Structured Products Flashcards
Which statements are TRUE regarding structured products?
I A “structured product” is a derivative security that is “structured” to have the characteristics of a debt, but give the higher returns typically associated with “equity” securities
II Structured products give a rate of return linked to an equity index such as the Standard and Poor’s 500 index
III Structured products have a fixed maturity at par in around 7 years based on an embedded option in the security
IV Structured products are standardized and liquid instruments
A. I and II only
B. III and IV
C. I, II, III
D. I, II, III, IV
The best answer is C.
Structured products are securities based on, or derived from, a basket of securities, an index, or other securities, commodities or currencies. There are many types of structured products, but generally they consist of a “bond” portion, which pays interest based on the performance of a well known index such as the S&P 500 Index. In addition, they have a derivative component (an embedded option) that allows the holder to sell the security back to the issuer (at par) at maturity. These are often marketed as debt instruments, but that is not really the case. Structured products are created by many different brokerage firms and each firm’s version is somewhat different. Thus, they are not standardized, and they are fairly illiquid.
Which statements are TRUE regarding structured products?
I Structured products are standardized
II Structured products are not standardized
III Structured products have a fixed maturity date (similar to a debt security)
IV Structured products do not have a maturity date (similar to an equity security)
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is C.
Structured products are securities based on, or derived from, a basket of securities, an index, or other securities, commodities or currencies. There are many types of structured products, but generally they consist of a “bond” portion, which pays interest based on the performance of a well known index such as the S&P 500 Index. In addition, they have a derivative component (an embedded option) that allows the holder to sell the security back to the issuer (at par) at maturity. These are often marketed as debt instruments, but that is not really the case. Structured products are created by many different brokerage firms and each firm’s version is somewhat differen
Which statements are TRUE regarding market index linked certificates of deposit?
I Early redemption can result in the imposition of a penalty of 3-5% of the principal amount invested
II The CD can only be redeemed on a specified date during each calendar quarter
III The rate of return may be capped to a limit that is lower than the return of the reference stock index
IV Market index linked CDs typically have a minimum life of 3 years
A. I and II only
B. III and IV only
C. I, II, III
D. I, II, III, IV
The best answer is D.
Market Index Linked CDs are a type of “structured product” that consists of a “zero-coupon” synthetic bond component that grows based on the returns of an equity index; and that has a maturity established by an embedded option, typically 3 years from issuance.
Market Index Linked Certificates of Deposit tie their investment return to an equity index, usually the Standard and Poor’s 500 Index. This can give a potentially better rate of return than that of a traditional CD. If held to maturity, there is no penalty imposed on any CD. For an early withdrawal, traditional CDs may reduce the interest earned, but there is no loss of principal. In contrast, market index linked CDs typically impose a 3-5% principal penalty for early withdrawal. This “early withdrawal” penalty is imposed because the embedded option that established the maturity of the instrument was paid for and now is not being used.
Both regular and market index linked CDs qualify for FDIC insurance. Finally, the minimum life for market index linked CDs is typically 3 years; whereas traditional bank CDs can have lives as short as 3 months.
A customer wants to know the principal difference between a market index linked CD and a regular CD. As the registered representative, you should inform the customer that:
A. Market index-linked CDs give a rate of return tied to the S&P 500 Index, whereas regular CDs give a rate of return tied to market interest rates
B. Market index-linked CDs can have a loss of principal if held to maturity whereas regular CDs cannot have a loss of principal if held to maturity
C. Market index-linked CDs do not qualify for FDIC insurance whereas regular CDs do qualify for FDIC insurance subject to the $250,000 limit
D. Market index-linked CDs have a minimum life of 10 years, whereas there is no minimum life for regular CDs
The best answer is A.
Market Index Linked CDs are a type of “structured product” that consists of a “zero-coupon” synthetic bond component that grows based on the returns of an equity index; and that has a maturity established by an embedded option, typically 3 years from issuance.
Market Index Linked Certificates of Deposit tie their investment return to an equity index, usually the Standard and Poor’s 500 Index. This can give a potentially better rate of return than that of a traditional CD. If held to maturity, there is no penalty imposed on any CD. For an early withdrawal, traditional CDs may reduce the interest earned, but there is no loss of principal. In contrast, market index linked CDs typically impose a 3-5% principal penalty for early withdrawal. This “early withdrawal” penalty is imposed because the embedded option that established the maturity of the instrument was paid for and now is not being used.
Both regular and market index linked CDs qualify for FDIC insurance. Finally, the minimum life for market index linked CDs is typically 3 years; whereas traditional bank CDs can have lives as short as 3 months.
