Analysis and Valuation of Bonus Certificates

Diploma Thesis, 2008

90 Pages, Grade: 1,8


Table of Contents

Tables and Figures

List of Abbreviations

1 Introduction
1.1 Problem Definition
1.2 Procedure

2 Basics
2.1 Definition of Certificates
2.2 Components of Certificates
2.2.1 Fixed Income Securities
2.2.2 Stocks
2.2.3 Standard Derivatives Options Futures
2.2.4 Exotic Options

3 Benefits of Bonus Certificates
3.1 Investors
3.2 Issuers
3.3 The German Bonus Certificates Market

4 Characteristics of Bonus Certificates
4.1 Description of Bonus Certificates
4.1.1 Underlying
4.1.2 Conversion Ratio
4.1.3 Barrier
4.1.4 Bonus Level
4.1.5 Maturity
4.1.6 Default Risk
4.1.7 Costs
4.2 Design of Bonus Certificates
4.2.1 Zero-Strike-Call
4.2.2 Down-and-Out Put
4.2.3 Payoff-Profiles
4.3 Pricing of Bonus Certificates
4.3.1 Black-Scholes-Model
4.3.2 Underlying
4.3.3 Volatility
4.3.4 Dividends
4.3.5 Interest Rate
4.3.6 Maturity
4.3.7 Divergence of Pricing: Fair Value – Secondary Market
4.4 Taxation
4.5 Special Forms of Bonus Certificates
4.5.1 Capped Bonus Certificates
4.5.2 Quanto Bonus Certificates
4.5.3 Reverse Bonus Certificates
4.5.4 Multi Bonus Certificates

5 Empirical Analysis
5.1 Dresdner Bonus-Barrier-Certificate I
5.1.1 Description
5.1.2 Design
5.1.3 Pricing
5.1.4 Taxation
5.2 AGI Bonus Barrier Fund
5.2.1 Description
5.2.2 Design
5.2.3 Pricing
5.2.4 Taxation
5.3 Comparison: Dresdner Bonus-Barrier Certificate – AGI Bonus Barrier
5.4 Impact of current Stock Exchange Collapse on Bonus Certificates

6 Conclusion


Tables and Figures

Figure 1: Dax Performance Index vs. DivDAX Performance Index

Figure 2: Long Call

Figure 3: Short Call

Figure 4: Long Put

Figure 5: Short Put

Figure 6: Efficient Frontier

Figure 7: Open Interest - Volume of retail certificates

Figure 8: Payoff profile Down-and-Out Put

Figure 9: Asymetrical Payoff Profile of a DaOP

Figure 10: Impact of Volatility on DaOP

Figure 11: Payoff Profile Zero-Strike-Call

Figure 12: TUI

Figure 13: Impact of Maturity on DaOP

Figure 14: Payoff Profile Capped Bonus Certificate

Figure 15: Interest rate level

Figure 16: Payoff Profile Reverse Bonus Certificate

Figure 17: Dresdner Bonus Barrier Certificate

Figure 18: First Payoff Profile AGI Bonus Barrier

Figure 19:Second Payoff Profile AGI Bonus Barrier

Figure 20: Third Payoff Profile AGI Bonus Barrier

Figure 21: VDAX Volatility Index

Table 1: Payoff-matrix of a Bonus Certificate

Table 2: Market shares for investment certificates (Market Volume)

Table 3: Open Interest Volume December 2007 and May

Table 4: Market share Bonus Certificates

Table 5: Rating of Issuers

Table 6: Value Drivers for Hedge/ Quanto Costs

Table 7: Bonus Certificates with Barrier Violations

Table 8: Pricing Bonus Certificate

List of Abbreviations

illustration not visible in this excerpt

1 Introduction

1.1 Problem Definition

Since 1989, retail certificates have become core in the field of retail banking (Pilz 2006). Particularly, the stock crash between 2000 and 2003 has fostered the success story of these investment products because many private investors have sustained enormous losses with their stock exposures. Therefore, they have been looking for alternatives to traditional investment forms which are lower in risk but gaining satisfactory returns (Schiereck 2004).

