23 Flashcards
What is a structured product?
A structured product is a passive i vestment vehicle that is financially engineered to provide a specific risk and return characteristic.
What underlying product can the underlying security be based on?
Mortgage loans
Credit card receivables
Car loans
Equity indexes
Home equity loans
What are some examples of structured products?
Principal protected notes
Market linked GIC
split shares
Mortgage baked securities
Asset backed securities
What is a principal protected note
Bank issued debt security with returns linked to index, MF, ETF
What are split shares?
Equity securities with separate claims on the dividend and capital flow from a holding of underlying stocks
What are asset backed securities?
Short to medium term bond with equal claim on the principal and interest cash flows from a pool of receivables ie consumer loans, credit cards, auto
What are the disadvantages of structured products?
A thin secondary market so liquidity is a problem.
Also have built in cost structure to compensate for the return guarantee.
In addition to market risks, they can be subject to prepayment risks. Ie mortgages in a MBS paid off early
What is the structure of a principal protected note?
Debt instrument in a depository note. The interest rate is tied to the performance of an underlying asset. The interest rate is not guaranteed.
No prospectus is necessary
What are the roles of a PPN?
Guarantor, manufacturer, distributor
What is a zero coupon bond plus option structure?
The issuer invests most of the proceeds in a zero coupon bond that has the same maturity as a PPN. This guarantees the rerun if principal at maturity the rest is invested in the underlying asset
What are the most popular kind of PPN?
Index linked and stock basket linked.
For index linked, your return can be determined by a participation rate or by a performance cap
For stock basket linked, the return is equal to the average return on the individual common shares in the basket. Can also apply a cap or participation rate
What are the risks of PPN?
Liquidity risks - you can redeem before maturity but a lot of fees
Performance risk - performance can be lower than the underlying asset
Credit risk - guaranteed by banks but not CIDC
Currency risk - foreign assets exposed to corrige currency risk
Who are PPN not suitable for?
Not suitable for those who need predictable income.
Not suitable for those needing income. No suitable secondary income and may not have an accurate price
What is the tax treatment of PPN?
Taxed as interest income
Are GICs CDIC insured?
Yes
What variables are considered when calculating returns on a market linked GIC?
Initial index level
Ending index level
Index growth over term
The performance cap or participation rate
What is the tax treatment of a GIC?
Taxed as interest income and all taxed in the year of maturity
What is a split share?
A split share is a security that divides the common shares into separate components with different investment objectives.
What are the components of split shares?
Preferred shared and capital shares
What are preferred shares?
Receive the majority of dividends, appeal to equity investors looking for dividend income
What are capital shares?
These shares receive the majority of capital gains
What are the terms of split shares?
Issued for a specific term from three to ten years. At the end of the term, the shares are redeemed. Preferred share owners receive principal back and capital shares get back the gain
What risks do capital shares have?
Must be comfortable with losing the shares and the capital leverage
Volatility due to the leverage. More volatile than the underlying stock
May receive dividends and dangerous to dividend cuts. Shares may sold to fund dividends in the preferred shares
What are the risks of preferred shares?
Shares can be redeemed early by the company so the client misses out
The issuing company can have reduced credit resulting in lower price
Decline in value in the underlying portfolio
Dividend cuts mean that the value of the preferred shares are reduced. Can even sell off equity to fund dividends
What are asset backed securities?
Asset securitization is a process that makes mortgage backed and other asset backed securities possible. Makes these financial assets marketable
What is a special purpose vehicle?
The SPV is set up to purchase and manage the assets and take them off the originators statement of financial position.
What is an SPV tranche hierarchy?
There is a three tier tranche hierarchy
Senior - first claim on any income, largest, safest
Mezzanine - paid out next
Junior - least creditworthy, paid last, smallest
What is an asset backed commercial paper?
ANCO is a type of ABS with a maturity date of less than one year 90-180 days. More risky these days
What is a mortgage backed security?
MBS are income producing structured product designed to provide liquidity in an illiquid mortgage market
What are the risks of MBS?
Interest rate risk - increases either the length to maturity
Credit risk - change in the creditworthiness of the issuer
Prices are inversely related to interest rates. Market price drops when interest rates go up
What are the two types of MBSs?
Open - principal can be repaid which can result in unpredictable cash flows
Closed - made up of social housing with no no principal repayment
What are the benefits of MBS?
Guaranteed by the government of Canada
Regular monthly payments
CMHC does not limit size
Higher yields than government bonds
Low minimum investment $5,000
Can be held in a registered account
What are the risks of MBS?
Prepayment means a credit risk and reduce future interest payments
If a mortgage goes into default, you receive the amount. It reduced future payments
If a property is damaged, legal action can result in liquidation of the loan from the pool
If market rates increased and there is a long term to maturity, capital loss can be incurred when they are sold
