Structured products are investments, which are created by combining two or more financial instruments, at least one of which is a derivative...

Structured products are investments, which are created by combining two or more financial instruments, at least one of which is a derivative, to create a single product that replicates market performance.

It is probably safe to say that most investors, who desire to maintain exposure to markets with peace of mind, are interested in structured product with capital protection.

The final outcome of a 100 per cent capital-guaranteed product is the payment to the investor at maturity of the capital initially invested plus the payoff of the embedded derivatives strategy. Thus the maximum downside risk is the loss of interest on the capital invested.

In their early days, capital-protected products were viewed as passive investments to be bought and held to maturity, when the capital protection becomes effective. This perception has radically changed over the years.

Nowadays structured products are investments that can be actively managed either by altering the underlying derivatives strategy or by trading them in the secondary market. As a result secondary markets in structured products have developed and are now commonplace.

Indeed, even a cursory read of term sheets accompanying structured products shows that, most of the time, the issuer undertakes the obligation to offer under normal market conditions a secondary market with a reasonable bid/offer spread. Furthermore, investors often take advantage of the existence of the secondary markets to manage their structured products portfolios.

Activity in the secondary markets for many financial instruments is motivated (other than a desire to obtain liquidity) either by stop-loss or profit-taking.

This relative symmetry does not occur in the secondary markets for structured products, where most of the activity is related to profit-taking. This is not surprising given the capital-protected nature of the products, with protection becoming effective only at maturity.

An often recommended secondary-market strategy is to sell a so-far successful structured product and reinvest the proceeds in a clone. Far from futile, the strategy results in raising the level of guarantee, in effect locking in profits.

For example a structured product launched at par a year ago may be sold on the secondary market for 105 today. If the product is indeed sold and proceeds re-invested in a similar product, the capital guarantee at maturity will be 105 compared to 100 for the older product.

A few words may be in order about the valuation of the structured products prior to maturity, which is reflected in the price in the secondary market.

Take, for example, a structured product that has two components: a zero-coupon bond (which if held to maturity guarantees the full repayment of the capital) and an option strategy. At maturity the investor gets back the capital plus the outcome of the option strategy.

The interim market valuation of the product will be a function of the mark-to-market of the zero-coupon bond and the mark-to-market of the option strategy. Regarding the latter, it is very important for investors to understand that the value of the option will not fully reflect the change in value of the underlying instrument.

In option terminology this is known as the delta of the option which tells us that, until expiry date, for each 1 per cent change in the value of the underlying the change in the option value will be less than 1 per cent, and by how much.

Let us assume that an investor purchases a FTSE-linked three-year note with 100 per cent participation and the FTSE has gone up in the first year by 15 per cent. This does not at all mean that the value of the embedded option has gone by the same amount. The rise in the option value will be significantly less, and the exact amount will be dictated by the delta of the option.

It is important for the issuer of the structured products to explain the valuation mechanism and functioning of the delta. Otherwise investors are bound to be disappointed that the secondary-market price does not fully reflect the appreciation of the underlying asset.

Advice on secondary-market strategies should be viewed as an important part of the after-sale services provided by issuers of structured products.

For this purpose the issuers of structured products are currently building comprehensive data bases that are designed to keep track of structured products sold to clients and their ongoing mark-to-market prices. Further, the issuers should be able develop secondary-market strategies and communicate them to clients.

The issuer of the product is generally obligated by the terms of the agreement to provide a secondary market with a reasonable bid/offer spread. Generally the bid/offer spread is one percentage point and can go to two percentage points when the underlying is less liquid or very volatile (e.g. some commodities). The settlement of the trade usually takes place in three working days.

Thus, the secondary market for structured products is now relatively liquid. An investor can liquidate a product, in most instances expeditiously, and with no significant loss from its real market value.

This is a very positive recent development for structured products. However, this market is still less liquid than other financial markets since the investor is, most of the time, a captive audience for the issuer. More progress needs to be achieved.