CHAPTER

02
RISK CONSIDERATIONS
OF STRUCTURED PRODUCTS

IMPORTANT CONCEPTS DEFINITIONS/EXPLANATIONS

Market risk
General market risk
Issuer-specific risk
Issuer or swap counterparty credit The counterparty’s inability to meet contractual obligation is called
risk
Liquidity risk (Institution)
Liquidity risk (Investor)
Foreign exchange (FX) risk
Structural risk
Safety of principal
Leverage
Investment in derivatives
Investment concentration
Collateral
Legal risk
Regulatory risk
Market risk refers to the price volatility that comes from the fluctuation in
market prices of the underlying assets.
Affected by the general economic conditions and market outlook (e.g.
interest rates, inflation, exchange rate, commodity prices).
Risk factors that only affect the price of a particular issuer’s security (e.g.
downgrade in credit rating of a company).
“default”. The word “default” encompasses a range of failure to meet
obligations such as, paying interest when due, making futures delivery,
repayment of loan, etc.
• Liquidity from an institution’s perspective refers to insufficient cash to
meet its cash flow requirements.
• Risk = Financial position and resulting credit standing are inevitably
affected, leading to a possible downgrade in its securities and loss of
values to their investors.
• Liquidity from investor’s perspective refers to the ease of converting
his investments into cash.
• Risk = Investor may be unable to sell his investments for a reasonable
price.
• Investments are denominated in a foreign currency; investor may
suffer a loss on principal when he converts the maturity payment
(made in foreign currency) back into local currency.
• If the underlying assets are denominated in foreign currency, the
investment return is dependent on the FX rate as applied to the
performance measurement.
• Safety of principal.
• Leverage.
• Investment in derivatives.
• Investment concentration.
• Collateral.
• Different degrees of principal protection versus capital appreciation.
• Each product is structured to provide full, partial or no return of
principal upon maturity.
• “Leverage” (also called “gearing”) refers to techniques used to increase
the potential rate of return.
• Such techniques include trading on margin, use of derivatives to trade
on price differentials, and borrowing money to trade.
Other features in derivatives contracts that investors should consider. For
example, the kick-in and knock-out features.
Risk of putting all eggs in one basket.
Collateral risk refers to the risk that the value of collateral may not be
sufficient when collateral is exercised to cover the loss.
Legal risk refers to the potential loss arising from the uncertainty of legal
proceedings, such as bankruptcy, and potential legal proceedings.
Legislation or regulations may change during the life of the financial
contract.

6
 Correlation Correlation is a statistical measurement of how the prices of two securities
move in relation to each other and is represented by a correlation
coefficient.
• +1 indicates that the two securities are perfectly correlated. That is,
when the price of one security moves up or down, the price of the
other security moves in the same direction, by the same percentage.
• -1 indicates that the two securities are perfectly negatively correlated.
When the price of one security moves up or down, the price of
the other security moves in the opposite direction, by the same
percentage.
• 0 indicates movements of the securities have no correlation; they are
completely random.
Modelling Emergence of automated trading, also known as algorithmic trading, or
algo trading. It is the use of pre-programmed algorithm to decide on the
timing, price, or quantity of the trade orders. In many cases, the computer
initiates the order without human intervention.
Early redemption Subject to the market value adjustment or structure of the products;
depending on the market conditions, investors may suffer substantial
losses upon early redemption.

EXAMPLES OF KEY RISK THAT

AFFECT REDEMPTION AMOUNT

KEY RISK WHAT THIS MEANS WHAT HAPPENS REDEMPTION AMOUNT

Credit risk of the The issuer’s inability to meet a
issuer payment due will constitute an
event of default.
Derivative Derivative counterparty
counterparty becomes unable to make
defaulting payments due under the
derivative transaction (which
may be a swap or an option),
e.g. if it is insolvent or becomes
bankrupt.
This triggers an early (or
mandatory) redemption of
the notes.
This triggers an early (or
mandatory) redemption of
the notes.
The investor may lose all
or a substantial part of
his original investment
amount.
The investor may lose all
or a substantial part of
his original investment
amount.

If the derivative counterparty

defaults, the issuer will not
receive any payments under the
derivative transaction and may
not be able to meet its payment
obligations under the notes.
Certain events The assets constituting the This triggers an early (or The investor may lose all
adversely affecting collateral may suffer a loss in mandatory) redemption of or a substantial part of
the value or market value, thereby leading to the notes. his original investment
performance of the a loss in the market value of the amount.
collateral collateral as a whole.

The issuer of the collateral (e.g.

bonds) becomes insolvent or
defaults on any of its payment
obligations.