The parameters that CRISIL considers for determining the complexity levels of financial instruments are:
- Ease of calculation of payout and returns
The ease of calculation of payouts and returns affects the complexity of a financial instrument. For instance, in a corporate bond, the interest rate and debt repayment schedule are known beforehand, making payout calculation simple for an investor. On the other hand, determining the payouts for an equity-linked debenture requires considerable understanding and computational effort.
- Clarity on timing of cash flows
Certainty in cash flow timing helps investors plans their investments well. Any uncertainty will affect returns, and will need to be managed. For instance, prepayments on asset- or mortgage-backed securities expose investors to reinvestment risk, adding to the complexity of the investment process.
- Number of counterparties involved in the transaction
The number of counterparties involved in the instrument also adds to the complexity. For instance, consider a guaranteed corporate bond. The investor will have to take into consideration the risk associated with both the issuer and the guarantor, and also factor in the guarantee mechanism. In a plain vanilla bond, on the other hand, the investor is only concerned with the issuer's credit risk. This makes the plain vanilla bond far easier to analyse.
- Familiarity of market participants with the instrument
An instrument type that has been in the market for some time is easier for market participants to understand than one that has just been introduced. For instance, equity shares have been a routine investment for decades, and the market's understanding of shares is therefore good. On the other hand, when equity derivatives were introduced, there were very few participants who understood these instruments at all well. Over time, as the market gains familiarity with an instrument type, the implied complexity reduces. Hence, the Complexity Level of an instrument may change over time, as the market becomes increasingly familiar with it.