In order to fall in line with this growing specific demand of investors, major German banks have invented the new asset class of retail certificates. These products can offer depositors characteristics for every market scenario as its explicit strength (Löhr and Cremers 2007).

This booming development reached its peak in December 2007, as German private investors hold 135 bn EUR of retail certificates in their deposits (Barthel 2008).

Because of their attractive risk-return profile, Bonus Certificates, which were issued for the first time by the German bank Sal. Oppenheim in 2003, have gained a key position in this sector with a market share of 21.9% (Fischer 2008). The barrage of newly issued products has led to the circumstance that many private investors are facing the problem of lack in transparency concerning the structure of Bonus Certificates.

The present diploma thesis intends to provide the reader an extensive overview on the investment segment of Bonus Certificates. Thereby the author focuses on the conception and pricing of this financial structured product in order to develop an investment guideline for investors, how to deal with this complex derivative. In particular, the author analyses the influence of the input factors, both on each embedded option component and on the Bonus Certificate as a whole. Hence, investors may get a better insight of the disproportionate valuation of Bonus Certificates over maturity.

Due to current negative market situation, the author has also a look into the impact of issuer’s default risk and barrier violation on Bonus Certificates.

1.2 Procedure

The present diploma thesis consists of 6 chapters. Chapter 1 covers the problem definition and the author’s procedure with this thesis.

Chapter 2 deals with the fundamental basics of this topic which comprises the definition and the components of certificates in general. Thus, the reader is able to classify Bonus Certificates in the complex of structured products.

Now that the fundamentals of certificates have been clarified, the benefits for investors and issuers are discussed in chapter 3. So, the reader may understand why the examined German Bonus Certificate market has experienced a tremendous boom over the last five years.

With the so forth given background on the fundamentals and benefits of Bonus Certificates, the reader is taken to chapter 4 introducing to the main part of the present diploma thesis. Thereby the author describes the main features of Bonus Certificates and explains how investors can exclude information from special ratios for their investment decision. The chapter then reveals both integrated option components of Bonus Certificate and the possible payoff profiles of the structured product at maturity. Thereafter, the reader dives into the world of option pricing by getting to know the theoretical background of the Black-Scholes-Model. In this context, the author depicts the impact, of the value drivers of a Bonus Certificate, on the pricing of its option components and the structured product as a whole. Moreover, with respect to the valuation of Bonus Certificates, the author works out whether there exist any divergences in pricing between the theoretical fair value and the price quoted at the secondary market. In the last two subchapters, the author completes the main part by illustrating the taxation and special forms of Bonus Certificates.

In Chapter 5, the author finally conducts an empirical analysis of a single Bonus Certificate and a Bonus Certificate Fund. Both examined investment products are presented in a certain pattern allowing the reader to capture their description, design, pricing and taxation. The author concludes the empirical analysis of these investment instruments with an individual comparison taking their parameters as a whole into account. Thereafter the author focuses on the impact of the current stock market crash on Bonus Certificates in order to give the reader a differentiated overview of disadvantages and opportunities in such a specific market situation.

Chapter 6 covers the author’s final conclusion.

2 Basics

2.1 Definition of Certificates

Certificates are structured financial products that combine fixed income securities, stocks and derivatives in the form of a single security (Spremann and Gantenbein 2005). These products can diverge much in the features they offer - from capital-guaranteed to speculative products - from unlimited to limited maturity (Preissner 2007). Today issuers are able to engineer certificates in large numbers of variations.

From its legal definition, a certificate is a debenture of issuer that may be lenders or other financial institutions. Once investors purchase this securitized derivative, they turn into creditors of the issuing bank. If the issuer were to have difficulty, meeting its payments or become insolvent, the invested capital is not protected. Hence the holder of a certificate also bears a creditworthiness risk (Haarengel and Scheuble 2006).

Certificates have similarities to conventional asset classes, like bonds or stocks. But in contrast to these investments, certificates do not incorporate any steady interest or dividend payments, because the redemption of a certificate is derived from the performance of an underlying asset in a stipulated way (Pilz 2006).

Furthermore these derivatives differ from classic asset classes by improving investors’ risk-return profile (Löhr and Cremers 2007).

