Alternative Investments: Structured Products

Structured products are sometimes called 'synthetic notes'.

Synthetics are investment products that combine two or more financial instruments to create a product that artificially behaves like another security.

The advantage of synthetics is that the risk characteristics of the two separate financial instruments can be offset. In the case of structured products, the aim is to generate a product with the low volatility of a bond and the high return characteristics of other products . By using different combinations of instruments structured products can be manufactured to have varying risk/return profiles.

The use of derivatives is an important part of creating synthetic structures. Over-the-counter derivatives, in particular, enable the manager to predefine or tailor the exposure to a particular asset class. The ability to set these risk parameters has obvious advantage when creating synthetic notes.

Although the zero-coupon strategy is the foundation stone, the range of structured products is limited only by the creativity of the structurer.

One popular strategy is to imbed a long call in the note. In this case, the bonds will not actually be purchased unless the underlying securities fail to reach the strike price of the option. At this point, the working capital is lost, but the note is converted into bonds that will allow the investor to redeem the full value of the original capital at maturity.

Some structures may use a synthetic bond, such as a combination of a zero-coupon swap with a letter of credit. This frees up all the working capital from day one. While other strategies use options strategies, both for the upside and to defend the investment floor. These options strategies combat the negative effects of de-leveraging during drawdowns.

The selection of instruments is governed by a range of factors, including the interest rate environment, taxation issues and the time horizon of the investor. Different instruments also offer differing degrees of flexibility to redeem the investment earlier than the maturity date.