Understanding Structured Notes

Structured Notes are structured investment products sold by banks. The buyer of the note can either get principal protection or not get it. This affects the participation that he gets in the other financial products linked to the note. Let's say there is a 1 million USD structured note. To buy the note, client comes and gives 1 million dollar to the bank and the bank issues the 'note'. Now if this note is 100% Principal protected, this means that the holder of the note will get a minimum of 1 million USD at maturity and nothing less with a possibility of achieving higher than market returns. Say he was able to get a 3% return by simply buying the bond for one year. Buying this structured note gives a chance of getting higher than 3% return.

How does it work?

Investment Banks typically have a funding/ALM (Asset Liability Management) desk. This desk basically lends or borrows money to other desks and manages investments in short term instruments in the market to manage the effect on bank's balance sheet. When a note is issued from the bank, the money comes in and is deposited with ALM to get some promised returns. Let's say for our example we can get 3% return. So instead of depositing the whole 100% amount with ALM, only 100/(1+3%) is deposited. This should give us 100% after 1 year. This is the way 100% principal protection is achieved. So we are left with 100-100/1.03 = 2.91% with us today.

This 2.91% then goes into many things. Some of it goes into client income (CI) for the Sales person. Say he wants to earn 50 bps (=0.50%) in this case. Some may be given back to the client as an incentive to invest. This is called Client upfront, say another 50 bps. Thus, client effectively has to deposit only 99.5% of the Note's notional to begin with. Now the rest of 1.91% is used to sell some options to the client with an aim to enhance the coupon to more than 3%.

The easiest way to enhance the coupon is by selling a digital option to the client. Let's say in this case we sell a digital USDJPY put option with a strike of 97, and a payoff equal to 4% of the notional. This option costs approximately 1.91%. If, at maturity, USDJPY < 97, client receives 104% at maturity (100% from ALM and 4% from this option payoff. However, if USDJPY > 97 at maturity, client receives on 100% (principal protected) and the digital option expires worth less. The option that we buy from this 1.91% can vary from digitals to various other option structures and can be structured as per client views.