qwertyuiopasdfghjklzxcvbnmqwertyui opasdfghjklzxcvbnmqwertyuiopasdfgh jklzxcvbnmqwertyuiopasdfghjklzxcvb nmqwertyuiopasdfghjklzxcvbnmqwer Structured tyuiopasdfghjklzxcvbnmqwertyuiopas products dfghjklzxcvbnmqwertyuiopasdfghjklzxcvbnmqwertyuiopasdfghjklzxcvbnmq 4/26/2010 wertyuiopasdfghjklzxcvbnmqwertyuio pasdfghjklzxcvbnmqwertyuiopasdfghj Ayushi Singhania klzxcvbnmqwertyuiopasdfghjklzxcvbn mqwertyuiopasdfghjklzxcvbnmqwerty uiopasdfghjklzxcvbnmqwertyuiopasdf ghjklzxcvbnmqwertyuiopasdfghjklzxc vbnmqwertyuiopasdfghjklzxcvbnmrty uiopasdfghjklzxcvbnmqwertyuiopasdf ghjklzxcvbnmqwertyuiopasdfghjklzxc Introduction: Earlier whenever the investors wanted to invest their money they had limited options. The major source of investment used to be equity markets. If they needed any diversification they would turn to debt, bullion, commodities and at the very best, Real Estate. But the constraints of these instruments like high investment, low liquidity in the market and long term lock in periods are not unknown to anyone. After these finally mutual funds entered the markets and are still considered to be the best way to invest. Investment manage all over the globe are continuously striving to design new products that suit the investor requirements. Asset managers in the developed markets have been offering structured products across asset classes such as equities, debt, forex, and commodities for a long time now. However in India the pace of growth of these products has been slow due to regulatory constraints and awareness among the investors. Mutual funds Debt Bullion Real estate Commodities What is a structured product? It is generally a pre-packaged investment strategy based on derivatives, such as a single security, a basket of securities, options, indices, debt issuances and/or foreign currencies, and to a lesser extent, swaps. The variety of products just described is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of some structured products is a "principal guarantee" function, which offers protection of principal if held to maturity. Structured products in India are different from the complex securitized debt that has been the centre of the financial crisis in the global markets. They are relatively a new category of investment options here. They are available in the form of debentures that have returns linked to underlying stock indices such as Nifty. They are also available indirectly in the form of mutual fund products, mostly in the category for debt schemes as fixed term funds. As such, structured products were created to meet specific needs that cannot be met from the standardized 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 utilize the current market trend. The strategic combination of these components provides control and flexibility to address a wide range of investor return objectives and risk appetites. Depending on how the various elements are combined, you can structure the pay-out profile of a product. No other instrument lets you shape risk/return characteristics as precisely as structured products. If the structured product is designed well then no matter how the market condition is one can benefit from it. One can make money not only in rising rates but also sideways moving market and falling markets. Composition of a structured product: Structured products are usually issued by investment banks or affiliates thereof. They have a fixed maturity and have two components thereof: a note and a derivative. derivative this component is often an option. it provides for payment only after maturity. note provides periodic interest payments to the investor at a pre determined rate. Some products use the derivatives as a put option whereas the other products use the derivatives to provide for a call option. Nature of a structured product: y y y The unique feature of structured products is that it limits losses which other conventional products such as equity or plain vanilla equity funds don¶t. But at the same time, these conventional products promise the same returns whereas structured products don¶t. These products use time-tested quantitative models and mathematical formulae, which indicate the proportion that investments in stocks and safe avenues, such as bonds and cash, should have in a portfolio at various market levels. The product may also specify that if the value of the portfolio falls below a certain floor level, the capital guarantee clause will set in to ensure that the investor¶s capital is protected. However, this protection may come at a very expensive rate as these products may charge initial subscription fees annual recurring expenses and an exit load for investors who y y want to exit before the maturity period.( in some cases expenses can go up to as high as 5-6% of the investment.) Market sizing and issuances: Structured product can be positioned as a low risk, medium risk, or high risk product depending on the features offered. For low risk investors, structured products are like a fixed deposit or a mutual fund as the returns from these standard products would be even lower post inflation, with no liquidity in the meantime. A small amount of risk can lead to a higher kicker in structured products. For the investor with a higher risk appetite, these products provide a safer way to speculate. The main risks are market risks and counterparty credit risks. Clients of structured products: Investors originators structurers Wrappers Distributors In the current volatile stock markets, such products that are being offered as ³capital protected´ equity exposures offer good value to the financially savvy. As retail and HNI (high net worth investment) investors gain exposure to structured products via print media and wealth managers, they are going to be an increasingly acceptable form of investment. Due to the hybrid nature of these products they can be positioned to satisfy the appetite of any kind of investor. The widening of wealth management arms of any banks and brokerage have seen a dearth of financial products other than mutual fund Structured products have the potential other than the mutual funds contract. Structured products have the potential to satisfy the vacuum created by the competition. By