The real risks of structured products?
A computer may be a more complex tool for playing a CD than a player itself but it doesn’t mean it poses a greater risk of loss or damage to that album. So too can the argument be made for structured products – complexity doesn’t equal greater risk anymore than simplicity eliminates it.
Over time structured products have evolved, although their basic ideal of growing and protecting capital remains. Some products may still appear complex to investors, but liquidity in the sector has improved, making trading easier, as have access to information and tools for analysis. These have all helped to familiarise and reassure investors as to how structured products are constructed and where the risks lie. After that it comes down to individual choice.
Dealing with counterparties
All structured products involve a product issuer and a counterparty, typically a financial institution, that helps deliver the product’s returns – as long as it remains solvent enough to do so. The counterparty plays a large role in the creation of a structured product but even here there are ways to mitigate its risks. As well as providing the upside, this institution also provides the protection element of a product by providing a zero coupon bond.
If that institution – the issuer of the zero coupon bond – fails and subsequently defaults on the bond, the protection and the product itself could collapse. As such, the greater the creditworthiness of the counterparty, the more likely the terms of the product will be met when it matures.
The importance of counterparties and the role they play is now better understood. Information is readily available for investors to make an informed decision. Just as food retailers indicate the calorie count of an item to notify the buyer as to what they are getting, structured products not only name their counterparty in all their literature, but they also provide its credit rating.
Credit ratings are given to financial institutions by independent third party ratings agencies and are considered to be long-term indicators of their financial strength. However, as they are long-term such ratings may be slow to change in response to near-term events, which could render a strong institution financially weaker.
These days there are tools that can be used to help fill in that information gap. Shorter-term indicators such as credit default swaps can act as a proxy indicator of creditworthiness. Credit default swaps (CDS) price in financial markets’ expectations that an institution will default. If companies are deemed to be higher risk, they trade at higher spreads – in other words, it is more costly to use credit default swaps to insure against the risk of them defaulting. Current CDS levels can be found on several financial websites or from a structured product provider.