What a Structured Product Is: One Name, Several Obligations

A structured product is one instrument written over several obligations. The buyer signs a single line at a single price. The seller owes a set of legs, each of which already has a name of its own: typically a promise to pay a stated amount at a stated date, and an option contract whose value comes from something else. Written as one thing, owed as several.

Three inputs generate every figure that follows: a spot price of Rs 2,000.00/- for the reference asset, financing of 6.50 per cent a year, and a call premium of Rs 180.00/- that is given rather than worked out. The reference asset pays nothing at all while it is held. The absence of a payout is not filler. A payout during the year would change every number that follows it, and this reference asset makes none.

What arrives as one instrument, and what is owed underneath it?

Nothing inside one of these is new. Every legOne of the separate promises inside a packaged instrument. Each leg has a name of its own and can be written down, priced and asked about on its own. is a contract the reader has already met under its own name, and the packaging is simply the act of selling those contracts together, under one name, at one price. Taking one of these apart works at all for that reason: the parts are not hidden, they are just not listed on the front.

Here is the everyday version, and it is closer than it looks. A household pays one amount every month for a phone connection. Inside that single line sit three arrangements that have nothing to do with each other: a handset being paid off over two years, a quantity of calls and data, and a cover that repairs a cracked screen. Three obligations, three different things being bought, one line on one bill. Nobody would call that dishonest. Equally, nobody who wanted to know what they were actually paying for would stop reading at the single line.

A packaged instrument is that bill, written in contracts. The buyer signs one line with one price against it. The seller owes a set of separate promises that happen to be sold together. Write the instrument out as its legs before reading anything else about it. That instruction is the whole of the method.

What is the leg that does not depend on the reference asset?

The first is a promise legA promise to pay a stated amount at a stated date. A promise leg does not move with the reference asset, and what it is worth to a holder depends on who made the promise.: a promise to pay a stated amount at a stated date. Those terms are the whole of it. In this example it is a promise to pay Rs 2,000.00/- at the end of the year, and it will pay Rs 2,000.00/- at the end of the year whether the reference asset has doubled, halved or sat still. The promise leg is what makes the rest of the document possible to write. Almost every packaged instrument a person is shown begins with one.

Two things decide what that promise is worth to a holder, and neither of them is arithmetic: who owes it, and what stands behind the promise. A promise to pay Rs 2,000.00/- in a year is not one object. The promise is as many different objects as there are parties who might make it and arrangements that might sit behind it. The working record behind these figures carries no seller of any kind, no issuer, and no arrangement standing behind anybody, so which of them is in front of a reader cannot be settled. Naming one would mean inventing it, and an invented party standing behind an invented promise is exactly the thing a reader might carry away and use.

The other question is arithmetic: what does a promise of that shape cost to buy today? The cost is a present value, moving one amount back through one year at one rate, and the method is already established. The arithmetic is done in full below, in the same place as everything else that has a number attached.

What is the leg that does depend on the reference asset?

The second is an option legThe contract inside a packaged instrument whose value comes from the reference asset. In this example the option leg is a call. A call gives its buyer a choice at the end and binds its writer to that choice., and here it is a call struck at Rs 2,000.00/-. A call gives its buyer a choice at the end and it binds its writer to that choice, and the amount paid for that choice is a premiumThe amount paid for an option contract. The premium is paid at the start and does not come back, whatever the contract goes on to do. which does not come back.

The option leg is the only leg inside the instrument whose payoffWhat a contract owes at the end, before anything paid for it is counted. A call struck at Rs 2,000.00/- has a payoff of nil at any level at or below Rs 2,000.00/-. moves when the reference asset moves, so every sentence in a document about what happens if the level rises is a sentence about that leg and about nothing else. That single fact rearranges how a document reads. Four printed sides describing rises, falls, levels and dates are four sides about one of the two things the buyer has bought, and the other thing, which took most of the money, is described in half a line on the first of them.

Keep two words apart while reading it. A payoff is what the contract owes at the end before anything paid for it is counted. A profitThe payoff after what was paid for the contract is counted, carried forward at the financing rate to the same date so that the two amounts are compared on the same day. is that payoff after what was paid is counted, carried forward to the same date so that the two amounts meet on the same day. The premium of Rs 180.00/- carried forward one year at 6.50 per cent is Rs 191.70/-, so a payoff of Rs 130.00/- is a payoff of Rs 130.00/- and it is not a profit. Keep those two words apart throughout. A document that blurs them is describing one thing while a reader hears another.

What do the words principal protection name?

Principal protection is a phrase printed on the front of a document, and it is a label rather than a property of anything. The distinction between a label and a property is the sharpest thing about these words. What the words name can be set out. Whether any given instrument does what its label says cannot.

The label names a leg that promises the return of a stated amount at a stated date. The promise leg set out above is exactly that leg. That is a real thing with real terms, and it is not a trick. A promise to pay Rs 2,000.00/- at the end of the year is a promise to pay Rs 2,000.00/- at the end of the year. The words on the front are a plain-language description of the shape of that promise, and as descriptions go it is accurate.

