A financial institution splits a structured product into a bond and derivatives to examine the risks before buying it. A distributor does the same to check the gap between a structured note's theoretical price and its sale price.

Products with embedded derivatives

A structured product is an ordinary bond, deposit, or loan with derivatives such as swaps and options built into it. A bond combined with derivatives is a structured note, a deposit combined with derivatives is a structured deposit, and a loan combined with derivatives is a structured loan. Examples include Nikkei Stock Average-linked notes among structured notes and callable time deposits among structured deposits1.

A derivative built into a contract such as a bond is called an embedded derivative. In a structured note, the embedded derivative can make the amount of interest depend on interest rates or on other indexes such as an equity index or an exchange rate, or can change the redemption amount or the maturity date2.

What passes between the investor, the issuer, and the dealer

In a structured note, the investor pays the principal to the issuer and receives interest (coupons) and the redemption amount from the issuer. For the embedded derivative, the investor is in the same position as if it had traded the derivative with the issuer. In many structured notes, the investor sells an option to the issuer2.

The issuer may enter into a transaction of the same form as the embedded derivative, in the opposite direction, with a swap counterparty. For example, in a credit-linked note (CLN, a bond with the credit risk of a particular company built into it), the issuer sells the swap counterparty the same protection on that company's credit risk that it bought from the investor. In return, it receives a premium3. In an interest rate structured note with a zero floor, the issuer sells the investor a guarantee that the coupon will not fall below 0% (the zero floor) and buys a floor of the same form from the swap counterparty4.

Consider a fictional example of a structured note issued by Company A, in which the financial institution that structures the product (the dealer) is also the swap counterparty.

InvestorCompany AIssuerDealerSwap sidePrincipalCoupon, repaymentOptionOptionPremium
Figure 1What passes between the investor, Company A, and the dealer in a structured note
Figure description

The dealer is the swap counterparty ("Swap side" in the figure). The investor pays the principal to Company A and receives higher coupons and the redemption amount ("Coupon, repayment" in the figure) from Company A. Through the note, the investor sells an option to Company A. Company A sells the same option to the dealer and receives a premium from the dealer in return. The extra coupon that Company A pays the investor comes out of this premium, after fees are deducted.

Splitting into a bond and a sold or bought option

Splitting a structured product into an ordinary bond and the embedded derivative shows the shape of its gains and losses. For example, the value of a convertible bond (formally called a convertible bond with share options in Japan) can be viewed as the sum of the value of the bond and the value of an option on the shares5. How gains and losses differ between the buyer and the seller of an option is covered in Option Basics: Calls and Puts.

The table below splits the main products in this chapter. An exchangeable bond (EB) in the table is a bond that, depending on how a share price moves, may be redeemed at maturity in shares of a company other than the issuer instead of cash6.

Product Form when split Investor's position
Exchangeable bond7 A bond and a put option on the underlying shares Sells a put
Callable bond (a bond the issuer can redeem before maturity)8 A bond and the issuer's right to redeem early Sells the redemption right
CLN3 A bond and protection on the credit risk of a reference entity (a credit default swap) Sells protection
Convertible bond (CB)5 A bond and a call option on the shares Buys a call
Interest rate structured note with a zero floor on the coupon9 A bond and a floor that keeps the coupon from falling below 0% Buys a floor

When the investor sells an option, the premium received makes the coupon higher (the fees deducted from it are covered in the next section). In return, if market values move against the investor, the investor bears the loss7. When the investor buys an option (a convertible bond, a zero floor), the investor is the one paying the premium9. The interest rate on a convertible bond is generally lower than on a straight bond10.

Why yields are higher and what costs are deducted

Many structured products raise the yield through the payment (premium) the investor receives for selling options, or through a feature that multiplies the movement of an index or rate into the coupon (leverage)1.

Not all of the premium reaches the investor. When the option is embedded, a fee that becomes revenue for the financial institution that structures the product (the structuring fee) is taken from the premium, and the distributor charges a fee when it sells the product to the customer (the sales fee)11. In the CLN example too, the extra coupon the issuer pays the investor is smaller than the premium the issuer receives3. The Financial Services Agency has pointed out that, for exchangeable bonds, customers are not getting returns commensurate with the risks, citing these fees as one of the reasons11.

