From vanilla to structured
#basic
From an investor perspective, an investment is a vehicle that captures some real life phenomenon and converts that into money. In other words, a phenomenon can be someone's business, global warming, mineral resources, government performance, inflation, consumer behaviour etc… Among vehicles you will find stocks, bonds, funds and… structured products. When you decide to participate in some phenomenon, you screen for a representative “underlying” and a proper investment vehicle. After you enter a contract you “gain exposure” to this phenomenon and there is no way back :)
Do not get disturbed by the level of abstraction, here is an example. When you buy an Apple share, you gain exposure to the Apple’s business, which itself is exposed to many different factors, like consumer well-being in developed and developing countries, prospective niches as autonomous driving, competitive position against other players, Chinas regulation of consumer electronics etc… In this case, the phenomenon is the consumer’s demand for high-end products, the underlying is the Apple’s business and the vehicle is the stock. By buying the Apple’s stock you gain the exposure to the extent, that this vehicle offers: your upside are the dividend payments and the stock price growth and your downside is floored at a loss of 100% of your investment. Now imagine, you want to secure 50% of your investment or participate in the Apple’s growth by factor 10. This is where the structured products come into play.
Let us see investment vehicles as strategies. Some examples of plain vanilla strategies:
- A bond is a strategy, that promises you some coupon payment and a return of notional. Your upside is known and capped at coupon level plus notional and your downside is bankruptcy and associated losses (does not have to be 100% though). If you go deeper into the bond landscape, you will find more ways to tune this strategy, but the main pay-off strategy remains the same.
- A strategy for a stock is described above, i.e. upside is the growth potential + corporate actions (both with a factor 1x) and downside is 100% of your investment. Again, within stock’s landscape you fill find some features, that will offer you a slightly amended pay-off.
- A stock option is a strategy, that gives a buyer a right to participate in an upside (long call option) or in a downside (long put option). By combining these options and their parameters you can draft a more exquisite payoff, that brings us one step closer to understanding the structured products.
So what is the strategy behind the structured products?
There is no one specific strategy, as there is no universal opinion on the market. The market participants are exposed to different risks and primarily do not agree on future market development. This diversity facilitates the market for complex strategies: buyers hedge their specific risks or simply make precise bets, while sellers (investment banks) can issue a portfolio with structured products, that is hedging itself (aka risk neutral). An attentive reader can already see, that sellers do not pursue any investment strategy, but rather collect the margins.
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What might a buyer want?
- Capital protection (maximum potential loss smaller than 100%)
- Stable cash flow (aka coupon)
- Enhanced growth participation (factor greater than 1x)
- Get exposure to specific asset classes
- Tax efficiency
How does a buyer get it?
The most sophisticated buyers can contact the investment bank and enter a unique OTC trade. An ordinary retail investor would rather open a brokerage account and type in an ISIN of some structured product (aka secondary market). A wealthy investor will probably wait until his private banker sells him that product (aka primary market).
How do I navigate among these endless ISINs? See my next text.
