Describe Structured Financial Instruments

Structured financial instruments comprise a range of products designed to repackage and redistribute risk. They are pre-packaged investments based on a single security, a basket of securities, options, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. They include asset-backed securities (ABS) and collateralized debt obligations (CDOs).

There is no universally accepted taxonomy used to subdivide and classify structured financial instruments. For the purpose of this reading, we look at the following four categories.

Yield Enhancement Instrument

Yield enhancement instruments offer the potential for a higher expected return, subject to increased risk. A good example of a yield enhancement instrument is a credit-linked note (CLN). The note offers fixed coupon payments but a redemption value that depends on the occurrence of a well-defined credit event, such as a rating downgrade or the default of an underlying asset, called the reference asset.

A credit-linked note allows the issuer to transfer a given credit event to investors. If the event does not occur, the investor is entitled to the full par value of the CLN. If the event occurs, the par value of the CLN is reduced by the nominal value of the reference asset to which the CLN is linked.

Participating Instrument

A participating 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). For instance, in 2005, the Italian government issued 15-year floaters with a coupon rate equivalent to 85% of the 10-year constant maturity swap rate. Thus, it gave investors the opportunity to “tie” their returns to the movement of the 10-year constant maturity swap rate.

Leveraged Instruments

These are instruments created to magnify returns and offer the possibility of high payoffs from small investments. A good example of a leveraged instrument is an inverse floater whose cash flows are adjusted periodically and move in the opposite direction of changes in the reference rate.

$$ \text{Inverse floater coupon rate} = C – (L × R) $$

Where:

C is the maximum coupon rate reached if the reference rate is equal to zero;

L is the coupon leverage; and

R is the reference rate on the reset date.

The coupon leverage is a multiple by which the coupon rate changes in response to a 100 basis points change in the reference rate. For example, if the coupon leverage is two, the inverse floater’s coupon rate will decrease by 200 bps when the reference rate increases by 100 bps.

Capital-Protected Products

CPPs offer a guaranteed repayment of principal (upon maturity) as well as the opportunity to participate in price gains of some underlying instruments.

Example: Capital-Protected Product

Let’s assume that an investor has $100,000 available for investment. He can buy a zero-coupon bond priced at $99,000 to receive $100,000 at maturity. He can then use the remaining $1,000 to purchase a call option on some underlying asset. At that point, the two investments can be prepackaged to form a capital-protected product, as shown below:

$$
\begin{array}{l|c|c}
\textbf{Investment} & \textbf{Outflow} & \textbf{Inflow at Maturity} \\
\hline
\text{Zero-coupon bond} & \text{(\$99,000)} & \text{\$100,000} \\
\hline
\text{Call option} & \text{(\$1,000) [premium paid]} & \text{Unlimited upside potential} \\
\end{array}
$$

On one hand, we have the zero-coupon bond, which provides the investor capital protection. At maturity, the investor is guaranteed 100% of the capital invested even if the call option expires worthless. On the other hand, we 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, the investor would lose a maximum of $1,000 – the price paid for the option.

Question

An inverse floater uses the 3-month US Treasury bill rate as the reference rate. As of 31^st March 2019, the US T-bill rate stood at 1.66%. Given that the fixed rate is 20% and the coupon rate changes by a factor of 2 in response to a 100 basis points change in the reference rate, the floater’s coupon rate is closest to:

1. 16.68% 
2. 18.34%
3. 23.32%

The correct answer is A.

Coupon Rate = K – (L × R) = Fixed rate – (Coupon Leverage × Reference Rate)

Fixed Rate = 20%,
Coupon Leverage = 2
Reference Rate = 3-month Treasury bill rate = 1.66%

Therefore, Coupon Rate = 20% – (2 × 1.66%) = 16.68%