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Trading and Capital-Markets Activities Manual

Instrument Profiles: Structured Notes
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Structured notes are hybrid securities, possessing characteristics of straight debt instruments and derivative instruments. Rather than paying a straight fixed or floating coupon, the interest payments of these instruments are tailored to a myriad of possible indexes or rates. The Federal Home Loan Bank (FHLB), one of the largest issuers of such products in the United States, has more than 175 indexes or index combinations against which cash flows are calculated. In addition to the interest payments, the redemption value and final maturity of the securities can also be affected by the derivatives embedded in structured notes. Most structured notes contain embedded options, generally sold by the investor to the issuer. These options are primarily in the form of caps, floors, or call features. The identification, pricing, and analysis of these options give structured notes their complexity. 

Structured notes are primarily issued by government-sponsored enterprises (GSEs), such as the Federal Home Loan Bank (FHLB), Federal National Mortgage Association (FNMA), Student Loan Marketing Association (SLMA), and Federal Home Loan Mortgage Corporation (FHLMC). Although the credit risk of these securities is minimal, other risks such as interestrate risk, market (price) risk, and liquidity risk can be material. 

CHARACTERISTICS AND FEATURES 

There are many different types of structured notes; typically, a structure is created specifically to meet one investor's needs. Thus, an exhaustive description of all the types of structures in which an institution may invest is impossible. However, certain structures are fairly common and are briefly described below. 

In many cases, very complex probability and pricing models are required to accurately evaluate and price structured notes. As mentioned earlier, most structures have embedded options, implicitly sold by the investor to the note's issuer. The proper valuation of these options poses unique challenges to investors considering structured notes. Many popular structures include embedded, path-dependent options for which pricing involves complex models and systems. 

Inverse Floating-Rate Notes 

An inverse floating-rate note (FRN) has a coupon that fluctuates inversely with changes in the reference rate. The coupon is structured as a base rate minus the reference rate, for example, a three-year note with a semi-annual coupon that pays 13 percent minus six-month LIBOR, and an interest-rate floor of 0 percent, which ensures that rates can never be negative. The return on an inverse FRN increases in a decreasing-rate environment, and decreases in an increasing-rate environment. An investor in an inverse FRN is taking a view that rates will decrease. An inverse FRN has the risk characteristics of a leveraged fixed-rate instrument: inverse FRNs will outperform non-leveraged fixed-rate instruments when rates decrease and under-perform when rates increase. If rates increase significantly, the investor may receive no coupon payments on the note. 

The leverage inherent in an inverse FRN varies with each structure. The leverage amount of a particular structure will be equal to the underlying index plus one (that is, 13 percent minus 6-month LIBOR has a leverage factor of 2; 20 percent - (2 6-month LIBOR) has a leverage factor of 3). The degree of leverage incorporated in an FRN will increase the volatility and, hence, the interest-rate and price risk of the note. 

Step-Ups/Multi-Steps 

Step-up notes or bonds are generally callable by the issuer; pay an initial yield higher than a comparable fixed-rate, fixed-maturity security; and have coupons which rise or ''step up'' at predetermined points in time if the issue is not called. If the coupon has more than one adjustment period, it is referred to as a multi-step. Step-up notes have final maturities ranging from one year to as long as 20 years. Typical lock-out periods (periods for which the note cannot be called) range from three months to five years. 

An example of a step-up note is a five-year note which has an initial coupon of 6 percent; the coupon increases 50 basis points every six months. The note is callable by the issuer on any six-month interest-payment date. 

Step-up notes contain embedded call options ''sold'' to the issuer by the investor. Any time an issue is callable, the purchaser of the security has sold a call option to the issuer. In the above example, the investor has sold a series of call options, called a Bermuda option, to the issuer. The note is callable on any interest-payment date after a specified lock-out period. Unlike callable issues which pay a flat rate until maturity or call, the step-up feature of these securities increases the value of the call options to the issuer and likewise increases the prospect of early redemption. Multi-steps can also be thought of as one-way floaters since the coupon can adjust higher, but never lower. As such, they can be viewed as securities in which the investor has bought a series of periodic floors and has sold a series of periodic caps in return for abovemarket initial yield. 

