Structured investment products are customized financial instruments with fixed maturities, consisting of a note and a derivative. They are typically composed of a bond that protects the principle and an option that depends on an underlying asset’s performance. All terms, however, can be tailored to suit an investor’s risk attitude and financial objectives.
Structured investment products are mainly offered by large investment banks with global presence, and are readily available to individual investors, particularly in Europe and Japan. The main advantages of these investment products are that they provide access to the derivative market with a minimum of fees, trading volume requirements, or prerequisite understanding of finance. They can also diversify a portfolio in order to reduce return volatility.
One attribute of structured investment products that appeals to risk averse clients is the downside protection provided by their bond component. Principle protection may be guaranteed by government backed notes such as the Federal Deposit Insurance Corporation backed certificate of deposits in the United States. The issuer may offer a guarantee with more favorable terms in exchange for the higher financial risk. A risk lover may ignore principle protection altogether in favor of potentially higher returns.
The performance of structured investment products is linked to the performance of an underlying asset such as an equity, an interest rate, a commodity, or a foreign exchange rate. Although no options are actually bought and sold, the issuer will mimic their performance in terms of market view and investment objectives. An investor may prefer periodical interest payments to generate income, or a payment at maturity in order to increase capital. He might dabble in new and foreign markets that he might not have the financial clout to enter without the backing of the issuer. A more conservative investor might accept a capped option to further reduce the volatility of his expected return.
For instance, a mildly bullish investor buys a structured investment product with principle protection costing $1,000 US Dollars (USD) with a fixed maturity of 5 years and an option on the S&P 500, currently at 1000. The issuer will buy a 5 year, zero coupon bond for $800 USD that will be worth $1,000 USD at maturity, guaranteeing the principle. The other $200 USD pays for the option. If the S&P 500 finishes under 1500 at the maturity date, then the investor receives nothing, if it is over 1500, then he receives his principle of $1000 USD plus 75% of the simple appreciation in the S&P 500, up to a cap of $2000 USD.
In exchange for protecting his principle, the investor has foregone possible returns of over $2000 USD. He has fine tuned the option to meet his investment objectives by reducing the volatility of expected returns. A risk neutral investor might observe that his expected returns may be higher with traditional instruments than with structured investment products.