A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. Structured products are not homogeneous — there are numerous varieties of derivatives and underlying assets — but they can be classified under the aside categories. Typically, a desk will employ a specialized "structurer" to design and manage its structured-product offering.
Formal definitions
U.S. Securities and Exchange Commission (SEC) Rule 434 (regarding certain prospectus deliveries) defines structured securities as "securities whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investor's investment return and the issuer's payment obligations are contingent on, or highly sensitive to, changes in the value of underlying assets, indices, interest rates or cash flows".
Utility
From the investor's point of view, the concept of structuring means customizing a specified return stream; structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend. From the issuer's point of view, structuring means that a number of existing financial products are combined to achieve the client's desired return function. Theoretically an investor can do this themselves, but the cost and transaction volume requirements of many options and swaps are beyond many individual investors. As such, structured products were created to meet specific needs that cannot be met from the standardized financial instruments available in the markets. The more outlandish the idea and with less time to play out, the cheaper pricing will naturally be (see moneyness).
Two typical use cases: An investor dislikes a specific stock and does not want to hold it in their portfolio, but knows how much regret a 20 percent rise in the stock would cause. Therefore, the investor chooses to purchase a structured product on the stock instead: an agreement ('contract', 'certificate', 'note') with another entity (e.g. a bank) that pays out the full return on the given stock, but only if the stock surpasses a specified threshold, such as this 20%, over a specified time period. This product is known as a market-linked note. Numerous combinations of conditions and assets are available to construct this, see below, and the pricing is then based on past likelihoods and actual occurrences, and current market expectations of such returns happening over such timespans given the agreed constraints. A feature of some structured products is a principal guarantee function, which offers protection of principal if held to maturity. For example, an investor invests $100, the issuer simply invests in a risk-free bond that has sufficient interest to grow to $100 after the five-year period. This bond might cost $80 today and after five years it will grow to $100. With the remaining funds, the issuer purchases the options and swaps needed to perform whatever the investment strategy calls for. See structured note.
Origin
Structured investments arose from the needs of companies that want to issue debt more cheaply. This could have been done by issuing a convertible bond—i.e., debt that could be converted to equity under certain circumstances. 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 would accept lower interest rates in the meantime. However, the worth of this tradeoff is debatable, as the movement of the company's equity value could be unpredictable.
Investment banks then decided to add features to the basic convertible bond, such as increased income in exchange for limits on the convertibility of the stock, or principal protection. These extra features were all strategies investors could perform themselves using options and other derivatives, except that they 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 investment banks was to increase profit margins since the newer products with added features were harder to value, and thus harder to gauge bank profits.