Structured notes

Structured notes are bonds that contain embedded derivatives, usually some type of embedded option.

If the embedded derivative is an option, then either issuer or the holder may be the option writer.

There are a number of ways in which the derivatives are embedded. It is not possible to list all the possibilities (which are endless) but examples include:

  • interest rates linked to an equity index or the price of a commodity
  • repayment in a different currency
  • an interest rate that is a multiple of a benchmark rate, rather than being a fixed premium above it as a floating rate would be
  • an interest rate that rises when a benchmark rate falls and vice-versa (this is called an inverse floater).
  • a repayment of the principal that is linked to the performance of some index.

Certain types of structured notes are purchased by financial institutions and repackaged into investments more suitable for retail investors. Many products that offer exposure to equity markets, but with a limit on losses, are based on structured notes. As consumers (or even the advisers available to consumers) are rarely able to value these accurately, this can be a very profitable business.

Copyright Graeme Pietersz © 2005-2020