Structured product
Also written Structured products
A pre-packaged instrument built on a traditional investment such as a bond or currency, with an embedded derivative such as an option or swap — complex, customised, illiquid and meant for high net worth investors.
In plain language
Take something ordinary — a bond, or an exposure to a currency — and fuse a derivative into it. What comes out is a structured product.
The workbook's definition: pre-packaged instruments essentially linked to a traditional investment product such as a bond or currency, but with embedded derivatives such as options or swaps.
Why bother? Because the embedded derivative can enhance the return on the traditional asset, which is what makes the product attractive. Structures can also give access to asset classes such as commodities, which retail investors find difficult to invest in directly.
The catch is in the same paragraph of the workbook: structured products are complex to design and highly customised, so they are illiquid — and generally suitable for high net worth investors with a high risk appetite.
How it works
Two parts, one wrapper.
| Part | Role |
|---|---|
| Traditional asset (e.g. a bond) | The base: a known set of cash flows from an issuer |
| Embedded derivative (e.g. an option, a swap) | Changes the pay-off — linking it to an index, a commodity or a currency |
The investor buys one instrument and cannot pull the two parts apart.
Why they are illiquid. A plain bond of a given issuer and maturity may have many holders and a secondary market. A structured product is designed for particular investors with a particular pay-off, so there are few natural buyers if you want to sell before maturity.
Why they suit HNIs. The investor must understand the derivative well enough to know what they have given up for the enhanced return, accept that it may be hard to exit, and bear the risk of the issuer as well as of the underlying.
Where it sits. Chapter 2 lists structured products among asset classes "apart from debt and equity" and names them, with commodities and distressed securities, as alternative asset classes.
A worked example
An illustrative structure — the design and numbers are assumptions, not a workbook product. An issuer offers a 3-year note, Rs 10,00,000, that pays no coupon. At maturity it returns the Rs 10,00,000 plus 50 per cent of any rise in the Nifty over the three years. The embedded derivative is an option on the index.
| Nifty over 3 years | Payout at maturity (Rs) | Gain (Rs) |
|---|---|---|
| Falls 10% | 10,00,000 | 0 |
| Flat | 10,00,000 | 0 |
| Rises 30% | 10,00,000 + 50% × 3,00,000 = 11,50,000 | 1,50,000 |
| Rises 60% | 10,00,000 + 50% × 6,00,000 = 13,00,000 | 3,00,000 |
Compare a plain bond from the same issuer paying an assumed 7 per cent a year: Rs 70,000 × 3 = Rs 2,10,000 of coupons, whatever the index does.
So the investor has given up Rs 2,10,000 of certain interest in exchange for a pay-off that beats it only if the Nifty rises by more than 42 per cent (Rs 2,10,000 ÷ 50% ÷ Rs 10,00,000). And if the investor needs the money in year 2, there may be no ready buyer for such a customised note. That is the return enhancement, the complexity and the illiquidity of the workbook's description, in one table.
Why NISM asks about it
Chapter 2 (Securities: Types, Features and Concepts of Asset Allocation and Investing) defines structured products in its list of products beyond debt and equity, and names them among alternative asset classes in the chapter objectives. Expect a definition question (a traditional product with an embedded derivative), a suitability question (high net worth investors with high risk appetite) and a feature question (complex, customised, illiquid).
Common exam traps
- The embedded derivative is the defining feature. A bond without one is not a structured product.
- Options or swaps are the workbook's examples of the embedded derivative.
- Enhanced return is possible, not promised. The derivative can enhance the return; it can also leave the investor with less than a plain bond would have paid.
- Illiquid because complex and highly customised — do not confuse "pre-packaged" with "standardised".
- Suitable for high net worth investors with a high risk appetite, not retail investors.
- They can give access to commodities, which retail investors find hard to invest in directly.
Where this is taught
Free preparation for NISM Series XXI-BRelated terms
- DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
- Embedded derivativeA derivative component hidden inside a non-derivative contract, which Ind AS 109 requires to be pulled out and accounted for separately unless it is "closely related" to the host contract.
- Market Linked DebentureA debenture whose return is linked to an underlying index or security rather than being a fixed coupon; since Section 50AA its gains are short-term capital gains taxed at slab, whatever the holding period.
- OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
- SwapA derivative in which two parties agree to a specified exchange on future dates — typically one pays a fixed interest rate and receives a floating one on an agreed principal that never itself changes hands.
- Distressed securitiesEquity, bonds or trade debt of a company that is near or in bankruptcy, or has suffered a massive credit-rating fall, trading at a steep discount because regulated investors are forced to sell.