As the investor has sold a series of call options to the issuer, a step-up note will outperform a straight bond issue when rates are relatively stable and under-perform in a volatile rate environment. In a decreasing-rate environment, the note is likely to be called and the investor will be forced to invest the proceeds of the redemption in a low-interest-rate environment. Conversely, in a rising-rate environment, an investor will be in a below-market instrument when rates are high. Step-up notes with very long maturities (beyond 10 years) may have greater liquidity and price risk than other securities because of their long tenor. 

Index-Amortizing Notes 

An index-amortizing note (IAN) is a form of structured note for which the outstanding principal or note amortizes according to a predetermined schedule. The predetermined amortization schedule is linked to the level of a designated index (such as LIBOR, CMT, or the prepayment rate of a specified pass-through pool). Thus, the timing of future cash flows and, hence, the average life and yield to maturity of the note become uncertain. The IAN does have a stated maximum maturity date, however, at which time all remaining principal balance is retired. 

An embedded option feature, called a path-dependent option, is present in this type of security. The option is termed path-dependent because the payoff structure of the option will depend not only on the future path of the underlying index but on where that index has been in the past. The investor, in return for an above-market initial yield, effectively sells this option to the issuer. The issuer has the option to alter the principal amortization as the interest-rate environment changes. Caps and floors may also be present if the issue has a floating-rate coupon. 

A typical IAN is structured so that as the designated index (for example, LIBOR) rises above a trigger level, the average life extends. Conversely, if the designated index is at or below the trigger level, the IAN's principal will quickly amortize, leading to a shorter average life. The outstanding principal balance will vary according to the schedule at each redemption date. One may equate the amortization of the note to the retirement (call) of some portion of the principal. As the amortization quickens, more and more of the note is ''called.'' 

IANs generally appeal to investors who want an investment with a CMO-like risk-return pro-file, but with reduced uncertainty as to the average life. As the amortization schedule of an IAN depends only on the level of the underlying index, an IAN eliminates the non-economic prepayment factors of a CMO. However, like a CMO, an IAN will outperform a straight bond issue in a stable rate environment and under-perform it in a volatile rate environment. In a decreasing-rate environment, the IAN is likely to be called, and the investor will be forced to invest the proceeds of the redemption in a low interest-rate environment. Conversely, in a rising-rate environment, the maturity of the IAN will extend, and an investor will be in a below-market instrument when rates are high. 

De-Leveraged and Leveraged Floaters 

De-leveraged and leveraged floating-rate notes give investors the opportunity to receive an above-market initial yield and tie subsequent coupon adjustments to a specific point on the yield curve. A leveraged note's coupon will adjust by a multiple of a change in the relevant interest rate, for example, 1.25 LIBOR + 100 basis points. Conversely, a de-leveraged security's coupon adjusts by a fraction of the change in rates, for example, .60 10-year CMT + 100 basis points. 

De-leveraged floaters are combinations of fixed- and floating-rate instruments. For example, a $10 million de-leveraged floater with a coupon of 60 percent of the 10-year CMT + 100 basis points is equivalent to the investor holding a $6 million note with a coupon equal to a 10-year CMT/LIBOR basis swap and a $4 million fixed-rate instrument. If rates rise, an investor in a de-leveraged floater participates in the rise, but only by a fraction. The leverage factor (for example, 60 percent) causes the coupons to lag the actual market. Thus, de-leveraged floaters will outperform straight bond issuances in a declining or stable interest-rate environment. 

Conversely, a leveraged floater such as the example above should be purchased by investors with an expectation of rising rates in which they would receive better than one one-to-one participation. The degree of leverage amplifies the risks as well as the rewards of this type of security. The greater the leverage, the greater the interest-rate and price risk of the security. 

Other alternatives in this category include floaters which do not permit the coupon to decrease, so-called one-way de-leveraged floaters which can effectively lock in higher coupons in an environment where the index rises then falls. 

Ratchet Notes 

Ratchet notes typically pay a floating-rate coupon that can never go down. The notes generally have periodic caps that limit the amount of the increases (ratchets) or that set a predetermined increase for each quarter. These periodic caps are akin to those found in adjustable-rate mortgage products. 

