Your IndustryOct 31 2013

Different types of structured products

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Structured capital ‘protected’ products and structured capital-at-risk products are referred to collectively as structured investment products.

1) Structured Deposits

These are essentially fixed-term deposit accounts where, instead of interest being earned at a set or variable rate, the return is fixed but depends on the performance of the underlying asset, such as the FTSE 100.

So, for example, a deposit plan might offer 20 per cent return on the capital after three years as long as at the end of the investment term, the FTSE 100 is at or more than the level at which the investment started.

While nothing is completely risk free, Mr Lowes says structured deposits are designed to return investors’ original capital as a minimum at maturity.

As with most UK deposit accounts, he says structured deposits usually include the potential benefit of protection should the deposit taker become insolvent during the investment term.

This protection is provided by the Financial Services Compensation Scheme and UK eligible claimants have a right to claim up to £85,000 per individual per institution in such circumstances.

The availability of such compensation is, however, dependent upon the investor’s eligibility as defined under the terms of the FSCS.

Mr Lowes says structured deposits are proving popular in the current low interest environment as they can offer stock market-linked returns with the surety that whatever the market does, the investor’s capital will be returned in full.

Often, he says the market only has to be at or more than the strike level by any amount no matter how small, for the full return to be paid.

Hence, using the example above, Mr Lowes says if the index was at 5800 and in three years it as at 5801, the investor receives the 20 per cent return.

The market risk the investor takes is that the underlying reference, usually an index, falls below the strike point during the term and does not recover, so no gain is achieved.

2) Structured Capital ‘Protected’ products

Structured capital ‘protected’ products are like structured deposits in that they are designed to return the original capital at maturity as a minimum.

However, like structured capital-at-risk products they are often structured as loans to a bank or other financial institution.

The returns outlined for any structured capital ‘protected’ plan, including the return of capital, are dependent upon the counterparty, usually a major bank, remaining financially solvent for the full product term.

In the most extreme circumstance of the relevant counterparty being declared bankrupt and/or being unable to meet its liabilities, Mr Lowes warns investors may lose all of their original capital investment.

This is because these products do not have recourse to the Financial Services Compensation Scheme for institutional default.

3) Structured Capital-at-Risk products

Structured capital-at-risk products are the most prevalent in the market, according to Mr Lowes.

He says these investments generally offer the highest return on investment, because as well as the reward of potential returns, there is the risk that the capital invested can be lost in adverse market conditions.

The investor is offered a premium for taking the greater risk.

Many capital-at-risk products will protect capital unless there is a large fall in the markets.

For example, Mr Lowes says some products will only reduce the capital returned if the FTSE 100 falls by more than 50 per cent.

This event is only likely to occur in extreme market conditions, Mr Lowes points out, as the FTSE 100 did not fall by more than 50 per cent in the financial crisis, for instance.

Capital return is dependent upon movement in the underlying asset and the extent of any protection barrier.

Also, Mr Lowes says rather than being deposits, like structured capital ‘protected’ products, structured capital-at-risk products most often take the form of loans to banks or other financial institutions.

The returns outlined for any structured capital-at-risk plan, including the return of capital, are therefore dependent upon the counterparty remaining financially solvent for the full product term.

This is because these products do not have the benefit of the Financial Services Compensation Scheme in the event of the insolvency of the counterparty.

Within these categories of structured products are three primary product types, according to Mr Lowes: income, growth and autocalls.

Autocalls are growth products that are able to mature early depending on market conditions.

Common types of structured products are kick outs, reverse convertibles, digitals and accelerated growth products, according to Graham Devile, managing director of Meteor Asset Management.

Kick out products can mature early at set observation points if the performance of the referenced underlying has met, or exceeded, a pre-determined value or percentage value of its strike level.

If the conditions are not met at an observation point, Mr Devile says the product continues until the next date where the test is applied again.

If the kick out conditions are not met on any observation date, the product will have run its full term.

At this point, Mr Devile says the capital and investment returns will be calculated as per a pre-defined formula.

Reverse convertible products are also known as income products, says Mr Devile, and these are designed to pay an income in excess of the rates available from high street deposit account providers and ahead of inflation

The income may be paid monthly, quarterly, half-yearly or annually.

In order to achieve this return, Mr Devile says the capital invested is usually put at risk, with its return at the end of the product term linked to the performance of a referenced underlying asset.

The maximum return that can be achieved is a full return of capital, Mr Devile says, plus the income payable throughout the term.

Digital products are fixed term products with three possible payoff outcomes, Mr Devile says.

A fixed return is delivered if the underlying asset performance requirements are met at a specified observation point.

If the conditions are not met only the initial capital (often protected) is returned.

If the performance requirements are not met and the underlying asset breaches the capital protection barrier at maturity, capital will be reduced by the same percentage that that underlying is below its opening level.

Mr Devile says: “They can offer an attractive return for flat to moderate market growth

“The downside is that growth is capped at the fixed return rate and if the underlying asset were to rise by more than this, the investor would not benefit from this growth.”

Accelerated growth products offer geared exposure to the upside performance of the referenced asset.

Mr Devile says they are especially popular in a recovering market when there is potential for leveraged exposure to a greater perceived upside.

In order to achieve this return, Mr Devile says the initial capital is usually put at risk, with the return at the end of the product term linked to the performance of the referenced underlying asset.

There are four different types of protection in place with structured products, according to Adrian Neave, managing director of Gilliat Financial Solutions.

1) Continuous – rarely seen in retail products nowadays, Mr Neave says the reference asset is observed at all times that it is trading and if at any time it falls below the barrier level then capital can be lost at the end of the term if it is still down.

2) American or daily close – the level of the reference asset is observed at the close of business each day and if it is below the quoted barrier on any day then capital will be lost if the asset is till down at the end of the term.

3) European or maturity – in this case the level of the reference asset is only relevant at the end of the product. Movements during the term of the product are disregarded.

4) Leveraged put – in this case capital will be lost once the barrier is breached but in a linear fashion.

For example, if the barrier was at 50 per cent then capital would be lost on a 2:1 basis for each percentage point that the asset ends below 50.

So if the asset ended down 60 per cent, Mr Neave says the investor would lose only 20 per cent of their capital.