Risks common to structured products

The risks that many structured products share are the credit risk of the issuer and the risk of being hard to turn into cash before maturity. Repayment of a structured note depends not only on the index or rate of the embedded derivative but also on the issuer's credit. If the issuer's business or financial condition worsens, payments of principal or interest may be delayed or may not be made at all. If the issuer's credit weakens and the price of the note falls, selling before maturity may bring back less than the principal12.

Many structured products are hard to sell before maturity. Many trade in small volumes in the market, and even if you try to sell to the distributor, you cannot always do so. Even when you can sell, the actual sale price may be well below the theoretical price (a price calculated with a model from market values)13. Structured notes in the United States also often carry greater liquidity risk than many other securities, and the smaller the amount sold at one time, the harder they are to sell (as of 1998)14. A structured deposit in principle cannot be canceled before maturity, and even if it can be canceled, the amount received may be well below the principal15.

The risk of getting back less than the principal depends on the form of the embedded derivative. On a Nikkei Stock Average-linked note with a knock-in condition, if the equity index falls to or below a set level (the knock-in price), that is, if the note knocks in, the redemption amount becomes linked to the equity index. If the index keeps falling after that, the note is redeemed at far less than the amount invested, and depending on the structure, the principal can fall to zero16.

On the other hand, a so-called principal-protected structured note is designed to return the full face value if held to maturity, however the index or rate moves17. One example redeemed at maturity at the same amount as the issue price is an interest rate structured note with a zero floor whose issue price and redemption price are both set at 100 yen9. However, the face value returned is an amount in the currency of the note (in US dollars for a US dollar note). The issuer's credit risk remains18, and for a note in a foreign currency, currency risk can make the amount received in yen fall below the amount invested19. The Japan Securities Dealers Association's guidelines on advertising, as amended in 2023, ask that complex structured notes not be labeled "principal-protected" merely because redemption is 100% in the currency of the note20.

Sales rules for structured notes in Japan

On April 18, 2023, the Japan Securities Dealers Association amended its rules on investment solicitation and customer management by association members, together with the related guidelines and other rules, for soliciting sales of complex structured notes and similar products. The amendments took effect on July 122. The Financial Services Agency has said that distributors need to respond to these amendments and to the Q&A published by the association, treating them as the minimum standard23.

The guidelines on criteria for starting solicitation require distributors to set criteria that exclude customers without a certain level of investment experience from solicitation. The guidelines also give, as examples of customers who should not be solicited, customers for whom a large loss would make it hard to maintain their livelihood, such as those investing for stable returns24.

The guidelines on reasonable-basis suitability require distributors to obtain the theoretical price from the financial institution that structures the product and to verify whether the difference from the sale price is reasonable. They also require distributors to verify, product by product, whether there are customers to whom the product can be sold and, if so, which customers25.

The guidelines on explaining important matters include among the important matters to explain the reasons why buying the structured note is considered suitable for the customer. They also say that explanations should not overemphasize high interest rates or high credit ratings26.

Structured deposits offered by banks are classified as specified deposits under the Banking Act and are subject to rules such as a duty on the providing bank to give information before the contract is concluded27.

Products covered in this chapter

This chapter covers structured notes first, then structured deposits and structured loans. It helps to read Exchangeable Bonds (EB) first. The exchangeable bond is the typical share-linked structured note in which the investor sells a put, and it makes the way the other pages split products easier to follow.

Equity index-linked notes are structured notes linked to an equity index, and they also cover the difference between the so-called principal-protected type and the type with a knock-in. Bonds with early redemption features and callable bonds cover, respectively, bonds automatically redeemed early when a condition is met and bonds the issuer can redeem before maturity. Convertible bonds (CB) are an example of a product in which the investor is the option buyer. Credit-linked notes (CLN) are a product in which the investor sells protection on a reference entity. PRDC notes are structured notes linked to exchange rates, and digital coupon notes are also part of this chapter. Structured deposits are products that combine deposits with derivatives, and structured loans are products that combine loans with derivatives.

