Structured finance products are a variety of different investments that are used to provide investors with the opportunity to earn income through interest. Some of these investments include mortgage-backed securities, credit default swaps, ETNs, covered mortgage bonds and more.
Mortgage-backed securities
Mortgage-backed securities are structured finance products that represent claims on cash flows from a pool of mortgage loans. They are typically bought and sold on the secondary market. Typical buyers of MBS include investors, corporations, and individuals.
The price of MBS varies depending on prepayment assumptions. These are based on a variety of factors, such as the interest rate, the credit rating, the location of the properties involved, and the economic environment.
If a homeowner does not repay his or her loan, the mortgage-backed security will lose money. But if the borrower is able to repay the mortgage, the investor gains from the payments.
There are two primary types of MBS. The first is pass-through. These are structured as trusts and are taxed under grantor trust rules. Typically, pass-throughs have maturities of five to thirty years.
The second is a more complicated type of mortgage-backed security called a collateralized mortgage obligation. This is a pool of mortgages organized into separate tranches, each with a different maturity.
Covered mortgage bonds
Covered mortgage bonds are structured finance products that are often regarded as high-quality investments. They are typically rated investment grade and offer higher yields than many debt instruments. They also provide some protections that may make them more appealing for investors.
These investments are issued by banks, depositary institutions and other regulated financial entities. Generally, they have a maturity of three to seven years. Typically, they have an investment grade rating and draw from a pool of collateral. This pool is known as the cover pool.
The cover pool usually contains high-quality residential mortgage loans. In case of the issuer’s insolvency, the proceeds of the assets in the cover pool can be used to meet the principal payment obligation on the bonds. The quality of the assets in the cover pool contributes to the investment grade rating.
There are a number of different types of structured products. These include asset- backed securities (ABS) and mortgage-backed securities (MBS). The difference between ABS and MBS is the type of asset involved.
Credit default swaps
Credit default swaps are structured finance products that are sold to investors to mitigate the risks of a potential underlying asset’s default. They are also used for hedging. In exchange for a fee, the buyer of the CDS receives compensation in the event of the reference asset’s default.
These contracts are generally traded through a central clearinghouse, such as ICE TCC. There are two main competing theories for pricing credit default swaps: the probability model and the no-arbitrage model.
The probability model calculates the expected value of cashflows over a specified time horizon, weighted by the likelihood that the cashflows will be non-defaulted. This value is then divided by the inverse of the premium. This is referred to as the “credit spread”.
The no-arbitrage model proposes that the investor in a CDS should be paid for taking the default risk of the reference asset. However, the premium is only paid when the credit event occurs.
The CDS market is a large and active one, offering a multitude of options for users. The market is open to speculation as well as for hedging purposes.
ETNs
Exchange-traded notes (ETNs) are structured finance products that allow investors to track a benchmark index and receive a cash payment based on its performance. ETNs are typically issued by large financial institutions.
There are several risks associated with investing in ETNs. The risks include the risk of the issuing bank failing to pay its debts. Additionally, there is the risk that the share price of the note will drop substantially.
In addition to the risks of the issuing bank, ETNs are also vulnerable to market volatility. When the price of an ETN deviates from the underlying index, an investor may experience a loss. This is known as contango. Contantango has been particularly problematic in the energy markets over the past few years.
The price of an ETN will also depend on the credit rating of the issuer. If an ETN issuer’s credit rating declines, the value of the note could be less than its underlying index. An issuer can call the note before maturity or delist it from national exchanges.