An investor in a ratchet note has purchased from the issuer a series of periodic floors and has sold a series of periodic caps. As such, a ratchet note will outperform a straight floating-rate note in a stable or declining interest-rate environment, and it will under-perform in a rapidly rising interest-rate environment. In a rapidly rising interest-rate environment, a ratchet note will perform similarly to a fixed-rate instrument with a low coupon which gradually steps up. The price volatility of the instrument will therefore depend on the frequency of resets, the amount of coupon increase at each reset, and the final maturity of the note. Longer maturity notes, which have limited reset dates and limited coupon increases, will be more volatile in rising- rate environments and will therefore have a greater degree of interest-rate and price risk. 

Dual-Index Notes 

A dual-index note (sometimes called a yield curve anticipation note (YCAN)) is a security whose coupon is tied to the spread between two market indexes. An example is a three-year security which pays a semi-annual coupon equal to (prime + 250 basis points - 6-month LIBOR). Typical indexes used to structure payoffs to these notes are the prime rate, LIBOR, COFI, and CMT yields of different maturities. Yield-curve notes allow the investor to lock in a very specific view about forward rates. Such a play, while constructable in the cash market, is often difficult and costly to an investor. A purchaser of this type of security is typically making an assumption about the future shape of the yield curve. These notes can be structured to reward the investors in either steepening or flattening yield-curve environments. However, these notes can also be tied to indexes other than interest rates, such as foreign-exchange rates, stock indexes, or commodity prices. 

An example of a note which would appeal to investors with expectations of a flattening yield curve (in a currently steep yield-curve environment) would be one with a coupon that floats at 

[the 5-year CMT - the 10-year CMT + a designated spread]. 

Based on this formula, the coupon will increase if the yield curve flattens between the 5-year and the 10-year maturities. Alternatively, a yield-curve-steepening play would be an issue that floats at- 

[the 10-year CMT - the 5-year CMT + a designated spread]. 

In this case, coupons would increase as the spread between the long- and medium-term indexes widens. 

A dual-index note is equivalent to being a long basis swap (in the example above, the investor receives prime and pays LIBOR) and to being long a fixed-rate instrument. As such, the note has the risk-return elements of both a basis swap and a comparable fixed-rate instrument. The note will under-perform comparable fixed-rate instruments in an environment when the basis relationship (between prime and LIBOR in the above example) narrows. These instruments are subject to incremental price risk in a rising-rate environment in which the basis spread is narrowing. 

Principal-Linked Notes 

An example of a principal-linked note is a one-year security which pays a fixed semi-annual coupon of 8 percent, and the principal received at maturity is determined by the following formula using market yields two days before maturity:

 P = 100 + 5 ( ( (2-year swap rate - 3-month LIBOR) - 1.40) ) 

The resulting principal-redemption amount under varying rate scenarios would be as follows in table 1. 

Table 1-Examples of Possible Principal-Redemption Schemes 


Under a principal-linked structured note, the maturity and the fixed coupon payments are unchanged from the terms established at issuance. The issuer's redemption obligation at maturity, however, is not the face value of the note. Redemption amounts are established by a formula whose components reflect historical or prevailing market levels. Principal-linked notes have been issued when the principal redemption is a function of underlying currency, commodity, equity, and interest-rate indexes. As the return of principal at maturity in many types of principal-linked notes is not ensured, these structures are subject to a great degree of price risk. 

Range Notes 

Range notes (also called accrual notes) accrue interest daily at a set coupon which is tied to an index. Most range notes have two coupon levels; the higher accrual rate is for the period that the index remains within a designated range, the lower rate is used during periods that the index falls outside the range. This lower level may be zero. Range notes have been issued which reference underlying indexes linked to interest rates, currencies, commodities, and equities. Most range notes reference the index daily such that interest may accrue at 7 percent on one day and at 2 percent on the following day, if the underlying index crosses in and out of the range. However, they can also reference the index monthly, quarterly, or only once over the note's life. If the note only references quarterly, then the index's relationship to the range matters only on the quarterly reset date. With the purchase of one of these notes, the investor has sold a series of digital (or binary) options:1 a call struck at the high end of the range and a put struck at the low end of the range. This means that the accrual rate is strictly defined, and the magnitude of movement outside the range is inconsequential. The narrower the range, the greater the coupon enhancement over a like instrument. In some cases, the range varies each year that the security is outstanding. 