In some cases issuers manifest in their offering terms, a special right to call for repayment. Hence they can convert structured products, with unlimited maturity into investment with limited maturity (Schmidt 2008).

In contrast to certificates as a whole, Bonus Certificates are one of the equity-linked structured products that built-in exotic options in its design. Bonus Certificates can be considered as second generation of retail certificates which incorporates partial capital protection dependent, on the price of the underlying asset, over the term to maturity of the certificate. The yield of the investment in Bonus Certificates is also linked with the performance of a predetermined underlying asset over a set period (Götte 2007).

In order to determine the performance of the underlying asset, the certificate issuers consider only the change in the asset price; while the cash dividends paid during the period are not included (Societe Generale 2007). In other words, investors in Bonus Certificates do not receive dividends even though the underlying assets pay dividends during the term of maturity.

2.2 Components of Certificates

Retail certificates consist basically of two essential elements: an original instrument and a derivative one.

Former certificates were mostly designed from fixed income securities, stocks and standard derivatives, which are also denoted as Plain Vanilla. In recent times, issuers of structured products have begun to integrate exotic derivatives into these complex securities (Das 2001).

Hence the author wants to discuss the possible components of a certificate in following chapters:

2.2.1 Fixed Income Securities

Fixed income securities or bonds are financial contracts which incorporate a fixed maturity and set continuous cash flow, from the issuer respectively debtor to the creditor.

From a legal standpoint, fixed income securities, are treated as debt capital, on the balance sheet of the issuer. That is, investors bear a default risk, because bonds are defined as liabilities. So in case of bankruptcy, holders of bonds can lose their entire invested capital (Wiedemann 2007).

However, issue of bonds is still an efficient instrument for companies to gather capital for their business activities.

In the context of certificates, the most important sort of fixed income securities, are zerobonds. They are fundamental because many certificates can be built up from them like guarantee certificates. In contrast to straight bonds, they do not provide a periodic interest payment to creditor. The payment on the redemption date, is the only payment during the entire contract period. This reimbursement includes, the entitled interest payments of the creditor. The usual zerobonds are issued as discount bonds. Because of missing annual interest payments, the pricing of zerobonds reacts, more sensitive towards change in market’s interest rates than straight bonds (Steiner and Bruns 2007).

The buying rate is also denoted as present value (PV) which is negative related to the time of maturity and the interest rate level. The PV can be determined using following formula (Bodie et al. 2004):

Present Value = Par Value : (1+ interest rate) maturity

For instance, a zerobond incorporating a par value of 100 EUR, duration of six years and an interest rate of 5% p.a. calculates its present value as follows:

100: (1+ 5%)6 = 74.62 EUR

That means, investors buy this zerobond for a buying rate of 74.62 EUR. The secured gain of this discount paper amounts 25.38 EUR for six years. For instance, issuers of certain certificates use this difference sum, to construct the value components of these structured products.

2.2.2 Stocks

Equities securitize the ownership in a company, for example a German Aktiengesellschaft. By means of this security, shareholders are able to have a stake in the registered capital of the concerning company. So they do not take in the position of creditors, but the rank of co-owners of the corporation. Hence the shareholders have all rights and liabilities according to the German Aktiengesetz ( Eller 1999).

As co-owners, they even bear a business risk due to the possibility of losing their invested capital.

With respect to certificates, equities are common underlying securities. Their pricing is influenced by the demand and supply of the exchange. Even though equities are part of investors’ certificate, they do not become shareholders, but creditors of the issuing company. Thus owners of certificates do not obtain any rights according to German Aktiengesetz; for instance the claim for dividends or voting rights (Beike 1999).

It is common that issuers use this disclaim of dividends for financing the structure of their certificates. So, issuers prefer to choose stocks with high dividend yields as underlying asset (HVB 2008). Moreover, these dividend bearing companies have outperformed their benchmark in the main, through stable and sustainable growth. Hence the probability of a successful certificate investment is enhanced. Particularly, following example proves this fact: The German DivDAX Performance-Index has outperformed its benchmark DAX Performance-Index in last five years.

illustration not visible in this excerpt

Source: Dresdner Bank AG (2008b) internal data.

