It is divided into four parts: an introduction to structured products (Chapters 14), specific types of structured products (Chapters 512), various trading strategies and capital-raising approaches (Chapters 13, 14, and 15), and an extensive resource guide. Chapter 1 provides a concise orientation as to the variety of structured products discussed in this book, including what they are, why they are used, and who uses them. On Wall Street, the term structured product refers to financial instruments designed or engineered to meet specific financial or investment objectives. Business activities related to the creation, marketing, and valuation of the structured products discussed herein are collectively referred to as financial engineering. Structuring refers to a nontraditional process of creating and fabricating a wide variety of financial products whose values are linked to or derived from one or more underlying assets, such as equities, bonds, commodities or currencies, or other economic interests.
Structured products are often referred to as derivatives , a generic term used to describe a wide variety of financial instruments ranging from standardized, exchange-listed products, such as options and futures, to custom-tailored, over-the-counter instruments to those whose values are linked to or are derived, in whole or in part, from the price or value of one or more underlying assets, including equity indices, exchange rates, interest rates, or commodity prices. Elemental derivatives are the building blocks of structured products and can be fabricated into a diverse array of innovative financial instruments. Elemental derivatives fall into two general categories: forward-based , such as forward contracts, futures, and swaps; and option-based , including put and call options, caps, floors, and collars (see display).
Compared to traditional financial instruments, many structured derivative products have other unique, as well as controversial, characteristics, including:
Lack of Regulation. Although many of the products discussed herein are some of the most heavily regulated securities in the world, many structured derivative transactions occur outside of established regulatory regimes. This characteristic enhances the unfettered creativity that has been the hallmark of numerous derivative products around the world and is currently the subject of a great deal of controversy, study, and debate.
Borderless International Transactions. Given their birth during the globalization of the capital markets, derivative instruments can be denominated in almost any currency, structured within almost any legal and regulatory environment and around almost any obstacle. They are designed to exploit market inefficiencies within, across, or between international political borders.
Innovation. From unleveraged and principal preserving to highly leveraged and speculative, from "plain vanilla" to "exotic," structured products continue to be developed with features and nuances that cater to the specific needs of investors around the world.
of Secondary Trading Liquidity. Other than standardized derivative securities and structured products that are listed on securities exchanges around the world, many such instruments trade over-the-counter and have no established market for secondary trading, other than "upstairs" markets made for clients by originating brokerdealers.
Off-Balance Sheet Accounting. Because they often fall outside traditional regulatory and accounting categories, many structured derivative products are treated as off-balance-sheet items and, other than financial footnotes, are not always reflected in traditional disclosure materials and financial ratios used by investors to analyze the performance of corporate users and issuers of such instruments.
Financial Leverage. Using derivatives and structured instruments, end users can achieve almost any degree of financial leverage or "gearing" desired in pursuing financial objectives; relatively small capital outlays can finance products that produce potential cash surpluses and deficits and positions that have tremendous potential to appreciate as well as depreciate.
Organizations successful in structuring and trading derivative financial instruments integrate such activities into their firm's strategic business plans and usually have managers who understand and support such activities. Chapter 2 highlights many of the responsibilities of officers and directors overseeing structured product activities and a sampling of the regulations (proposed, pending, and adopted) affecting derivatives. Some firms enter the derivative business without taking a systematic approach toward trading, structuring, and risk management. Occasionally, companies have entered, abruptly exited, and later reentered the business over the course of several years. The nature of organizational support for structured product trading, origination, and risk management should include the features explained in the accompanying display on the facing page.
Structured derivative products typically undergo significant financial and legal scrutiny. Positions relating to and used to offset or hedge the risk associated with issuing various structured derivative products often comprised combinations of exchange-listed options, futures, options on futures, and cash securities that produce virtually no credit risk to the issuer of structured products. Exchange-traded derivative instruments and contracts are issued by securities or futures exchanges and are regulated by government agencies.
Structured derivative product positions are generally valued and marked-to-market daily by financial control personnel assigned within firms managing the market price risk related to such positions. They monitor and prepare regular management reports on derivative trading activities and positions. To the extent back-to-back, over-the-counter options (i.e., nonpublic or nonstandardized options) are purchased from third parties to hedge market risk relating to the issuance of structured products, they are typically purchased from counterparties whose creditworthiness, among other factors, undergoes a formal credit review. Also, exchange-listed structured products in the United States, for example, must be registered with the U.S. Securities and Exchange Commission where they undergo a particularly stringent review process. They are listed on securities exchanges 1 under specific derivative listing and investor suitability standards. Chapter 3 discusses the origination process and the legal and marketing activities that comprise new product creation. Chapter 4 illuminates some of the basic quantitative aspects of new financial product development.
Chapters 5 through 12 review the general characteristics of various categories and permutations of structured products available to investors around the world, such as warrants, structured notes, and exotic options. Chapter 13 discusses structured financial products and strategies available to shareholders seeking to monetize or hedge large equity positions or restricted stock holdings. Chapters 14 and 15 relate to certain structures available to corporations for their capital-raising activities.
It is important to note that structured derivative products require the involvement of an issuer (e.g., a corporation, government, or government agency, etc.) who is the ultimate obligor to whom investors look for fulfillment of the terms of each particular transaction. Structured products must also be supported by risk management capabilities that are employed to reduce or eliminate various market risks that influence an issuer's obligations to perform under such offerings. Risk management capabilities are fulfilled by entities (either affiliated or unaffiliated with the issuer) with the trading, quantitative, and other financial engineering skills necessary to engage in capital market activities that act as a counterbalance to the issuer's performance obligations under a portfolio of structured product liabilities. Issuers of structured products often hedge their balance-sheet exposure to such obligations using their own in-house derivative trading desks or by purchasing such market protection from creditworthy counterparties through identical, back-to-back transactions. Issuers then fund their obligations to investors by periodically unwinding or monetizing a portion of their hedge.
For example, a public corporation that issues a combination of stock and bonds uses the proceeds to fund its particular operating capital and investment needs. However, an issuer and obligor of a structured derivative product uses a substantial portion of the proceeds from such an offering for hedging 2 purposes or for "immunizing" itself from exposure to the risk of price fluctuations relating to the market or asset on which the structured product is based. Such hedging activity requires the continuous buying and selling of options, futures, cash securities, and other instruments and investment contracts, often around the clock and in financial markets around the world, using some or all of the proceeds generated from an offering. The success of a risk manager is, in large part, a function of the costs incurred and the amounts of offering proceeds consumed in hedging a portfolio of structured product obligations. Profitability is a function of the level of success in managing position risk and retaining as much of such proceeds as possible over the life of the position. The securities that constitute the hedge often include instruments with shorter or even longer terms than the structured products sold to investors. This mismatch of terms and instruments in the hedge with those related to the structured product generates risks (e.g., gap risk, roll risk, and tracking error, as defined in Chapter 3) that must be closely managed by the obligor and its risk managers.
The extensive Resource Guide at the end of this book provides a great deal of background and reference material that supports the information contained in Chapters 115. Sample structured product presentations to management, information about offering expenses, the activities of structured product working groups, legal, marketing, and pricing information are included. There are also sample term sheets supporting many of the types of products discussed in this book. A glossary of terms is also included.
The format of much of the material is intended to provide concise summations of the material in a readable form which, when combined with the text, enhances immediate comprehension and understanding without assuming an extensive knowledge of derivatives and structured products.
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