Understanding Structured Products - Expert Views

Denis Groven: Structured products today form an integral part of the investment solutions offered by banks, insurance companies, wealth managers, and other players in the financial sector. Structured products are tailored investment solutions. They are a combination of financial instruments that provide exposure to market movements in equity, stock market indices, interest rates, commodities, and funds. Building these tailored products is a way for investors to optimise their risk-return ratio according to their expectations, objectives and constraints. Unlike most traditional investments, such as shares whose value fluctuates depending on supply and demand, the performance at maturity of a structured product is predetermined by a mathematical formula. Let’s take a look at the key principles of building structured products to get a better idea.

Two essential building blocks

Justine Tassart: Structured products combine two types of instruments: bonds and options. Bonds guarantee or protect the invested capital when the product matures. Options give exposure to the performance of a reference financial instrument — the underlying — such as a stock market index.

Denis Groven: Can you give us more details on these two components?

Justine Tassart: The bond component is made of a zero-coupon bond issued by the financial institution tasked with building the structured product. Unlike your standard bond, the investor is not paid out any interest over the lifetime of the zero-coupon bond. The trade-off is that the investor buys it at a discount. The investor receives the accrued interest at maturity, which means they recoup their invested capital.

Denis Groven: Got it. And the option component?

Justine Tassart: An option is a contract between a buyer and a seller. It gives the holder the right to buy or sell an asset at a predetermined price and on a specified date. Depending on the markets, at maturity the option can turn break even, turn a profit or a loss.

Denis Groven: OK! So how are these two building blocks used together to build a structured product?

Justine Tassart: Very good question. Let’s take a deep dive into the construction of two big structured product families. They are capital-protected products and capital-at-risk products.

Capital-protected structured products

Justine Tassart: As their name suggests, capital-protected products guarantee the repayment of the investor’s initial investment at maturity, whatever the performance of the underlying asset. Let’s take an example. An investor wants to take advantage of the European equity markets without putting their capital at risk at maturity. Based on their personal constraints and expectations, they decide to invest 100 euros in a five-year maturity product.

Denis Groven: So, how will you structure the product to meet their requirements?

Justine Tassart: We will split the 100 euros into the two building blocks we discussed: the zero-coupon bond building block, and the option building block. Ninety euros will be invested in a five-year zero-coupon bond. At maturity, these 90 euros will be worth 100 euros. This instrument therefore protects the invested capital.

Denis Groven: Will the remaining 10 euros be invested in the equity option?

Justine Tassart: That’s correct. With the 10 euros we can buy an option with a five-year maturity period, with the chosen European equity index as the underlying. This option exposes the investor to the index’s upside potential over a period of five years, in accordance with their requirements.

Denis Groven: And what happens at maturity?

Justine Tassart: There are two possible scenarios: if the market was bullish, the investor will recoup their capital and a return of 100% of the index increase. But if it was a bear market, the option loses its value. The investor will nevertheless recoup their initial investment thanks to the bond component of the product.

Denis Groven: Makes perfect sense! We used the example of a stock market index, but we can also structure capital-protected products whose return is indexed on interest rates. What about products that could lead to a capital loss at maturity?

Structured products carrying a risk of capital loss at maturity

Justine Tassart: The other big family of structured products are those without capital guarantee. The investor stands to earn a higher return but puts their capital at risk to do so. The capital protection for this kind of product is conditional on the level of the underlying asset when the product matures.

Denis Groven: Are these what we call barrier capital-protection products?

Justine Tassart: That’s right. And let me point out that these products are based on a combination of a zero-coupon bond and one or more options for generating return, which can be periodic or at maturity, guaranteed or conditional. But unlike capital-guaranteed products, in this instance options are also used to set up capital-protection barriers. Let’s take the example of a -40% capital barrier: the product we create will allow the investor to recoup their capital if, at maturity, the underlying asset has decreased by not more than 40% since the start of the product. On the other hand, if at the end date the underlying asset decreased by more than 40%, the investor is exposed to a capital loss equal to the decrease of the underlying over the period. The investor could therefore suffer a partial or total capital loss at maturity.

Denis Groven: If you are interested in structured products and would like to find out more, Societe Generale Private Banking is here to assist you. Societe Generale Group has teams of engineers specialised in building these products, using structures and underlying assets best suited to market conditions. Feel free to contact your Private Banker for further information.