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Structured Financial Products Research Team | Posted On Sunday, January 11,2009, 11:17 PM

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Structured Financial Products



Good things never last long. They come in waves and leave behind unwanted wastes which are picked up by the concerned authorities. It strikes a note similar to the one drafted by the meltdown in the financial market. The investors as well as the governing bodies were swept completely away as the Wall Street succumbed to the 'Greed-is-good' culture. The global financial crisis burst on the scene in August 2007. The last 15 months witnessed over $600 billion of net worth written down by financial firms. This was the aftermath. This was, however, immediately preceded by an era that boasted of sophisticated business processes, leveraged transactions and structured financial products. This was the period when the dealing street woke up to the illusory phenomenon called financial engineering.

Financial Markets:

In these years, the financial markets were flooded by a number of Structured Financial Products which were readily lapped by both institutional and private investors. Although these securities are generally nothing more than a bundle of traditional securities such as bonds and stocks, and derivatives, they offered investors the opportunity to purchase securities that provided more complex pay-off profiles. Besides US, Germany represented an outstanding growth in offering these products to the retail market. Citigroup's YIELD (Yield Income Enhanced Listed Deferred Securities), Goldman Sachs JBWere's GLRs (Growth Linked Return Investments) and Macquarie's ALPS (Alternative Listed Protection Securities) are few examples of such leveraged products.

These products have made inroads in the Indian retail markets over the last one year. What seems remarkable about this product is that the time when it got launched. These products used to rule the US and other foreign markets when the yields on government bonds were high and the cost of buying index options were low, especially in consolidating market. The asset management companies would usually adopt the most conservative path that involved investing in government zero coupon bonds, which sold at a discount and paid zero interest, but gradually compound in value to mature at a higher value. This would get combined with index options to retrieve a bigger pay-off.

The product made a timely entrance in the Indian markets when the party for mostly over at the local bourses. A time when investors were looking at low risk options which would protect their principal amount at least. This however serves the purpose of the high net worth individuals as the ticket size for these products usually remain high. One can pull off this risk mitigating act by putting his investible surplus in to the zero coupon bonds and options strategically and save the asset management fees charged by the companies.

The structure remains same for most of these products as the pay-offs are devised in similar ways across the globe. However, these products can be designed in many ways and can combine the best of the commodities and the currency markets. But as of now, structured products are usually a blend of both the equity and the debt market. The type and levels of sophistication have a long way to go.

A typical layout of such an offer floated by an Indian asset management company goes something like this:

Nature of Debenture:

Unsecured Redeemable Optionally Convertible
Tenor: 39 Months (variable, usually 3 years)
Debenture Coupon: The Interest on the debenture shall be calculated as follows :

  • Step I: The closing Nifty for the 6 dates mentioned below shall be noted.
  • Step II: The 6 Nifty close prices will be averaged (i.e. summed and then divided by 6).
  • Step III: The difference between this average value in Step II and Entry Nifty shall be calculated and expressed as a percentage of Entry Nifty. (Entry Nifty is the closing price of Nifty on the deemed date of allotment).
  • Step IV: 45% shall be applied to the percentage obtained in Step III.
  • Step V: The interest shall be calculated by applying the aggregate percentage figure obtained in Step IV to Rs.10,00,000/- (Rupees Ten Lakhs only) per debenture. In case the interest figure obtained as per the above calculation is less than 0%, the interest payable shall be NIL (i.e. Capital Protected)
  • Step VI: 24% (Assured Coupon) of Rs.10,00,000/- (Rupees Ten Lakhs only) shall be added to the figure in Step V to obtain the final payout.

Debenture Pay-Off :

Assume, Entry Nifty on DA – 6000
Assume, the 6 Nifty closing are – 6500, 6600, 6700, 6800, 6900, 7000
Then the interest on the Debenture shall be calculated as follows :
  • Step 1 : The 6 Nifty Closing Prices are noted
  • Step 2 : Average = 6750
  • Step 3 : (6750-6000)/6000 = 12.5%
  • Step 4 : 45% * 12.5% = 5.625%
  • Step 5 : 5.625% of Rs. 10,00,000/- (Rs Ten Lakh only), i.e., Rs. 56,250/- per debenture
  • Step 6 : 24% of Rs. 10,00,000/- (Rs Ten Lakh only), i.e., Rs. 2,40,000/- per debenture is added to Rs. 56,250/-. So, the final payout is Rs. 2,96,250/-.
Debenture Premium: 2.5% of face Value
Face value: Rs10 lakh

Though it turns out to be an example of simple diversification of funds into time-tested investment avenues, it proves to be a lot more sensible than the products which came out as a result of the 'financial innovation'. If everything sounds perfect, then where's the catch. What made these products a nightmare for the investors? Well the hunky dory tale would meet an abrupt end once the yield on government securities lower or the options become costly. The US players who had launched such schemes substituted the government bonds with their own unsecured securities. This however was clearly mentioned in their disclosure. And it wouldn't have hurt much as long as the street delivered. But to the amazement of some, it failed miserably, flushing millions down the drain. Thus the lessons to be learned by the investor are the same, sounding as old as the art of investment itself: If it sounds too good to be true, it probably is.

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