Structured Note Markets

In the wake of great financial crisis of 2008, FINRA and SEC have come up with regulations around these products to increase transparency and requiring the players to understand these products and their risks.

I will focus this discussion around structured note market place with emphasis on motivations for variety of participants and taxonomy of products created and traded on the market.  Then I will discuss the mechanics and design aspects of a structured note and its components.  From there we will uncover the valuation building blocks needed in pricing of a note. After that we will focus on understanding various risks embedded in a note.

  Structured Note Products

Market Landscape: Structured note product market is a global market place where investors looking for alternative investment opportunities and issuers with need to fund their operations effectively come together.  In Europe region these products are very popular among retail and institutional investors.  My current talk is focused on US structured note market. In United states issuers like investment banks ( goldman, morgan stanly, jp morgan) have been issuing notes to both retail and institutional investors. Average note issuance over last 5 years has been around 40-50 bn. Growth in this market is attributed to factors like,

1. Investors are able to design customized solutions to meet their investment needs.
2. Issuers are able to fund cheaply
3. Financial engineering techniques are now better understood in analyzing risks in these products

For instance, an investor wants exposure to S&P 500 and Gold price not outright performance of these assets but outperformance of S&P 500 over gold.

1.           He can then approach an issuer (an investment bank) to originate this note.
2.     Issuers will employ a pricing model (financial engineering  technique) to value the underlying derivative component and then design the note meet the client requirements.

As we know structured note products can be tailored to a variety of needs. There are hundreds of them on the market.  Fortunately we can classify them by the risk inherent in them into following types.

Capital guaranteed: In these notes, investors can safely assume their initial investment is protected from market risks. Commonly traded notes are step up callable notes.

Be aware, they are still exposed to the risk of the default of the issuer.  That is if the issuer defaults on the note, these notes will become worthless.

Yield enhancement:  In these notes, investors are exposed to underlying asset market with some protection around their initial principal.  Commonly traded notes are buffered return notes.

Performance Notes: These notes are mainly designed to gain exposure to commodity markets. Investors participate in market performance of a commodity index like Dowjones UBS Total return commodity index.

Leverage: Finally, some notes are designed with more attractive coupons by adding leverage to their performance. These notes are potentially riskier due to the possibility of loss of entire principal. Next I will cover details of the components of this type of note.

Now that we have learnt about the market place and various note types, let us dive into design components of a structured note.

Here I will consider a note issued by HSBC on S&P 500. This note is called Buffered Accelerated market participation securities.  This note will pay investors twice the gain in S&P 500 with a cap of 12.5% at maturity. On the down side this note will participate in 1:1 market performance with a protection up to 10% of losses.

This note has two components

1.        Derivative component that tracks the return of the underlying asset
2.         Bond component that tracks the initial principal investment

For the Derivative component:  we have to long two call options at the initial level 1419 and short two call options at 1589. These four options together replicate the return of the note on the upside.

Now on the down side, we will short a put option at 1277 to protect from losses up to only 10%.

Above 5 options together replicate the derivative component of the Note. To this we will add a zero coupon bond that expires at maturity to replicate the initial principal.

Now we have designed all elements of the note. Now we are ready to value these options and bond to estimate the price of the note.

Valuing the options in this case need volatility as an input. Our note is constructed using some OTM options and volatility skew becomes very important in pricing this product.  We will assume in our case volatility is given and we employ Black scholes model and price these options (Volatility skew is currently out of scope of this discussion)

Now that we have designed and valued a structured note, let us go over the risks embedded in this note to evaluate pros and cons of the note.

Investors of this note are exposed to 3 different risks, market, issuer credit and Liquidity risks.

Market risk: This note is designed with s&P 500 as underlying. Therefore it is exposed to all S&P 500 returns and volatility. On the upside, this note is more like a bull call spread strategy. In this kind of strategy, you are exposed to limited losses. On the down side, we are short a put. This is very dangerous one. As we are exposed to unlimited losses (most of the initial investment)

Credit risk: This note is unsecured debt and if issuer defaults, you might get nothing.

Finally, these notes are traded on a limited basis in secondary markets so the bid-offer spreads are very wide

At this point we have touched upon various aspects of structured note products to get flavor of this market and the product features. Thank you for reading.