Structured note

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A structured note is an over the counter derivative with hybrid security features which combine payoffs from multiple ordinary securities, typically a stock or bond plus a derivative. When it depends on a credit payoff, it is called a credit-linked note.

A simple example of a structured note would be a five-year bond tied together with an option contract. The addition of the option contract changes the security's risk/return profile to make it more tailored to an investor's comfort zone. This makes it possible to invest in an asset class that would otherwise be considered too risky.[1]

From the investor's point of view, a structured note might look like this: I agree to a three-year contract with a bank. I give the bank $100. The money will be indexed to the S&P 500. In three years, if the S&P has gone up, the bank will pay me $100 plus the gain in the S&P. However, if the S&P has gone down, the bank will pay me back the entire $100 - an advantage known as downside protection. (In reality the downside protection is usually "contingent", i.e. it only applies up to a certain threshold amount. For example, with a threshold of 40%, if the S&P has gone down by more than 40%, the bank will no longer pay me back $100, but instead it will pay me the proportional value indexed to the S&P - e.g. $55 if the S&P has gone down by 45%.[2] Because no such actual security exists outside of the sponsor creating such hybrid, the creditworthiness of this structured note depends on the strength of the sponsor.

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  1. ^ Robert W. Kolb, James A. Overdahl (2003), Financial derivatives, p. 245
  2. ^ UBS Financial Services, Structured Products: January products guide. (2010)