Structured Products face a number of challenges in the current environment of tighter credit conditions and elevated volatility. As volatility has increased so too has the cost of derivatives. It is now more expensive to buy an option on an underlying asset than it was before the credit crunch. Another challenge in constructing structured products is the credit rating of the institutions involved. Investors are now very sensitive, not only to the credit rating of an institution, but also to their perception of that institution. The slightest negative connotation about a firm and many investors are unwilling to engage in any business with that organization.
In this environment, a number of innovations are currently taking place. As options are now more expensive, new payoffs that still allow appealing products are being implemented. One way to improve the payoff of an option is to build a profit cap into the structure. As this limits the maximum potential return to the investor it means that options can be written on an underlying that would otherwise be too expensive. A similar result can be achieved by adding an auto-call feature. This is where if the underlying asset has appreciated by a prescribed amount by certain time then the option pays out. Once again this decreases the cost of the option.
Another area of focus has been in the underlying assets. Underlying assets that are by nature lower in volatility are becoming more popular. Market neutral strategies, long/short strategies, volatility capped strategies and algorithmic strategies all look set to become more popular with investors.
As innovative payoff structures and lower volatility underlying assets become more popular, investors always should bear in mind that the most important factor when evaluating a structured product is the underlying investment rationale.