Structured Products

What are structured products?

If we had to guess, we would say you are not reading these lines because you have decades of experience in finance and manage your own fund – and if we are mistaken, we apologise. We start this way because structured products are instruments designed to provide a broad range of investors with the opportunity to invest in underlying assets (equity indices, shares, bonds, ETFs, currency pairs, commodities) that would otherwise be inaccessible via the spot market, or accessible only without the leverage effect that can amplify gains … or losses.

These are hybrid instruments combining elements of the spot market with those of the derivatives market. As an investor, your maximum loss is limited to the amount invested in the structured product. At the same time, by purchasing a structured product, you also assume the issuer’s credit risk (typically a bank or broker), in addition to the central counterparty risk associated with derivatives markets, which is generally considered minimal.

Pricing of structured products

The way prospectuses are structured means that prices tend to move closely in line with the underlying asset. However, as usual, actual market quotations are determined by supply and demand, and the most competitive quotes are typically provided by a market maker, within the limits imposed by the exchange on which the structured product is traded.

To generate a return, the market maker will quote a slightly different ask price compared to the bid price, resulting in a spread that is generally wider than that observed in the primary market of the underlying asset.

Some structured products have no maturity (being legally classified as perpetual bonds) or are issued for very long periods (e.g. 99 years), while others have a maturity ranging from several weeks to several years. Most products offering leveraged exposure tend to have shorter maturities, while others are typically long-dated or perpetual.

Because investors cannot lose more than the amount invested when purchasing a structured product, leveraged products include an additional feature. Specifically, they embed a knock-out option. In practice, the price paid by the investor represents the premium of this option.

If the underlying asset reaches a predefined price level known as the “barrier”, the investment is fully knocked out and the investor loses the entire amount invested. Since the barrier is determined based on developments in the primary market of the underlying asset (most often a derivatives market), it is periodically adjusted by the issuer of the structured product.

What does this mean for you? It allows you to position for either rising or falling prices of the underlying asset. You may speculate on market movements or hedge existing holdings of financial assets (such as shares or bonds) or real assets (such as oil or gold), typically involving the same underlying asset as the structured product.

Classification of structured products

If you have reached this point, you likely have a natural curiosity regarding the classification of structured products. We generally distinguish three main categories: structured certificates, ETCs, and warrants. Structured certificates themselves can be further divided into index certificates, turbo certificates, and other structured formats. Depending on the source and the jurisdiction in which they are issued and registered, structured products may be defined and classified differently. The framework presented here is the one we consider most appropriate.

Structured certificates, sometimes referred to as ETNs (exchange-traded notes) or structured notes, are legally classified as variable-interest bonds. Their payoff formula is designed to replicate the performance of an investment in the underlying asset, with or without leverage or additional features. Index certificates are the simplest form and provide returns similar to a direct investment in the underlying asset. Turbo certificates add leverage, amplifying both gains and potential losses, while ensuring that losses do not exceed the initial investment.

Building on these primary certificate types, additional structures have been issued that include clauses designed to reduce investor risk in exchange for a lower expected maximum return. For example, bonus certificates allow for potentially higher returns within predefined ranges, while capital-protected certificates offer protection of the invested capital at maturity (within the limits of the nominal value) in exchange for significantly lower maximum returns. In all cases, market prices prior to maturity are determined by supply and demand.

ETCs (exchange-traded commodities) emerged as a result of regulatory restrictions within the European Union, which limit retail investors’ access to U.S.-domiciled ETFs and prevent EU ETFs from investing in a single underlying asset. ETCs allow exposure on the spot market to a single commodity, with full physical or synthetic backing. Currently, due to restrictions imposed by the Romanian Financial Supervisory Authority, ETCs are not available to retail investors in Romania.

Warrants were developed as an innovative method for companies to raise capital. They are similar to financial options, except that they are traded on the spot market and are not issued by an exchange nor backed by a central counterparty. As a result, investors also assume the issuer’s credit risk. A warrant holder has the right, but not the obligation, to purchase the underlying asset at a predetermined exercise price, either at maturity (European-style warrants) or at any time prior to maturity (American-style warrants).

Variable (from moderate to high, depending on the replicated assets, legal structure, and issuer)

In theory, risks range from moderate to high, particularly for leveraged products. A structured product fully collateralised with U.S. blue-chip equities and issued by a bank with the highest credit rating may be significantly less risky than certain sovereign bonds or individual securities issued by weaker entities.

As with all spot market instruments, an important point to note is that losses are limited to the amount invested (unlike derivatives and margin trading). In addition, exposure to a diversified basket of assets can reduce overall investment risk, depending on the degree of diversification achieved.