Different Terms in Financial Products in Market
October 3rd, 2008 by ALVIN SOONG
Note the different terms in plans out in the market, esp the difference between capital gaurantee and capital protected.
1) Effective rate of return
Most structured products pay a guaranteed minimum rate. Some pay this out as a lump sum - after a period of time - into the deposit, for example, after the first year. Because of the short span of time, the returns will appear inflated. The smart thing to do is divide this by the total number of years to get the effective rate of return.
For instance, if the bank pays 8 per cent after the first year and the tenure of the product is four years, the effective interest rate is 2 per cent per annum.
In fact, many investors may be unaware that the first payout of, say, 8 per cent, is taken from their investment. The bank had simply returned some of their money. They will see a profit, if any, only at maturity.
Any investor who liquidates the product the day after receiving this first payout will find that his investment has dropped by 8 per cent.
2) Types of ‘observations’
The higher returns of structured deposits are linked to the performance of an underlying investment. This ‘performance’ is measured at intervals known as observations which, in turn, dictate how the returns are paid out.
For example, if a structured deposit has only one observation throughout the life of the deposit, the odds of getting the higher return hinge solely on that one event. This, of course, reduces significantly the odds of the investor earning a higher return.
Structures that have more observations - for example, daily observations - thus give the investor greater odds of earning a higher return. The easiest way to picture this is to think of the number of spins one can have at a game of wheel of fortune. Single-observation structures are like single spins while daily accrual structures give the investor multiple spins of the wheel.
3) Frequency of payouts
The more frequent the payouts, the earlier the customer will get to enjoy returns.
Hence, if an investor is comparing two long-tenure structures with similar maturities, the structure with quarterly payouts will be better than the one that pays the return only at the end.
4) Choice of underlying investment
The golden rule here is: greater returns can be achieved only by taking on more risks. Its corollary is: the more complicated the underlying structure, the higher the risk taken. So, know the type of risk you are taking by understanding what is the underlying investment.
For instance, if the underlying instrument is currencies, your exposure is to forex risks; if it is gold, oil, or metal, you are exposed to commodity prices.
5) Callability
Callability means that the issuer may terminate the structure before the maturity date. Callability is often used as a sweetener by the financial institutions in long-term structures as it gives investors the chance to get their money earlier than the maturity date.
The other way to grasp this is that the bank gives itself the option to buy you out via an ‘early redemption’. If your investment is doing well, your profits will be limited if such a ‘cap’ kicks in.
Banks make this sound like it is an advantage to you when you get your money sooner. In fact, you’re better off with the option of holding on to your investment if it is generating high returns. Think golden goose.
6) Reference entities
Investors should become familiar with the primary reference entities, usually well-known financial institutions, that are linked to the structured products they have bought.
Usually, they are highly rated entities but we know now that even their fate can change drastically over a short period. Investors should be aware of the credit ratings of these entities as they would give an indication of their financial strength.
7) Credit event
A credit event is a financial term that is broadly used to describe a change in a borrower’s credit standing or an actual default in payment that will affect the payoff or value on a structured product.
A credit event could include bankruptcies (as in the Lehman case), defaults on a loan agreement (as in the sub-prime fiasco) or if a creditor raises doubts about a debtor’s ability to meet loan obligations.
By far, bankruptcies are the most common credit events.
A ratings downgrade by credit- rating agencies such as Standard & Poor’s or Moody’s on a particular bank or financial institution can also trigger a credit event.
Bottom line: You need to understand what a credit event is since it is an additional risk factor to consider when buying a structured product.
If you feel that an underlying stock is in danger of triggering a credit event, you can then take appropriate action early.
8) Capital protected
When you buy a fixed income instrument, be it a deposit or a bond, your capital is typically protected until maturity. Usually, the principal sum is invested in safe investments like bonds which, on maturity, are expected to provide the 100 per cent capital protection.
You will of course need to hold the instrument until maturity, to ensure that your capital is returned to you, provided nothing happens to the issuer of the instrument.
Bear in mind the possibility that the issuer and/or the underlying safe investments may default. If that happens, how your capital is paid back to you depends on where you stand in line as a creditor.
On the other hand, if you terminate your holding before maturity, early termination fees may apply. You will then get back less than your capital sum.
9) Capital guaranteed
In this case, the guarantee is usually provided by a third-party financial institution. If there is a 100 per cent capital guarantee on a fund, the third-party guarantor or the insurer will provide the 100 per cent capital guarantee at maturity regardless of the performance of the underlying investments in the fund.
In the event that the issuer of the instrument goes bust, your capital is guaranteed. So, where’s the risk? If the guarantor - the third-party financial institution - defaults, that’s where the buck stops.
The issuer typically pays a fee to the guarantor. This fee is then taken off the returns of the instrument. This explains why capital- guaranteed structures tend to either cost more or give lower returns.
Back in 1999, the first ‘more cautious’ generation of structured products were capital-guaranteed, so they were low-risk but the returns were low too.
So if you have invested in a capital-guaranteed product, you have an additional layer of protection, compared to a capital-protected product. This is because in the event the instrument goes bust, your capital is guaranteed by a third party.
In the case of a capital-protected product, the capital is not guaranteed but the issuer tries to place sufficient protection in the structure so as to limit the loss of capital.
Of course, for both capital-protected and capital-guaranteed products, there is nothing to stop either the issuer or the guarantor from going under.
Extracted from Sunday Straits Times
