Browse Analysis of Managed and Structured Products

23.2 Overview Of Structured Products

This section provides an in-depth understanding of structured products, defining their advantages, disadvantages, associated risks, and more. Learn about the benefits and features that make structured products an interesting investment vehicle.

Overview of Structured Products

1 | Summarize the Advantages, Disadvantages, and Risks of Investing in Structured Products

A structured product is a passive investment vehicle financially engineered to provide specific risk and return characteristics. The value of a structured product tracks the returns of the underlying asset. The underlying assets can consist of various entities, such as:

  • A single security
  • A basket of securities
  • Foreign currencies
  • Commodities
  • Indices

Examples of Underlying Assets of Structured Products

  • Mortgage loans
  • Credit card receivables
  • Car loans
  • Equity indexes
  • Home equity loans

Structured products are designed to have less risk than their underlying assets, while providing higher risk-adjusted returns than conventional investments. Investors in these products purchase a share of the total pool of underlying assets.

Advantages

  • Risk Management: Structured products are tailored to bring down the associated risks compared to their underlying assets.
  • Higher Risk-adjusted Returns: These products aim to offer better returns than traditional investment options without proportionately increasing the risk.
  • Accessibility to Diverse Assets: Structured products allow individual investors to gain exposure to diversified underlying assets they might not otherwise access.

Disadvantages

  • Complexity: The financial engineering involved can make these products difficult to understand, even for seasoned investors.
  • Liquidity Risk: Some structured products are less liquid, meaning it may be harder to sell them when needed.
  • Fees and Costs: The costs of assembling and maintaining structured products can be higher, gradually affecting returns.

Risks

  • Market Risk: Structured products still bear some market risk that stems from the underlying assets.
  • Credit Risk: The issuer may default, making the structured product potentially worthless.
  • Early Redemption Risk: Some products can be called away or redeemed early by the issuer under certain conditions, impacting potential returns.

Issuers of Structured Products

Issuers of these investment vehicles include established financial institutions, such as banks or consumer finance firms. These institutions benefit from economies of scale and extensive market reach to create packages of underlying assets that most people could not afford or manage independently.

For example, an individual investor typically wouldn’t have access to a pool of mortgage loans suitable for creating a mortgage-backed security (MBS). Individuals often lack the expertise needed to evaluate and assemble these loans. Conversely, banks that issue mortgages can efficiently pool loans into an MBS.

Diagram: Process Flow of Structured Products Creation

    flowchart LR
	    A[Pooling of Assets] --> B[Financial Engineering]
	    B --> C[Structured Product Creation]
	    C --> D[Market Distribution]
	    D --> E[Investor Purchases]

Key Takeaways

  • Structured products provide a way to obtain different risk-return profiles using various underlying assets.
  • These financial instruments can offer higher risk-adjusted returns while minimizing certain risks compared to direct investments in underlying assets.
  • They come with their array of risks, including market, credit, and early redemption risks, which must be carefully considered.
  • Complexities and necessary due diligence require investors to become thoroughly knowledgeable before committing to these products.

Glossary

  • Structured Product: A financial instrument engineered to provide specific risk-return characteristics by pooling multiple underlying assets.
  • Underlying Asset: The primary security, commodity, currency, etc., whose performance is tracked by the structured product.
  • Mortgage-Backed Security (MBS): A type of structured product backed by a pool of mortgage loans.
  • Credit Risk: The risk that an issuer will default and fail to meet its financial obligations.
  • Market Risk: The risk of losing value due to changes in the overall market.

Frequently Asked Questions

  1. What are the primary benefits of investing in structured products? Structured products can offer better risk-adjusted returns and diversify an investment portfolio by providing exposure to various underlying assets.

  2. How risky are structured products compared to traditional investments? While structured products are designed to reduce some risks, they come with their own set of complexities and potential risks, such as liquidity, credit, and market risks.

  3. Who typically issues structured products? Structured products are typically issued by established financial institutions, like banks and consumer finance companies, leveraging their resources for creation and maintenance.

