The following definition reflects such a proposition if we compare two financial arrangements that share the same objective:
a) Investment instruments are motivated by the same or similar financial objective from both the issuer’s and the investor’s point of view, but they differ in legal form and functional implementation. They also might require a different valuation due to a varying or different transaction structure and/or security design.
b) Investment instruments are substantively equivalent (i.e. they are evaluated exactly the same in line with an equilibrium price relation), but they differ in legal form and might require a different valuation due to a varying or different transaction structure and/or security design.
Although investors should expect the same returns for CDOs as for similar credit risk exposure in plain vanilla debt, their risk profile of CLOs tranches varies dramatically in response to changes in the valuation of the underlying
(reference) asset (Jobst, 2005a).
In the first instance, pure credit derivatives are clear examples of structured products for credit risk transfer, which allow very specific and capital-market priced credit risk transfer. Credit insurance and syndicated loans share the same financial objective; however, they do not constitute an arrangement to create a new risk-return profile from existing reference assets. Another example in this vein would be the comparison of MBS and Pfandbrief-style transactions. Although both refinancing techniques convert a credit claim or a pool of claims into negotiable securities, they represent two distinct forms of covered bonds obtained from securitizing the same type of reference asset either off-balance sheet (asset-backed securitization) or on-balance sheet (“Pfandbrief-style” securitization), or even through synthetic securitization.
In the second case, for instance, an Islamic loan becomes a structured finance instrument whenever its formation through replication of conventional asset classes involves a contingent claim. In Islamic finance traditional fixed income instruments are replicated via more complex arrangements in order to establish compliance with the religious prohibition on both interest earnings (riba), the exchange of money for debt without an underlying asset transfer, and non-entrepreneurial investment. Structured finance redresses these moral impediments to conventional forms of external finance. For instance, Islamic banks use synthetic loans for debt-based bond finance, where the borrower re-purchases, or acquires the option to re-purchase, own assets at a mark-up in a sell-and-buyback transaction (on existing assets as a cost-plus sale (murabahah) or future assets as project finance (istina)). The lender can refinance the selling price and/or the indebtedness of the borrower via the issuance of commercial paper. Alternatively, the ijarah principle prescribes an asset-based version of refinancing a synthetic loan, where the lender securitizes the receivables from a temporary lease-back agreement as quasiinterest income. The debt transaction underlying each of these forms of refinancing reflects a put-call paritybased replication of interest income, where the lender holds the ownership (stock S) of the notional loan amount and writes a call option (C) to the borrower to acquire these funds at an agreed premium payment subject to the promise of full payment of principal and mark-up after time T (put option P). Both options have a strike price equal to the mark-up and the notional loan amount. So the lender’s position at the time the synthetic loan is made is S-C+P, which equals the present value of principal and interest repayment of a conventional loan.
