Structured product In structured finance , a structured product, also known as a market linked investment, is generally a pre-packaged investment strategy based on derivatives , such as a single security , a basket of securities, options , indices , commodities , debt issuance and/or foreign currencies , and to a lesser extent, swaps. The variety of products just described is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of some structured products is a "principal guarantee" function, which offers protection of principal if held to maturity. For example, an investor invests 100 dollars, the issuer simply invests in a risk free bond that has sufficient interest to grow to 100 after the five-year period. This bond might cost 80 dollars today and after five years it will grow to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and transaction volume requirements of many options and swaps are beyond many individual investors. [1] As such, structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio , or to utilize the current market trend. U.S. Securities and Exchange Commission (SEC) Rule 434 [2] (regarding certain prospectus deliveries) defines structured securities as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows." The Pacific Stock Exchange defines structured products as "products that are derived from and/or based on a single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign currency, among other things" and include "index and equity linked notes, term notes and units generally consisting of a contract to purchase equity and/or debt securities at a specific time." [citation needed ]
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Structured productIn structured finance, a structured product, also known as a market linked investment,
is generally a pre-packaged investment strategy based on derivatives, such as a
single security, a basket of securities, options, indices, commodities, debt issuance
and/or foreign currencies, and to a lesser extent, swaps. The variety of products just described
is demonstrative of the fact that there is no single, uniform definition of a structured product. A feature of
some structured products is a "principal guarantee" function, which offers protection
of principal if held to maturity. For example, an investor invests 100 dollars, the issuer
simply invests in a risk free bond that has sufficient interest to grow to 100 after the
five-year period. This bond might cost 80 dollars today and after five years it will grow
to 100 dollars. With the leftover funds the issuer purchases the options and swaps needed to perform
whatever the investment strategy is. Theoretically an investor can just do this themselves, but the costs and
transaction volume requirements of many options and swaps are beyond many individual investors.[1]
As such, structured products were created to meet specific needs that cannot be met from the standardized
financial instruments available in the markets. Structured products can be used as an alternative to a direct
investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current
market trend.
U.S. Securities and Exchange Commission (SEC) Rule 434[2] (regarding certain prospectus deliveries) defines
structured securities as "securities whose cash flow characteristics depend upon one or more indices or that
have embedded forwards or options or securities where an investor's investment return and the issuer's
payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets,
indices, interest rates or cash flows."
The Pacific Stock Exchange defines structured products as "products that are derived from and/or based on a
single security or securities, a basket of stocks, an index, a commodity, debt issuance and/or a foreign
currency, among other things" and include "index and equity linked notes, term notes and units generally
consisting of a contract to purchase equity and/or debt securities at a specific time."[citation needed]
Risks
The risks associated with many structured products, especially those products that present risks of loss of
principal due to market movements, are similar to those risks involved with options.[3]The potential for serious
risks involved with options trading are well-established, and as a result of those risks customers must be
explicitly approved for options trading. In the same vein, the U.S.Financial Industry Regulatory
Authority (FINRA) suggests that firms "consider" whether purchasers of some or all structured products be
required to go through a similar approval process, so that only accounts approved for options trading would
also be approved for some or all structured products.
In the case of a "principal protected" product, these products are not always insured in the United States by
the Federal Deposit Insurance Corporation; they may only be insured by the issuer, and thus have the potential
for loss of principal in the case of a liquidity crisis, or other solvency problems with the issuing company. Some
firms have attempted to create a new market for structured products that are no longer trading. These
securities may not be trading due to issuer bankruptcy or a lack of liquidity to insure them. Some structured
products of a once solvent company have been known to trade in a secondary market for as low as pennies on
the dollar.[4]
The regulatory framework with regard to structured products is also hazy. These may fall in grey areas legally.
In India, equity related structured products seem to be in violation of the Securities Contract Regulation Act
(SCRA). SCRA prohibits the issue and trade of equity derivatives except those that trade on nationally
recognized stock and derivatives exchanges.
Origin
Structured investments arose from the needs of companies that wanted to issue debt more cheaply.
Traditionally, one of the ways to do this was to issue a convertible bond, that is, debt that under certain
circumstances could be converted to equity. In exchange for the potential for a higher return (if the equity value
would increase and the bond could be converted at a profit), investors would accept lower interest rates in the
meantime. However this trade-off and its actual worth is debatable, since the movement of the equity value of
the company could be unpredictable.Investment banks then decided to add features to the basic convertible
bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection.