keeping the structured products simple, transparent and accessible, we can avoid the mistakes made by overseas markets. Risks of structured products: The risk of structured products that present risks of loss of principal due to market movements are similar to those risks involved with options. Purchasers of some or all structured products are supposed to go through an approval process, so that only accounts approved for options trading would also be approved for some or all structured products. In the case of a principal protected product, these products are not always Federal Deposit Insurance Corporation insured; they may only be insured by the issuer, and thus have the potential for loss of principal in the case of a liquidity crisis, or other solvency problems with the issuing company. Some firms have attempted to create a new market for structured products that are no longer trading. These securities may not be trading due to issuer bankruptcy or a lack of liquidity to insure them. Some structured products of a once solvent company have been known to trade in a secondary market for as low as pennies on the dollar. Benefits of structured products: Principal protection. tax fficient access to fully taxable instruments. enhanced returns within an investment. reduced volatility within an investment. Limitations of structured products: Credit risk Lack of liquidity No daily pricing Highly complex Structured Notes: Interest Rate-Linked Notes Interest rate-linked notes, through the underlying structures built into the note, often pay a higher coupon than straightforward term deposits. Credit-Linked Notes A credit-linked note usually offers a higher yield compared to a basic bond with a similar credit rating. Equity-Linked Notes Equity-linked notes pay a return linked to the performance of an equity market over a defined period. On the maturity date, the note pays the initial principal amount plus return, if any, based on the percentage change in the underlying equity market. FX-Linked Notes This type of note pays a return linked to a global foreign exchange (FX) market. It is usually a short-term note that pays out a fixed minimum rate of interest determined by the movement in foreign exchange rates over the life of the note. On the maturity date, the note pays the initial principal amount plus return, if any. Dual Currency Notes These types of notes provide an interest rate on a short-term note in one currency (base currency) in return for accepting possible repayments of the note principal in another currency (alternate currency). This product may be suitable if you desire yield enhancement and exposure to either of the two currencies. Hedge fund linked notes It pays a return linked to the performance of a commodity (e.g. Natural Gas or Aluminum) or basket of commodities over a defined period. On the maturity date, the note pays the initial principal amount plus return, if any, based on the percentage change in the underlying hedge fund. Commodity-Linked Notes A commodity-linked note pays a return linked to the performance of a commodity (e.g. natural gas or aluminum) or basket of commodities over a defined period. On the maturity date, the note pays the initial principal amount plus return, if any, based on the percentage change in the underlying commodity (or basket). Precious Metal-Linked Notes With these notes, you receive a return linked to the performance of a precious metal (e.g. price of gold or silver) over a defined period. On the maturity date, the note pays the initial principal amount plus return, if any, based on the percentage change in price (for example) in the underlying precious metal at maturity or an average over time. Structured products gaining popularity in India Structured products have been in India for 3 years but they have attracted the investors for the past few months because of the volatility in the stock market. Structured products are designed in such a way that the initial investment of the investors is protected even if the stock market falls sharply. A large no. of wealth managers have started offering such products to their clients in order to diversify their portfolio. Wealth managers such as Benchmark Asset Management, ICICI Prudential Asset Management, DSP Merrill Lynch, Kotak Mahindra Group and HDFC Asset Management have been active in this market. HSBC Asset Management (India) Pvt Ltd and JM Financial Ltd are the latest entrants. The no. of companies offering structured products is on a rise. Even the conservative investors who only invested in RBI relief bonds have started getting attracted to structured products. The money invested in the 13 structured products currently available in the market is estimated at Rs. 2000-2500 crores by executives in companies offering such products. Examples of Structured Products: 1. Performance Tracking Certificates: They can be based on underlying investments such as stocks, indices, sectors, themes, commodities, interest rates, currencies, actively managed funds etc. The investment performance of these certificates will be the same as the performance of the underlying assets. Performance Tracking Products are intended for medium to long term investors. Some investments having international underlying carry currency risks. In order to resolve these risks Quanto certificates can be purchased by the investor as these remove the risk of currency fluctuations. This enables the investor to freely participate in the international market, in their own currency. Performance tracking certificates provide easy access to large variety of alternative investments. Their small denominations, low transaction costs and transparent fees facilitate the investor to invest in the world markets. They often have high liquidity as many are listed and are traded on exchanges. Risk factor: The risk related to investing in a performance certificate is comparable to that of direct investments in the underlying. If the underlying decreases, the value of the certificate also decreases and in some cases the investor might even lose his entire investment. 