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M9A — Structured Products & Structured ILPs

Risk Considerations of Structured Products

Structured products carry layered risks: market (general and issuer-specific), issuer/swap-counterparty credit, liquidity, foreign exchange, and structural risks such as leverage, concentration and collateral, plus legal/regulatory, correlation, modelling and early-redemption risks. Because a product's return is mainly supported by derivatives, a default or price move up the chain flows straight through to the investor — and capital protection is only ever as good as the credit of the party providing it.

7 sections~7 min read

Must-know for the exam

Market risk has two strands: general market risk (economy-wide drivers like interest rates, inflation, FX and commodity prices) and issuer-specific risk (e.g. a credit-rating downgrade, operational, business, litigation or regulatory events).
The fixed-income (principal) leg's risk drivers are interest rates and issuer credit standing; the derivative (return) leg's drivers are the underlying assets, counterparty credit worthiness and FX.
Default means a counterparty's inability to meet an obligation (interest, delivery, repayment) and does NOT require full bankruptcy — a liquidity crunch, permanent financial deterioration or a regulatory prohibition can all cause it.
Counterparty risk is mitigated three ways: use exchange-traded (centrally cleared) derivatives, require collateral on OTC trades (ISDA standardised documentation), and payment/settlement netting.
Exchange-traded derivatives are guaranteed by a central clearing party, minimising counterparty risk — but a small residual risk remains that the exchange itself defaults.
Collateralisation surged after the 2007 crisis: the ISDA survey (released April 2010) reported 78% of large-dealer OTC derivatives collateralised in 2009 (97% for credit derivatives), with ~US$4 trillion of collateral in circulation in 2008.
Institutional liquidity risk = insufficient cash for cash-flow needs (e.g. margin calls); investor liquidity risk = difficulty converting to cash — and a stock-exchange listing does NOT guarantee liquidity.
FX risk arises two ways: a loss of principal when converting a foreign-currency maturity payment home, and a measured return that depends on the FX rate for foreign-currency underlyings.
Worked FX loss: US$1 = S$1.5336 in 2006 vs S$1.3536 in 2022 — a fully USD-protected US$1,000 principal still lost value in SGD, needing ~13.30% total return just to offset the FX loss.
Structured deposits are investment products and are NOT covered by Singapore's Deposit Insurance Scheme, so principal protection is never truly guaranteed — its reliability depends on the protection-provider's credit.
Leverage (gearing) magnifies both gains and losses; a worked option example shows a 20% move in the underlying producing a 60% swing in intrinsic value, and some leveraged trades (e.g. futures) can lose more than the amount invested.
Collateral reduces but does not eliminate counterparty risk — collateral risk is that its value proves insufficient (under-collateralised, or deteriorated after pledging) when called upon.
Legal/regulatory risk is illustrated by the Lehman Brothers Minibonds; correlation risk uses a coefficient from -1 to +1 (+1 identical, -1 opposite, 0 unrelated).
Modelling risk: algo/quant models can be flawed or non-robust — automated trading was a factor in the US Flash Crash of 6 May 2010 (Dow fell ~900 points in minutes; SEC/CFTC joint report Sept 2010).
Early redemption is subject to a market-value adjustment (possible substantial loss) and can be triggered by the issuer or underlying design — callable bonds, breached kick-in/knock-out levels, or shrink-size covenants — with unwinding costs worsening the outcome.
Three key risks can force an early/mandatory note redemption and cause loss of all or a substantial part of principal: issuer credit default, derivative-counterparty default, and loss of value (or issuer default) on the collateral.

Market risk: general and issuer-specific

Market risk is the price volatility that arises when the market prices of the underlying assets fluctuate. In theory a security's market price is the present value of the issuer's future cash flows, but in practice it is largely set by supply and demand. Anything that changes those expected cash flows moves the price, and structured products inherit this volatility through their underlying assets.

Market risk splits into two strands:

•General market risk — economy-wide drivers that affect the prices of ALL securities: interest rates, inflation, exchange rates, commodity prices and the broader economic outlook, because they feed directly into business profitability and cash flows. Given global connectivity, both domestic and overseas conditions matter. These factors are correlated, so their combined effect on prices is often hard to anticipate.
•Issuer-specific risk — factors that hit only a particular issuer's securities, e.g. a credit-rating downgrade, operational risk, business risk, litigation or regulatory action. A downgrade pushes down the issuer's shares and bonds, which in turn makes derivatives written on them lose value. Issuer-specific risk can spread across a whole sector (e.g. a large liability award against one tobacco company affecting all tobacco manufacturers).

For any given structured product it is important to identify the actual risk drivers. The fixed-income (principal) component is driven mainly by interest rates and the credit standing of its issuer. The derivative (return) component is driven by the underlying assets (equity index, commodity, basket of stocks, currencies or digital assets), by the credit worthiness of the derivative counterparty, and by foreign-exchange rates wherever foreign currencies are involved.

Issuer or swap counterparty credit risk

A counterparty is the party on the other side of a transaction. In a crude-oil forward where A agrees to buy oil from B, A's counterparty risk is that B fails to deliver, and B's counterparty risk is that A fails to pay. Because a structured product's return is mainly supported by derivative contracts, a counterparty failure translates directly into losses for the investor.

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Traps that cost marks

Issuer insolvency is credit risk, difficulty selling is liquidity risk and currency conversion loss is FX risk — all distinct from market (price) risk.
A single company's downgrade, lawsuit or operational failure is issuer-specific, affecting only one company, not the whole market.
General market risk involves economy-wide factors, not a single-issuer downgrade.
Underlying-asset prices and FX drive the derivative component, not principally the fixed-income leg.
Although it originates with one issuer, issuer-specific risk is not always confined to that single company; it can ripple across a sector.
Default is broader than bankruptcy; equating the two is the classic error.
Central clearing addresses counterparty (credit) risk, not market risk, and does not remove fees or guarantee higher returns.
Currency choice, unlisted securities and removing maturity dates do nothing to reduce counterparty exposure.

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Exam-style questions

A manager wants to hedge a S$1,700,000 portfolio (beta 0.9 to the STI) using STI futures priced at 2,500 points with a S$10 multiplier. The correct number of contracts to short isAnswer explained →A manager hedges a specific stock portfolio by selling index futures. A fundamental limitation of this hedge is thatAnswer explained →An investor holds a structured product that fully returns principal in US dollars at maturity. If the USD has depreciated against the SGD since purchase, on maturity the investorAnswer explained →An option to buy a share at S$10 has an intrinsic value of S$5 when the share trades at S$15. If the share price rises 20% to S$18, the option's intrinsic value rises to S$8 — a 60% increase. This demonstrates thatAnswer explained →Which statement about the limits of diversification is CORRECT?Answer explained →

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