ABSTRACT

There are various ways in which structured products can be classified, and we are going to discuss them in detail.

1.2.1 History and product development

In the early 1990s, many investment banks thought up new solutions to attract more investors to equity markets. The idea was to create innovative options (products?) with sophisticated payoffs that would he based on all types of assets such as stocks indices, commodities, foreign exchange, and all kinds of funds. Also, banks were looking for intelligent ways to provide investors with easy access to these innovations by issuing wrappers (medium-term notes, insurance life contracts, and collective funds) in a tax-efficient manner. Moreover, it was important to structure a business that was capable of following an issued financial asset throughout its life. Therefore, structured roles were created to compose complex over the counter products, while quantitative analysts developed pricing models to enable traders to hedge the products until maturity. Banks were also conscious of the importance of providing secondary markets that introduced the liquidity the business needed to expand. (See Exotic Options and Hybrids: A Guide to Structuring, Pricing and Trading by Mohamed Bouzoubaa and Adel Osseiran.)

Another school of thought considers that structured investment products came into being because companies wanted to issue debt, implying fewer opportunity

costs to the investors. Traditionally, one of the ways to do this was to issue a convertible bond, i.e., debt that under certain circumstances can be converted into equity. In exchange for the potential for a higher return (if the equity value would increase and the bond could be converted at a profit), investors were willing to accept lower interest rates. However this trade-off and its actual worth are debatable because the movement of the equity value of the company was unpredictable. Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on convertibility of the stock, or principal protection. These extra features were all based on strategies investors themselves could formulate, using options and other derivatives, but these were prepackaged as one product. The goal was again to give investors more reasons to accept a lower interest rate on debt in exchange for certain features. On the other hand, the goal for the investment banks was to increase profit margins because the newer products with added features were harder to value, making it harder for banks’ clients to see how much profit the banks were making from it.