CFA Level I Fixed Income - Structured Financial Instruments

[Music] structured financial instruments represents a broad sector of financial instruments this sector includes asset backed securities and collateralized debt obligations which we've briefly discussed earlier and we'll be discussing in detail in a later topic our focus here shall be on other types of structured financial instruments they include capital protected instruments yield enhancement instruments participation instruments and leveraged instruments let's get started a common attribute of all structured financial instruments is that they repackage and redistribute risks these instruments typically have customized structures that often combine a bond and at least one derivative derivatives are financial instruments that derive value from one or more underlying assets such as equities bonds and commodities as such the risks and returns to an investor of a structured financial instrument are linked to the performance of the underlying asset will be making references to a few derivatives in this lesson so if you're not familiar with them do refer to the course on derivatives the CFA curriculum categorizes such structured financial instruments into four broad categories the first category is capital protected instruments such an instrument offers a guarantee of a minimum value at maturity as well as some potential upside gain for example an issuer can promise to return a hundred percent capital after one year plus a percentage of any gains on Apple stock over the year how does the issuer achieve this one simple way to structure such a security is to combine a zero coupon bond with a call option on the underlying asset which in this case is the Apple stock so as in this case let's say the securities priced at $1,000 the investor places $1,000 at initiation and is promised that she will receive the $1,000 back at maturity plus a percentage of any gains from Apple's stock let's say there's a risk-free zero coupon bond with a face value of $1,000 that matures in one year selling at a discounted price of nine hundred and fifty dollars this constitutes the maximum return of $1,000 to the investor at maturity the remaining $50 from the investor can be used to buy a cool option on Apple's stock with a predetermined strike price if Apple's stock price ends up below the strike price the option will simply expire out of the money and there is no loss to the long call if Apple's stock price ends above the strike price at maturity the difference between the spot and the strike price is the gain that will form the potential upside to the investor so now you see how easy it is to achieve capital protection by combining a zero coupon bond with a cool option such a structured financial instrument is called a guarantee certificate because the guarantees payoff is equal to the initial cost of the structured security this does not always have to be the case though for instance an issuer can reduce the capital protection level to 80 percent by putting less money in the zero coupon bond this allows the issuer to purchase more call options thus multiplying the potential upside to the investor another category of structured financial instruments is yield enhancement instruments yield enhancement refers to increasing risk exposure in the hope of realizing a higher expected return a credit linked note is an example of a yield enhancement instrument purchasing a CLN can be viewed as buying a note and simultaneously selling a derivative known as a credit default swap let's break down the payoffs from the two instruments firstly a note by itself pays regular coupons and the return of principal at maturity to enhance the yield of this note the issuer takes the position of a CD s seller on some underlying asset a CD s can be likened to an insurance contract against default of the underlying asset as a seller the issuer receives regular premiums from the buyer of the CD s such regular premiums can be used to top-up the regular coupons to bump up the yield of the credit linked note at the expiration of the CD s if the credit event did not occur the issuer can redeem the CLN at par value the issuer has successfully increased the yield of the note through selling the CD S however if by expiration the underlying asset did default the credit event has occurred the issue of being the credit protection seller will draw from the principal that is supposed to be returned to the CLN holders to pay it to the CD S buyer in such a case the CLN holder may not receive the full power value back at maturity and the attempt to increase the you has failed let's move on to the third category of structured financial instruments a participation instrument is one that allows investors to participate in the return of an underlying asset the floating rate notes can be viewed as a type of participation instrument its payoff can be viewed as a regular fixed coupon note combined with interest rate forwards as we've learned earlier the coupon rate of a floating rate note is usually calculated based on a spread plus the reference rate which is usually the libel rate the regular fixed coupons from the note provides the spread to the FRN the returns from the LIBOR rate are captured by the interest rate foods thereby making adjustments to the regular coupons this gives us floating rate coupons that participate in the movement of interest rates a floating rate notes has very little interest rate risk because changes in the cash flows limit the effect of changes in interest rates on its price besides this application of mitigating interest rate risks participation instruments are also designed to give investors in direct exposure to a particular index or asset price for example a participation instrument can be structured to give investors an indirect exposure to US equity you may be wondering why gain indirect exposure when one could directly invest in the US market some fund managers may be restricted to invest only in debt securities so having such instruments which are considered debt securities can give them the exposure that they desire from equity and we conclude with the last category leveraged instruments leverage instruments are very much like participation instruments the coupon rates are just based on the performance of the underlying asset however in this case the returns from the underlying can be magnified by a leverage factor leveraged instruments are created to magnify the returns of an underlying asset in order to offer the possibility hi payoffs from small investments an inverse floater is an example of a leveraged instrument in the case of an inverse floater the leverage factor is a negative number the cash flows move in the opposite direction of changes in the reference rate so when the reference rate decreases the coupon payment of an inverse floater increases if the magnitude of the leverage factor is less than 1 the inverse floater is called ad leveraged inverse floater the coupon payouts are less sensitive to changes in the reference rate conversely if the magnitude of the leverage factor is greater than 1 the inverse floater is called a leveraged inverse floater the coupon payouts are more sensitive to changes in a reference rate and that concludes this lesson where we are introduced to full classes of structured financial instruments other than asset-backed securities regardless of the classification the payouts from a structured financial instrument can usually be decomposed to a combination of a bond and derivatives you're watching an excerpt from our comprehensive and animation library for more videos like these head on down to prep Nuggets comm let's prep Nuggets let us do the hard work for you

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Keywords: CFA Level 1, CFA Level I, Fixed Income, CFA Prep Course, CFA Prep Provider, CFA Lesson, CFA Tutorial, CFA Video

Id: sXjDN3zy-L0

Length: 8min 41sec (521 seconds)

Published: Tue Jan 28 2020