An Overview of Structured Financial Products

Structured finance deals with lending instruments designed to mitigate serious financial risk associated with complex assets or investments. A complex financial instrument, structured finance options are available to large companies or financial institutions with financing needs that cannot be satisfied through conventional financial products. Structured products appeal to investors who are prepared to invest for fixed periods and yet seek some degree of protection for their capital.

Because traditional lenders don’t offer structured financing, it provides an essential cog in the financial services industry. Structured financial products are pre-packaged investment tools that normally include assets linked to one or more derivatives. A derivative gets its value from an underlying entity or group of assets with predefined features.

Structured finance products provide major borrowers with the needed capital injection when traditional lenders or alternative sources of financing won’t work or are unavailable. Their ability to offer hard-to-reach asset classes’ with customized exposure makes structured financial products a useful complement to traditional options. Typically, structured financial products are non-transferable, which means that unlike with a standard loan, they cannot be shifted between various debt types.

When a standard loan won’t sufficiently cover certain transactions, several structured finance products may be considered. These products range from derivatives to complex investments that refer to multiple financial indices or assets. Also, these products are not homogeneous and include syndicated loans and credit default swaps (CDSs), among others.

Extended by a group of lenders, a syndicated loan provides a credit line to a large borrower. In the syndicate, each lender contributes and shares in the lending risk. Syndicates often include banks, insurance companies, mutual funds, and pension funds.

A credit default swap (CDS), on the other hand, is a credit derivative that covers the buyer against payment default and other risks. In the CDS agreement, the seller commits that, in case the debt issuer defaults, they will pay all the premiums and interest that would have accrued or are due on the maturity date.

Most structured products generally incorporate “options.” This is a derivative product that can give the investor (or buyer) the right to sell or buy something at a “strike price” (at a pre-determined price and on or before a certain date). Also, the options clause may have the investor giving a financial institution the right to sell to them or buy from them something at a pre-determined price.

Nevertheless, many structured financial products come with several associated risks. This particularly applies to products that present potential for loss due to market volatility, similar to options and other assets. Because the performance of a structured product depends on the underlying index’s or asset’s performance, any adverse price movements may lead to a capital loss.

Another risk factor revolves around the fact that investors will generally have no access to their principal for the term of the structured product unless they are ready to incur some loss of the principal. Some structured products, however, come with a principal guarantee designed to offer protection of the principal if held to maturity.

However, in the US, “principal-protected” financial products are not insured by a government agency such as FDIC. This means they may only be insured by the issuer, and if there is a bankruptcy or liquidity crisis, the principal could be lost.

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