In order to recommend a structured product to a customer, all of the following statements are true EXCEPT:
A. the member firm must perform a “reasonable basis” suitability determination evaluating the characteristics of the product to be recommended against competing products
B. completion of the “reasonable basis” suitability determination means that the structured product can be recommended to all the firm’s customers
C. the member firm must perform a “customer specific” suitability determination prior to recommending a structured product to a customer
D. the member must use its expertise to determine if the potential yield of the structured product is an appropriate rate of return in relation to the volatility of the reference asset
The best answer is B.
Because of the complexity of structured products, which is typically a zero-coupon “synthetic bond” that gives a return tied to a market index such as the NASDAQ 100 Index or the Standard and Poor’s 500 Index; and which has a maturity based on an embedded option; FINRA requires that the member firm perform a “reasonable basis” suitability determination to evaluate the product’s potential rewards and risks (relative to other similar structured products offered by other firms). Once a “reasonable basis” suitability determination has been completed, then the member firm can offer the structured product only to its customers that are suitable for that investment. This is “customer specific” suitability. It cannot be recommended to all customers, since a specific suitability determination is required for each recommendation.
Which statements are TRUE about ETNs?
I ETNs are a structured product
II ETNs are an investment company product
III ETNs are suitable for investors seeking income
IV ETNs are suitable for investors seeking long-term capital gains
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
An ETN is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. ETNs make no interest or dividend payments, so they are not suitable for an investor seeking income. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to conventional debt instruments.
A bank issuer’s ETN has been downgraded by Moody’s from Aaa to Aa. The price of the ETN rose 2% after the downgrade was announced. What should the registered representative tell the client?
A. The bank downgrade does not matter because the price of the ETN rose by 2%
B. The bank downgrade can affect the marketability of the ETN
C. The bank downgrade is not meaningful because the ETN is still rated investment grade
D. The bank downgrade does not matter because the ETN can be redeemed at par at maturity
The best answer is B.
ETNs are “Exchange Traded Notes.” They are an equity index linked structured product, that is listed and trades on an exchange. Because they trade, the liquidity risk aspect of structured products is eliminated. What is not eliminated, however, is credit risk. These products are only as good as the guarantee of the issuing bank. These products typically have a 7 year maturity and a lot can go wrong in 7 years.
If the issuing bank is downgraded, then it would be expected that investor interest in the ETN would fall. This should make the issue less marketable and also should cause the price to fall. In this question, the price rises, which can only be attributable to market interest rates falling. However, the ETN will still become less marketable after the downgrade.
When comparing an ETN to a structured product, which statement is TRUE?
A. ETNs can be traded at any time while structured products cannot
B. ETNs offer current income while structured products do not
C. ETN income is taxable at higher rates than income from structured products
D. ETNs are equity securities that are exchange listed
The best answer is A.
An ETN is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. They are not an equity security - they are a debt instrument. ETNs are listed on an exchange and trade, so they have minimal liquidity risk. In comparison, a regular structured product is non-negotiable and, if redeemed prior to maturity, imposes an early-redemption penalty. ETNs make no interest or dividend payments. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to other structured debt products.
When comparing an ETN to a structured product, which statements are TRUE?
I ETNs can be traded at any time while structured products cannot
II Structured products can be traded at any time while ETNs cannot
III ETN income is taxable at lower rates than income from structured products
IV Structured product income is taxable at lower rates than income from ETNs
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is A.
An ETN is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. ETNs are listed on an exchange and trade, so they have minimal liquidity risk. In comparison, a regular structured product is non-negotiable and, if redeemed prior to maturity, imposes an early-redemption penalty. ETNs make no interest or dividend payments. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to other structured debt products.
An elderly customer that is currently invested in bonds for income is concerned about declining yields due to record low interest rates. He has contacted his registered representative and inquires about purchasing a reverse convertible note on a Blue Chip stock because it offers a higher yield. The customer should be informed about all of the following EXCEPT the:
A. note is not an obligation Blue Chip corporation
B. note is subject to the credit risk of the issuing bank
C. customer can potentially lose 100% of the principal amount due to a stock price decline
D. “knock-in” price of the underlying security gives the customer the right to put the note back to the issuer at par at maturity
The best answer is D.
Reverse convertible notes were created for customers looking for enhanced yield in a low interest rate environment. Of course, any enhanced yield comes with higher risk. The note is linked to the price movements of an underlying stock (or very rarely, an underlying index). At maturity, the holder will receive par value, as long as the price of the reference stock is above the “knock-in” price (typically 70-80% of the initial reference price). On the other hand, if at maturity, the reference stock falls below the “knock-in” price, then the holder will receive the shares of stock. Thus, if the market price of the reference stock declines below the “knock-in” price, the customer receives the stock at maturity and not par value.
