These formulas can incorporate one or more indices, amortization schedules, interest rate differentials or embedded options such as caps, floors, or call features. For example, the Federal Home Loan Bank alone has more than 175 indices or index calculations against which cash flows are calculated for its bonds. Most structured notes are designed for institutional investors and money managers. Once the dealer devises a structure it thinks is acceptable to the investor, an issuer is approached with a structured bond and a series of interest rate swaps. Lastly, the underwriter earns an underwriting fee while generating additional derivatives business, referred to as its book.
Structured notes are attractive investments for banks for several reasons.
In addition, the use of indices or embedded options can allow a bank to offset existing interest rate risk in its balance sheet. Again, when analyzed and managed properly, structured notes can be appropriate investments for banks. The characteristics of structured notes can result in inappropriate investments for some institutions. While they earn above normal returns under some scenarios, the bonds will earn below normal returns if these scenarios are not realized. Customized features and embedded options can be complex and difficult to evaluate.