It has been said a lot about structured products(SPs) since the last credit crunch in 2008.
Many articles claimed SPs to be very risky investments with unpredictable outcomes.
As for me, I have doubts about such rumors. Firts of all, SPs can be characterized by its Functionality(payoff), Opportunities and Risks.
Taking into account these characteristics SPs can be divided into four groups. Groups where risk is too high can be very dangerous indeed, especially for small and private investors.
Why? Because it is too hard to understand how the price of such SP can vary in the future.
On the volatility market, SPs price can change by 30% per day easily.
Not everyone is ready for such surprise, if 30% of market value is lost per one trading day.
Therefore it is a good idea to clasify SPs, so even an individual investor can understand how much risk he/she can expect.
It is said SPs are divided by four groups as follows:
1. Capital Protection
3. Yield enhancement
The degree of risk can be shown by Risk-Return diagram as below.
From my point of view, I clasify Participation and Yield Enhancement notes as notes that have almost the same risks because downside of these notes are not capped.
Sometimes they differ by having additional lower barrier, that decreases risks until it is broken.
More detailes with payoffs will be shown in the next articles describing briefly these notes.
Before we dive into the definion of each group,instruments and payoffs (in the next articles), let’s firstly clarify why SPs exist at all.
SPs replacing the usual payoff with non-traditional payoff, so risk/return can be fully customized including special needs of a buyer.
For example, you need to hedge your specific risks which occurs due to production of some goods, or may be you have a loan from the bank where the rate is float, or may be you want to hedge some FX risks? If this is a case, the market can offer a wide range of so called “vanilla” or “simple exotics” instruments for your needs.
But what if your need more sophisticated and special instrument? What if there is no such an instrument on the market?
Ok, this is the reason why SPs exist. Many institutionals can provide fully customized and innovative solution to cover your needs. Therefore, except non-traditional payoff and customized risk/return, SPs are usually over-the-counter(OTC) products.
Example. WTI costs $85 per barrel. At this price you plan to sell WTI in the market and don’t want the price to decrease. The simple solution is to buy a put option with a strike, say, $85. This contract is available on the market, NYMEX.
Now, let’s say you believe that WTI price can drop to $70 in 3 months but recover thereafter to $90 as highest in the next 6 months. Additionally, you may expect Brent prices to stay still in the same periods and if you are correct, you may want to earn some coupon in form of percentage payment.
If you go to the market it would be not so easy to find such a contract. But you may structure a contract to cover your specific needs:
1. In the next 3 months WTI is going to be at $70.
2. Next 6 months WTI recovers to $90.
3. During these 9 months, Brent doesn’t change so you earn the coupon.
Also, it is possible to add some more conditions into the package above, like if EUR/USD changes to some level and Natural Gas drops to some levels etc. Actually SPs can be viewed like a portfolio of instruments. Now, I expect it is clear why we need SPs.
SPs offers solutions on many underlyings including indices, stocks, FX, commodities, interest rates, credit derivatives and anything else you may find on the market.
Short summary: SPs are flexible, fully customizable. They give payoffs according to the needs of investor. It is really a magic world for those who can’t find a required instrument on the market. But disadvantages come as well.
The first and the worst, as for me, it is price. What is the price of the SP from the example above? I can’t say directly. It takes too much affords to understand it because of too many parameters taken into account when the SP priced. Here is a risk. Risk of misunderstanding the products and its price.
Now imagine you bought SPs. Do you know the average volume traded in this SPs? No, you don’t due to OTC market where a seller can sell unlimited numbers of contracts. So here is the second disadvantage: SPs can give zero cost supply, that means that there is no fixed upper limit to the scale of SPs and this explains why crisis can happen.
The third disadvantage is credit risk on institutional that sold SP to you. Usually, institutionals require to receive initial margin in order to sell SPs to a client but expects that a client will never send a margin call to the institutional because they are to big to fail.
Now, having all the major points stated it is time to answer the main question: Are SPs too dangerous to trade and invest? I would surely say NO if you know what you trade.