Structured Products: Market Risk

This article focuses on market risk and clarifies the difference between financial engineering and traditional active investing.

What is market risk

Market risk is defined as the risk of loss on financial investments caused by adverse price movements.

The “market” refers to all that is happening in the broader environment, covering issues such as the state of the economy, regulatory changes, exchange rate volatility and changes in policy by governments or central banks.

Market risk is particularly relevant to structured products, because every structured product is based on a range of outcomes that are determined by market forces.

An example

Consider a structured product that consists of a zero-coupon bond with a call option on a commodity such as crude oil.

Although this product is theoretically “capital guaranteed” (i.e. the investor may not receive the value of the bond at the end of the period), the issuer may default on the bond under adverse market conditions. This point will be covered in more detail in future articles.

If the price of crude oil rises, the call option will increase in value due to the difference between the market price and the “strike” price and the value of the product will improve.

But if an expected global economic slowdown occurs, the price of crude oil could fall significantly. If it has not recovered by the end of the investing period, the call options will have no value and expire worthless and the product will decline in value.

The structured product may also be designed with the expectation that crude oil would fall in value due to continuing economic stagnation and feature a “put” option instead of a call option.

A sudden crisis—such as a war—may cause the price of oil to spike. If the oil price remains elevated for the duration of the investing period, the options would again lose all value.

Other considerations

The losses described above can be more severe if leverage is applied to the derivative component. Leverage magnifies the gains and losses. Therefore, an investor could receive less than their original investment in a loss scenario.

More complex structured products often involve assumptions about correlations between multiple assets where assets with low historical correlation are used as a risk prevention measure—i.e. if one falls, the others remain steady.

But historical precedent does not determine the future. Asset classes may move unexpectedly in the same direction (in case of a global financial crisis, for example), taking away the downside protection.

How private markets investments differ

John Maynard Keynes said famously, “Markets can stay irrational longer than you can stay solvent.” It is impossible to predict how markets move, which is a problem for any asset. Even cash—the least risky asset of all—can lose value through unexpected high inflation.

The problem with structured products is that they are held for specific periods, and their design cannot be altered once purchased.

Even if the assumption on which a structured product is based—such an undervalued sector, an overpriced commodity—proves correct, the correction must occur within the lifetime of the product, which is often short.

Private market investments are also subject to market risk, but they differ from structured products in two important respects.

First, the holding period of private investments is typically longer (several years to decades) than that of structured products, and not fixed.

Second, it is possible to adapt to market changes by cutting costs, investing in marketing or refocusing products.

A long-term horizon provides time to make adaptive changes to the business, allowing investors to ignore the “noise” of the market and focus on the long-term success of the asset itself.

Conclusion

An investment with a longer-term horizon—such as a private market investment—can adapt to the environment, allowing it to withstand short-term market conditions and deliver superior long-term performance.