Structured Products and Derivatives | Index One

In this edition of Index One Insights by Index One, we look at the definitions of structured products and derivatives and how indexing plays a crucial role in the creation of structured products.

Structured Products and Derivatives | Index One

What are structured products?

A structured product is a pre-packaged structured finance investment strategy that is based on a single asset, a basket of securities, options, indices, commodities, debt issuance, foreign currencies, or derivatives.

They are typically linked to an index or a basket of assets and are intended to provide highly personalized risk-return objectives. This is accomplished by taking a standard security, such as an investment-grade bond, and replacing typical payment elements like periodic coupons and final principal with non-traditional payoffs based on the performance of one or more underlying assets rather than the issuer's own cash flow.

Structured products can be an effective way to achieve specific investment goals. For example, an investor looking to protect their capital while still earning some income might consider a structured product with principal protection and a fixed return. On the other hand, an investor seeking higher returns might consider a structured product linked to the performance of a stock index or other benchmark. However, structured products can be complex and may not be suitable for all investors.

What are derivatives?

Derivatives are financial contracts in which the value is determined by an underlying asset, group of assets, or benchmark. A derivative is a contract entered into between two or more parties that can be traded on an exchange or over-the-counter (OTC).

Derivatives can be used to hedge against risks or to speculate on the future direction of prices. For example, a futures contract allows a farmer to lock in a price for their crops, protecting them against potential price declines. A speculator can use futures contracts to profit from price movements in the underlying asset. Options are another type of derivative that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price and time.

Derivatives can offer a range of benefits, including the ability to hedge against risks and to profit from price movements. However, derivatives can also be complex and carry significant risks, such as counterparty risk and market risk. Derivatives can also be used for speculative purposes, which can lead to significant losses if the underlying assets do not perform as expected.

What is the difference between structured product and derivatives?

Derivatives, unlike structured fixed income products, are not backed by underlying pools of assets, necessitating a particular skill set for assessing these instruments. The financial markets offer a variety of contract types, each with its own set of risks and processes to keep track of, such as counterparty risk, liquidity risk, basis risk, and trade settlement. Depending on the contract, the skill set, knowledge, and technology required to monitor a derivatives trade vary.

Indexing for structured products

Generic or custom indices can be utilized in several different ways to create structured products and derivatives. Here are some examples:

Index-linked notes: These are debt securities that are linked to the performance of an equity index. They offer a fixed or variable interest rate, and at maturity, the investor receives a payment based on the performance of the underlying index. For example, a note linked to a US 500  index might pay a fixed interest rate plus the percentage increase in the index over the note's term.

Structured notes: These are debt securities that are designed to offer a customized payoff to investors based on the performance of an underlying asset. Structured notes linked to equity indexes can offer investors downside protection or leveraged returns, depending on the terms of the note.

Index-linked annuities: These are insurance contracts that are linked to the performance of an equity index. They offer investors a fixed or variable rate of return, with the potential for higher returns based on the performance of the underlying index. At maturity, the investor receives a payment based on the performance of the index.

Barrier options: These are derivative contracts that pay out if the underlying equity index reaches a certain level (the barrier) during the term of the contract. Barrier options can be designed to provide investors with enhanced returns or reduced risk depending on the level of the barrier and the terms of the contract.

Learn more about how Index One can help create custom indices for use in structured products here.

Conclusion

Structured products and derivatives are two important financial instruments that offer investors a range of investment options. Structured products can be customized to meet specific investment goals, while derivatives can be used to hedge against risks or to speculate on price movements. However, both structured products and derivatives can be complex and carry significant risks. It is important for investors to carefully evaluate their investment goals and risk tolerance before investing in these instruments.

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References

Structured Products, WallStreetMojo

Structured Products Strategy Indices: Benchmarks for Investment Strategies, The Swiss Stock Exchange?