Structured Finance- Final

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STRUCTUREDFINANCE

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Structured Finance

Structured finance denotes the art (the science) of designing financialproducts to satisfy different needs of investors and borrowers as closely aspossible. The essence of structured finance activities is the pooling of economic assets (e.g. loans, bonds, mortgages) and subsequent issuanceof a prioritized capital structure of claims, known as tranches, againstthese collateral pools. Thus, structured finance is a broad term used tosolve and describe a sector of financethat was created to help transferriskusing complex legal and corporate entities.Structured finance encompasses all advanced private and public financialarrangements that serve to efficiently refinance and hedge any profitableeconomic activity beyond the scope of conventional forms of on-balancesheet securities (debt, bonds, equity) in the effort to lower cost of capitaland to mitigate agency costs of market impediments on liquidity. Inparticular, most structured investments combine traditional asset classeswith contingent claims, such as risk transfer derivatives and/or derivativeclaims on commodities, currencies or receivables from other referenceassets, or replicate traditional asset classes through synthetication.Structured finance is invoked by financial and non-financial institutions inboth banking and capital markets if established forms of external financeare either unavailable (or depleted) for a particular financing need, ortraditional sources of funds are too expensive for issuers to mobilizesufficient fund for what would otherwise be an unattractive investmentbased on the issuer’s desired cost of capital. Structured finance offers theissuer’s enormous flexibility in terms of maturity structure, security designand asset types, which allows issuers to provide enhanced return at acustomized degree of diversification commensurate to an individualinvestor’s appetite for risk. Hence, structured finance contributes to amore complete capital market by offering any mean-variance trade-off along the efficient frontier of optimal diversification at lower transactioncost. However, the increasing complexities of the structured financemarket, and the ever growing range of products being made available toinvestors, invariably create challenges in terms of efficient assembly,management and dissemination of information. The premier form of structured finance is capital market-based risktransfer whose two major asset classes include asset securitization (whichis mostly used for funding purposes) and credit derivative transactions (ashedging instruments) permit issuers to devise almost an infinite number of ways to combine various asset classes in order to both transfer asset riskbetween banks, insurance companies, other money managers and non-

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