23.2 Overview Of Structured Products

Overview of Structured Products

1 | Summarize the Advantages, Disadvantages, and Risks of Investing in Structured Products

A structured product is a passive investment vehicle financially engineered to provide specific risk and return characteristics. The value of a structured product tracks the returns of the underlying asset. The underlying assets can consist of various entities, such as:

• A single security
• A basket of securities
• Foreign currencies
• Commodities
• Indices

Examples of Underlying Assets of Structured Products

• Mortgage loans
• Credit card receivables
• Car loans
• Equity indexes
• Home equity loans

Structured products are designed to have less risk than their underlying assets, while providing higher risk-adjusted returns than conventional investments. Investors in these products purchase a share of the total pool of underlying assets.

Advantages

• Risk Management: Structured products are tailored to bring down the associated risks compared to their underlying assets.
• Higher Risk-adjusted Returns: These products aim to offer better returns than traditional investment options without proportionately increasing the risk.
• Accessibility to Diverse Assets: Structured products allow individual investors to gain exposure to diversified underlying assets they might not otherwise access.

Disadvantages

• Complexity: The financial engineering involved can make these products difficult to understand, even for seasoned investors.
• Liquidity Risk: Some structured products are less liquid, meaning it may be harder to sell them when needed.
• Fees and Costs: The costs of assembling and maintaining structured products can be higher, gradually affecting returns.

Risks

• Market Risk: Structured products still bear some market risk that stems from the underlying assets.
• Credit Risk: The issuer may default, making the structured product potentially worthless.
• Early Redemption Risk: Some products can be called away or redeemed early by the issuer under certain conditions, impacting potential returns.

Issuers of Structured Products

Issuers of these investment vehicles include established financial institutions, such as banks or consumer finance firms. These institutions benefit from economies of scale and extensive market reach to create packages of underlying assets that most people could not afford or manage independently.

For example, an individual investor typically wouldn’t have access to a pool of mortgage loans suitable for creating a mortgage-backed security (MBS). Individuals often lack the expertise needed to evaluate and assemble these loans. Conversely, banks that issue mortgages can efficiently pool loans into an MBS.

Diagram: Process Flow of Structured Products Creation

    flowchart LR
	    A[Pooling of Assets] --> B[Financial Engineering]
	    B --> C[Structured Product Creation]
	    C --> D[Market Distribution]
	    D --> E[Investor Purchases]

Key Takeaways

• Structured products provide a way to obtain different risk-return profiles using various underlying assets.
• These financial instruments can offer higher risk-adjusted returns while minimizing certain risks compared to direct investments in underlying assets.
• They come with their array of risks, including market, credit, and early redemption risks, which must be carefully considered.
• Complexities and necessary due diligence require investors to become thoroughly knowledgeable before committing to these products.

Glossary

• Structured Product: A financial instrument engineered to provide specific risk-return characteristics by pooling multiple underlying assets.
• Underlying Asset: The primary security, commodity, currency, etc., whose performance is tracked by the structured product.
• Mortgage-Backed Security (MBS): A type of structured product backed by a pool of mortgage loans.
• Credit Risk: The risk that an issuer will default and fail to meet its financial obligations.
• Market Risk: The risk of losing value due to changes in the overall market.

Frequently Asked Questions

1. What are the primary benefits of investing in structured products? Structured products can offer better risk-adjusted returns and diversify an investment portfolio by providing exposure to various underlying assets.

2. How risky are structured products compared to traditional investments? While structured products are designed to reduce some risks, they come with their own set of complexities and potential risks, such as liquidity, credit, and market risks.

3. Who typically issues structured products? Structured products are typically issued by established financial institutions, like banks and consumer finance companies, leveraging their resources for creation and maintenance.

4. Can an individual investor create structured products on their own? Generally, no. Creating structured products requires extensive knowledge and resources, which are typically only accessible to large financial institutions.

In this section

• 23.2.1 Types Of Structured Products
  Detailed overview of various types of structured products including principal-protected notes, market-linked guaranteed investment certificates, split shares, mortgage-backed securities, and asset-backed securities.
• 23.2.2 Advantages Of Structured Products
  Learn about the advantages and features of structured products within the Canadian securities landscape. Understand their benefits, risks, and tax implications.