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##### Subject 5. Structured Financial Instruments

Structured financial instruments include asset-backed securities (ABS) and collateralized debt obligations (CDOs). They are pre-packaged investments based on a single security and a derivative. They are designed to repackage and redistribute risk.

#### Capital Protected Instruments

They provide profit potential, and also protect your capital investment (fully or partially). A CPI product claiming 100% capital protection assures that investing \$100 will at least allow you to recover the same amount of \$100 after the investment period. If the product generates positive returns (say +15%), you yield a positive return of \$115.

Say you have \$10,000 to invest for one year, and you aim to protect your capital fully. Any positive return above that will be welcome.

U.S. Treasury bonds provide risk-free guaranteed returns. Assume a one-year Treasury bond offers a 5% return. If you invest \$10,000 for one year, your maturity amount after one year will be 10,000 x 1.05 = \$10,500.

Reverse engineering this simple calculation allows you to get the required protection for your capital. How much should you invest today to get \$10,000 after one year? \$10,000 / 1.05 = \$9,523

You should invest \$9,523 today in Treasury bonds to yield \$10,000 at maturity. This secures your principal amount of \$10,000.

You can use the remaining \$477 to purchase a call option on some underling asset.

The T-bond + option can be prepackaged to form a capital protected instrument.

At maturity, you are guaranteed 100% of the capital invested even if the call option expires worthless. On the other hand, you have the call option which provides unlimited upside potential (if the call is in-the-money at expiry) while limiting the downside to the price (premium) paid. In our example, you would lose a maximum of \$477 - the price paid for the option.

A CPI product is easy to design for the investor with a basic understanding of bonds and options. Depending on the investor's appetite for risk, capital protection can be at 100%, 90%, 80%, or less.

#### Yield Enhancement Instruments

Yield enhancement instruments offer the potential for a higher expected return, subject to increased risk. A credit-linked note (CLN) is a yield enhancement instrument that allows the issuer to transfer specific credit risks to credit investors.

Issuers of credit-linked notes use them to hedge against the risk of a specific credit event that could cause them to lose money, such as when a borrower defaults on a loan. Such instrument provide a function similar to insurance.

Investors who buy credit-linked notes generally earn a higher yield on the note in return for accepting exposure to specified credit risks.

#### Participation Instruments

A participation instrument allows investors to participate in the return of an underlying asset. A good example of a participating instrument is a floating rate bond whose coupon rate adjusts periodically according to a pre-specified formula - usually a reference rate plus a risk margin (spread).

#### Leveraged Instruments

They are created to magnify returns and offer the possibility of high payoffs from small investments. A good example is an inverse floater, which is a bond or other type of debt instrument that has a coupon rate that varies inversely with a benchmark interest rate. Investors who purchase inverse floaters will receive interest payments that are adjusted according to changes in the current interest rates. For an inverse floater, the interest rates the investor receives will adjust in the opposite direction of the prevailing rates; thus, when interest rates fall, the rate of the bond's payments increases.

Investors of inverse floaters face interest rate risk, which is the potential for investment losses due to changes in interest rates.

The general formula for the coupon rate of an inverse floater can be expressed as:

Floating rate = Fixed rate - (Coupon leverage x Reference rate)

As with all investments that employ leverage, inverse floaters introduce a significant amount of interest rate risk. When short-term interest rates fall, both the market price and the yield of the inverse floater increases, magnifying the fluctuation in the bond's price.

On the other hand, when short-term interest rates rise, the value of the bond can drop significantly, and holders of this type of instrument may end up with a security that pays little interest. Thus, interest rate risk is magnified and contains a high degree of volatility.