Structured Products 101

After coming across some weird people in the course of my work, let me just do the world a favour and give everyone a mini-lesson in structured products.

Today's lesson: Structured Deposits (Interest Rates)

Background: SIBOR refers to Singapore InterBank Offer Rate, which is the rate at which banks lend to each other in Singapore.

Some might know of the products that pay better interest of (x-SIBOR)% if SIBOR is smaller than a certain rate x, but zero interest if SIBOR is greater than x. These products include a clause that stipulates that

"the bank may, at any time repay the entire amount of the principal."

Sounds good right? If SIBOR is greater, you don't lose, and the bank can pay you your deposit back. If SIBOR is smaller, you get a much higher return on your money than you would in a conventional savings account or fixed deposit.

WRONG.

Here's the thing, if SIBOR is greater than x, PLEASE DON'T EXPECT THAT...

"The investments are not performing, so the bank will pay you your full principal back"

Bullshit. You wait longlong lor. You can say that to the face of any sales staff who tries to tell you that.

Here's why.

Would the bank actually refund you your deposit if SIBOR is greater than x? If SIBOR is greater than x, what happens? Congratulations! You've effectively locked yourself into a (insert number of years here) year INTEREST FREE DEPOSIT. In other words, loser^(max).

And the bank? Winner^(max), as by taking your money and loaning it to other banks they earn the SIBOR rate instantly. They don't even have to take the trouble and absorb the credit risk by loaning it out to a company or individual. Good deal.

However, if SIBOR is much smaller than x, what happens? Good for you right? Sit back, relax and collect the much larger interest on your deposit with whatever bank you've purchased that product from.

WRONG (Again. I just love telling you that you're wrong. So sue me).

Whenever it becomes cheaper to pay off your principal rather than loaning out the money (at SIBOR or otherwise), the bank will just pay you in full, and you lose the anticipated higher interest rate. You'll probably place the funds in a fixed deposit or savings account, and since SIBOR is lower now, the corresponding floating rate you get will be lower too. Alternatively, you could get yourself into another structured deposit. In other words, loser^(max) again.

And why can the bank do this?
Well, by signing on the dotted line, what have you effectively done?
You've sold the bank an Interest Rate Option.
And instead of getting cash for selling this option, you're actually delivering your money to them too. Well done. Of course, you could get the potentially higher returns, BUT... what happens when your returns get too high?

That's right. The bank repays the principal. loser^(max) situation again.

Please note that while this post focuses on interest rate structured products, the same logic applies to forex deposits and the like too...

A final line?

"Caveat Emptor."

Good luck for your investing.
Heh.