An Introduction to Structured
Finance
First, of course, the legal
disclaimer
Please note that the
information in this guide is not to be used as consulting, accounting, or legal
advice. The following information is provided with the understanding that this
article is not a substitute for professional advice, and is merely for
informational purposes. BizPlanDB.com is not responsible for the use of any
information contained below or for the factual accuracy of any statements made
below.
The Article
Fixed income rivals the size of
the equity markets, although far less common interest is paid to bonds than
stocks. Almost everyone has had an experience with a fixed income product. As a
kid, you may have received a
Interest on bonds can be
delivered in two methods. Some bonds pay interest on a yearly, semi-annually, or
quarterly basis while other bonds sell at a discount and receive zero interest
payments over the life of the bond.
Bonds trade in secondary
markets much the same way that stocks trade. When you purchase a stock on the
open market, you are not giving your money to the company directly. The money
that you have given to purchase a stock is given to another investor who is
selling their shares to you. Only during an initial public offering is money
given directly to the issuing business. The same is true of publicly traded
debt.
Bonds are traded much in the
same way that stocks are traded. There are several exchanges that trade debt,
and there are also several auctions that are held by the government. Bonds also
trade on margin, and usually to a much higher extent than stocks. Most
brokerages will allow you to trade bonds with up to ten times the equity in your
account. However, as we know, leveraging an investment can greatly increase the
risk. Bonds tend to trade in less violent swings than stocks and so brokerages
and banks feel comfortable in allowing higher leverage for these instruments. If
you are trading bonds the interest received from the bonds will help offset the
margin loan granted to you from your broker. However, this offset will only
cover a portion of the interest that you owe to your broker, and it will never
fully offset your margin borrowing costs. Your brokerage firm will always charge
a higher rate to you as a margin borrower than the interest received from a
treasury security. Corporate and foreign debt have lower margin levels since the
risk associated with holding these bonds are significantly higher than holding
U.S. Treasury debt.
Overall, bond trading is more
complicated and more expensive than trading stocks. Among retail traders, stocks
tend to be more popular as they have fewer complexities than bonds. When an
investor looks at a bond, he or she must evaluate the credit risk, the market
interest rate, and the underlying business.
Structured financial products
are investments that allow companies to raise capital for profit generating
projects or working capital. These finance vehicles are very similar to
convertible bonds in that they carry features that are not found in traditional
bonds or other debt instruments. In some instances the structured product that
you purchase may carry a convertible feature. Much like convertible bonds,
structured finance notes offered by companies typically carry these features as
a means to entice investors to invest in their debt structure. The companies
that raise money in this fashion typically are higher risk companies that would
not normally be able to borrow through traditional lending routes. The added
features to these debt instruments are often offered as a means of decreasing
the risk associated with holding debt.
The American Stock Exchange is
a popular exchange for these instruments. Occasionally, the New York Stock
Exchange handles some of these issues, and they can be purchased as easily as
purchasing a share of stock. These issues tend to be thinly traded, and so you
may have to pay a large spread on the trade.
Earlier in the text, the Index
Powered CD was discussed as a means for enjoying the returns of the stock market
without having to take a capital risk. This product is a great example of a
structured product. Additionally, the creations of portfolios that have these
attributes are extremely mathematical and complex and it is to your advantage
that you can acquire these instruments without having to construct the
underlying portfolio. In this scenario, a derivative is purchased and the
balance of the loan is invested in high grade corporate debt or government
securities. Upon maturity the loaned funds have appreciated to an amount equal
to the face value of the structure product. If the derivative did not make a
profit then the investor will have broken even on the certificate of deposit. If
the derivative has appreciated in value then the investor will receive a payout
in addition to the return of their principal. Risk for this investment is
related to the rate of inflation. There is the possibility that a profit payout
will not be made, and as such the time value of money may have decreased since
the certificate of deposit has been issued. However, this risk is rather small
because the derivatives that are purchased for the CDs are usually linked to a
broad index of stocks. Inflation usually has a positive influence of the prices
of stocks. As stated earlier in the text, complicated mathematical models are
used to determine the pricing of these securities and an attempt to recreate
these portfolios may be difficult.
