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Structured Financial Products: Financial Innovations with Odds and Traps

AUTHOR: Professor Marco Wilkens and Professor Timothy Devinney   DATE: 08.12.05   ISSUE 3, 2005

In recent years, many financial markets have seen tremendous growth in the development of Structured Financial Products (SFP) offered to both institutional and private investors. Although these securities are generally nothing more than a bundle of traditional securities such as bonds and stocks, and derivatives (e.g., futures and different types of options), they offer investors the opportunity to purchase securities that provide more complex pay-off profiles.

Germany represents an outstanding example of this growth, particularly in the retail market where a large variety of different sorts of these products are on offer (Figures 1 and 2). However, one will find other places like Australia where such pro­ducts are offered to private investors as well. Examples are Citigroup's YIELDS (Yield Income Enhanced Listed Deferred Securities), Goldman Sachs JBWere’s GLRs (Growth Linked Return Invest­ments), Macquarie's ALPS (Alternative Listed Protection Securities), and Macquarie's Capital Plus (see http://www.asx.com.investment_products.htm for details). Apart of this, there is a huge market for private placements serving investors such as insurances, (smaller) retailbanks, and funds.

Figure 1: Number of monthly issues of SFP at the German retail market (Source: Deriva GmbH)

Figure 2: Number and share of current issues of different sorts of SFP at the German retail market at February 2005 (Source: Deriva GmbH)

How do Structured Financial Products operate?

It is very difficult, indeed sometimes even impossible, to understand SFP by looking merely at the product itself; a fact that can be explained by the complexity of these financial products and the never-ending creation of new SFP with unique features. However, it is not necessary to get lost in this complexity to understand the basics of SFP as a whole, as they are nothing other than combinations of standard financial products sold as a single security. To understand SFP, therefore, it is helpful to divide them into their fundamental constituents; in other words, to do a little reverse financial engineering. This process is outlined in Figure 3.

Figure 3: Evaluation by Duplication

Understand and value the Structured Financial Products by comparing with alternatives

To do this reverse financial engineering, one must consider which combination of SFP can generate cash flows identical to the SFP at redemption. If this duplication portfolio is known, the value of the SFP can be calculated simply from the market prices of the fundamental elements. If market prices are not available, standard algorithms can be used for pricing the fundamental elements.

This is all the issuer does: Buying the necessary elements – at the capital market or in-house – and selling the product for a more or less higher price than its duplicating value. Roughly speaking, and with respect to the costs of structuring the SFP, the difference is the margin income realized without taking any risk.

Therefore, a first indicator for the decision whether to buy a specific SFP is this margin. Since there is sophisticated data available for the German retail market for SFP, there is a lot of literature on that question. The general findings are the following:

• The newer the product idea the higher the margins; margins became much lower within the last years in Germany, for standard SFP they have been on average 3-5 percent and are now 1-2 percent.
• The more complex the SFP the higher the margins; for SFP with exotic options involved sometimes margins up to 10 percent where found.
• The younger the issue the higher the margins; starting with a price above the duplicating value and converging over time against it.
• The margins differ between issuers sometimes heavily.

Of course, here the most fundamental question arises: Why do rational investors buy these products for a price higher than its duplicating portfolio value? The answer is simple: if they constructed the SFP for themselves, it would cost them even more due to market barriers and transaction costs. Moreover, sometimes they are not able to buy the necessary elements at all, especially the (short) positions in standard and exotic options involved.

The duplication approach explained above can also be used to understand the SFP in more detail. For instance, especially professional investors can calculate the return distributions (or statistical parameters such as the Value at Risk) by historic data for the components of the SFP (such as expected returns, volatilities and correlations).

Reconsider the need of the Structured Financial Products

There are three possible motivations for purchasing SFP: investment, speculation and hedging. In general, bonds and shares are cheaper if bought directly rather than through a SFP, a fact reinforced as the time period for investment lengthens. However, for investors possessing limited financial resources to diversify sufficiently, it might be worth investing in appropriate index certificates. But from our point of view, it is doubtful whether long-term investments in SFP as permanent combinations of “traditional investments” and options are meaningful. The same holds for other complex SFP.

Very often SFP are the only possibility open to (specifically private) investors wanting to bet on changes in stock prices, interest rates, currencies, volatilities, and correlations using long and short (forward) positions as well as standard and exotic options. In that case SFP can be useful, especially for short-term bets. Whether it is worth trying to speculate in order to get higher rate of returns compared to traditional buy-and-hold strategies is not be addressed here.

Under what conditions should SFP be used for hedging risks? Firstly, it should be recognised that short-term hedging is a special case of speculation if the financial product to be secured is not supposed to be sold in the near future. To secure long-term investments it is generally cheaper to sell them and to invest the capital at the risk-free interest rate instead. Thus, the hedging motivation appears pretty irrelevant for private investors.

Beside this, there are more explanations as to why investors, especially institutional investors, may purchase SFP:

• They want to gain from specific risks that they are not allowed to take on formally due to government regulations (e.g., for banks, insurances, funds …). Sometimes this risk must not to be taken by buying or selling derivatives, but by buying SFP it is possible since they are not regulated yet.
• They want to gain from specific risks but don’t want to reveal this to stakeholders (e.g., shareholder, bondholder, …). Sometimes SFP appear just as “bonds”, therefore, the involved risks are not always visible.
• They want to move earnings into other periods of time. This could be possible due to accounting rules if SFP are not market valued; e.g., consider a SFP with high coupons in the near future and risks visible at the end of maturity.
• Tax reasons.
• They don’t really understand SFP and/or don’t behave rationally (“greater fool theory”).

Conclusion

SFP can contribute to the completeness of the financial market and, therefore, have the potential to produce benefits for both investors and issuers. The reason and precondition for this is that investors really need these pay-off profiles and that they cannot duplicate them cheaper themselves by combining the underlying instruments directly. Even it is doubtful that this is always the one-and-only truth for buying SFP in financial reality, this sort of financial innovation will have a future, since it obviously meets the what-ever-interests of customers. However, assuming further decreasing margins over the coming years, SFP will no doubt become even more attractive, also for rational investors.

For details and literature on this topic see Devinney, Timothy and Wilkens, Marco (2005): The Retail Market for Compound Instruments in Germany – Developments and Benefits, Working Paper AGSM/UNSW.