How Structured Products Work

April 17, 2016

This article is a simplified, broad overview of the basic characteristics of Structured Notes.
Obviously, each Note is individually customized to meet the requirements of a particular audience so terms and conditions of each Note must be examined independently

Characteristics of Structured Notes

Structured Notes represent a debt obligation of the issuer, therefore the issuers credit rating is a significant aspect in pricing.

Notes provide exposure to almost any asset class such as Equities, Commodities, Currencies, Foreign Exchange, Interest Rates, Credit, Funds, and Indices.

They may deliver a full or partial capital guaranty.

Usually notes trade daily in the secondary market, with a 1% bid/ask spread. 

They are highly customized to meet a client’s needs

Who should consider Structured Products?

Clients trying to achieve any of the following outcomes with their investments:

  1. An increase in yield versus currently available rates
  2. Leveraged exposure to a market
  3. Investment tied to a specific market view
  4. Diversification into new markets, or asset classes such as currencies or credits
  5. Principal protection (Capital Guarantee)
  6. Tax efficient returns

Components of Structured Notes

There are two common ways that are generally used to create a structured product:

  1. Option-based strategies
  2. Delta one strategies

Option-based Strategies

By combining a zero coupon bond and one or more options a Structured Note can be formed  The zero coupon bond represents the principal protection part of the note.  The option piece provides exposure to a chosen asset class, or classes. 

Delta-one Strategies

These structures invest in the chosen asset class directly.  The appropriate structure will depend on the characteristics of the chosen asset class and the features of the note required.

Valuation of a Structured Note

The valuation of a Structured Note is based on the value of its component parts.  For a note that incorporates a delta-one structure, the component parts will be the underlying assets to which the note is linked.  These will normally have a valuation that can be readily verified by the market prices of the underlying assets.  For an option-based note, the component parts will be the zero coupon bond and the option(s).  The zero coupon bond is synthetically created but can be valued based on market rates.  The value of the option is comprised of two parts:

Intrinsic Value – positive value associated with the level of the market versus the  base level setting (strike). 

Extrinsic Value or Time Value – value associated with the fact that the option still has time left until expiry during which the market will continue to fluctuate.  Time value is determined based on a number of different factors including:

  1. Volatility of the underlying market
  2. Time until expiry of the option
  3. Level of relevant interest rates