As stated earlier, it is
possible to invest in the stock market without losing your initial principal
over the long run. In fact, despite the highly mathematical nature of these
instruments, it is possible to recreate a principally protected structure in
your own investment account. Let’s take a look at a simple example. Imagine that
you want to be able to profit from an increase in the value of the S&P 500 index
without having to risk your principal. Today the value of the S&P 500 index is
1171. In the last decade a tracking stock known as the S&P 500 Spider is
available for investors to purchase. This stock trades in value equal to
one-tenth of the value of the S&P 500 Index. This equates to a Spider price of
$117.10 per share. If you wanted to experience the gain or loss of the S&P 500,
you could simply purchase shares of this trust and, you would make or lose money
depending on the movement of the stock. But, you don’t want to take the risk
that you could lose money should the market turn against you. Let’s imagine we
have $120,000 to invest. If we wanted to buy the stock outright, we could
purchase roughly 1000 shares of the index tracking stock, or we could do
something else. Today, a two year, at-the-money call option on this index trades
for $14.30 per share. If we wanted to replicate the profit of the index, we
could purchase $14,300 worth of call options. If the index increases by an
amount greater than $14.30, then our position will become profitable. Should the
stock decrease, we would only lose the value of the call options and no more.
However, that is a pretty significant risk to take since the index must rise by
a pretty large percentage, and since we are no longer in a boom period, it is
very possible that we would not make any money on this trade. However, if we
take the $120,000 that we have planned to invest and purchase a zero-coupon
Treasury bond along with the call option, we can take zero risk and still make
the profits from a rise in the index. In this example, we will assume that the
current Treasury rate is 5%. This strategy will require an amount of capital
equal to the value of the S&P 500 index times the amount of shares that you
would want to purchase. This strategy must be done in lots of 100 shares since
call options are always sold in this denomination. When we purchase the
zero-coupon bond, the interest received from the note will pay for our call
option. The dollar amount of zero-coupon bonds that we will purchase must earn
enough interest so that the value of the bonds will cash out at exactly the
current price of the index. I know that is a lot to handle, so let’s take a look
at it mathematically (Please note that this example makes not reference to taxes
or commissions):
Custom-made Principally
Protected S&P 500 Note
Bond Portion
We start with $120,000.
We purchase a five year 5%
zero-coupon note for $91,750.00
After 5 years the bonds will
appreciate to $117,100.00
The interest received over the
five year period will be $25,350. This interest will be used to pay for the call
options over the five year period.
Call Option Portion
After the bond purchase we have
$28,250 in our account.
We purchase 1000 two year call
options for $14,300.00
Overall Portfolio
We have 1000 two year Spider
Call options worth $14,300.00
We have $91,750.00 worth of 5
year zero-coupon bonds.
We are left with $13,950.00 in
our cash account.
This brings us to the $13,950
of cash left in our account. This leftover capital will be invested in a sweep
account that pays the 5% compounding interest rate. Over the two year period of
holding the call options, this remaining capital will earn $1,429.00 of
interest. We will use this money when we purchase another set of call options
after the current options expire.
For this position, we used
slightly more capital than was needed. If you are going to be employing a more
sophisticated method of investing then it is a good practice to always have a
small cushion of capital for unexpected purchases or costs.
After we set up this position
there is nothing else that needs to be done. Later, I will show you how to trade
this position, but you can leave it just as it is and only look it on the days
on which the options will expire.
As you can see, the interest
received on the zero-coupon notes almost full pays for the risk capital. The
amount of interest gained will not fully cover the cost of risk capital over the
five year period, but the additional risk capital that we must invest is a
rather small amount. If done properly, you can limit you risk exposure (over the
five year period) to under 3% of the total value of the portfolio. This strategy
is probably best done in an IRA account since the taxes from interest and
capital gains will not be taxed until you begin to withdraw the money for
retirement. As always, it is prudent to consult a tax advisor before you engage
any investment activity.
One of the better aspects of
this strategy is that you can consistently lock in gains should the value of the
index rise. If we had purchased the index in the form of stock then it would be
impossible for us to lock in gains while continuing to hold the position. For
instance, if we had purchased the shares at 117.10 and they had appreciated to
150.00 then we must sell out the entire position in order to reap our profit. If
we wanted to continue to hold the position then we would have to repurchase
those shares, and should they decrease in value then we would lose our profits.
