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This section explains the typical mechanism of product issuance and hedge, and product wrappers with their characteristics.

Issuance and Hedge

When a structured derivative product is issued, it typically involves three parties: investors, an issuer and a derivative desk. The investors buy the product (e.g. a structured note) from the issuer, who subsequently hedges the derivative risks with a derivative desk. The flow is illustrated in Figure 2.4 and described in Table 2.7.

Figure 2.4 Flow of product issuance and hedge

Table 2.7 Flow description

Notes:

¹ Issuer's position can be booked as a floating rate note (with coupon L_f) plus a swap. Net-net this is equivalent to a zero coupon bond plus an option.

² Issuer's total funding level (L_f) includes issuer-specific credit spread (s₁). L_f is an important factor in derivatives pricing given it is included in the swap hedge.

³ If the structured note is callable or autocallable, the swap and funding leg are also callable or autocallable. One needs to assess or value the associated callable effects.

From investors' perspective, in addition to the market risks, the counterparty (issuer) risks in the structured products must be taken into account when they make investment decisions. The pricing of the products must include the counterparty (issuer) risks and it is typically manifested in issuer's funding spread.

Wrapper Categories

Structured products are distributed to investors via different channels in various wrappers. Different wrappers have different features and benefits. In a nutshell, a wrapper specifies what the product will be issued as (e.g. a security or bank saving account), and their subsequent tax and financial protection treatment. Naturally, different jurisdictions have different preferences in terms of meeting investors' needs.

Table 2.8 lists some of the key structured product wrappers and their features.

Table 2.8 Key structured product wrappers

SPVs for Collateral

Banks sometimes set up special purpose vehicles (SPVs) to issue structured products. SPVs can be used to hold collateral, among other tax and rating conveniences. After the SPV issuing a note, it will enter a swap transaction to completely hedge the product payoff. The SPV can then use the proceeds of the issuance to purchase collateral as security for the note principal repayment, for example. If dealers use their own bonds as collateral for the structured products they originated, then when they collapse, as in the case of Lehman Brothers, the value of collateral will also collapse. In such cases, the losses on the structured products are due to the significant decline in the collateral value, even if the derivatives embedded in the products may perform well.

A SPV with good collateral management will substantially reduce investors' counterparty risks. It is therefore very important for SPVs to seek high-quality and safer collateral for structured products.