Structured products can be explained, analyzed and used to solve problems: trainers

By Emma Trincal

New York, Oct. 24 - During a one-day workshop, financial advisers, compliance staff and index experts learned the nuts and bolts of structured products - from their definition and limitations to their best use in a portfolio as well as how they are built, structured, hedged and priced.

Training was also provided on the regulatory and tax fronts by two specialized lawyers: Lloyd Harmetz and Remmelt Reigersman from Morrison Foerster, the New York law firm that hosted the seminar on Monday.

The workshop was organized as an introduction to the Structured Products Association's Conference to be held in New York City on Tuesday.

Eric A. Greschner, founding partner of Your Financial Coaches and Regatta Research & Money Management, LLC, began the educational boot camp with an introduction on structured products.

What is it?

Acknowledging that the definition of structured products may be complex, Greschner broke it down to "four traits" shared by most products: the combination of a debt and an option; the predefined formula for the payoff; the existence of an issuer; and the wrapper.

The goal was to demystify certain terms - "wrapper," for instance, is only the legal form of a transaction, he said, which can be a FDIC certificate of deposit, a Securities and Exchange Commission registered note, an annuity or even a fund or a special purpose vehicle.

But the important thing is the flexibility offered by those products, Greschner said.

"There is a formula introduced to determine the profits, and you can determine the asset class and the security," he said.

"You can sculpt it in anything you want."

'Elegant' structures

Later, Greschner introduced some of the "most elegant" structures available to investors, which offer good answers to specific financial planning problems, such as market timing uncertainties, often guided by behavioral finance errors, or asset allocation decisions.

One problem, though, as one class participant noted, is that some of the best structures are not necessarily found on the shelves. Greschner recommended that planners and advisers create their own bespoke structured products, but such a step requires learning about them.

Greschner encouraged planners to use structured products the smart way in order to solve typical financial problems.

"I'm not saying that you should use structured products at all times and that they are a solution to all problems. But you should be aware of the options and tools that are available," he said.

Some of the common benefits include, for instance, the ability to "manage your payoff profile in line with your risk-reward profile."

Another advantage, especially for retail investors, is to get easy access to the over-the-counter market.

But investors should also think about using structured products when trying to make crucial decisions, such as when to buy and when to sell, he said.

"Structured products can help you make better market timing decisions by reducing the entry or exit risk," he said.

"Deciding when to buy and sell an asset class or position is very difficult. Investors are susceptible to common behavioral errors such as selling in a panic or doubling down on losing investments," he said.

He suggested the "switch-trade vehicle," a simple strategy to lock in profits with an asset that has recently experienced a substantial appreciation, one sign of a possible "bubble."

Bubble

Gold came to mind.

Greschner said that for investors with a strong position in gold who worry about a correction, but still want to benefit from the rally, if the rally has legs, they could simply sell their position and invest the proceeds in a fully principal-protected structured note linked to gold.

"You can lock in your gains and still participate in potential future gains," he said.

This strategy may be preferable to putting a stop-loss on the position, he said. The stop may be misplaced, generating either losses or opportunity costs.

Greschner gave many other examples of structures offering "solutions" to investment problems: a digital note, for instance, can enhance the yield necessary for retirement; a ladder or high water mark structure, which locks in gains, can solve market timing issues; a payoff linked to volatility can hedge an equity position; or a rainbow structure, which picks the optimal allocation within a basket of uncorrelated assets, can achieve an effective asset allocation.

Structuring, pricing

Tim Mortimer, managing director of Future Value Consultants, a research and analytics firm specializing in structured products in the U.K., provided the quantitative tools to understand how structured products are put together and priced.

His firm has provided analysis for the U.K. structured products market since 1999 and has now launched its U.S. service "Structured Edge."

Future Value Consultants analyzes each product based on price, projected returns and risk and has developed a series of scores to run its models and project return outcome probabilities.

Mortimer explained that certain myths persist in regard to the issuer and its hedging role.

"It's a common misconception to think that structured products are a zero-sum game or that they can only have one 'winner' between the bank and the investor," he said.

Credit risk apart, the issuer is "contracted" to pay the payoff, and hedging is only part of the bank's best practice, he said.

Mortimer laid out the principles of product construction. First the issuer establishes the total cost base, which is the amount invested minus the fees. This will represent the amount that can be spent on assets.

This sum is spent on the zero-coupon bond, which is always used as a basis even for not fully principal-protected notes. What is left is used to buy the options.

The cost of options will vary based on volatility while the interest rate environment will impact the cost of the zero-coupon bond.

Those two variables may determine how products are shown in the market.

For instance, capital protected growth products have much longer durations.

"That's because in a low interest rates environment, you need to have long duration in order to have the zero coupon priced down so that you can get a decent optionality," Mortimer noted.

Some structural features are introduced to manage those price constraints. He showed with examples how the introduction of a cap could boost the participation rate.

Reverse convertible products do well when volatility is high, he said, as there is in those products the sale of a call to generate the coupon and the sale of the put, which introduces the risk below the barrier.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.