In this strategy we can do something differently. Let’s imagine that the S&P 500
index increases greatly over a one year period due to a period of economic
expansion. For this example, we will assume that the index has risen from 117.10
to 135.00. This equates to a 15.2% increase in value over the one year period.
According the Black-Scholes Theory, a rise of this magnitude would cause the
value of our options to increase from $14,300 to $28,350. If we wanted to lock
in some of this gain, we could sell the options and receive the $28,350 and
immediately repurchase another 1000 call options at the strike price of 135 for
$18,365. We would realize a gain of $9,985. This gain is ours to keep because
even if the index were to decrease in value to the original price of 117.10, our
interest from the bond portfolio would continue to fund our option purchases.
This is the best way to trade this type of portfolio because you can continually
lock in gains as the index increases in value.
Let’s take a look at the
portfolio as the options expire. Now that the two years has passed and the
options are worth their intrinsic value, we can see how our portfolio has
changed. For this example we will assume that the S&P 500 index has appreciated
at a rate of 9% per year. In other words, the index has risen from 117.10 to
139.12. Since we purchased our call options with a strike price of $120, our
call options will have a value of $19.12 per share.
End of Two Year Investment
Cycle
The call options expire with a
value of $19,120.
The interest gained on our
bonds and cash is $11,569.
Our net profit is $16,389.
If we had purchased the Spider
shares outright, our net profit would have been $22,020. We made less than this
amount, but we did not have to take nearly as much risk in order to make 75% of
the return. Again, this investment was not completely risk free. The
differential between the cost of the call options and the interest received was
$2,731. This risk correlates to 2.2% of our portfolio.
In the next example, we will
look at what happens if there is a decrease in the value of the index. For our
example, we will use a severe decline in the market so that we can see the
benefit of having a principally protected portfolio. Earlier this decade, we
watched the S&P 500 decrease from 1500 to 800 in less than two years. If you had
purchased at this peak, you would have watched nearly fifty percent of your
portfolio vanish. The index has not returned to this point, and if you had
invested at the height of the market – you would still be holding losses today.
However, if you had purchased the principally protected portfolio then you would
only experience a minimal loss. Let’s take a look at what happens when a major
index suffers a major decline. For this example we will assume that we started
this investment when the index was at 1500, which corresponds to a Spider price
of $150. We will also assume that we will purchase this portfolio to correspond
to purchasing 1000 shares of the Spider stock. This portfolio will require
$150,000 of investment capital. As always, our options will have a time horizon
of two years until expiration.
S&P 500 Note – Index @ 1500.00
(Start)
We purchase 1000 call options
for a cost of $18,436.
We purchase $117,528 of
zero-coupon bonds (5 Year).
Our Cash Balance is $14,035.
Now let’s see what happens when
the stock index declines from 1500 to 800 over the two year period.
S&P 500 Note – Index @ 800.00
(End)
The 1000 call options expire worthless.
Our bond gains $12,988.
Our cash balance gains $1,403.
The portfolio has a net loss of $4,045.
This loss correlates to a 2.7% decline in the value of the portfolio.
The S&P 500 Index lost 46.6% of its value. We can see from this example that a
vast majority of our portfolio was protected from losses. If we had purchased
the index in the form of stock we would have lost seventeen times the amount of
money then if we had purchased the principally protected note.
One of the main perks to this strategy is that if an event like the
one described above happens then you can easily repurchase the portfolio and
make a profit as the index rises. For the next example we will repurchase the
portfolio when the index is at a value of 800. The above example caused our
portfolio to drop from $150,000 to $145,955. Since the index is now at 800, the
corresponding Spider price is $80 a share. We assume that volatility levels and
interest rates have remained the same. According the Black-Scholes model, the
corresponding two year call option price on the Spider stock is $9.83 a share.
