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Structured Notes

Structured notes are financial products that appear to be fixed income instruments, but contain embedded options and do not necessarily reflect the risk of the issuing credit. These options may be 'plain vanilla' or they may be highly leveraged exotic options. Due to the fact that each one is unique, the risks inherent in any one structured note may not be obvious.

Bell Canada 10.00% 00-14 bonds represent a plain vanilla structured note. The issuer sells the lender a "deep out of the money" option to extend the maturity of the bond to 2014 from 2000. The investor assumes Bell credit risk through out the term of the bond.

Plain vanilla structures include callable, puttable, retractable and extendible bonds. These types of structures are fairly common and most investors do not consider them to be structured notes in the sense of derivative exposure.

Structured notes may be used prudently to mitigate the risks to a portfolio of a systemic shock. An example would be to insulate against the effect on the Canadian dollar of a win in a referendum on sovereignty by Quebec Separatists. A structured note could be purcahsed with an embedded Canadian dollar put versus the US dollar. It would be prudent to hedge the currency risk of this event with a structured note along these lines. The premium would be considered insurance, as opposed to speculation.

Structured notes may also be used by investors to expose their portfolios to asset classes or markets in which they can not directly invest due to investment mandates and regulatory restrictions. Due to the fact that the note looks, and smells like a bond, with a credit exposure that makes it appear a solid credit, many investors utilize them to get involved with asset classes and markets outside of their general scope of business.

For example, let's say that Uncle Pipeline issues a structured product, the FinPipe 16.50% Six-Month Note. The investor takes the credit risk of a major financial institution (the stalwart Financial Pipeline!), giving the note a AA(H) credit rating. The investor actually owns a leveraged exposure to the equity of a TSE 300 basket of stocks.

The concept underlying the note is that in a time of market uncertainty the investor may realize a cash benefit from the high premiums for options on individual stocks or a basket of stocks. The payoff is either 16.50%, or common stock if the stock is at or below a certain level. If, however, the market rallies, the coupon payoff decreases significantly.

Many of these notes can cause the investor to lose part or their entire principal. Many investors are not aware of the inherent risks when buying a structured product. Structured notes have grown in popularity as investors find it increasingly difficult to utilize derivatives overtly in their portfolios. As with any product with derivative exposure, the investor must understand the costs, cash flows and risks inherent in the product before making any purchase decision.

 

 


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