  4. Can an individual investor create structured products on their own? Generally, no. Creating structured products requires extensive knowledge and resources, which are typically only accessible to large financial institutions.


CSC® Exams Practice Questions

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markdown ## What is a structured product in the context of investment? - [ ] An active investment strategy - [ ] A manual trading technique - [x] A passive investment vehicle engineered for specific risk and return characteristics - [ ] A traditional mutual fund > **Explanation:** A structured product is a passive investment vehicle designed to provide a specific risk and return profile. It achieves this by tracking the value of underlying assets. ## Which of the following can be underlying assets for structured products? - [ ] Single securities - [ ] Commodities - [ ] Equity indexes - [x] All of the above > **Explanation:** Underlying assets of structured products can be diverse, including single securities, baskets of securities, foreign currencies, commodities, and indexes. ## What is a primary advantage of investing in structured products? - [ ] High risk without risk-adjusted returns - [ ] Exposure to a single asset class only - [ ] Lower risk, yet higher risk-adjusted returns compared to conventional investments - [ ] Lack of diversification > **Explanation:** Structured products are designed to offer less risk than their underlying assets and provide higher risk-adjusted returns than traditional investments. ## Who are typically the issuers of structured products? - [ ] Individual investors - [ ] Small start-up firms - [x] Established financial institutions - [ ] Government bodies > **Explanation:** Structured products are typically issued by established financial institutions like banks and consumer finance firms. These issuers have the resources and expertise to create such products. ## What advantage do issuers of structured products have over individual investors? - [ ] Lack of market reach - [ ] Less access to financial derivatives - [ ] Smaller economies of scale - [x] Economies of scale and market reach > **Explanation:** Issuers leverage economies of scale and market reach to create packages of underlying assets that individual investors could not afford or assemble on their own. ## Which of the following is NOT a typical underlying asset for structured products? - [ ] Mortgage loans - [x] Real estate properties - [ ] Credit card receivables - [ ] Car loans > **Explanation:** Real estate properties themselves are not typical underlying assets. Instead, loans and receivables, such as mortgage loans, can be used in structured products. ## What do investors in structured products really own? - [ ] The physical assets themselves - [ ] Only a small portion of each underlying asset - [x] A share of the total pool of underlying assets - [ ] Direct ownership of commodity goods > **Explanation:** Investors buy a share of the total pool of underlying assets, not the individual physical assets themselves. ## What expertise do individuals typically lack that issuers of structured products possess? - [ ] Stock trading knowledge - [ ] Marketing and sales skills - [ ] Tax planning abilities - [x] Expertise to evaluate and assemble pools of loans and other assets > **Explanation:** Issuers like banks have the expertise to evaluate and pool loans or other assets to form structured products, something individual investors typically lack. ## Why might an individual investor face difficulties in creating a mortgage-backed security (MBS)? - [ ] Lack of access to stock exchanges - [x] Lack of access to a pool of mortgage loans and the expertise to evaluate them - [ ] Lack of interest in mortgage investments - [ ] Limited understanding of foreign currencies > **Explanation:** Individuals do not typically have access to a large enough pool of mortgage loans, nor the necessary expertise to evaluate them, which banks possess. ## How are structured products different from conventional investments? - [ ] They carry higher risk without any return advantages - [ ] They offer direct holdings in commodities - [x] They provide higher risk-adjusted returns and are engineered for specific risk-return profiles - [ ] They do not offer any diversification benefits > **Explanation:** Structured products are designed to offer higher risk-adjusted returns than conventional investments while carrying specific risk-return profiles engineered through financial structuring.

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In this section

  • 23.2.1 Types Of Structured Products
    Detailed overview of various types of structured products including principal-protected notes, market-linked guaranteed investment certificates, split shares, mortgage-backed securities, and asset-backed securities.
  • 23.2.2 Advantages Of Structured Products
    Learn about the advantages and features of structured products within the Canadian securities landscape. Understand their benefits, risks, and tax implications.
Sunday, July 21, 2024