These extra features were all based around strategies investors themselves could perform using options and
other derivatives, except that they were prepackaged as one product. The goal was again to give investors
more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand the
goal for the investment banks was to increase profit margins since the newer products with added features
were harder to value, so that it was harder for the banks' clients to see how much profit the bank was making
from it.
Interest in these investments has been growing in recent years and high net worth investors now use structured
products as way of portfolio diversification. Nowadays the product range is very wide, and reverse convertible
securities represent the other end of the product spectrum (yield enhancement products). Structured products
are also available at the mass retail level - particularly in Europe, where national post offices, and even
supermarkets, sell investments on these to their customers.
Below is a brief description of how structured products are manufactured.
Combinations of derivatives and financial instruments create structures that have significant risk/return and/or
cost savings profiles that may not be otherwise achievable in the marketplace. Structured products are
designed to provide investors with highly targeted investments tied to their specific risk profiles, return
requirements and market expectations.
These products are created through the process of financial engineering, i.e., by combining underlyings
like shares, bonds, indices or commodities with derivatives. The value of derivative securities, such
as options, forwards and swaps is determined by (respectively, derives from) the prices of the underlying
securities.
The market for derivative securities has grown quickly in recent years. The main reason for this lies in the
economic function of derivatives; it enables the transfer of risk, for a fee, from those who do not want to bear it
to those who are willing to bear risk.
Benefits of structured products may include:
• principal protection (depending on the type of structured product)
• tax-efficient access to fully taxable investments
• enhanced returns within an investment (depending on the type of structured
product)
• reduced volatility (or risk) within an investment (depending on the type of
structured product)
• the ability to earn a positive return in low yield or flat equity market environments
Disadvantages of structured products may include: .[5]
• credit risk - structured products are unsecured debt from investment banks
• lack of liquidity - structured products rarely trade after issuance and anyone
looking to sell a structured product before maturity should expect to sell it at a
significant discount
• no daily pricing - structured products are priced on a matrix, not net-asset-value.
Matrix pricing is essentially a best-guess approach
• highly complex - the complexity of the return calculations means few truly
understand how the structured product will perform relative to simply owning the
underlying asset
Structured products are by nature not homogeneous - as a large number of derivatives and underlying
can be used - but can however be classified under the following categories
• Interest rate-linked notes and deposits
• Equity-linked notes and deposits
• FX and commodity-linked notes and deposits
• Hybrid linked notes and deposits
• Credit-linked notes and deposits
• Constant proportion debt obligations (CPDOs)
• Constant Proportion Portfolio Insurance (CPPI)
• Market-linked notes and deposits
How good is Reliance Capital’s equity-linked debenture, Series B-57?••••
• 3 comments
• + COMMENT MONEYLIFE DIGITAL TEAM | 27/09/2012 04:23 PM |
If you are an HDFC Bank customer, you may have been approached to buy equity-linked debenture of Reliance Capital. Should you?
Reliance Capital, which has investments in broking, insurance and asset management andinvestments through private equity and investment banking, has launched its S&P CNX Nifty Index Linked Debenture named Series B-57, and its exclusive distribution has been handed over to HDFC Bank. Many of the bank’s
customers are being wooed to buy this product. Does it make sense?
Key Features of ELD The product is a 40-month equity-linked debenture (ELD), whose performance is linked to S&P CNX Nifty with the following return structure:
• If at the end of the 36th month, the market is higher than the initial level (by any quantum), the investor gets an absolute return of 49%, which equals an annualised compounded rate of return of 12.68%
• If at the end of the 36th month, the market is lower than the initial level, the return willreduce by 2.45 times of each percentage reduction in the index. For example, if the market falls by 5% the return will reduce by (2.45*5)%, that is, 12.25%. Therefore, the final return for the investor in this case would be 49-12.25=36.75%, which is an annualised rate of return of around 9.9%. The compounded return comes to 9.9%.
• If the market falls beyond 20%, the rate of return becomes 0% (because 20*2.45=49%), and the investor gets back only his/her initial investment.
The following table gives a complete scenario at different Nifty levels.