Notes

  1. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (Understanding and managing the risks of investing in structured products, in Japanese), page 3, "１．仕組商品とは" (1. What structured products are). ↩ ↩2

  2. Board of Governors of the Federal Reserve System (FRB), "Trading and Capital-Markets Activities Manual," Section 4040.1 "Structured Notes," page 1, "General Description," and page 3, the paragraph containing "tied to indexes other than interest rates." ↩ ↩2

  3. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (in Japanese), pages 13–14, the section on CLNs and the "基本的な仕組み" (Basic structure) figure ("A社の信用保証" (credit protection on Company A), "プレミアム（β）" (premium (β)), "※α＜β"). ↩ ↩2 ↩3

  4. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (in Japanese), pages 7 and 9, the "基本的な仕組み" (Basic structure) figures (reverse floater notes and CMS notes; "ｾﾞﾛﾌﾛｱ保証" (zero floor guarantee) and "ﾌﾛｱ＊" (floor)). ↩

  5. Fuminobu Otake, Nobuyuki Oda and Toshinao Yoshiba, "転換社債の市場価格分析とリスク管理" (Market price analysis and risk management of convertible bonds), Institute for Monetary and Economic Studies, Bank of Japan, Discussion Paper No. 98-J-15, August 1998 (in Japanese), page 5, the formula "転換社債価値（CB）＝社債価値（B）＋株式オプション価値（OP）" (convertible bond value (CB) = bond value (B) + equity option value (OP)) and "シンプル・モデル" (the simple model). ↩ ↩2

  6. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (Results of monitoring customer-oriented business conduct by distributors of investment trusts and other products, in Japanese) (June 2022), page 28, note 25. ↩

  7. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), page 29, "① 商品性に関する問題点" (① Problems with product characteristics) and note 27. ↩ ↩2

  8. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (in Japanese), "ﾏﾙﾁｺｰﾗﾌﾞﾙ" (multi-callable) on pages 4 and 6, and FRB, "Trading and Capital-Markets Activities Manual," Section 4040.1, pages 1–2, "Step-Ups/Multi-Steps." ↩

  9. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (in Japanese), "ｾﾞﾛﾌﾛｱ" (zero floor) on pages 4, 6, and 8, and "発行・償還価格：100円" (issue and redemption price: 100 yen) in the worked example. ↩ ↩2 ↩3

  10. Japan Exchange Group, "転換社債型新株予約権付社債（CB）とは" (What are convertible bonds with share options (CB)?), CB overview (in Japanese), "特徴" (Features). ↩

  11. Financial Services Agency, "投資信託等の販売会社による顧客本位の業務運営のモニタリング結果について" (in Japanese) (June 2022), page 30, the paragraph beginning "また、オプションを組み込む際" (In addition, when embedding an option) in "① 商品性に関する問題点" (① Problems with product characteristics). ↩ ↩2

  12. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (What are the features and risks of Nikkei Stock Average-linked notes?, in Japanese), page 3, "発行者の信用リスク" (Credit risk of the issuer). ↩

  13. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (in Japanese), pages 15 and 30, "（1）シナリオ分析の重要性" ((1) The importance of scenario analysis) and "（１）購入前の検討" ((1) Considerations before buying) in "４．リスク管理のポイント" (4. Key points of risk management). ↩

  14. FRB, "Trading and Capital-Markets Activities Manual," Section 4040.1 "Structured Notes," page 7 (page dated February 1998), the paragraph on liquidity risk. ↩

  15. Japanese Bankers Association, "仕組預金" (Structured deposits, in Japanese), "「仕組預金」にもリスクがあります。" (Structured deposits also carry risks). ↩

  16. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), pages 1–2, "○償還金額が変動する日経平均リンク債" (Nikkei Stock Average-linked notes whose redemption amount varies) and "〇 注意すべき事項" (Points to note). ↩

  17. Financial Industry Regulatory Authority (FINRA), "Understanding Structured Notes With Principal Protection" (April 12, 2023), the opening paragraph and the first paragraph of "How Do These Notes Protect My Investment?" ↩

