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Structured products: structured products are investments that combine bonds and equities with derivatives--instruments whose value is derived from futures and options to buy, rather than from a physical asset.

This makes them potentially lucrative and relatively diverse, and an increasingly important part of the financial marketplace. Even so, their complexity leads many investors to avoid them.

The products can be made up of I) traditional investments such as stocks and bonds, II) non-traditional investments such as hedge funds, foreign exchange and commodities, and III) financial investments such as options and futures.

We recommend structured products for sophisticated investors who are looking to diversify their portfolio but still require a level of protection. They may not be suitable for inexperienced investors and we therefore recommend clients consult a financial professional to evaluate each product's risk profile.

In my experience, the majority of people who ask about structured products are between 30 and 75 years old and feel they have invested sufficiently in mutual funds, pensions and property and are ready to include something more adventurous.

Capital protected products

A mix of the aforementioned products creates an opportunity to profit from shortterm market opportunities as part of a long-term strategy. Certain combinations can allow the investor to take advantage of upward (or downward) movements in the market while providing partial or full capital protection at the same time.

For example it is possible for an investor to face no downside risk over the lifetime of a product, but to take part in 100 per cent of any upside performance.

This can be achieved by purchasing a zero coupon bond--which makes no regular interest payment during its lifetime, but is issued at a discount against the payout at maturity--and using the discount to purchase a 'call option' or option to buy. The zero coupon bond matures at par, thereby guaranteeing the investor's capital, while the call option maintains the upside exposure required.

For the inexperienced investor, a capital protected product is often the best way of getting to know structured investments. The degree to which an investor participates in the performance of the financial asset, and the risk to capital invested, will vary from product to product.

This will largely depend on the maturity profile, forward interest rates, yield and volatility of the underlying investments on which the asset is based, whether these be currencies, bonds, equities, indices or precious metals (and ignoring any foreign exchange considerations).

To sum up, structured products allow you to invest according to future market scenarios, and can provide an excellent return if these scenarios unfold.

Furthermore, you do not necessarily have to take on additional risk or alter your current investment strategy. Derivatives can easily be incorporated into an existing investment strategy.

Some structured products offer capital protection at expiration as well as fixed interest payments, and can thus be equated with fixed-income investments such as money market instruments or bonds.

Investors relinquish a part of their interest income to exploit a particular market situation.

Other types of structured products offer the opportunity for above-average capital gains, and are thus more comparable with equities.

Advantages

Structured investments can be used to:

* Replace underperforming investments

* Diversify a portfolio

* Access investment strategies not typically available to individual investors

* Manage risks and taxes

Risks

These can include but are not limited to:

* Price fluctuations of the underlying investment

* Substantial or complete loss of the principal investment

* Liquidity restrictions

* Credit risk (Issuer)

* The limited participation in the upside of the underlying investment (Don't forget the use of a structured product is not equivalent to a direct investment in the underlying investment)

* Their complexity means the risk may not be fully explained or understood.

Let's take a brief look at two products from Switzerland's leading banks.

Credit Suisse: CPU Capital Protected Unit

The CPU is a structured derivative that is a defensive alternative to a direct investment in the corresponding underlying asset(s). Given a positive performance of the underlying investment, it gives investors a chance to earn higher returns than with comparable fixed-income instruments, and capital protection at maturity (usually between 90-100 per cent).

The CPU has two main components. The first, a zero-coupon bond, ensures the minimum redemption at maturity. The second, the option to buy, makes it possible to participate in the performance of the underlying asset at maturity.

Influence of interest rates

To achieve the protected minimum repayment at maturity, a large proportion of the money invested in the CPU is invested in a zero-coupon bond with the same maturity. This bond does not pay any coupons. Instead, all payments are included in the repayment at maturity. The interest rate sensitivity of such bonds is higher than that of traditional coupon paying bonds and corresponds precisely to the remaining time to maturity.

Like all bonds, the price of a zero coupon bond moves in the opposite direction to interest rates. The price falls when interest rates rise, as the future capital payment is discounted at a higher rate, resulting in a lower present value. The higher the interest rates, the lower the present value of the minimum repayment. As a result, the price of the CPU drops when interest rates are rising, and increases when interest rates are dropping.

Influence of the underlying asset

The performance of underlying asset influences the option component of the CPU, which determines the participation at maturity.

However, the price's sensitivity to a positive performance of the underlying instrument during the lifespan is relatively limited.

Investors profit only from a positive performance of the underlying asset at maturity. As a result, particularly if the asset rises sharply at the beginning of the lifespan, there remains a certain likelihood that negative performance prior to maturity of the note will reduce the profits again.

Moreover, profits are only reflected in the current price on a discounted basis, since they will only be distributed at maturity.

On the other hand, sensitivity to a falling underlying asset is low too, and even decreases in the event of consecutive plunges. Once it has reached a certain level, the note barely reacts at all to further losses, and investors benefit from the capital protection.

Conclusion

The components of a CPU are influenced by both interest rates and the underlying asset(s). Even when the asset remains stable, the price of the CPU can still vary considerably due to changing interest rates. However, interest rates have less impact on the price of the CPU as maturity nears because the minimum repayment becomes more significant as the remaining time to maturity declines.

In contrast, the sensitivity of the CPU's price to the asset increases as maturity nears. Investors who are prepared to accept slow participation in the underlying asset's performance at the beginning of the term have the potential to achieve attractive returns at maturity.

UBS AG: GROI Guaranteed Return of Investment

This is a structured product combining a fixed-interest investment (capital protection component) with an option strategy (income-producing component). The degree of capital protection set on issue determines the minimum that is repaid to you at the end of the GROI's term.

However, it should be kept in mind that the capital protection does not apply during the term of the GROI, but only when it matures. GROI's have an income-producing component that is also determined when the product is issued. This defines the extent to which the investor may participate in the performance of the GROI's underlying asset(s) and the maximum payment on maturity.

One of the features of GROIs is the fixed participation rate that, depending on the product, can be more or less than 100 per cent. The rate determines to what extent the investor may participate in the performance of its underlying asset.

Important

The aforementioned products are complex and can involve a high risk of loss. This article does not take into account the particular investment objectives, financial situation and needs of individuals. Before entering into any transaction, an investor should determine if the product suits his or her particular circumstances and should independently assess (with a professional advisor) the specific risks (maximum loss, currency risks, etc.) and the legal, regulatory, credit, tax and accounting consequences.

Next month:

How pension changes impact you.

Brien Donnellon

Brien Donnellon is the owner of KEY INVESTMENT, a financial services company providing unbiased financial advice and solutions for Swiss-based expats, HR departments and foreign investors.

The company, formed in 1997, is authorised and regulated by the Swiss Federal Banking Commission.

For further information please visit www.keyinvestment.ch or write to bd@keyinvestment.ch or call 081 257 13 14
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Title Annotation:MONEY
Author:Donnellon, Brien
Publication:Swiss News
Date:Aug 1, 2007
Words:1403
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