The label leaves three things unnamed, and every one of them matters more than the shape. It does not name who owes that amount. The words do not name what stands behind the promise. And they do not name what happens to a holder who wants out before the date. A document may answer all three inside it. The words on the front answer none of them, and a reader who stops at the front has stopped at the least informative part of the document.

What do the words capital guarantee add, and what do they still not say?

Capital guarantee is the second set of words these instruments are sold under, and the difference between the two sets is exact enough to state in one line. The first set of words describes the shape of a promise, and the second set reaches for something about who stands behind it. The difference is real and worth noticing: describing an obligation is not describing its backing.

Then comes the part that closes the section. A guarantee is itself a promise by somebody. So the second set of words moves the question along rather than answering it: instead of asking who owes the amount, the question becomes who made the guarantee, and what stands behind that. Move one step and the same question is waiting, wearing a different coat. None of that is a criticism of the words. The words are what they are, and reading them as an answer is the error.

Neither set of words tells the reader who owes the money, and the identity of the party owing it is the single thing a label cannot supply. A label is printed. A party is a name in a document with terms attached. The Securities and Exchange Board of India (SEBI), at sebi.gov.in, sets what may be claimed in the name of an instrument of this kind. A requirement is not an arithmetic result, and requirements change.

What do the parts cost here, and what is left of the outlay?

Now the arithmetic itself, rather than a description of it. The phrase to hold on to is short: price the parts and see what is left. The buyer puts in an outlayThe amount a buyer puts in. The outlay is a price paid for the instrument, and it moves from the buyer to whoever sold it. of Rs 2,000.00/-, which is a price paid for the instrument. Two legs are written over it. Leg one promises Rs 2,000.00/- at the end of the year. Leg two is a call struck at Rs 2,000.00/-.

Before the numbers, one thing a careful reader has already noticed and would otherwise assume was a transcription error. Three quantities in this guide are all Rs 2,000.00/-, and they agree for three separate reasons. The spot price of the reference asset is Rs 2,000.00/-. The strike of the option leg is Rs 2,000.00/- because this leg is struck at the money, and that is exactly what at the money means. And the outlay is Rs 2,000.00/- because this worked example has the buyer put in precisely the value of one unit of the reference asset. Three quantities, one number, three different reasons, and none of them was copied into another.

The promise leg costs an amount of arithmetic. One plus 6.50 per cent is 1.065, and Rs 2,000.00/- due at the end of one year divided by 1.065 gives Rs 1,877.9343/-. The check runs in the other direction in one step: Rs 1,877.9343/- multiplied by 1.065 comes back to Rs 2,000.00/- to the paisa. Nothing was assumed to produce it beyond the rate and the year.

The option leg costs a premium of Rs 180.00/-, and that figure is given rather than computed. Computing it would need a figure for how far the reference asset might move over the year, and no such figure exists anywhere in the working record behind these numbers. This matters more than it looks. A premium that is given can be used, checked against other given premiums and reasoned with. A given premium cannot be defended as correct. Where a pricing model would otherwise supply the figure, there is an absence instead, and the absence is named.

Subtract, and the leftover has a name. The budgetWhat is left of the outlay once the promise leg has been paid for. The budget is the only part of the outlay available to buy an option leg with. is what remains of the outlay once the promise leg has been paid for.

Turn the same arithmetic around and the closing point appears. A promise of the whole Rs 2,000.00/- plus one whole call costs Rs 1,877.9343/- plus a premium of Rs 180.00/-, a total of Rs 2,057.9343/-. Against an outlay of Rs 2,000.00/- that is short by Rs 57.9343/-. The budget is smaller than the premium of one whole call at these figures, so an instrument written to return the whole outlay cannot also pass on the whole of a move, and the shortfall is not a mystery but a price.

The shortfall is a price already met. The shortfall of Rs 57.9343/- is the put premium at this strike and this date. The working record behind these figures carries that put premium as Rs 57.93/-. Nothing was fetched to produce it. The figure falls out of the parity relationship established earlier: at one strike and one date, the call premium less the put premium equals the spot price less the present value of the strike.

The check holds the rest of the arithmetic together, so it is worth stating in full. The budget of Rs 122.0657/- is also the parity difference between the two premiums. And Rs 180.00/- less Rs 57.93/- is Rs 122.07/-, against an exact parity difference of Rs 122.0657/-. The put premium is rounded to the paisa for use. Those two therefore differ by 0.43 paise, being forty-three hundredths of a paisa, and the relationship holds to the paisa rather than exactly.

One last label is the easiest thing of all to get wrong. The Rs 2,000.00/- the buyer puts in is an amount that actually moves, from the buyer to whoever sold the instrument. The Rs 2,000.00/- of reference asset the option leg is written on is exposureThe value of the reference asset a contract is written on. Nobody has paid it and it does not move between the parties. Exposure is the quantity the contract references., which nobody has paid and which never moves anywhere. On these figures the two happen to be the same number. The coincidence makes the distinction harder to see rather than easier, and stating it plainly beats assuming it.

Where is the packaging paid for?

An instrument of this kind is offered at a price. Its legs cost something to buy separately, at prices somebody else set. The price asked less the cost of the parts is where the packaging is paid for. That sentence describes a subtraction, and it is allowed for exactly that reason.