Figure 1: Dax Performance Index vs. DivDAX Performance Index

2.2.3 Standard Derivatives Options

Options are one of the most well-known derivatives and can be used to increase or decrease risk exposures or to earn leveraged gains. These standardized derivatives are also known as plain vanilla and are listed at public stock exchanges.

Basically, an option can be defined as a contract that provides its owner, the right to purchase or sell a certain asset for a fixed price on or up to a future date (Eller 1999).

A call option gives its owner, the right to buy some underlying asset for a set price at some future time. A put option confers the right to sell an asset for a fixed price at some future date. Therefore, the option acquirers have to pay an upfront option premium (Bloss and Ernst 2007).

Options can be linked with a wide range of underlying securities. Possible underlying securities for options are stocks, commodities, currencies, interest rates, exchange rates and indices (Hull 2008).

The terms of option contracts state the parameters, namely the duration of the contract and the price to be paid for the asset. This price is called exercise price or strike price. The act of buying or selling the asset is said to be exercising the option or assignment. If the put options or call options are not exercised on maturity date, they will mature worthless (Andersen 2006).

The pricing of options, is basically influenced by the intrinsic value which is the difference between strike and spot price and by the time value which decreases progressively towards the expiry date.

There are two types of options concerning the exercise moment: The European option and the American option. The owner of European options can only exercise the right at the end of the contract period, whereas the owner of American options can assign, at any time during the contract period (Uszczapowski 2005).

Furthermore option types can be distinguished in the way of settlement:

Either a cash settlement may take place or the underlying asset must be delivered physically, subject to the availability of the underlying physical asset (Heussinger et al. 2000).

For instance, in terms of index options, it is usual that settlement is transacted with cash, caused by lack of securities. an underlying physical asset. So, there is no trade of physical In course of physical assignment, a clearinghouse is implemented between the two partners to exercise the delivery.

There are always two parties in an option contract, namely the buyer of an option and the seller respectively the writer. So this situation leads to different payoff profiles for the involved parties (Hull 2008):

The buyer of a call option is in the long call position, whereas the seller of a call option takes in the short call position. illustration not visible in this excerpt

Source: Modelled after: Hull (2008), p.10.

Figure 2: Long Call

illustration not visible in this excerpt

Source: Modelled after: Hull, p. 10

Figure 3: Short Call

A purchaser of a long call expects rising prices for the underlying assets. By means of the option, he has the right to acquire the underlying, for a set price K in future. His maximum loss is limited to the paid premium P. If the price of the underlying S (T) exceeds the strike price, the long will exercise the option. The breakeven respectively the maximum value of the call is given in following situation (Bloss and Ernst 2008):

S (T) = K + P

C= Max (0, S (T) – K)

If the price will drop below the strike price K, the owner of the call option expires his contract. Consequently, he realizes a loss of the amount of P.

His counterpart normally has a bearish expectation to underlying asset and pursues the aim of earning the premium P paid by the long. When the option writer does not have the underlying asset to meet the requirements of the contract, the deal is denominated as naked call writing. The antonym is called, covered call writing and is applied in the concept of discount certificates (Krimphove and Regel 2002).

Writers of naked calls are endangered by a possible unlimited loss. If the spot price S (T) of the underlying asset increases above the strike price K, writer’s loss L will raise, too. The short’s loss is calculated as follows (Bloss and Ernst 2008):

L = (S (T) – K) – P

But if the spot price S (T) falls below the strike price K, the writer will achieve his aim of gaining the amount of P.

In case of covered call writing, the writer’s loss is limited because he already owns the underlying assets. illustration not visible in this excerpt

Source: Modelled after: Hull (2008), p.10.

Figure 4: Long Put

illustration not visible in this excerpt

Source: Modelled after: Hull (2008), p.10.

