Structured securities are complex financial instruments often derived from pooled assets such as mortgages or other loans. These securities are split into different tranches or classes, each representing a distinct level of risk and return. The cash flows from the principal and interest payments of the underlying assets are divided among these tranches in a predefined structure, which allows different levels of priority for payment of interest and principal.
Characteristics of Structured Securities
Risk Allocation: The tranches are typically set up to absorb losses differently with senior tranches getting priority over subordinate (junior) tranches in case of default on the underlying loans. Senior tranches usually offer lower returns compared to riskier junior tranches.
Interest Payments: The payment of interest may vary by tranches. Higher-ranked tranches could potentially receive their agreed upon interest payments before the lower-ranked tranches.
Pricing and Valuation: The valuation of each tranche depends on the probabilistic estimation of defaults and the recovery rate, along with the influence of interest rates and market conditions.
Examples of Structured Securities
Collateralised Debt Obligations (CDOs): These consist of various loans like auto loans, credit card debt, or corporate debt.
Mortgage-Backed Securities (MBS): Includes home loans pooled and securitized to back the issue of the security.
Regulatory Environment
Investors considering investing in structured securities should be familiar with laws and regulations such as the Securities Exchange Act and regulations enforced by the SEC which are designed to protect investors and ensure market integrity. More specific outlines and regulations can be found within the Dodd-Frank Wall Street Reform and Consumer Protection Act, aiming to improve transparency and accountability in this market segment.
Understanding the complexities and inherent risks of structured securities is essential for effective investment planning and risk management.