No amount follows for it, large or small. The working record behind these figures holds no seller of a packaged instrument, no offered price and no fee, so the first term of that subtraction is simply not here. An invented fee on an invented instrument is exactly the sort of number a reader might carry away and use somewhere it does not belong.

Filling in that gap needs two short and obtainable things: the terms actually offered, and the price of each leg on the same date, from somebody quoting them. That is a missing quantity, not a hard question. Somebody selling one of these knows both numbers.

Two further readings do not follow. First, the cost of the parts computed here is the cost at the figures in this record, on one date, and it is not a claim about what any leg costs anywhere. Second, the packaging being paid for somewhere is a fact about how selling works rather than a comment on any instrument or on anybody selling one. Every packaged thing anybody has ever bought had its packaging paid for somewhere, and saying so is a description rather than a complaint.

Which quantities cannot be worked out at all, and why?

Three quantities cannot be worked out from the figures given, and they are the reason several sentences above stop where they stop.

First, what either leg is worth beyond the figures given. Pricing either leg would need a figure for how far the reference asset might move over the life of the contract, and the working record holds no such figure of any kind. No leg is therefore priced from scratch, and neither what a packaged instrument is worth nor whether a price offered for one is fair can be settled. Second, how often anything pays or how likely any level is. No probability, no distribution and no realised outcome exists in that record either. Third, what the packaging costs, for the reason set out in full above.

Each of those is a missing quantity rather than a hard question, and the difference matters: a missing quantity can be obtained from somebody who has it, and a figure guessed at in its place is a manufactured one. That distinction is worth stating plainly against any document that answers all three without saying where the answers came from.

How is this used by somebody with a document in front of them?

The arithmetic above is not an exercise. The arithmetic is what somebody reading one of these actually does, whether they are a person deciding for a household, an analyst writing a note on an issue, or a lender working out what a borrower is holding. The sequence is the same for all three, and it takes about ten minutes with a calculator.

1. List the legs, by what each one obliges Not by what the document calls them. A promise to pay a stated amount at a stated date is one line. An option contract on a reference asset is another. If a third obligation is in there, it gets its own line rather than being folded into one of the first two.
2. Put a cost beside each leg, and mark where it came from Two marks are enough: arithmetic, or a quote from somebody. In this example the promise leg is arithmetic, at Rs 2,000.00/- divided by 1.065, and the option leg is a premium of Rs 180.00/- that was given. A note, a document or a set of workings that cannot say which of the two a number is has not finished the work.
3. Subtract, and name the leftover The outlay less the cost of the promise leg is the budget. Write that number down before reading anything about what happens if the level rises, because every such sentence is about what the budget bought.
4. Write who owes each leg beside it This is the column with no arithmetic in it and it is usually the one that decides the answer. A promise leg is worth what the party making it is worth, and no amount of accurate discounting substitutes for that name.
5. What could not be filled in Not as a failure. As a list of questions with obtainable answers, addressed to the person who has them. What the parts cost on the day, what leaving before the end date would cost, and what stands behind the promise are all things somebody knows.

The sequence produces a description of what is owed and by whom rather than a verdict. A description of that kind is the one thing a person cannot get from the front of a document. A household that has done it can ask the seller a question with a number in it. An analyst who has done it can say which part of an issue is a rate exposure and which part references something else. Neither of them has been told what to do, and neither needs to be. The questions are now specific enough to answer.

Should a reader who now understands this hold one?

Arithmetic does not answer that, and the reason is stated rather than cautious. Four things would have to be known before anybody could answer it, and not one of them appears anywhere above.

1. Who owes the amount, and what stands behind that promise A name in a document with terms attached, not a phrase on a front page.
2. What the parts cost on the day the instrument is offered Not at the figures in this record, which belong to one invented example on one date.
3. What leaving before the end date would cost Every figure above assumes the year runs to its end.
4. The reader's own circumstances No general treatment can see those, and none ever will.

The second half of this matters more than the first, and most treatments of the subject skip it: a decomposition is not a reason to keep away from one of these either. Turning a decomposition into a warning would be giving advice just as surely as turning it into a pitch, and it is the easier of the two mistakes to make after an afternoon spent watching how the parts add up. A packaged instrument is not thereby a poor thing to hold, a shortfall is not thereby a charge, and nobody holding one has thereby been done badly by. None of those statements is available from arithmetic.

Knowing how something is put together is not a reason to hold it and not a reason to refuse it. A decomposition establishes what is being owed to the holder, and by whom.

Who sets what may be claimed in an instrument's name?

Everything above is arithmetic and description, and it holds wherever the arithmetic is carried out. The requirements that sit around it do not work that way. Requirements are set by an authority, they differ by instrument, and they move. Each row below names the authority that sets it, and every one of those requirements changes.

The packaged instrument, the reference asset, the spot price of Rs 2,000.00/-, the strike of Rs 2,000.00/-, the outlay of Rs 2,000.00/-, the financing rate of 6.50 per cent a year and the call premium of Rs 180.00/- are all invented.
Educational material. Not advice on any investment, tax, budget or market position.