Rs50,000 -20% (49-(2.45*20))=0% Rs50,000Nil, you get back you initial investment
Rs50,000 -30%(49-(2.45*30))= -24.50%, but you will get 0%
Rs50,000Nil, you get back you initial investment
What works in its favour: • It is an AAA-rated security and therefore has the highest degree of safety in terms of getting timely returns. The rating, however, can be revised and changed whenever the rating agency gets new information about the financial condition of
the company.• Your initial investment is secure till maturity. Even if the markets crash in the 36th month of your investment period, you still get back your investment.• A coupon rate of 49% for 40 months works out to be an annualised compounded return of 12.68%, a good return for a fixed investment in a stagnant or falling interest rate market. What works against it: • If you do not hold the debenture till 40 months, your initial investment is not guaranteed. That means if you want to withdraw your money, your returns may be linked with the actual return of the market. The brochure does not give any information on this issue.• Also, if the company buys back the debentures, the return will be calculated on basis of fair market value and that could hurt your initial investment as well.• Besides these, credit risks attached to debentures stand Does it make sense? Every single recommendation regarding this product will start by saying: “If you are bullish about the markets...” In effect, the onus is on you to make the product work for you. Remember, the essential factor behind the success of the product is your successful market call. Do you want to be a market forecaster to make 12% plus? Apart from this, there is another basic flaw in all these structured products. It never makes sense to mix fixed income products with market-linked products. You cannot calculate the odds of total returns if you mix fixed income products with market index. They are essentially totally different products in nature and all you are doing is reducing the effectiveness of one with the other. You must stick to an asset allocation plan which will mean investing in a systematic manner in fixed income (bonds, bond funds, fixed deposits and debentures) to protect your wealth and separately in shares or well-chosen equity mutual funds to grow your wealth. In this case, who really knows what the Nifty will do three years from now and why would you want to bet on that outcome? Also, 12.68% compounded return in the best of circumstances is nothing attractive; there are perpetual bonds, for instance, which could give you similar fixed returns with an upside if the interest rates fall, without you having to bet on the direction of the Nifty.
Structured product market in a spot over RBI regulation
Final decision on time-gap between successive issuances key, say experts
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The Reserve Bank of India (RBI)’s move to regulate the time gap on issuance of debentures by non-banking financial companies (NBFCs) has created some confusion for the Rs 12,000 crore structured product market.
The central bank had on June 27 come out with a note asking NBFCs to space out their debenture issuances by at least six months. This resulted in a halt in the launch of such products as it put restrictions on NBFCs who issue debentures for the structured product space, according to wealth management officials.
“We had plans to come out with a structured product issuance, but shelved the same following the RBI’s notification. All structured products would have been impacted by the circular,” said one person with a foreign wealth management firm.
RBI subsequently came out with a clarification on July 2, saying it was deferring its earlier move. “A decision on the appropriate minimum time gap would be taken by the Bank in due course,” it said.
But this hasn’t completely eased concerns.
“They have simply postponed the decision on that matter. We don’t know if they will actually make it three months or something like that,” said a senior official with a domestic wealth management firm.
The head of wealth management at another Indian wealth manager also said no clear indication of the final guidelines had been communicated to the NBFCs as of yet. “They will reconsider it… NBFCs have made a representation to the central bank on the issue… We don’t know yet what form the final regulation will take,” said the person.
Structured products are debentures generally sold by wealth management firms to high networth individuals. They offer returns linked to the movement of an asset class like equity. For example, a debenture’s returns may track the National Stock Exchange’s Nifty index. Industry insiders say RBI’s circular last Thursday would have severely limited their issuance. To be sure, RBI’s intention seems to have been to curb retail exposure to such securities.
The circular noted that NBFCs raised capital through issuing debentures either by public issue or private placement. In the case of public issue of such securities, institutions and retail investors can participate. Private placement, on the other hand, may involve institutional investors.
“It has, however, been observed that NBFCs have lately been raising resources from the retail public on a large scale, through private placement, especially by issue of debentures,” said the RBI
notification.
The central bank has subsequently asked NBFCs (including those coming out with debentures for the purpose of issuing structured products) to provide a detailed plan for how often they plan to come out with such issuances.
“NBFCs, in the meantime, are advised to put in place before the close of business on September 30, 2013, a board approved policy for resource planning which, inter-alia, should cover the planning horizon and the periodicity of private placement,” it said in the July 2 note.
Meanwhile, if RBI does go ahead with its earlier decision to take a six-month gap, the structured product market could take a significant hit, say experts.
“It’s likely that the issuers will try to space out their issues to avoid hitting the market all at the same time. Overall, the impact could be 30 per cent though it’s probable that it could be higher,” said the person.
The India Wealth Report released by Karvy Private Wealth in November 2012 stated the assets in structured products in the form of equity-linked debentures are Rs 12,000 crore. Another Rs 150 crore is in debentures linked to the price of gold, according to the report.
