A structured product is a customized investment vehicle created by financial firms for specific types of clients. They typically involve a debt and derivative component combined together into one product. While these investments tend to be complicated and customized to fit specific client profiles, we’ll build a simplified structured product together to better understand them.
Let’s assume a person wants to invest $100,000 and gain the returns of the S&P 500 over a 5 year period while protecting themselves from a bear market. A financial firm could create a structured product with these two components:
The zero coupon bond component represents the principal protection the investor was hoping for. As long as the issuer of the bond (usually the financial company creating the structured product) does not default*, it will mature at $100,000 at the end of five years. Even if the S&P 500 index call ends up worthless, the investor still gets their $100,000 back at maturity.
*Due to the possibility of default, structured product investors must be comfortable with credit risk.
An S&P 500 index call is bullish on the index, resulting in gains if the S&P 500 rises. Should this occur, the investor obtains gains on the option in addition to the $100,000 principal received from the zero coupon bond. If the S&P 500 declines, the option becomes worthless and results in no return.
This example is one of many ways a structured product can be created. While many real-world versions are similar, technically any combination of two or more financial instruments to create a new customized product is considered a structured product. Due to their customization, there is typically no public secondary market available. This makes most structured products subject to significant levels of liquidity risk.
There’s one primary exception to be aware of in regard to liquidity risk. Exchange traded notes (ETNs) are technically considered structured products, but trade on stock exchanges. When a financial instrument trades on an exchange, it can be assumed liquidity risk is very low. ETNs are one of the only structured products that can be assumed to have little-to-no marketability problems.
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