Legal Definitions - structured security

A structured security is a complex financial instrument whose value and payment schedule are derived from, or linked to, the performance of one or more underlying assets, indices, or formulas. Unlike traditional securities like plain stocks or bonds, structured securities are custom-designed to meet specific investment objectives or risk profiles. They often combine features of different financial products, such as bonds, options, and derivatives, to create a unique risk-reward structure.

Here are some examples to illustrate the concept of a structured security:

• Example 1: Commodity-Linked Note

  Imagine an investment product called a "Precious Metals Growth Note." This note promises to return your initial investment (principal) at maturity, plus an additional payment based on the average performance of a basket of gold, silver, and platinum over a five-year period. If the average price of these metals increases, you receive a percentage of that gain; if they fall, you still get your principal back, but no additional gain. This is a structured security because its return is tied to the performance of underlying commodities, and it has a built-in principal protection feature, making it more complex than simply buying shares in a gold mining company.

• Example 2: Equity-Indexed Certificate

  Consider a "Market-Linked Growth Certificate" offered by a financial institution. This certificate guarantees your initial investment at maturity, but any potential interest earnings are linked to the performance of a major stock market index, such as the S&P 500. For instance, it might offer 70% of the S&P 500's positive return over a three-year term, up to a maximum cap of 15%, but with no participation in losses. This is a structured security because its interest payments are not fixed but are derived from an equity index, and it incorporates both a floor (principal protection) and a cap (maximum return), creating a specific risk-reward profile different from a standard savings certificate or direct stock market investment.

• Example 3: Collateralized Loan Obligation (CLO)

  A financial firm pools together hundreds of corporate loans made to various businesses. They then create different "slices" or tranches of securities from this pool, each with a different level of risk and expected return. For example, the "senior tranche" might have the lowest risk and receive payments first, while the "junior tranche" might have higher risk but offer potentially higher returns. Investors purchase these tranches. This is a structured security because its value and payments are derived from a diverse pool of underlying loans, and it is "structured" into multiple parts with varying risk characteristics to appeal to different types of investors.