Remember, the model really only gives a very good estimation of what the options
should cost. In reality, the price will deviate from that number and the model
should really be used only to create an estimation of what you should be paying
for an option. Our portfolio has not changed much since the expiration of the
options. We are still holding our bond portfolio. Our options have expired with
no value. Our cash balance is now $4,045 smaller. Let’s break down what is in
our portfolio:
Our zero coupon bond is worth
$130,516.00
Our cash balance is $15,439.00
Over the next two year period,
our bonds will gain another $12,988. However, the cost of 1000 call options at a
strike price of $80 is only $9,830. We can use the entire amount of interest
income to purchase options, so instead of purchasing 1000 call options we will
now purchase 1300 contracts. Now let’s see what we have:
S&P 500 Note – Index @ 800.00
(Start)
We have zero-coupon bonds worth
$130,516.00
We have 1300 call options at a
value of $12,988.00
Our cash balance is $2,451.00
This is a real world example. The S&P 500 Index rose from 800 to 1150
over the two years following the very steep decline. Let’s take a look at our
portfolio at the after the option expiration:
S&P 500 Note – Index @ 1115.00
(End)
Our zero-coupon bonds gains
$12,988.00
Our 1300 call options gain
$32,512.00
The cash balance earns $251.22
of interest.
Our net profit is $45,751.22
Since this is the second round
of call purchases in our five year portfolio, we must peg this gain against the
loss we took when the index declined. So, our total gain in the portfolio is
approximately $41,706. Remember, we started this portfolio when the S&P 500 was
at 1500. If we had purchased 1000 shares of the Spider stock then we would still
be holding a $35,000 loss. Instead, we were able to make a 27% return on our
initial $150,000 investment despite the fact that the index was still well below
the level from which we started. Now, that’s just good investing.
Another feature of this
investment is that we can borrow against the value of our bond and cash account.
Most brokerages will allow you to borrow 90% of the value of the bond, and our
cash account is always available for withdraws. Of course, the loan will have a
higher interest rate than we will receive on the bond. Therefore, the dynamics
of the portfolio will change should you chose to borrow money against the debt
and cash of the account. It is not recommended that you do this since the
interest expense from the margin loan will create a portfolio that is no longer
principally protected. Essentially, the portfolio’s profit/loss will be based on
the movement of the call option. As I stated before, it is best to borrow
against the value of the portfolio only if you need the money or that the money
you borrow will be reinvested at a higher rate. Stock options do not have a loan
value and cannot be pledged as collateral for a loan.
There are drawbacks to creating
principally protected notes. First, the expenses will be higher. Our example
excluded commissions, and if you purchase this portfolio then you will certainly
have to pay a large commission for the call options. A typical discount
brokerage will charge a base commission plus one dollar to two dollars per
option contract. The above transaction would probably cost around thirty to
fifty dollars. Additionally, there is a spread associated with the purchase of
call options. You will most likely pay about twenty dollars per contract for the
bid-ask spread that is created by the market maker. This spread compensates the
market maker for the illiquidity of longer dated options. In total the cost for
establishing a 10 contact option position will cost approximately $250. The bond
potion of the portfolio will also have a commission expense. The second drawback
is that options do not receive dividends. If this strategy is used for a single
stock transaction then you may be missing out on a good portion of the expected
return, and so this strategy is not really appropriate for slow moving blue chip
stocks that pay dividends.
Another drawback to this method
of investing is that you may not gain the entire return of the index should the
market increase greatly. In the above examples we saw that we gained, on
average, about 75%-80% of the gain on the index. This is the trade off for the
principally protected feature.
The above strategy is one of
the least complex principally protected strategies. Most index and stock linked
notes have many more attributes that are beyond the scope of this book. This is
not the only type of principally protected note that you can purchase. The key
to building these custom instruments is to allow yourself to reinvest the
interest you will receive from a debt instrument into a derivative equity
option. It is possible to even make these notes based on the movements of
individual stocks, but it may require that you invest additional risk capital to
cover the difference between the cost of a call option and the interest
received. Volatility will be the determining factor as to how much additional
risk capital will need to be employed. Higher volatility will lead to a higher
risk cost.
These notes can be structured
so that profits are made in a downturn of an index/equity’s value. Put options
are purchased instead of call options. If you feel that the market is heavily
overvalued, it is possible to take this position in lieu of a short position. In
the long run, stocks always have had a tendency to rise, and taking a position
that profits from a market decline will usually work against your favor. Let’s
quickly run through an example. We will use the numbers from the above example
for the sake of simplicity. The amount of capital needed is still equal to the
value of the Spider stock multiplied by the number of shares that we would want
to purchase or sell short. For our example, we will use the same 1000 share
increment. Again, we will use two year put options. Let’s take a look at our
starting and ending portfolios:
S&P 500 Note with Put Options –
Index @ 1500.00 (Start)
We purchase $117,500 of
zero-coupon bonds (5 years).
