Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 18. Structured Securities: Examples

INTRODUCTION

One of the strengths of derivatives is that they can be combined in many ways to create new risk-management solutions. Similarly, banks and securities houses can use derivatives to create new families of investments aimed at the institutional and retail markets. Products can be developed with a wide range of risk and return characteristics, designed to appeal to different categories of investors in different market conditions. The choice is no longer limited to buying bonds, investing in shares or placing money in a deposit account. Derivative instruments can create securities whose returns depend on a wide range of variables, including currency exchange rates, stock market indices, default rates on corporate debt, commodity prices – even electricity prices or the occurrence of natural disasters such as earthquakes.

Some structured products are aimed at the more cautious or risk-averse investor. They incorporate features that protect at least some percentage of the investor's initial capital. Others actually increase the level of risk that is taken, for those who wish to achieve potentially higher returns. A classic (and infamous) example is the 'reverse floater' whose value moves inversely with market interest rates. The problem is that it may also incorporate a significant amount of leverage, so that if interest rates rise the potential losses are enormous. In 1994 Orange County in California lost over $1.6 billion through ...