A reverse convertible note is a structured product that is an obligation of the issuing bank - not the corporation or the corporate securities on which the product is based. As such, the note only as good as the credit of the issuing bank. Furthermore, if the market price of the stock declines to, or through, the “knock-in” price, the customer receives stock at maturity and that stock could potentially be worthless. The customer should be made aware of all of these points.
A customer purchases a reverse convertible note. Under which scenario will the customer receive less than par value at maturity?
I The market price of the reference stock has declined
II The market price of the reference stock has increased
III At maturity, the price of the reference stock is above the “knock-in “ price
IV At maturity, the price of the reference stock is below the “knock-in “ price
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
Reverse convertible notes were created for customers looking for enhanced yield in a low interest rate environment. Of course, any enhanced yield comes with higher risk. The note is linked to the price movements of an underlying stock (or very rarely, an underlying index). At maturity, the holder will receive par value, as long as the price of the reference stock is above the “knock-in” price (typically 70-80% of the initial reference price). On the other hand, if at maturity, the reference stock falls below the “knock-in” price, then the holder will receive the shares of stock. Thus, if the market price of the reference stock declines below the “knock-in” price, the customer receives the stock at maturity and not par value.
Auction Rate Securities:
I have the interest rate reset weekly via Dutch auction
II have a fixed interest rate for the life of the issue set by competitive bid auction
III have an embedded put option
IV do not have an embedded put option
A. I and III
B. I and IV
C. II and III
D. II and IV
The best answer is B.
Auction Rate Securities are long-term debt issues where the interest rate is reset weekly (or monthly) via Dutch auction. This gives the issuer the advantage of paying a short-term market interest rate on a long-term security. However, unlike a variable rate demand note (VRDO), they have no embedded put option - meaning that the issuer is not obligated to buy them back at the reset date. The failure of the weekly auctions in 2008 created a situation where holders could not sell these securities to get out of them.
All of the following statements are true about Auction Rate Securities EXCEPT:
A. Auction Rate Securities have an interest rate that steps up or steps down with the market
B. The Dutch Auction method is used to set the interest rate
C. Failure of an auction is not possible because of broker-dealer bidding
D. Auction Rate Securities are issued by corporations and municipalities
The best answer is C.
Auction Rate Securities are long-term bonds that have the interest rate reset weekly (or sometimes monthly) via a Dutch auction. This gives the issuer the benefit of lower short-term interest rates as compared to those of a traditional long-term bond. The interest rate “steps-up” or “steps-down” as market interest rates move. Unlike variable rate demand notes, these securities do not have an embedded put option, so they cannot be “put” back to the issuer at the auction reset date. Instead, a holder of an ARS needs to find a buyer at the auction if it wishes to sell.
A lack of bidders at the auction means that holders cannot sell these securities - which is exactly what happened when the market “froze” in early 2008. Broker-dealers that acted as agents for corporations and municipalities that issued ARSs would typically bid at the weekly auctions, but they pulled out as credit conditions worsened and the market imploded. The future for ARSs is pretty bleak, but they are tested.
Customer “A” buys a Credit Default Swap (CDS) from Customer “B,” with the reference loan being one made to Customer “C.” If Customer “C” continues to pay interest and principal on a timely basis, then:
A. Customer A benefits
B. Customer B benefits
C. Customer C benefits
D. any benefit to a specific party is based on the terms of the contract
The best answer is B.
In a Credit Default Swap (CDS), the buyer pays a premium to the seller, where the seller agrees that if the reference loan defaults, the seller will pay the face amount of the loan to the buyer. The buyer pays an annual “insurance-like” premium for this. If the loan does not default, the seller wins - collecting the premiums without having to make a payout. If the loan does default, the buyer wins - since the seller must pay the buyer the face amount of the loan in cash.
Customer “A” buys a Credit Default Swap (CDS) from Customer “B,” with the reference loan being one made to Customer “C.” If Customer “C” defaults, then:
A. Customer A benefits
B. Customer B benefits
C. Customer C benefits
D. any benefit to a specific party is based on the terms of the contract
The best answer is A.
In a Credit Default Swap (CDS), the buyer pays a premium to the seller, where the seller agrees that if the reference loan defaults, the seller will pay the face amount of the loan to the buyer. The buyer pays an annual “insurance-like” premium for this. If the loan does not default, the seller wins - collecting the premiums without having to make a payout. If the loan does default, the buyer wins - since the seller must pay the buyer the face amount of the loan in cash.
