An Introduction to Structured Products
A structured product is the packaging of an underlying asset and a derivative contract that allows investor to gain a non linear exposure with respect to stock and/or bond index returns.
There are three generations of structured products:
- Constant Proportion Portfolio Insurance
- Option – Based Portfolio Insurance
- Third generation of structured products based on exotic derivatives
Constant Proportion Portfolio Insurance
The higher the multiplier, the more the investor will participate in a sustained relative increase in risky asset. On the other hand, the higher the multiplier the faster the portfolio value will approach the floor in case of a sustained relative decrease in risky asset.
As the cushion approaches zero, exposure to risky asset is also converging to zero, which in principle prevents the portfolio value from ever breaching the floor value. In practice, however, because of discrete trading, the portfolio value can fall below the floor value in case of a sharp decrease in value before the investor has a chance to trade.
As a result of this analysis, it appears that the optimal multiplier value should be a decreasing function of the risk of the risky asset and an increasing function of trading frequency.
Option Based Portfolio Insurance
Starting with the example of a structure based on a simple European call option, we can write the payoff at maturity of the structured product as:
gSo + k max (St – So, 0)
where g is % guarantee and k is % participation to upside potential.
In order to achieve this payoff, a portfolio consisting of the following two components may be created
- Pure discount bond investment of gSoe^-rT
- European Call option investment of kCo
Third Generation Structured Products
Starting with the example of a structure based on a simple European call option, we can write the payoff at maturity of the structured product as:
So + k max (Smax – So, 0)
In order to achieve this payoff, a portfolio consisting of the following two components may be created
- Pure discount bond investment of Soe^-rT
- Hindsight call Call option investment of kHCo
The Bottom Line
Structured products, which allow their user to achieve a non-linear option-like exposure with respect
to the return on traditional asset classes, are natural investment vehicles for institutional investors, who have a particularly strong preference for non-linear payoffs because of the non-linear nature of the liability constraints.
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