Globalisation of the world economies, has led to the rapid growth in the financial services industry. The market for financial instruments has increased considerably, in size and complexity. Clients are becoming more sophisticated and demanding, causing financial institutions to provide innovative structures, appropriate to clients' financial needs.
One of the by-products of this situation has been the development of structured products, offering the best of both worlds - participation in the growth of the underlying investments as well as capital protection. The main drivers for the explosive growth of these structured products were the 'financial derivatives markets'. Investors' perceptions of derivative instruments are that they are highly risky and appropriate for speculative investors.
However, today the financial derivative markets play an integral role in the range of structured products which are available on the market.
Structured products are hybrid investment products tailormade to fulfil clients' investment needs. The mechanism behind structured products offers investors capital protection and participation in any market, being the stock market, bond market or forex market. The return, calculated by a pre-defined formula, is linked to the performance of one or more investment instruments called derivatives that are linked to the performance of an underlying investment. Typical underlying investments are baskets of equities, indices, commodities, funds and forex rates. Such products may also be issued in different forms, the most popular being deposit accounts, notes, bonds, insurance products and collective investment schemes.
The market for structured products has been around for over ten years and has grown significantly over this period. Following the declines in global stock markets between 2000 and 2005, inexperienced stock market investors became more risk-averse and there was an increase in demand to alternative investment products offering the protection of capital.
The advent of the euro and the historic low levels of interest rates in the Eurozone since the early Noughties, prompted investors to seek these alternatives rather than deposit accounts or stock market investments. European countries like Germany, Italy, Spain, France and Belgium have seen explosive growth in the market for structured products, a market that is dominated by retail banks, post offices and insurance companies, through their branch networks.
Pricing
Structured products consist of a combination of two positions: a bond component that provides investors with protection of the capital invested, and an option component, providing investors with an opportunity to participate in the market of the underlying investment, without assuming all the associated risks.
The type of bond used to guarantee the amount of capital is called a 'zero coupon bond', an instrument that is traded at a discount (below par value) and which on maturity pays out the par value, i.e. 100.
Since the bond is purchased at a discount, the 'discounted interest', i.e. the amount of money left over, will be used to purchase an option on a chosen underlying instrument.
The features offered by structured products depend on the pricing of the zero coupon bond and of the option, the prices of which are influenced by factors such as interest rates, market volatility of the underlying and the duration of the product.
Structured products' role in portfolio management
Over the last years, investment managers and financial advisers are increasingly positioning structured products as an asset class in their own right.
The risk and return characteristics of structured products give financial advisers the possibility to expose cautious investors to high-risk instruments without exposing them to the full implications of the associated risks to the capital invested.
Structured products can also be used to hedge positions in an investment portfolio. Investors having exposure to a particular stock market index, currency, particular equity and to some extent, even interest rates, may continue to increase their exposure further while at the same time protecting their capital. The development of fund-linked structures defied the perception that structured products are passive investments.
Structured products are positioned as actively managed investments, providing investors with the opportunity to access different fund managers, without paying any initial fee. The latest innovation is the multi-asset class structured products, linking the potential return to different, non-correlated asset classes in the market.
The sky is the limit and the range of asset classes these structured products may be linked with is unlimited, from equities to fixed income, commodities, real estate, currencies, interest rates and hedge funds. Through these multi-asset class structured products, retail investors will benefit from further diversification in terms of asset classes, with a relatively small amount of money.
Even though some of these asset classes may be traded in different currencies, the mechanism behind structured products enables investors to have an umbrella structure denominated in one currency, the currency of the structured product.
Any appreciation or depreciation of the underlying investments' currencies against the currency of the structured product will have no impact on the return of the product, as the return is based on the positive performance of the underlying investments.
The future of structured products
To improve the transparency of structured products in Europe, the leading players formed the Derivative Forum in Germany in 2005, a local trade body aiming to provide a risk rating service in the market.
To underpin the transparency process of structured products, major stock exchanges in Europe, primarily the London Stock Exchange and France's Euronext, started to offer listing opportunities for structured products. Others, like the Swiss, Italian and Frankfurt stock exchanges have followed suit.
The key drivers to the future growth of structured products will be structuring capability and product performance. As product providers, we should play our role in designing innovative products in line with the market trends. Structured products should provide a medium for the retail investors to access exciting markets and different asset classes.
Last but not least, product performance will be the main driver in determining whether the market will continue to expand.
Mr Agius is manager, Investments Wealth Management, Bank of Valletta plc