  18. FINRA, "Understanding Structured Notes With Principal Protection" (April 12, 2023), the last paragraph of "How Do These Notes Protect My Investment?" ↩

  19. Japan Securities Dealers Association, "日経平均リンク債の特徴やリスクとは？" (in Japanese), page 6, "〇日経平均リンク債に特有のリスク" (Risks specific to Nikkei Stock Average-linked notes). ↩

  20. Japan Securities Dealers Association, "複雑な仕組債等の販売勧誘に係る「協会員の投資勧誘、顧客管理等に関する規則」等の一部改正について" (Partial amendments to the rules on investment solicitation and customer management by association members and related rules concerning the solicitation of complex structured notes and similar products, in Japanese) (April 18, 2023), the attachment "「広告等に関する指針」の一部改正について" (Partial amendment of the guidelines on advertising), page 5 (page 44 of the PDF), item ⑥ (as amended) of "(10) 仕組債" ((10) Structured notes) in "４．個別銘柄の広告等" (4. Advertising of individual issues) under Part 2, "Ⅲ．債券" (III. Bonds). ↩

  21. Bank of Japan, Financial System and Bank Examination Department, Center for Advanced Financial Technology, "仕組商品投資のリスク把握と管理" (in Japanese), pages 29–34, "（１）購入前の検討" ((1) Considerations before buying), "（２）購入時の決裁手続き" ((2) Approval procedures at purchase), and "（３）購入後のモニタリング" ((3) Monitoring after purchase) in "４．リスク管理のポイント" (4. Key points of risk management). ↩

  22. Japan Securities Dealers Association, "複雑な仕組債等の販売勧誘に係る「協会員の投資勧誘、顧客管理等に関する規則」等の一部改正について" (in Japanese) (April 18, 2023), pages 1–2, "Ⅰ．改正の趣旨" (I. Purpose of the amendments) and "Ⅱ．改正の骨子" (II. Outline of the amendments), and page 8, "Ⅲ．施行の時期" (III. Effective date). ↩

  23. Financial Services Agency, "リスク性金融商品の販売会社による顧客本位の業務運営のモニタリング結果" (Results of monitoring customer-oriented business conduct by distributors of risk-bearing financial products, in Japanese) (June 2023), page 8, "（イ）商品導入・販売に際して販売会社に求められる事項" ((a) What distributors are required to do when introducing and selling products) under "① 仕組債" (① Structured notes). ↩

  24. Japan Securities Dealers Association, "複雑な仕組債等の販売勧誘に係る「協会員の投資勧誘、顧客管理等に関する規則」等の一部改正について" (in Japanese) (April 18, 2023), pages 5–6, item (2) of "３．「協会員の投資勧誘、顧客管理等に関する規則第５条第２項の考え方」（勧誘開始基準ガイドライン）" (3. Guidelines on criteria for starting solicitation). ↩

  25. Japan Securities Dealers Association, "複雑な仕組債等の販売勧誘に係る「協会員の投資勧誘、顧客管理等に関する規則」等の一部改正について" (in Japanese) (April 18, 2023), page 3, items (5) and (6) of "２．「協会員の投資勧誘、顧客管理等に関する規則第３条第３項の考え方」（合理的根拠適合性ガイドライン）" (2. Guidelines on reasonable-basis suitability). ↩

  26. Japan Securities Dealers Association, "複雑な仕組債等の販売勧誘に係る「協会員の投資勧誘、顧客管理等に関する規則」等の一部改正について" (in Japanese) (April 18, 2023), page 7, items (1) and (2) of "５．「協会員の投資勧誘、顧客管理等に関する規則第３条第４項の考え方」（重要事項説明ガイドライン）" (5. Guidelines on explaining important matters). ↩

  27. Financial Services Agency, "仕組預金の説明態勢等に係る監督指針の改正（概要）" (Amendments to the supervisory guidelines on explanation practices for structured deposits (outline), in Japanese) (July 2026), "概要" (Outline) and its note. ↩