio. Structured Products are a diversification tool that can help mitigate portfolio risk by controlling volatility and focusing on specific financial goals. With a wide range of complexities and objectives, structured products provide investors exposure to varying asset classes as well as the potential to capitalize on a market view to achieve desired investment results. Issuers are designing Structured Products to help investors meet one or a combination of investment objective. These objectives include:


  • Principal Protection
  • Enhanced Yield or Income
  • Leverage Returns

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Sage Capital Advisors, Inc (“Sage”) is registered as an investment advisor with the Office of Financial Regulation of the Florida Financial Services Commission. The information and opinions contained in this document are for background purposes only and do not purport to be full or complete, and is subject to change. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this document, and no liability is accepted as to the accuracy or completeness of any such information or opinions. Sage does not provide tax, legal, or accounting advice. In considering this material, you should discuss your individual circumstances with a tax, legal and/or accounting professional before making any decisions.

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