How Structured Products Work

Structured products have certainly suffered much of their popularity during the financial crisis 2008. However, after 2008 there has been a raised interest in structured products again. Today I’m going to explain you how they work, how banks earn money with them and why you should keep your hands off them.

There’s no point in talking about the more complex instruments. These products are only really understood by the investment product services department of their issuing banks, or maybe not even by them. Therefore I will speak about a simple standard structured product with the following terms:

Denomination: USD 1,000
Interest: 5% p.a.
Strike: USD 50
Ratio: USD 1,000: 20 shares
Lifetime: 1 year

There are two possible redemption scenarios on expiration:

Scenario 1: Underlying share closes above strike. Investor receives USD 1,000 in Cash per denomination.
Scenario 2: Underlying share closes below strike. Investor receives 20 underlying shares per denomination.

When talking about structured products there are always different point of views. One is the investor’s view and the other is the issuer’s view. Structured products are issued by banks and as such the issuing bank’s main focus is to earn money with the structured product. This conflicts to some degree with the investor’s interest to earn money with the product. So as an investor in the above product you will want the first scenario to happen. In this case you would receive your investment of USD 1,000 plus USD 50 interest on expiration. You would then pat yourself on the back for your flair for investments. On the other hand you could also be hit by the second scenario. You would then receive 20 shares plus USD 50 interest on expiration. The value of the redemption will then be lower than your initial investment.

So as you can see, by investing in this structured product you basically “buy” yourself a buffer of USD 50 on your investment if the share price stays level or goes south. On the other hand though you renounce any possible profits if the prices should raise and you also renounce the possible dividend of the company. Remember you receive no dividend from the company for holding the structured product.

Now how does a bank make money from the structured product? It’s not too complex actually and yet pretty clever. This works in two steps. The first step happens when the structured product is bought so you’ll want to know what technically happens at this point. Basically the investor buys a bond from the issuer while at the same time selling the issuer a put warrant on the underlying share. The issuer has now USD 1,000 plus a put warrant from the investor. The second step now is about what the issuer is going to do with the money from the investor. The issuer will invest a considerable amount (let’s say USD 900) into a bond that will yield enough profit to repay the USD 1,000 on expiry. With the remaining USD 100 the issuer will buy a call warrant on the underlying share. In the end the issuer has USD 900 invested in bonds plus one call warrant and one put warrant.

So whether the markets go through the roof or they crash on the ground the issuer will profit either from the call warrant or from the put warrant. The only risk for the issuer is if the prices stay about level. In this case both warrants will be more or less worthless but due to the USD 900 initially invested in bonds the issuer will be able to repay the USD 1,000 to the investor. There’s only three ways the market price can go: up, down or stay level. With the above technique the issuer has a 66% chance to make a considerable profit while the risk is rather limited.

If you would buy the share directly you would renounce the USD 50 interest but on the other hand you would receive the dividend if a dividend is paid. The risk of dropping prices is the same but you would also be able to profit from raising prices. That’s something you can’t do if you buy the structured product. So I can barely see a reason to buy a structured product. The chances for a better profit over the direct investments are pretty low.

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