Figure 5: Short Put

The long put investor speculates on a decline of the underlying asset and pays a premium P to obtain the right to sell the underlying asset for a set price. This strategy is an efficient hedging instrument for investors (Boyle and Boyle 2001). If the spot price S (T) rises above the strike K, the long will make a limited loss of premium P. If the spot price drops below the strike price, the purchaser of the option will face a gain G. The breakeven point and the value of the put option are given in these equations (Bloss and Ernst 2008):

S (T) = K – P P= Max (0, K – S (T))

The short expects a stagnating or slight decreasing performance of the underlying and therefore he can earn a maximum gain of P. This condition is that the spot price of the underlying surges above the strike. But, if the spot price drops below the strike price, the writer will make a loss of:

L= (K-P) – S (T)

Because of the different payoff profiles of the involved parties, the risk-return-profile of plain vanilla option is said to be asymmetrical (Anderson 2005).

In the course of engineering certificates, options are generally used as components to hedge risk exposures or to gain additional incomes. Futures

A future contract is also an important instance of a standard derivative. It is an arrangement, closed today, to buy something in the future for a fixed price (Hull 2008).

A future contract can be issued on almost every type of underlying asset. The buyer of future contract is in the long position and the seller of future contract take in the short position.

Consequently, in the future the long has the obligation to purchase the underlying at a set price on a predetermined date, whereas the short is compelled to sell the underlying asset (Wiedemann 2007).

Differently from options, the buyer of a future contract does not have to pay any up- front fee and is forced to perform the contract. Besides in terms of future, the short has to leave a margin as security at the clearinghouse in order to ensure its performance at expiration (Bloss and Ernst 2008).

The settlement of a future contract can be differentiated between a cash-settlement and a physical settlement by means of a clearinghouse. Otherwise the procedure of the settlements is equal to that of options.

The price to be paid for the asset is termed as the delivery price or the contract price. This price is fixed at interception and does not change over the term of the contract. Quite the reverse, the price of the underlying will change during the contract period.

If the price of the asset raises a lot over the term of the contract, the asset will be worth more than the contract price at the delivery date. In this case, the holder of the future in the long position would benefit, because they can purchase the underlying asset cheaper than its current spot price. If the price of the underlying falls during the contract period, the writer of the future contract in the short position would be favoured, because they can sell the asset more expensive than the market value (Heussinger et al. 2000).

So futures provide as well a hedging instrument as a speculating instrument for the investors.

2.2.4 Exotic Options

An exotic option is a derivative with a more complicated payout structure than a plain vanilla put or call option. These derivative securities are normally traded in the OTC- markets because of its non-standardized features.

Several reasons can motivate treasurers of companies or investment banks to ask for these exotic options respectively to engineer them for their customers.

For example, these exotic securities may suit to specific hedging needs or they attract customers due to legal, tax or regulatory reasons. Moreover companies or lenders may be interested in their payoff profiles that can match to their specific expectations in terms of possible future movements in particular market variables. Hence, these exotic securities can support purchasers to have an improved risk-return profile with regard to their portfolios or investments (Hull 2008).

There are a number of ways in which an exotic option payout can differ from that of a plain vanilla.

In case of Asian options, its function illustrates the difference between a strike and an average price for the underlying during some part of the life of the derivative. The method of calculating the average price can differ.

The payout profile of exchange options can be based on the difference or swap between prices for two several underlying assets. The performance of high-low options is dependent on the same underlying at different times. Outperformance options are focused on the correlation between two or more underlying securities (Grabbe 1996).

The payoff of lookback options and shout options are the disparity between a strike and the spot price at some time other than expiry. Binary option respectively digital option is a derivative with an irregular payoff profile. Its payoff will be a fixed amount if the spot price touches the set strike price one time during maturity of the option (Hunt and Kennedy 2004).

Furthermore, multiple trigger conditions can determine the profile of an exotic option as in case of corridor options (Anderson 2005).

In terms of Bonus Certificates, barrier options are the common instrument in order to provide their attractive bonus structure. They can exist in forms of American or European call and put options. But their payouts are conditional on certain trigger conditions being met. Generally, barrier options will be activated or nullified if a spot price falls or rises through a predetermined trigger level. The knock-out-level or knock- in-level can be set up or down of the current spot rate (Gerhardt 2006).

Hence there are eight varieties of this exotic option (Hull 2008):

- Up-and-in call / put
- Down-and-in call/ put
- Up-and-out call/ put
- Down-and-out call/ put

In recent times, this exotic option has been modified with features of capital guarantee or without money-back elements and with a dynamic barrier adaption.

