When you put money into a structured product, you're making an unsecured loan to the issuer — let's call it Bank A. Sometimes Bank A promises to return your principal (minus hefty fees and commissions). But this promise isn't backed by a government guarantee.
Your return depends on the performance of underlying financial instruments — like stocks, stock indexes, bonds, commodities, or foreign currencies. Bank A doesn't always buy the underlying investments — it often bets on their future performance through an agreement with another party. That agreement, called a derivative, has a value based on the underlying investments' price movements.
Your return is based on a complex formula that gives Bank A the lion's share of any gains. You're usually protected from losses, but only up to a certain point, after which you lose money. Here's a real-life example: a structured product with a three-year maturity. The underlying instrument is the Standard & Poor's 500 Index. You'll get 100 percent of your principal back in three years if the index hasn't fallen more than 30 percent at the end of the three-year term. If the index falls more than 30 percent, you eat all the losses. If the index rises, you'll earn 1.5 times the gain, up to a cap of 58.6 percent. The fees total 2.5 percent of your investment.
The bottom line
With this investment, all you own is the issuer's IOU and part of the bet. If the issuer gets into financial trouble, or the bet goes sour, you can lose money — often, a lot.