However, range notes also exist which require that the investor sell two barrier options:2 a down-and-out put struck at the low level of the range and an up-and-out call struck at the high level of the range. For these range notes, the index must remain within the target band for the entire accrual period, and sometimes for the entire life of the instrument. If it crosses either barrier on even one day, the investor's coupon will drop to zero for the whole period.3 This type of range note is quite rare, but investors should pay careful attention to the payment provisions attached to movements outside the range. 

As the investor has sold leveraged call and put options to the issuer of these securities, a range note will outperform other floating-rate instruments in stable environments when the index remains within the specified range, and it will under-perform in volatile environments in which the underlying index is outside of the specified range. Given the degree of leverage inherent in these types of structures, the securities can be very volatile and often exhibit a significant degree of price risk. 

1. A digital option has a fixed, predetermined payoff if the underlying instrument or index is at or beyond the strike at expiration. The value of the payoff is not affected by the magnitude of the difference between the underlying and the strike price.
2. Path-dependent options with both their payoff pattern and their survival to the nominal expiration date are dependent not only on the final price of the underlying but on whether the underlying sells at or through a barrier (in-strike, out-strike) price during the life of the option. 
3. McNeil, Rod. ''The Revival of the Structured Note Market.'' International Bond Investor. Summer 1994, pp. 34-37.

USES 

Structured notes are used for a variety of purposes by investors, issuers, and underwriters or traders. Banks are often involved in all three of these capacities. 

Uses by Investors 

Structured notes are investment vehicles that allow investors to alter the risk profile of their portfolios and/or to express a viewpoint about the course of interest rates or other financial variables. The basic appeal of structured notes lies in their attendant customized risk parameters. Attributes that typically are not available (or not easily available) to an investor are assembled in a pre-packaged format. Additionally, investors find the notes attractive for other distinct reasons. In a sustained period of low interest rates (such as the United States experienced for the five years leading up to February 1994), receiving an ''acceptable'' return on an investment became increasingly difficult. Structured notes, whose cash flows and market values are linked to one or more benchmarks, offered the potential for greater returns than prevailing market rates. The desire for higher yield led investors to make a risk-return trade-off which reflected their market view. 

The fact that most structured notes are issued by government-sponsored enterprises (GSEs) means that credit risk-the risk that the issuer will default-is minimal. GSEs are not, however, backed by the full faith and credit of the U.S. government, though most have explicit lines of credit from the Treasury. As a result, investors were attracted by the potential returns of structured notes and by their high credit quality (implied government guarantee). As noted above, however, the credit risk of these notes may be minimal, but their price risk may be significant. 

Uses by Issuers 

Issuers often issue structured notes to achieve all-in funding rates, which are more advantageous than what is achievable through a straight debt issue. To induce issuers to issue complex and often very specialized debt instruments, investors often will sacrifice some return, which lowers the issuer's all-in cost of funding. Generally, only highly rated (single-A or better) banks, corporations, agencies, and finance companies will be able to issue in the structured-note market. A detailed discussion of issuing practices is included in the ''Description of Marketplace'' subsection below. 

Uses by Underwriters or Traders 

Investment banks and the section 20 subsidiaries of banks often act to underwrite structured-note  issuances. They are often actively involved in making a market in secondary structured notes. A detailed discussion of these activities is included in the ''Description of Marketplace'' subsection below. 

DESCRIPTION OF MARKETPLACE 

Background 

In its heyday, the structured-note market was a by-product of a unique period in financial history. In 1992 and 1993, Wall Street firms engineered debt that allowed borrowers to attain highly attractive below-market funding and that rewarded investors (in large part) as long as interest rates remained low. The incredible and at times implausible array of structure types came into being in response to the investment community's desire for higher returns during a sustained period of low interest rates. Issuers and investment dealer firms were more than willing to address this need, introducing investors to more attractive (and by definition riskier) securities whose cash flows were linked to, for example, the performance of the yen; the yen's relationship to the lira; and a host of other indexes, currencies, or benchmarks.4 Investors' quest for enhanced yield caused them to adopt, in many cases, very tenuous risk-reward measures with respect to potential investment choices. 

