DERIVATIVES 'R US/V1N3/Structured Notes
VOLUME 1, NUMBER 3
Last week's issue contained a couple of technical problems that hopefully will be cleared up this time. My formatting did not work properly for some people. It looked fine on my machine but I think I know how to fix it. Let me know if the problem persists. In addition I forgot to put the topic in the subject line.
The Baring's case continues to evolve but it's still too premature to comment. I would only be repeating the same news you've heard. I'll wait awhile before formulating an opinion to share with you.
This week's topic is:
***** STRUCTURED NOTES *****
Structured notes have been in the center of many of the derivatives controversies over the last year or so. Basically structured notes, sometimes called "hybrid debt," are intermediate term debt securities, whose interest payments are determined by some type of, and occasionally complex, formula. A pure floating rate security or "floater", where the interest is tied to LIBOR, is a kind of plain vanilla structured note that has been around for about 20 years. In the last few years, issuers have made the formulas more complex to meet the needs of users who want to take more specific positions against interest rates, such as anticipating a twist in the term structure.
An interesting thing about structured notes is that they do meet the definition of a derivative but often without including an option, forward or futures contract. Remember that a derivative is an instrument whose performance is tied to the movement of an interest rate, stock or stock index, commodity or currency. Thus, as I stated in my initial issue, derivatives encompass much more than simply options and futures.
There are a wide variety of structured notes. One in particular that has received a lot of unfounded negative publicity is the inverse floater. This is simply a floating rate instrument whose interest rate moves inversely with market interest rates. Reporters have tried to make this sound like some kind of financial monster, when in fact it makes for a rather nice hedge of a plain vanilla floater. Just because the coupon moves down when interest rates move up and vice versa does not make this instrument dangerous. It must be something about the way "inverse floater" sounds to the naive ear that suggests that it is a piece of complex exotica dreamed up by a crazy mathematician at Goldman Sachs.
Many structured notes, and particularly inverse floaters, have a leverage factor in which the rate adjusts by a multiple, such as 1.5 times LIBOR. This does give the instrument an extra kick that increases the risk but it doesn't take a rocket scientist to multiply LIBOR by 1.5 and see the potential effect.
Some recent and popular structured notes are called range notes. These typically pay interest at an above-market rate if LIBOR stays within a specific range, which may change according to a schedule. If LIBOR moves outside of that range, these notes may revert to a lower interest rate or no interest at all.
Other types of structured notes pay a promised rate but allow additional payments based on the movement of a commodity price or stock index. For example, consider a five-year note that promises to pay 2 % interest plus the percentage change in the S&P 500 over the five year period if the S&P 500 goes up. This is like a T-bill at a below-market rate plus a call option. Alternatively, it can pay the additional interest based on the decline in the S&P 500, which makes it like a T-bill and a put. The number of structures currently out there are too many to cover here and more are being created daily.
Why are structured notes used? They provide investors with an opportunity to take advantage of views not only about the direction of interest rates but the volatility, the range, the shape of the term structure (i. e., long term rates vs. short term rates), and the direction of commodity and equity prices. Many of these notes are not used for hedging but the trading they generate does provide liquidity as dealers hedge their positions in other markets that are widely used by hedgers. In addition some of these notes permit firms to take advantage of favorable tax and accounting treatment (we'll talk about some of these points in a later issue). In addition suffocating regulations are an impetus for structured notes (and, in fact, many derivatives). Structured notes sometimes provide a way to get around regulatory treatment. Also some of these notes provide a natural hedging device. Consider an oil company with a poor credit rating that wants to borrow. It issues a note with the interest payments tied to the price of oil. As oil goes up, its cash flows increase and it finds it easier to make the interest payments. When oil prices go down, its interest burden is lower.
If I've made any point here, I hope it is that there are a number of these instruments out there that contribute greatly to the efficient functioning of our markets. Do not let reporters lead you to believe that these complex securities are in some way so bizarre that they are nothing but gambling. Many of these securities are no more speculative than ordinary stocks and bonds and they serve a very useful purpose. They are often complex, however, and do require careful examination before doing a transaction.