Investment bankingAn investment bank is a financial institution that assists individuals, corporations, and governments in raising
capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may
also assist companies involved in mergers and acquisitions and provide ancillary services such as market
making, trading of derivatives and equity securities, and FICC services (fixed income instruments, currencies,
and commodities).
Unlike commercial banks and retail banks, investment banks do not take deposits. From 1933 (Glass– Steagall
Act) until 1999 (Gramm–Leach–Bliley Act), the United States maintained a separation between investment
banking and commercial banks. Other industrialized countries, including G8 countries, have historically not
maintained such a separation. As part of the Dodd-Frank Act 2010, Volcker Rule asserts full institutional
separation of investment banking services from commercial banking.
There are two main lines of business in investment banking. Trading securities for cash or for other securities
(i.e. facilitating transactions, market-making), or the promotion of securities (i.e. underwriting, research, etc.) is
the "sell side", while buy side is a term used to refer to advising institutions concerned with buying investment
services. Private equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the
most common types of buy side entities.
An investment bank can also be split into private and public functions with an information barrier which
separates the two to prevent information from crossing. The private areas of the bank deal with private insider
information that may not be publicly disclosed, while the public areas such as stock analysis deal with public
information.
An advisor who provides investment banking services in the United States must be a licensed broker-
dealer and subject to Securities & Exchange Commission (SEC) and Financial Industry Regulatory
Authority (FINRA) regulation.[1]
• 1 Organizational structure
• 2 Core investment banking activities
• 2.1 Front office
• 2.1.1 Investment banking
• 2.1.2 Sales and trading
• 2.1.3 Research
• 2.2 Front office/Middle office
• 2.2.1 Risk Management
• 2.3 Middle office
• 2.4 Back office
• 2.4.1 Operations
• 2.4.2 Technology
• 2.5 Other businesses
• 3 Industry profile
• 3.1 Global size and revenue mix
• 3.2 Top 10 banks
• 4 Financial crisis of 2008
• 5 Criticisms
• 5.1 Conflicts of interest
• 5.2 Compensation
• 6 See also
• 7 External links
• 8 Further reading
• 9 References
Organizational structure
Investment banking is split into front office, middle office, and back office activities. While large service
investment banks offer all lines of business, both sell side and buy side, smaller sell-side investment firms such
as boutique investment banks and small broker-dealers focus on investment banking and
sales/trading/research, respectively.
Investment banks offer services to both corporations issuing securities and investors buying securities. For
corporations, investment bankers offer information on when and how to place their securities on the open
market, an activity very important to an investment bank's reputation. Therefore, investment bankers play a
very important role in issuing new security offerings.[2]
Core investment banking activities
Investment banking has changed over the years, beginning as a partnership form focused on underwriting
security issuance (initial public offerings and secondary offerings), brokerage, andmergers and acquisitions and
evolving into a "full-service" range including sell-side research, proprietary trading, and investment
management. In the modern 21st century, the SEC filings of the major independent investment banks such
as Goldman Sachs and Morgan Stanley reflect three product segments: (1) investment banking (fees for M&A
advisory services and securities underwriting); (2) asset management (fees for sponsored investment funds),
and (3) trading and principal investments (broker-dealer activities including proprietary trading ("dealer"
transactions) and brokerage trading ("broker" transactions)).[3]
In the United States, commercial banking and investment banking were separated by the Glass–Steagall Act,
which was repealed in 1999. The repeal led to more "universal banks" offering an even greater range of
services. Many large commercial banks have therefore developed investment banking divisions through
acquisitions and hiring. Notable large banks with significant investment banks include JPMorgan Chase, Bank
of America, Credit Suisse, Deutsche Bank, Barclays, and Wells Fargo. After the financial crisis of 2007–
2008 and the subsequent passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act,
regulations have limited certain investment banking operations, notably with the Volcker Rule's restrictions on
proprietary trading.[2]
The traditional service of underwriting security issues has declined as a percentage of revenue. As far back as
1960, 70% of Merrill Lynch's revenue was derived from transaction commissions while "traditional investment
banking" services accounted for 5%. However, Merrill Lynch was a relatively "retail-focused" firm with a large
brokerage network.[2]
Front office
Investment banking
Corporate finance is the traditional aspect of investment banks which also involves helping customers
raise funds in capital markets and giving advice on mergers and acquisitions (M&A). This may involve
subscribing investors to a security issuance, coordinating with bidders, or negotiating with a merger target.
