Structured Notes Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Structured notes are a debt-based type of structured product, which the Securities and Exchange Commission (in rule 434) defines as

securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor’s investment return and the issuer’s payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows.

Those embedded components may be straightforward or may include exotic options; there is a wide variety of structured notes.

Structured notes originated with, and are still issued primarily by, investment banks. Investment banks wanted to increase the appeal of convertible bonds— bonds that could be converted into shares of the company issuing them, at a particular predetermined ratio, which encouraged investors to accept bonds of lower interest rates in exchange for the possibility of a higher profit after such a conversion. Because that higher return to the investor is tied to a greater success for the company, convertible bonds are an especially appealing way for investment banks to raise funds. Some such bonds were structured with additional features, such as risk protection or extra income; sometimes these extra features came with extra limits of their own, making structured notes potentially complicated, full of contingencies and multiple paths, always preserving a balance between investor appeal and a high profit margin for the investment bank. Such notes can be tailored very specifically to different types of investors.

Structured notes combine a debt security such as a bond with various derivatives, usually options.

Most do not guarantee repayment, for instance if the company should go bankrupt; some offer guaranteed protection of the principal investment, in whole or in part, as a feature. The exotic options may include shout options (allowing the investor to lock in the price of the note at any time), capped-style options limiting the profit (to offset some investor benefit and preserve the issuer’s profit margin), or involve one of the so-called mountain range options pioneered in the late 1990s, in which the value of the option depends on the performance of multiple underlying assets in the “basket.”

Bibliography:

Erik Banks and Paul Siegel, The Options Applications Handbook: Hedging and Speculating Techniques for Professional Investors (Wiley, 2007);
Espen Gaarder Haug, The Complete Guide to Option Pricing Formulas (McGraw-Hill, 2007);
Andreas E. Kyprianou, Wim Schoutens, and Paul Wilmott, Exotic Option Pricing and Advanced Levy Models (Wiley, 2005);
Riccardo Rebonato, Interest-rate Option Models: Understanding, Analysing and Using Models for Exotic Interest-rate Options (McGrawHill, 1998).

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