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Examine the Components of Structured Investment Products

Opponents of structured investment products in the UK love to talk up the risks and then in a solemn voice intone that they’re fiendishly complex and the work of clever rocket scientists out to diddle the poor unsuspecting investor.

Some structured investments are, indisputably, poorly built, horribly complex and of debateable value (especially those sold on main street by big banks and mutuals). But, in reality most products sold direct to investors through advisers or listed on a stock exchange are fairly transparent in their construction.

Peer under the bonnet of nearly all structured investments and you find a common set of components; you don’t need to worry too much that they exist just understand what’s involved.

Add up these differing components to a structured product and you can quickly see that an issuer can derive a number of different sources of income or capital gain (premiums from issuing the barrier put, forgone dividends contained within the call that tracks an index, plus the difference between the zero coupon bond value at maturity less the sum paid upfront), which all go towards funding the cost of the upside call plus any bank charges and fees.

Discover the call option

The most important working bit of a structured investment component is a call option. This derivative-based option pays the upside return via the annual defined return (say, 5 per cent per annum) or the geared participation rate (say, 5 times the index return).

Underwriting an option that promises to pay out, say, 5 per cent per annum for the next five years doesn’t come free! The call option costs the structured-product issuer real, hard money and other parts of the structure have to pay for it.

Luckily this isn’t completely a black and white case of a call issuer funding the 5 per cent per annum for the next five years. The call option may perhaps track the FTSE 100 index, which can be good news for the call option issuer.

Some profit is to be had by selling away the likely flow of dividends that an investor would have received if the option had tracked the underlying index. Over a five-year period, for instance, the combined companies within the FTSE 100 index may pay out as much as 20 per cent in compound dividend return.

The issuer of the call option pockets that return as part payment for guaranteeing to make an upside return, in turn selling on that dividend participation in the dividend futures markets.

In addition, remember that the call option may never be triggered; that is, markets fall disastrously and the barrier is breached. If that’s the case, the call option is never used, no return is ever paid out and the issuer of the (upside) call option simply pockets the premium income and moves on to the next deal.

In these circumstances guaranteeing to pay out 5 per cent per annum on the upside may seem like a reasonable bet.

Enjoy the downside: The put option

Another option lurking around is called a put option, which is linked to the barrier that’s usually set at around 50 per cent or 40 per cent of the initial index level of the FTSE 100 or S&P 500 when the structure is issued.

In reality, this barrier is a downside or put option, which means that someone (probably a pension fund) has been willing to write an option that pays out a generous premium in return for making a big profit as markets dive by more than 50 per cent over the duration of the structure.

If the barrier isn’t breached the option expires worthless and the structured-product issuer pockets the premium to help pay its costs and fund the cost of the call option. The premium from writing these downside options isn’t huge but pension funds are keen buyers because these options give them some opportunity to make money in a collapsing stock market.

Get insurance: The zero coupon bond

Sitting at the heart of the zero coupon bond structure is a bond the bank issues behind the structured product. In effect, this bond guarantees that your initial investment (say, £100) is paid back in full as long as the barrier isn’t breached. Think of it as the insurance policy on paying you back your initial investment.

But insurance doesn’t come free and the bank has to fund it by going to the markets using something called a zero coupon bond. This bond is like any other bond issued by a bank with one big exception – it doesn’t pay a coupon every year but rolls up the annual cost at maturity.

Assume the bank wants to make a payout of £100 in five years’ time to fund your structured product. Given its current credit rating it discovers that it can issue a zero coupon bond that promises to pay out £100 in five years’ time but which costs just £80 today; that is, the £20 difference is the cost of funding that loan through annual interest rolled up over five years.

A risky bank (that is, one that is regarded as more likely to have problems repaying its debts by the markets) may discover that its high yields work in its favour – it may only have to pay £70 today to make £100 in five years’ time. The key, though, is that the zero coupon bond issued by the bank (it hopes) pays out the initial investment of the investor.

The difference between the eventual cost of the zero coupon bond (£100) and the initial cost (between £70 and £80) represents the cost of borrowing, which is in turn ploughed back into the structured investment to pay for the upside call option.

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