2. Leveraged Certificates: Leveraged certificates are based on the view of the investors on the price of underlying. It is suitable for the investors who want to take a leveraged directional position on a specific underlying, while ensuring that they know the maximum possible loss on the position. Leveraged long certificates are developed for the investors who have a bullish view and the Leverages short certificates are developed for the investors who have a bearish view. Thus the products are suitable only for experienced investors. Main advantages: y y y y y y y Leveraged earnings potential. Certainty about maximum loss (equal to premium). No volatility element in the price of a certificate. High pricing transparency No margin requirements Access to many underlying in different asset classes (shares, indexes, bonds, FX, commodities)and different regions Built-in stop-loss The investor investing in a leveraged certificate receives the full increase or decreases in the price of the underlying, but only finances a part of the underlying the rest is financed by the issuing bank. This is called financing level. Leveraged certificates are open-ended i.e they do not have any maturity date. They do have a stop-loss which is to ensure that the investor doesn¶t lose more than the price initially paid for the investment. If the price of the underlying hits or breaches the stop-loss level, the leverage certificate will get terminated and the investor will receive the difference if any. The theoretical value of a Leveraged Certificate is the difference between the price of the underlying and financing level multiplied by the amount of underlying an investor partially buys when buying one leveraged certificate. Leveraged Certificates are by definition highly leveraged investments, where buyers risk losing their entire invested capital 3. Warrants: Warrants are certificates issued by banks which give the option to buy or sell a certain amount of an underlying at a specific price before or at a pre-determined date. Call warrants enables the investors to profit from rising markets. Put warrants enables them to profit from falling markets. Warrants are basically issued on shares, basket of shares, commodities, foreign exchange, indices and bonds. In every way, warrants are bank issued options and have the same pricing characteristics and risks as options. 4. Capital protected notes: Capital protected notes are the most popular structured notes among the retail investors as they are designed to partially or fully protect the invested capital. Capital protected notes offer a defensive investment and are a suitable way to invest in financial markets with low or no capital risk. Capital protected notes are usually a combination of zero coupon bonds and a call option. The main advantages of capital protected notes are: y y y Investor capital (partially or fully) protected at maturity Higher potential return than fixed income investments Participation possible in a broad range of underlying Three levels of capital protection exist: y 100% of invested capital y Less than 100% (in this case investors will generally get a higher participation rate) y Greater than 100% (in this case investors will generally get a lower participation rate) Risk factor: The risk associated with capital protected noted is not only related to the performance of the underlying but it also dependant on other factors. These risks are associated to owning a zero coupon bond or an option which are not traded on the exchange. On the secondary market, the price of the capital protected note fluctuates in relation to prices of underlying, the volatility level of underlying and interest rates. 5. Reverse exchangeable (REX): Reverse exchangeables are securities that pay above market coupons. In coupon, there is no guarantee that the full amount of investment will be recovered. At maturity, the price of the underlying is compared to the price set at the time of issue. The advantages of the popularly known REX are : y During the life of the investment, investors receive a coupon higher than the risk free rate at issue y The high coupon received may offset potential capital losses even if the underlying asset price falls slightly below the reference price The price of the reverse exchangeable rises as the underlying asset price rises. The higher the price of the underlying, the greater the chance that investors will receive the full amount of invested capital at maturity. In addition to the coupon, reverse exchangeables offer two possible payouts at maturity: y y If the price of the underlying share is above or equal to the strike price, you would receive an amount corresponding to 100% of the nominal amount invested. There is no upside participation on a REX. If the price of the underlying is below the strike price, you would receive units of the underlying or an equivalent cash settlement valued at the current price at maturity. This would be a loss of principal, but not necessarily a loss on the product. Additional Features can be used to obtain a certain level of protection in case of a fall in the price of the underlying. Here a ³barrier option´ can be used. In this case, in addition to the coupon, the investor fully recovers their initial investment if the underlying price is above the barrier. The barrier can be monitored continuously, during the whole life of the structure or at maturity only. 6. Discount certificates: Discount certificates are like REX in structure, but are designed to enable investors to purchase an instrument at discount, rather than get high coupon payment. When discount certificates are purchased the investors acquire an underlying instrument at a discount agree on a cap level on the profit. y y If the price of the underlying asset is above the cap level at expiry then the investors will get an amount equal to the cap level and if the underlying price is less than the cap level then they will get an amount equal to the price of the underlying. By limiting the upside potential of the investment, the certificate can be offered at a discount. Risk factor: With discount certificates, as with reverse exchangeables, the risk is if at maturity the underlying price settles well below the strike price. In such cases, redemption will be below Par and involve a capital loss. In the worst case, the