On the one hand, their main advantage compared to ordinary options is given by their low costs. But on the other hand, investors have to take into consideration a total loss of its capital (Tiedemann 2007).

Engineers of Bonus Certificates use Down-and-Out Puts or Up-and-out calls to construct the extraordinary payoff profiles of these popular securities.

By and large, exotic options are essential instruments for many financial engineers to construct a majority of the existing certificates in the market.

3 Benefits of Bonus Certificates

3.1 Investors

The main advantage of Bonus Certificates for investors is given by the fact that they can improve their risk-return profile compared to a direct investment.

This assumption can be derived from the portfolio theory referred to Markowitz focusing that asset allocation is related to the parameters of risk and return (Krimphove and Regel 2002).

According to the portfolio-selection-model, investor can decrease the standard deviation of their portfolio gains by selecting assets that are not perfectly positive correlated. So, by means of portfolio diversification they may optimize their risk-return-profile (Schölzel 2007).

However, the portfolio selection theory is based on following assumptions (Steiner and Bruns):

The market for capital assets is composed of risk-averting investors which will be explained later in this chapter.

All investors have the same decision horizon. This implies that the portfolio opportunity set available to each investor is made at the same point in time, and the horizon considered is making these decisions is the same for all.

Capital markets are perfect in the sense, that all assets are infinitely divisible, there are no transaction costs or taxes, information is costless and available to everybody, and borrowing and lending rates are equal to each other and the same for all investors.

Expectations and portfolio opportunities are homogenous throughout the market. That is, all investors have the same set of portfolio opportunities, and view the expected returns and standard deviations of return provided by the various portfolios in the same way.

With regard to the differentiation of risk, the portfolio theory distinguishes risk between unsystematic and systematic risk: The systematic is equal to the general market risk, whereas the unsystematic risk is a firm specific one.

Investors can remove unsystematic risk by means of diversification, whereas the systematic risk cannot be diversified away. Hence, there is a positive linear relationship between expected return and systematic risk (Levy and Sarnat 1984).

The standard deviation s measures the risk for investors. It describes the square root of the expected squared dispersion from the expected return (Brealey and Myers 2008): illustration not visible in this excerpt

The premise to determine the risk of the total portfolioop, the factor covarianceCOVij has to be integrated in the formula. This measure is defined as level to which the concerning assets are correlated (Brealey and Myers 2008). illustration not visible in this excerpt

In order to operationalize the results of the covariance, the measure of correlation coefficient is applied. The correlation measures the degree of synchronization between two assets: illustration not visible in this excerpt

The correlation coefficient is an important instrument for investors to reduce volatility in their portfolios because it determines their diversification grades.

A correlation coefficient which is perfectly positive cannot generate a diversification benefit, because there is a linear relation between the single returns on the assets. A coefficient between -1€ kij X +1 enables diversification. A coefficient which is perfectly negative correlated can diversify the unsystematic risk completely due to its inverse linear relationship between the single assets (Crochane 2005). Hence, correlation coefficient is essential to determine efficient portfolios.

A composition of the mentioned elements finally leads to the total risk of a portfolio (Steiner and Bruns 2007): illustration not visible in this excerpt

With respect to efficient portfolios, Markowitz assumes that investors based their investment decision-making process on the µ-o-principle. This rule presumes a normal distribution of the yield in order to provide a correct result. Besides, the µ-o-principle implies that risk o is dependent on the expected return µ and vice versa (Spremann and Gantenbein 2005).

But there are many circumstances in which it would seem reasonable for investors to assume risk-averse behavior, which can be defined as willingness to make a trade-off between expected return and risk. Hence, three situations can be distinguished for revealing efficient combinations of o and µ in a portfolio (Boyle and Boyle):

Firstly, given a choice of two different investment opportunities that yield the same expected return, but with different levels of associated risk, a risk-averter would prefer the one with the smaller risk.

Secondly, given a choice of two different investment opportunities that have equivalent levels of associated risk, but different levels of expected returns, a risk-averter would prefer the one with higher expected return.