Structured notes received heightened attention from both regulators and investors in the spring and summer of 1994. Many of these structured securities, created to satisfy a perceived need at the time, deteriorated in value as a result of the rate increases of 1994. In many cases, the leverage inherent in the security worked against the investor, obliterating once attractive coupon payments. Market values of many of these instruments fell below par as their coupons became vastly inferior to comparable maturity investments and as maturities were extended beyond investors' original expectations. 

4. As more exotic structured-note issues came into being (and especially in light of the Orange County debacle), much of the bad press centered on the (quasi-government) agencies who issued the paper. As discussed later, the impetus for the vast majority of deals in fact emanated from Wall Street.

Primary Market 

Structured notes are primarily issued by GSEs such as the FHLB, FNMA, SLMA, and FHLMC, which carry an implicit government guarantee and are rated triple-A. Many large corporations, banks, and finance companies, generally rated single-A or better, also issue structured notes. 

Most structured-note issuances originate with investors on a reverse inquiry basis, through the medium-term note (MTN) market. The process originates when an investor has a demand for a security with specific risk characteristics. Through a reverse inquiry, an investor will use MTN agents such as the underwriting desk of an investment bank or section 20 subsidiary of a bank to communicate its desires to the issuer. If the issuer agrees to the inquiry, the issuer will issue the security which is sold through the MTN agent to the investor. 

Although structured notes in the MTN market often originate with the investor, investment banks and section 20 subsidiaries of banks also put together such transactions. Most investment banks and section 20 subsidiaries have derivative-product specialists who design structured notes to take advantage of specific market opportunities. When an opportunity is identified, the investment bank or section 20 subsidiary will inform investors and propose that they buy the structured note. If an investor tentatively agrees to purchase the security, the MTN agents in the investment bank or section 20 subsidiary will contact an issuer with the proposed transaction. If the structure meets the funding needs of the issuer, the structured note will be issued to the investors. 

Secondary Market 

Structured notes are traded in the secondary market through market makers such as investment banks or section 20 subsidiaries of banks or through brokers. Market makers will buy or sell structured notes, at a predetermined bid and offer. Market makers will usually trade GSE structured notes through their secondary agency trader and trade corporate-issued structured notes through their corporate bond trader. Some market makers trade secondary structured notes through their structured-note desk, a specialized group who will buy and trade all types of structured notes. 

Investors in secondary structured notes may buy the notes at a discount or premium to issuance and receive the performance characteristics of the note as shown in the prospectus. Investors may also purchase structured notes on an asset-swap basis, which strips the optionality out of a note and leaves the investor with a synthetically created ''plain vanilla' return such as LIBOR. Asset-swap pricing is discussed in the ''Pricing'' subsection below. 

Secondary structured notes are also used to create special-purpose vehicles such as Merrill Lynch's STEERS program. In these types of programs, secondary structured notes are placed in a special-purpose vehicle, the receipts of which are then sold to investors. A series of swap transactions is then entered into between a swap counterparty and the special-purpose vehicle, which strips the optionality out of the structures. The investor therefore receives a trust receipt which pays a plain vanilla return such as LIBOR. 

Structured notes often possess greater liquidity risk than many other types of securities. The most important factor affecting the liquidity of the note in the secondary market is the size of the secondary note being traded. Generally, the larger the size of the note, the more liquid the note will be in the secondary market. Most investors will not buy a structured note of limited size unless they receive a significant premium to cover the administrative costs of booking the note. Similarly, most market makers will not inventory small pieces of paper unless they charge a significant liquidity premium. 

Another factor which may affect the liquidity of a structured note in the secondary market is the one-way ''bullishness'' or ''bearishness'' of a note. For example, in a rising-rate environment, leveraged bullish instruments such as inverse floaters may not be in demand by investors and may therefore have less liquidity in the secondary market. As many structured notes are sold on an asset-swap basis, the characteristics of the structured note can be ''engineered'' out of the note, leaving the investor with a plain vanilla return. The asset-swap market, therefore, helps to increase the liquidity of these types of notes. 