investor can lose their entire investment, if the underlying price goes to zero. 7. Bonus Certificates: Bonus Certificates are suitable for investors who want a certain level of security and target high returns. A bonus will be paid as long as the underlying price does not fall below a ³barrier level´. The bonus level and the barrier level are defined on the issue date. The bonus level is set above the initial price and the barrier level is set below. The barrier can apply continuously, during the whole life of the structure or at maturity only. Advantages with the Bonus Certificate are quite obvious: y y y Bonus payments - above average returns if the underlying is stagnant or falls slightly Reduced risk - bonus is paid even when the underlying price falls to a certain level Unlimited profit opportunity - 100% participation if the underlying rises above the Bonus level Bonus Certificates offer the following three possible payouts at maturity (for an American barrier): y If the underlying price has never breached the barrier level and is above the bonus level, investors receive a cash payment equal to the final level of the underlying. y If the underlying price has never breached the barrier level but is below the Bonus level, investors receive an amount equal to the bonus level. y If the underlying price has at least once breached the barrier level, investors receive the final level of the underlying and the bonus mechanism will no longer be active. Risk factor: The key is the choosing the correct barrier level because the bonus certificate converts into a normal certificate when the barrier level is breached. In that case, the risk related to investing in the bonus certificate is comparable to a direct investment in the underlying. If the underlying decreases, the value of the certificate decreases. In the worst case, the investor can lose their entire investment. 8. Airbag certificates: They are also known as partial protected certificates. In a way they are similar to the bonus certificates. Instead of providing 100% capital guarantee they give protection on the certain percentage on the downward movement in the underlying price. Any redemption on the invested capital is not guaranteed to the investors. At maturity the investor will receive a minimum of the 100% of the capital invested if the underlying price is higher than the airbag level otherwise there may be a capital loss but not as great as the underlying itself unless the value of the underlying is totally lost. Advantages of airbag certificates: y y An initial decrease in the price of the underlying will not reduce the redemption value of the certificate at maturity, as long as the airbag level is not breached. A higher participation on the increase of the underlying compared to a capital protected note. 9. Double-up certificates: They provide an exposure to a certain underlying and offer a 200% return on the capital appreciation up to the cap level. These certificates could be attractive to investors who have positive market expectations. Double-up Certificates offer the following three possible payouts at maturity: y If the underlying price is equal or larger than the cap level, the investor receives twice the difference between cap level and strike price, in addition to the initial investment. This is the maximum payout of this product. y y If the underlying price is between strike price and cap level, the investor receives twice the difference between underlying price and strike price, in addition to the initial investment. If the underlying price is equal or smaller than the Strike price, the investors receives the underlying, or a cash amount equal to the value of the underlying at maturity. Advantages of double-up certificates: y y Double participation in the underlying price increase up to the cap level Same risk as investing in the underlying in case of decreasing price. Risk factor: if the underlying decreases the value of the certificate also decreases. In the worst case the entire capital invested can be lost. 10. Outperformance certificates: They are some of the simplest structured products available. They are extremely popular in rising markets because they allow investors to participate in the increase of the underlying with a high level of participation without any cap level. Investors receive a leveraged amount of exposure in the price of the underlying which is more than 100% participation. The main advantage of performance certificates is their unlimited return potential. Risk factor: On the downside, investors are not guaranteed any protection for the invested capital in the event the price of the underlying decreases. In such an event, the payoff is similar to a direct investment in the underlying (excluding dividends). If the underlying decreases, the value of the certificate decreases. In the worst case, the investor can lose their entire investment. 11. Auto-callable notes: They are coupon paying products that offer potential high yields and a variable time investment horizon. The auto-callable feature of the note means the issuer will redeem the note prior to maturity if the underlying is at a certain level on pre-set valuation dates. This feature enables the investor to potentially achieve a very attractive yield. If a coupon is not paid for a specific year, it comes in addition to the potential coupon for the following year. At maturity, if the note is below the strike price but has not breached the barrier level, the note is redeemed at 100%. However if the underlying price falls below the Barrier level, the investor may suffer a loss which can be equivalent to the entire investment. Advantages of auto-callable notes: y y y Potential early redemption with a high yield realized over a short investment term Potential high coupon with memory mechanism Protection at maturity up to a certain level Bibliography: http://investmoneyinindia.com/ http://www.thehindubusinessline.com/ http://www.investopedia.com/ http://en.wikipedia.org/ StructuredProductsMadeSimple.com Guide for simple investors ± structured products. Author- Josh Anderson BNP Paribas Equities and Derivatives Handbook ± Guide to structured products. http://www.livemint.com/Home.aspx