Written by: Michel Barakat
Structured products are financial securities which provide investors access to the derivatives market. These products are traditionally issued by large investment banks or specialized structuring firms. Why are structured products relevant to investors and how do you make them accessible for your clients?
Structured products are highly customizable and can be tailored to meet an investor’s exact needs, a characteristic not available with vanilla options. Features available with structured products include limiting your downside, specifying your upside view and receiving coupon payments.
One example is the Barrier Reverse Convertible (BRC). The investor gives up the upside potential of a position in exchange for an enhanced coupon. He is also not exposed to the downside unless the underlying asset breaks through a predefined barrier (set at the inception of the product). Because of that, the BRC always outperforms the underlying on the downside.
Let’s consider an example: a BRC on the SPY index with a barrier at 60%. The payoff and coupon payments would look as follows.
Structured products are issued by financial institutions who are also market-makers de-facto holding a monopoly on the market for these products. Two products, each issued by one institution, might share the same underlying, payoff and cash flow payments but qualify as different securities. It is thus not possible for you to buy a product from one institution and sell it to another. If you decide to exit your investment, you are exposed to market liquidity risk (high spreads and lack of buyers). This is a condition you have consented to when you agreed to buy the structured product.
A second risk associated with structured products is price manipulations. In some jurisdictions, the issuer will get away with quoting prices artificially higher than what he would be comfortable buying at. This setup works in favor of the issuer who profits from high fees on the sale with little or no risk. Over the lifetime of the product, the issuer will adjust the market price of the structured product towards its theoretical value. In a nutshell, you could be losing up to 5% of your investment the moment you buy that product!
Lastly, you are exposed to counterparty risk. If the issuer who sold you the product goes bust, the contract is void and you lose your initial investment.Related: How Artificial Intelligence Will Reinvent Investment Advising
Structured products qualify as complex financial products and lack the investor protection available for exchange-traded vanilla options. Investors in structured products are required to sign a disclosure which qualifies them as sophisticated investors waiving their right to that protection.
Because of this requirement, the products are not easily accessible to retail investors. Many institutions set a minimum investment of $50,000 which limits the market to high net worth individuals and institutional investors.
Buying a vanilla option alone cannot reproduce the features of a structured product. However, combining several options creates customized payoff and cash flows. This is not to say that all structured products can be reproduced with a combination of vanilla options, but many payoff scenarios can be covered.
Options usually offer better liquidity than structured products and are less prone to price manipulations because of high frequency traders who regulate the market at all times. Prices are more competitive on blue chip stocks leading to tighter spreads. Trading options also does not require the same investor vetting process required with structured products which translates into lower barriers to entry for retail investors.
Coming back to the BRC product we mentioned earlier, we can create a setup close enough using a combination of long and short options as shown below.