A structured product is a pre-packaged investment that combines a fixed-income instrument with one or more derivatives. The derivatives modify the payoff profile — adding upside exposure to an index, limiting downside, or providing a conditional coupon. To understand the pricing, you need to reverse-engineer the product into its components and value each one.
Example 1: A Capital-Protected Note
A five-year, 100% capital-protected note linked to the FTSE 100 promises: return your full investment at maturity plus 80% of any rise in the FTSE 100 over the five years (no downside). The participation rate is 80%.
The bank constructs this product from two components:
Component 1: Zero-coupon bond. The bank needs to guarantee the return of £100 at maturity. To do this, it invests a portion of your £100 today in a zero-coupon bond. If five-year interest rates are 4.5%, the present value of £100 in five years is £100 / (1.045)^5 = £80.25. So the bank invests £80.25 in the zero-coupon bond and it grows to exactly £100 at maturity. This guarantees capital protection.
Component 2: Call option on the FTSE 100. The remaining £100 − £80.25 = £19.75 is available to buy upside exposure. The bank uses this to purchase a five-year at-the-money call option on the FTSE 100. If this call option costs, say, £16.00 (in option pricing terms, as a percentage of notional), the bank can buy £19.75 / £16.00 = 1.234 units of option — but it only offers you 80% participation (0.80 units). The remaining £3.75 (£19.75 − £16.00) is the bank's gross margin before distribution costs.
In practice, the full £100 is invested — the zero-coupon bond and the call option together cost less than £100, and the difference is the bank's profit:
- Zero-coupon bond cost: £80.25
- 5Y ATM FTSE call (for 80% participation): £16.00
- Total component cost: £96.25
- Issuer gross margin: £3.75 (3.75%)
The participation rate of 80% is the result of the margin taken — if there were no margin, the bank could offer 100% participation. When rates are higher (zero-coupon bonds are cheaper), more is left over for options and participation rates increase. When implied volatility is high (options are expensive), participation rates fall for the same margin level.
Example 2: A Reverse Convertible
A one-year reverse convertible on Vodafone shares pays a 12% coupon unconditionally. At maturity, if Vodafone is above its initial level, you receive £100. If Vodafone is below its initial level, you receive shares in Vodafone at the initial price — meaning you lose money proportional to the fall.
The components are:
- A one-year bond at (let's say) 5% risk-free: you buy a bond that returns £100 at maturity.
- A short put option on Vodafone at 100% of initial level: you have sold the right to put Vodafone shares to you at the initial price. If the share falls, you must buy them at the initial price — suffering the loss.
The premium received from selling the put option funds the above-market coupon. If the put option premium is 8%, and the risk-free rate is 5%, the total available for the coupon is 5% + 8% = 13%. The bank retains 1% as margin and passes 12% to the investor as the quoted coupon.
The investor has effectively lent their money to the bank (earning 5%) and sold equity put protection (earning 8%), for a total return of 13% — of which 12% is paid as coupon and 1% is kept by the bank. The risk is that Vodafone falls sharply, triggering the short put and causing capital losses far larger than the coupon received.
The Issuer's Margin: Where It Lives
The bank's margin on a structured product comes from several sources:
- Mid-market to client spread on the embedded derivatives: the bank prices the option it buys for the product using its internal (mid-market) rate, but the product is priced to the client using a slightly worse rate — the spread between mid and offer is the bank's option P&L.
- Funding benefit: the bank issues the note to the client, raising cheap funding (usually at a rate slightly below where it would otherwise fund in the market), and reinvests at a higher rate.
- XVA: the bank embeds CVA and FVA for the counterparty credit and funding risks.
- Distribution costs: typically 1–3% upfront paid to the distributor (private bank, wealth manager, or retail platform) for placing the note with end investors. This cost is included in the product's pricing — effectively reducing the participation rate or the coupon available to the investor.
Fair Value Disclosure and the PRIIPs KID
Under EU and UK regulations, issuers of retail structured products must provide a Key Information Document (KID) disclosing the product's fair value — the mark-to-market value of the product's components at inception, using the issuer's internal mid-market rates. This gives investors a basis for understanding how much of the issue price represents genuine value and how much is cost.
A KID that shows a fair value of 96% of the issue price tells the investor that they are starting the investment 4% "underwater" relative to the components' theoretical value. This does not make the product bad — the investor may be comfortable paying for the packaging, the convenience, and the access to complex derivatives they cannot replicate themselves. But it does mean the product must generate at least 4% of excess return just to break even on the embedded costs.
Secondary Market Liquidity and Fair Value
Structured products are not exchange-traded. Their secondary market value is determined by the issuing bank's own desk, which will apply a bid/offer spread of typically 1–3% of notional when buying back a note from an investor before maturity. In stressed markets, some issuers have widened this spread to 5% or declined to provide a secondary market price at all.
The secondary market value also reflects changes in:
- The underlying equity level (the option's delta)
- Implied volatility (the option's vega — higher vol makes put-embedded products cheaper for the investor, call-embedded products more valuable)
- Interest rates (affecting the zero-coupon bond's value)
- The issuer's own credit spread (affecting the note's value as an issuer liability)
A capital-protected note that was bought when rates were 1% and now rates are 4.5% has a very different secondary market value: the zero-coupon bond is worth less (rates have risen, bond prices fallen), and the call option may also have changed in value as dividends, volatility, and the equity level have all shifted.
How to Evaluate a Structured Product
The practical checklist for evaluating any structured product:
- Decompose it: identify the bond component and the derivatives component. What is each worth at mid-market?
- Check the fair value disclosure: what percentage of the issue price is genuine economic value vs costs?
- Identify the risks you are selling: what risk have you embedded as a short position? (Short put, short vol, short correlation, short credit?)
- Compare alternatives: could you replicate the risk/return profile more cheaply by combining simpler instruments directly?
- Assess liquidity: do you genuinely not need this money for the full term? Can you afford to hold to maturity?
- Assess issuer credit: are you comfortable with this bank's credit risk for the product's full term?