We purchase 1000 put options at
a cost of $13,500.00
Our cash balance is $19,000.00
S&P 500 Note with Put Options –
Index @ 800.00 (End)
Our bond gains $12,988.00 of
interest.
Our cash balance gains
$1,947.00
The put gains $56,500.00
Our net profit is $71,435.00
This profitability is only
achieved in a very violent swing. The index moved down 46.6%, and our account
correspondingly gained 47%. Again, these examples exclude applicable costs and
taxes.
Another possibility is to
create a principally protected straddle (purchasing both put and call options)
so that a move in any direction will create a profit over the life of the note.
Of course, in this strategy you would only be profitable on one side of the
investment. Any number of
combinations is possible with this type of investment strategy.
Index linked and equity linked
notes are similar to the Index Powered CD. Instead of being offered by smaller
commercial banks, they are issued by large investment banks. These notes are not
FDIC insured since they are not issued by a commercial bank. However, they may
be backed by the issuing investment bank in the case that the note has a
principal protection feature. If you purchase an index linked note, you are
loaning money to the investment bank. The yield on these loans is dependent upon
the change in value of a certain index such as the S&P 500 index. The amount
loaned to the investment bank appears on the bank’s balance sheet and is backed
by the credit quality of the issuer. Since only established investment banks
have the ability to issue these notes, the credit quality of the issue does is
not a major factor in determining investment suitability. It would be highly
unlikely that a large bank would default on these credit notes.
Structure products trade on the
national exchanges under ticker symbols and can be purchased as easily as
stocks. The daily volume of these issues is usually small so the bid-ask spread
may be excessively large. Although they are traded on the NASDAQ and NYSE, the
majority of structured products are bought and sold through the American Stock
Exchange. If you are interested in structured products then you should look into
opening an account with a broker that has access to this exchange.
Structured finance products are
very good investments because they offer the protection and income of a debt
instrument with the yields associated with an equity purchase. The risk
associated with these investments is determined by the nature of each note.
Since they contain elements of both equity and debt, it is important to analyze
the balance sheet, credit quality, and income growth of each business. Not all
structured finance vehicles are principally protected. Arbitrage is possible
within structured finance and it usually comes under the umbrella of capital
structure arbitrage. In this form of arbitrage, both equity and debt are
purchased and sold short in order to create a profit potential that may exist
with the fluctuation of value in these instruments.
Convertible arbitrage hedge
funds often deal with structured products because it offers a great amount of
versatility for the fund managers. Some of the notes that you can buy have a
convertible feature. Companies are now going directly to hedge funds to sell
their subordinated debt because it reduces the time needed to fully sell the
issue. The downside aspect for the company is that in all likelihood the value
of the share price will decrease as arbitrageurs short sell the stock to offset
the credit risk. However, the upside is that the capital received will be used
to finance profitable projects for the long term so the decrease in price is
only a short term effect of a new debt issue.
The amount of return that can
be achieved with a structured product is limited. Index linked notes may cap the
maximum gain on a monthly or yearly basis. From my research, I have found that
the average index linked note has a cap of about 18%. This is still a very
generous payout considering that indexes rarely rise at that rate. It is not
very often that a major index rises by an amount greater than 18% a year and
some of these notes have no upside potential cap.
Amplification of index and
equity returns is another feature of certain structured notes. These are very
attractive investments when the market seems to have no bias. The best example
of an index amplified note is the ARES type note offered by Credit Suisse First
Boston. In this structured finance product, CFSB pays out a rate of return that
is three times the rate of return produced by the S&P 500 index. The current cap
is 18% per year. During times of low market volatility, this is an extremely
attractive investment, as you may receive a return that is substantially higher
than the return of the overall market. The method of accomplishing this type of
return is extremely complex because it involves a complicated series of debt
investments coupled with an even more complicated array of futures and options.
Arbitrage is possible with this type of security because you can purchase notes
of the S&P while shorting an equal number of shares so that you will earn two
times the increase of the S&P assuming the value of the index does not increase
above 18%.
Great investing is simply about
limiting your risk while still enjoying a healthy amount of return. In the above
scenarios, we can see that we can take a very small capital risk but still
create wealth for ourselves. While it is true that higher risks can lead to
higher returns, the frequency of these vastly profitable scenarios is rare.