PRICING 

The two primary methods by which structured notes are priced in the secondary market are (1) on an asset-swap basis or (2) on a straight-pricing basis. Asset-Swap Pricing Structured notes are typically constructed by embedding some form of optionality in the coupon, principal, or maturity component of a debt issue. Once these embedded derivatives are quantified, a swap or series of swaps can be undertaken to strip out those options and effectively create a synthetic instrument with either fixed or variable cash-flow streams. This process is known as asset-swap pricing.5 

Asset-swap pricing initially involves decomposing and valuing the components of the note, including contingent cash flows. It conveys where those components can be cashed out in the market, often referred to as the break-up value of the note. After the note is decomposed, an alternate cash-flow stream is created through the asset-swap market. 

When structured notes are priced on an asset-swap basis, the issue is analyzed based on its salvage value.6 The salvage value on most agency structured issues varies based on the current market and the size, type, and maturity of the note. 

Liquidity in the structured-notes market exists because every note has a salvage value. If demand for the note as a whole is weak, its cash flows can be reconstructed via the asset-swap market to create a synthetic security. In many cases, the re-engineered security has broader investor appeal, thereby generating needed liquidity for the holder of the original issue. 

Straight Pricing 

Contrasted with an asset-swapped issue, a note trading on a straight-pricing basis is purchased and sold as is.7 Traders who price structured notes on this basis compare the note with similar types of instruments trading in the market and derive a price accordingly. 

5. See the Federal Reserve product summary Asset Swaps- Creating Synthetic Instruments by Joseph Cilia for a detailed treatment on the topic. 
6. Goodman, Laurie. ''Anatomy of the Secondary Structured Note Market.'' Derivatives Quarterly, Fall 1995. 
7. Peng, Scott Y., and Ravi E. Dattatreya. The Structured Note Market. Chicago: Probus, 1995. 

HEDGING 

Structured notes are, from a cash-flow perspective, a combination of traditional debt instruments and derivative contracts. As a result, the value (or performance) of a structured note can be replicated by combining components consisting of appropriate zero-coupon debt plus appropriate futures or options positions that reflect the optionality embedded in the issue. Similar to the decomposition process employed in an asset-wap transaction, the fair value of this replicated portfolio should be equivalent to the fair value of the structured note. 

Theoretically, one should be indifferent about investing in a structured note or in its equivalently constructed portfolio as long as the price of the note equals the present value of its replication components.8 Price discrepancy should govern the selection process between these alternatives. 

A hedge of a structured-note position involves engaging in the opposite of the replication trades noted above. To be fully protected in a hedge, the sum of the present values of each component of the hedge should be less than or equal to the market value of the note. If, for some reason, the note was priced higher than the cost of the worst-case replication components, the hedging firm stands to lock in a positive spread if that worst-case scenario fails to materialize.9 

A structured-note position itself can serve to hedge unique risks faced by the investor. For example, a company which is long (owns) Japanese yen () is exposed to the risk of yen depreciation. The FHLB issued a one-year structured range note which accrued interest daily at 7 percent if the /U.S.$ is greater than 108.50 or at 0 percent if the /U.S.$ is less than 108.50. If the yen depreciates, the note accrues interest at an above-market rate. Meanwhile, the company's yen holdings will decline in value. This note could serve as a perfectly tailored hedge for the company's business-risk profile. In fact, the design of many of the most complicated structured notes is driven not by the innovations of note issuers and underwriters, but rather by investors seeking to hedge their own unique risk profiles. 

RISKS 

Market Risk 

The embedded options and other leverage factors inherent in structured notes result in a great deal of uncertainty about future cash flows. Thus, price volatility is generally high in these types of securities. An institution should have- or should have ready access to-a model which is able to quantify the risks. The model should be able to forecast the change in market price at various points in time (for example, one year later or the first call date) for a given shift in interest rates. For the many variants of these products which are tied to the shape of the yield curve, the ability to model price effects from nonparallel interest-rate shifts is also crucial. In most cases (except for some principal-linked notes), full principal will be returned at maturity. However, between issuance and redemption, changes in fundamental factors can give rise to significant reductions in the ''market'' price. 

As with other types of instruments in which an investor has sold an option, structured notes will under-perform similar straight debt issuances in a volatile rate environment. For notes such as callable step-ups and IANs, the investor may be exposed to reinvestment risk (investing the proceeds of the note in a low-interest-rate environment) when rates decrease and to extension risk (not being able to invest in a highinterest-rate environment) when rates increase. 