Another term for the investment banking division is corporate finance, and its advisory group is often
termed mergers and acquisitions. A pitch book of financial information is generated to market the bank to a
potential M&A client; if the pitch is successful, the bank arranges the deal for the client. The investment banking
division (IBD) is generally divided into industry coverage and product coverage groups. Industry coverage
groups focus on a specific industry – such as healthcare, public finance (governments), FIG (financial
institutions group), industrials, TMT (technology, media, and telecommunication) – and maintains relationships
with corporations within the industry to bring in business for the bank. Product coverage groups focus on
financial products – such as mergers and acquisitions, leveraged finance, public finance, asset finance and
leasing, structured finance, restructuring, equity, and high-grade debt – and generally work and collaborate with
industry groups on the more intricate and specialized needs of a client.The Wall Street Journal , in partnership
with Dealogic, publishes figures on investment banking revenue such as M&A in its Investment Banking
Scorecard.[4]
Sales and trading
On behalf of the bank and its clients, a large investment bank's primary function is buying and selling products.
In market making, traders will buy and sell financial products with the goal of making money on each
trade. Sales is the term for the investment bank's sales force, whose primary job is to call on institutional and
high-net-worth investors to suggest trading ideas (on acaveat emptor basis) and take orders. Sales desks then
communicate their clients' orders to the appropriate trading desks, which can price and execute trades, or
structure new products that fit a specific need. Structuring has been a relatively recent activity
as derivatives have come into play, with highly technical and numerate employees working on creating complex
structured products which typically offer much greater margins and returns than underlying cash securities. In
2010, investment banks came under pressure as a result of selling complex derivatives contracts to local
municipalities in Europe and the US.[5] Strategists advise external as well as internal clients on the strategies
that can be adopted in various markets. Ranging from derivatives to specific industries, strategists place
companies and industries in a quantitative framework with full consideration of the macroeconomic scene. This
strategy often affects the way the firm will operate in the market, the direction it would like to take in terms of its
proprietary and flow positions, the suggestions salespersons give to clients, as well as the
way structurers create new products. Banks also undertake risk through proprietary trading, performed by a
special set of traders who do not interface with clients and through "principal risk"—risk undertaken by a trader
after he buys or sells a product to a client and does not hedge his total exposure. Banks seek to maximize
profitability for a given amount of risk on their balance sheet. The necessity for numerical ability in sales and
trading has created jobs for physics, mathematics and engineering Ph.D.s who act as quantitative analysts.
Research
The equity research division reviews companies and writes reports about their prospects, often with "buy" or
"sell" ratings. Investment banks typically have sell-side analysts which cover various industries. Their
sponsored funds or proprietary trading offices will also have buy-side research. While the research division may
or may not generate revenue (based on policies at different banks), its resources are used to assist traders in
trading, the sales force in suggesting ideas to customers, and investment bankers by covering their clients.
Research also serves outside clients with investment advice (such as institutional investors and high net worth
individuals) in the hopes that these clients will execute suggested trade ideas through the sales and trading
division of the bank, and thereby generate revenue for the firm. Research also covers credit research, fixed
income research, macroeconomic research, and quantitative analysis, all of which are used internally and
externally to advise clients but do not directly affect revenue. All research groups, nonetheless, provide a key
service in terms of advisory and strategy. There is a potential conflict of interest between the investment bank
and its analysis, in that published analysis can affect the bank's profits. Hence in recent years the relationship
between investment banking and research has become highly regulated, requiring a Chinese wall between
public and private functions.
Front office/Middle office
Risk Management
Risk management involves analyzing the market and credit risk that an investment bank or its clients take onto
their balance sheet during transactions or trades. Credit risk focuses around capital markets activities, such as
loan syndication, bond issuance, restructuring, and leveraged finance. Market risk conducts review of sales and
trading activities utilizing the VaR model and provide hedge-fund solutions to portfolio managers. Other risk
groups include country risk, operational risk, and counterparty risks which may or may not exist on a bank to
bank basis. Credit risk solutions are key part of capital market transactions, involving debt structuring, exit
financing, loan amendment, project finance, leveraged buy-outs, and sometimes portfolio hedging. Front office
market risk activities provide service to investors via derivative solutions, portfolio management, portfolio
consulting, and risk advisory. Well-known risk groups in JPMorgan Chase, Goldman Sachs and Barclays
engage in revenue-generating activities involving debt structuring, restructuring, loan syndication, and
securitization for clients such as corporates, governments, and hedge funds. J.P. Morgan IB Risk works with
investment banking to execute transactions and advise investors, although its Finance & Operation risk groups