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1.
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Definition
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Structured products are synthetic investment instruments specially
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.
Structured investments arose from the needs of companies which want
to issue debt more cheaply. Traditionally, one of the ways to do
this was to issue a convertible bond, that is, debt that under
certain circumstances could be converted to equity. In exchange for
the potential for a higher return (if the equity value would
increase and the bond could be converted at a profit), investors
would accept lower interest rates in the meantime. However this
tradeoff and its actual worth is debatable, since the movement of
the equity value of the company could be unpredictable. Investment
Banks (financial institutions which help other companies issue bonds
to borrow money) then decided to add features to the basic
convertible bond, such as increased income in exchange for limits on
the convertibility of the stock, or principal protection. These
extra features were all based around strategies investors themselves
could perform using options and other derivatives, except that they
were pre-packaged as one product. The goal was again to give
investors more reasons to accept a lower interest rate on debt in
exchange for certain features. On the other hand the goal for the
investment banks was to increase profit margins since the newer
products with added features were harder to value, so that it was
harder for the banks clients to see how much profit the bank was
making from it.
Interest in these investments has been growing in recent years and
high net worth investors now use structured products as way of
portfolio diversification. Structured products are also available at
the mass retail level - particularly in Europe, where national post
offices, and even supermarkets, sell investments on these to their
customers.
Other Resources:
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Criterion Investments:
Structured Products are investments that are uniquely designed
to provide investors with risk return, tax and diversification
characteristics that are not generally available from
traditional investments. More…
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2.
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Examples, Types, or
Variations
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A
structured product is generally a pre-packaged investment strategy
which is based on derivatives (ie. options and to a lesser extent,
swaps) but which features protection of principal if held to
maturity. For example, an investor invests 100 dollars, the issuer
simply invests in a risk free bond which has sufficient interest to
grow to 100 after the 5 year period. For example, this bond might
cost 80 dollars today and after 5 years it will grow to 100 dollars.
With the leftover funds the issuer purchases the options and swaps
needed to perform whatever the investment strategy is. Theoretically
an investor can just do this themselves, but the costs and
transaction volume requirements of many options and swaps are beyond
many individual investors.
Typical examples
of Structured Products include the following:
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Flow through share limited partnerships
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Funds of income trusts
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Funds of hedge funds
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High yield bond portfolios
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Covered call writing
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Split share corporations
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3.
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Formula
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The two common
elements in a Structured Product are:
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A bond product or another element
of capital safeguard.
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An alpha generator - which is any financial instrument (i.e. a
stock, currency, etc.)
A
brief description of how structured products are manufactured:
Combinations of derivatives and financial instruments create
structures that have significant risk/return and/or cost savings
profiles that may not be otherwise achievable in the marketplace.
Structured products are designed to provide investors with highly
targeted investments tied to their specific risk profiles, return
requirements and market expectations.
These products are created through the process of financial
engineering, i.e. by combining underlyings like shares, bonds,
indices or commodities with derivatives. The value of derivative
securities, such as options, forwards and swaps is determined by
(respectively, derives from) the prices of the underlying
securities.
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4.
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Related Terms
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Derivatives
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Zero-coupon Strategy
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Defensive
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Aggressive
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Structured Investment
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5.
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As
Used in the Hedge Fund World
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Other Resources:
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Dubai International
Financial Exchange: Furthermore, structured
products can be linked to any asset class. The alpha generator
could be a single stock, derivatives, commodities, foreign
exchange or even a basket of hedge funds.
More…
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6.
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Applications
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The
benefits of structured products (such as principal protected notes)
can include:
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principal protection
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tax-efficient access to fully taxable investments
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enhanced returns within an investment
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reduced volatility (or risk) within an investment
Structured products are by nature not homogeneous - as a large
number of derivatives and underlying can be used - but can however
be classified under the following categories
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Interest rate-linked notes
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Equity-linked notes
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FX and Commodity-linked notes
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Hybrid-linked notes
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7.
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Misused & Abused
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Other Resources:
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Securities Commission,
Malaysia:
With the
exception of industry professionals, the truth is that the
capacity or capability to manage the risks of structured
products is still lacking.
More…
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Ameriprise Financial:
Risks of structured products include the inability to close such
instruments, rapid changes in the market, and defaults by other
parties.
More…
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8.
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Additional Sources of Information
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Books
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News
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Scholarly Papers
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Back to Terms
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