8. Kawaller, Ira G. ''Understanding Structured Notes.'' Derivatives Quarterly, Spring 1995. 
9. Ibid., p. 32.

Liquidity Risk 

Due to the complex nature of structured notes, the number of firms that are able and willing to competitively price and bid for these securities is quite small; however, an active secondary market has developed over the past few years. When the structure is complex, however, bidders may be few. Consequently, an institution hoping to liquidate a structured-note holding before maturity may find that their only option is to sell at a significant loss. In certain cases, the issue's original underwriter is the only source for a bid (and even that is not always guaranteed). 

Some factors influencing the liquidity of the note include the type, size, and maturity of the note. In general, the more complex the structure or the more a note exhibits one-way bullishness or bearishness, the less liquidity a note will have. Although the asset-swap market allows the derivative components to be engineered out of these complex structures, liquidity may be impaired because many institutions have investment guidelines which prohibit the purchase of certain types of complex notes. Thus, the size of the potential market is diminished, and liquidity decreases. Also, notes with a smaller size (generally under $10 million) and a longer maturity (generally greater than five years) will tend to be less liquid. 

Volatility Risk 

For each of these structures with embedded options, assumptions about the volatility of interest-rate moves are also inherent. For any of these options which are purchased by investors (for example, interest-rate floors), the risk that expectations for market-rate volatility will decrease over time exists. If this happens, market valuation of these securities will also decrease, and the investor will have ''purchased'' an overvalued option for which he or she will not be compensated if the instrument is sold before maturity. For options which are sold by investors (for example, interest-rate caps), the risk that volatility increases after the note is purchased exists. If this occurs, the market valuation of the structured note will decrease, and the investor will have ''sold'' an undervalued option for which he or she will have to pay a higher price if the instrument is sold before maturity. 

ACCOUNTING TREATMENT 

The Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,'' determines the accounting treatment for investments in structured notes. SFAS 125 has been replaced by SFAS 140, which has the same title. Accounting treatment for derivatives used as investments or for hedging purposes is determined by SFAS 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

Structured notes issued by GSEs should be given a 20 percent risk weighting. Structured notes issued by investment-grade corporations should be given a 100 percent risk weighting. 

For specific risk weights for qualified trading accounts, see section 2110.1, ''Capital Adequacy.'' 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

The limitations of 12 CFR 1 apply to structured notes. Structured notes issued by GSEs are type I securities, and there is no limitation on the amount which a bank can purchase or sell. Structured notes issued by investment-grade-rated corporations are type III securities. A bank's purchases and sales of type III securities are limited to 10 percent of its capital and surplus. 

REFERENCES 

 Audley, David, Richard Chin, and Shrikant Ramamurthy. ''Derivative Medium-Term Notes'' and ''Callable Multiple Step-Up Bonds.'' Prudential Securities Financial Strategies Group, October 1993 and May 1994, respectively.   ''BankAmerica Exec Explains What Happened with Its $68M Fund Bailout.'' American Banker, October 17, 1994. 
 Cilia, Joseph. Product Summary- Asset Swaps- Creating Synthetic Instruments. Federal Reserve Bank of Chicago, August 1996. 
 Cilia, Joseph, and Karen McCann. Product Summary-Structured Notes. Federal Reserve Bank of Chicago, November 1994. 
 Crabbe, Leland E., and Joseph D. Argilagos. ''Anatomy of the Structured Note Market.'' Journal of Applied Corporate Finance, Fall 1994. 
 Goodman, Laurie, and Linda Lowell. ''Structured Note Alternatives to Fixed Rate and Floating Rate CMOs.'' Derivatives Quarterly, Spring 1995. Structured Notes   
 Kawaller, Ira G. ''Understanding Structured Notes.'' Derivatives Quarterly, Spring 1995. 
 McNeil, Rod. ''The Revival of the Structured Note Market.'' International Bond Investor. Summer 1994, pp. 34-37. 
 Peng, Scott Y., and Ravi E. Dattatreya. The Structured Note Market. Chicago: Probus, 1995. 

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