Thirdly, given a choice of two different investment opportunities that have different levels of expected returns and associated risk, a risk-averter would favor the one with both a higher return and lower risk (Crochane 2005). illustration not visible in this excerpt

Source: Modelled after: Brealey and Myers (2008), p.190.

Figure 6: Efficient Frontier

So investors would choose portfolio combinations which are located on the efficient frontier, because this segment of risk and return combinations are efficient due to the mentioned premises for risk-averse investors (Steiner and Bruns 2007).

Generally the portfolio selection theory is a very simple and powerful intuition. It shows that there is a linear relationship between return and risk.

Besides, this theory demonstrates that investors may gain diversification benefits. They must hold a portfolio of several assets which are not perfectly positive correlated.

With respect to certificates, investors can apply these principles of portfolio theory in order to customize their asset allocation on their risk aversion and time horizon.

Especially, a survey conducted by M. Schölzel (2007) on behalf of Deutsche Bank AG reveals how Bonus Certificates improve investors’ risk-return profile.

He compared a stock investment with a Bonus Certificate, including a bonus level of EUR 140 and a barrier of EUR 70, over a maturity of 10 periods and price movements of 5%. illustration not visible in this excerpt

Source: Available from: Schölzel (2007).

Table1: Payoff-matrix of a Bonus Certificate

The matrix shows that investors may expect a bonus payment of EUR140 at maturity if the price of the underlying asset has not touched, or fallen below the safety threshold of EUR 70 at any time during the time to maturity of the structured product. This matter of fact alone makes Bonus Certificates highly attractive. But in case that the stock price increases beyond the value of the bonus are no less attractive to investors. The repayment of the certificate at maturity fully reflects the performance of the underlying asset above the bonus level. So an investor of this Bonus Certificate would receive a price gain of EUR 155.13.

If the index or share price drops to or below the price threshold at least once during the term, investors have a direct investment in the underlying asset. The repayment at maturity of the certificate is equal to the performance of the underlying security during the maturity.

Hence, by means of Bonus Certificates, investors may extend their individual efficient frontier:

On the one hand, they profit from price gains, even in a sideward tending market and on the other hand, their investments are less risky due to partial compensation of volatility by the risk buffer. This leads to an improved risk-return profile of investors.

Beneath, investors may generate diversification benefits by investing in several Bonus Certificates including different parameters and underlying securities or simply in a Bonus Certificate Fund (HSBC Trinkhaus & Burhardt 2007).

Otherwise, Bonus Certificates have two separate disadvantages compared to a direct investment in the underlying asset. First, Bonus Certificates do not pay out any dividends, which holders of the underlying security receive at least once a year. Second, the above mentioned payback profile of Bonus Certificates is always linked exclusively to the maturity, i.e. the price of the certificate is not necessarily equivalent to the price of the underlying asset during maturity of the certificate (HVB 2008). Therefore; Bonus Certificates should be held until maturity in order to take advantage from the mentioned profit situation.

3.2 Issuers

For issuers, certificates and especially Bonus Certificates have become important and attractive investment products to increase their profits and to extend their array of products in order to satisfy investors’ needs (Simmons 2006).

By issue of Bonus Certificates, issuer may open new distribution channels in order to build up a new income source. Particularly, foreign providers benefit from this development because Bonus Certificates can be successfully sold by using a retail-style distribution policy without the need for large-scale production capacities (Zimmermann 2006).

Furthermore issuers, who offer Bonus Certificates, benefit from this additional array of products by a positive media attention because they present an alternative to the traditional forms of investment like funds or stocks (Rüppel 2006).

Compared to the traditional investment instrument funds, issuers of Bonus Certificates only have to pass a simple licensing procedure. Consequently, they may achieve a rapid implementation in product development in order to be competitive.

Considering the process of structuring those derivatives, issuers have a flexibility regarding the underlying and contract design.


Excerpt out of 90 pages


Analysis and Valuation of Bonus Certificates
University of Applied Sciences Essen
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Analysis, Valuation, Bonus, Certificates
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Dipl.-Kfm. (FH), BBA Jess Puthenpurackal (Author), 2008, Analysis and Valuation of Bonus Certificates, Munich, GRIN Verlag,


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