Structured Notes
Structured Notes Definition | What is it?
A structured note, sometimes called "hybrid debt," is an intermediate term debt security, whose interest payments are determined by some type of formula tied to the movement of an interest rate, stock, stock index, commodity, or currency. Although structured notes are derivatives, they often do not include an option, forward or futures contract.
Structured notes provide investors with an opportunity to take advantage of views not only about the direction of interest rates but the volatility, the range, the shape of the term structure (i. e., long term rates vs. short term rates), and the direction of commodity and equity prices. For example, consider an oil company with a poor credit rating that wants to borrow. It issues a note with the interest payments tied to the price of oil. As oil goes up, its cash flows increase and it finds it easier to make the interest payments. When oil prices go down, its interest burden is lower.
There are a wide variety of structured notes, including inverse floaters and range notes.
An inverse floater is a floating rate instrument whose interest rate moves inversely with market interest rates. Many structured notes, and particularly inverse floaters, have a leverage factor in which the rate adjusts by a multiple, such as 1.5 times LIBOR.
Range notes typically pay interest at an above-market rate if LIBOR stays within a specific range, which may change according to a schedule. If LIBOR moves outside of that range, these notes may revert to a lower interest rate or no interest at all.
Other types of structured notes pay a promised rate but allow additional payments based on the movement of a commodity price or stock index. For example, consider a five-year note that promises to pay 2 % interest plus the percentage change in the S&P 500 over the five year period, if the S&P 500 goes up. This is like a T-bill at a below-market rate plus a call option. Alternatively, it can pay the additional interest based on the decline in the S&P 500, which makes it like a T-bill and a put.
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