What are Structured Products and How do They Work?
- What Are Structured Products?
- Understanding How Structured Products Work?
- Components of Structured Products
- Features of Structured Products
- Benefits and Limitations of Structured Products
- Conclusion
What Are Structured Products?
Structured Products are a carefully selected, customized combination of traditional securities (such as equity and debt) and derivatives (options and swaps). These are issued by the financial institution or bank, which are later packaged and suitable for individual needs. They are often curated, keeping the individual's investment needs, market views, and risk tolerance level in mind.
The risk-return ratio is unstable, meaning it can vary across different investors. For example, depending on Mr. A's goals, the risk level may be moderate. Likewise, Mr. B may expect a high yield; thus, the structured product may have a similar set of securities. Consider them a hybrid investment option that aims to hedge against market volatility while improving achievable yields.
Note: The information, illustrations, and calculations provided in this blog are for general informational purposes only and should not be construed as investment advice or a recommendation.
Understanding How Structured Products Work?
While utilizing the hybrid feature of structured products, the traditional underlying assets are swapped with the yield of the derivative securities. The idea is to create a mix containing fixed income, a good yield rate, and minimal risk levels. A ratio proportion (as per the type of structured product) decides how much should be invested in each security. In other words, it combines bonds (for consistent income) and stock indices (for market-like rates) with securities like derivatives to hedge the overall risk of different assets.
For example, consider that Mr.A brought an equity-linked note of ₹1,00,000. Under this type, maximum allocation goes to a bond (fixed security) and the rest to a derivative option (linked to an index). Now, if ₹90,000 is invested in a bond for 3 years, assuming it will grow to ₹1 lakh in that period. There is full capital protection here, and you have a surety of getting the capital amount.
At the same time, the rest (₹10,000) stays in an option contract, let's say Nifty 50. Now, in a market scenario going up, the same will also reflect in the Nifty 50. So, if the index rises, the capital amount will increase by ₹20,000. The investor will make a payoff of ₹20,000 [₹100,000 (bond) + ₹20,000 (option) - ₹100,000 (initial investment)].
Note: The information, illustrations, and calculations provided in this blog are for general informational purposes only and should not be construed as investment advice or a recommendation.
Components Of Structured Products
There are three major components of structured products, as previously discussed. It includes:
- Equity Instruments: It includes equity securities or a set of instruments that offer high yields but carry higher risk. It can also be paired with other securities.
- Bonds: Here, bonds are the preferred option for giving fixed income and capital protection. Hence, a structured product invests in bonds to secure the capital investment for a no-loss situation.
- Derivatives Contracts: Acting as a determinant of overall risk in this mix, the value of derivatives contracts depends on the underlying asset (such as a stock, bond, currency, or commodity). It includes calls, options, and swaps. In the event that the option price goes up sharply, it covers the initial investment and yields positive returns. If an option turns flat or falls, the bond protects the capital.
Features Of Structured Products
These structured products have multiple features listed for investors. It includes:
- Combination of Assets: While risk-reward fluctuates in traditional investments, these products combine different securities, such as bonds, stock indices, and derivative contracts. As a result, these instruments help manage the overall risk.
- Capital Protection: The chances of receiving both capital and yield are very low. Although the yield rates are good, the capital guarantee is not fixed. But, with these products, it is possible to get the entire capital even if the market underperforms. Structured products take advantage of bonds here.
- Customized risk-return profiles: While one size does not fit all, the same goes for investments. Considering this, the fund managers can customize the basket to meet specific investment goals. Therefore, if you require capital protection, high yield, and exposure to various assets, the fund manager will create a structured product to meet these needs.
- Limited liquidity: Structured products are illiquid or have limited secondary markets, like bonds. In that case, exiting early brings in a penalty. Hence, this option is feasible for those long-term investors ready to wait till maturity.
Benefits And Limitations Of Structured Products
The following table explains the benefits and limitations of these products applicable to investors:
| Benefits | Limitations |
|---|---|
| Customization option available to investors | The risk of market fluctuations is always present. |
| Enough scope for asset diversification | There is limited liquidity available in this product. |
| Gives exposure to equities or indices with lower downside risk. | Often, investors find these products filled with complexity. |
| It can be linked to various asset classes (stocks, commodities, currencies, etc.). | When the issuer involved in the structured product fails to fulfill their obligations, counterparty risk arises. |
Conclusion
Structured products are a unique blend of safety and market-linked growth. It makes them attractive for investors who seek customized yields with defined risk levels. Plus, they are useful for those who want capital protection despite staying on the market upside. However, these products come with limitations as well. Hence, thorough knowledge of these products and associated risks can help investors make the right choice for their investment.
Disclaimer:This is for educational/information purposes only. The general topic and information do not aim to influence the investment/trading decisions of any investors.
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