Structured products are pre-packaged investments that normally include assets linked to interest plus one or more derivatives. They are generally tied to an index or basket of securities and are designed to facilitate highly customized risk-return objectives. This is accomplished by taking a traditional security such as a bond and combining it with non-traditional payoffs derived from the performance of one or more underlying assets.
From the investor's point of view, the concept of structuring means customizing a specified revenue stream; structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce the risk exposure of a portfolio, or to utilize the current market trend. From the issuer's point of view, structuring means that a number of existing financial products are combined to achieve the client's desired return profile. As such, structured products were created to meet specific needs that cannot be met by the standardized financial instruments available in the markets.
Two typical use cases:
- An investor dislikes a specific stock and does not want to hold it in their portfolio, but knows how much regret a 20 percent rise in the stock would cause. Therefore, the investor chooses to purchase a structured product on the stock instead: an agreement ('contract', 'certificate', 'note') with another entity (e.g. a bank) that pays out the full return on the given stock, but only if the stock surpasses a specified threshold, such as this 20%, over a specified time period. This product is known as a market-linked note.
- A feature of some structured products is a principal guarantee function, which offers protection of the principal if held to maturity. For example, if an investor invests $100 in such a product, the issuer simply invests it in a risk-free bond with a par value of $100. This bond might cost $80 today and after five years it will grow to $100. With the remaining funds, the issuer purchases the options and swaps needed to perform whatever the investment strategy calls for. This product is known as a principal protected note.