A Risk Profile of Discount-, Bonus-, Guarantee- and Factor-certificates

Content

LIST OF FIGURES

LISTOFTABLES

1 INTRODUCTION

2 CERTIFICATES IN GENERAL
2.1 Important definitions and characteristics of certificates
2.2 Advantages and disadvantages of certificates
2.3 Categorisation of certificates
2.4 Risk for all types of certificates

3 DISCOUNT CERTIFICATES
3.1 Definition, functionality and construction
3.2 Application fields and investment aims
3.3 Return and risk
3.4 Assessment as an investment possibility
3.4.1 Advantages
3.4.2 Disadvantages

4 BONUS CERTIFICATES
4.1 Definition, functionality and construction
4.2 Application fields and investment aims
4.3 Return and risk
4.4 Assessment as an investment possibility
4.4.1 Advantages
4.4.2 Disadvantages

5 GUARANTEE CERTIFICATES
5.1 Definition, functionality and construction
5.2 Application fields and investment aims
5.3 Return and risk
5.4 Assessment as an investment possibility
5.4.1 Advantages
5.4.2 Disadvantages

6 factor certificates
6.1 Definition, functionality and construction
6.2 Application fields and investment aims
6.3 Return and risk
6.4 Assessment as an investment possibility
6.4.1 Advantages
6.4.2 Disadvantages

7 CONCLUSION
7.1 Summary
7.2 Critical evaluation of certificates as investment vehicles

Appendix
Appendix 1: Calculation of a guarantee certificate and comparison with a direct investment
Appendix 2: Calculation of a bonus certificate and comparison with a direct investment
Appendix 3: Calculation of a guarantee certificate and comparison with a direct investment
Appendix 4: Calculation of a factor certificate and comparison with a direct investment
Appendix 5: Calculation of a factor certificate's performance in markets in volatile markets

Literature

List of figures

Figure 1: No. of certificates purchasable at Stuttgart Stock Exchange

Figure 2: Categorisation of certificates by different factors

Figure 3: Return- and risk expectation of certificates

Figure 4: Exemplary Profit & Loss Profile of a discount certificate

Figure 5: Exemplary pay-out scheme of a bonus certificate

Figure 6: Exemplary Profit & Loss Profile of a bonus certificate

Figure 7: Exemplary Profit & Loss Profile of a guarantee certificate

Figure 8: Factor certificates by investment position

Figure 9: Exemplary Profit & Loss Profile offactor certificates

Figure 10: Performance of Factor-Certificates within volatile markets

List of tables

Table 1: Overview on the three main discount-certificate strategies

Table 2: Overview of market expectations by type of certificate

Table 3: Issuer margin of the regarded certificates

Table 4: Comparison of a direct investment and a discount certificate investment

Table 5: Comparison of a direct investment and a bonus certificate investment

Table 6: Comparison of a direct investment and a guarantee certificate investment

Table 7: Comparison of a direct investment and a factor certificate investment

Table 8: Calculation of a factor certificate’s performance in volatile

1 Introduction

Since their introduction, which was not that long ago, certificates have become increasingly popular. With them, private investors can invest quickly and easily in almost all markets. This fact makes it worth taking a closer look at this product category. This will be done by analysing four different types, paying particular attention to their risk profile.

This term paper aims to achieve the analysis of the regarded by first defining and catego­rising certificates in general as well as providing a brief market overview and illustrating general advantages and risk of certificates. Secondly, the single certificates will be analysed more detailed. To achieve this, each single chapter will describe the specific functionality of the certificates as well as possible applications. Furthermore, the specific return and risk, profile and advantages and disadvantages will be outlined. After taking a look at each cer­tificate, this term paper will sum up the key insights of this paper by also working out a critical appraisal to finish this paper.

The regarded certificates possess many variations (e.g. rolling discount, double bonus) achieved by choosing the components differently which has an impact on the functionality of the certificate and thus, makes them applicable for several investment aims. But for the sake of simplicity, this term paper will only consider the simple form of each certificate.

These certificates were chosen because they are applicable for (nearly) all types of under­lying and because they are very different in their original usage to pursuing different invest­ment targets. Moreover, the regarded certificates possess also very different risk profiles which was one more reason for their selection.

2 Certificates in general

2.1 Important definitions and characteristics of certificates

Certificates can be defined as obligations, typically issued by banks for which certificates represent a source of debt-refinancing, which possess derivative components such as op­tions which leads to a special risk- and return profile which will be explained in detail, later in this paper. This combination of an obligation with derivative leads to the fact that certifi­cates are also described as ‘Structured Products’ and are referred to the group of financial derivatives. Compared with usual bonds, the issuer of a certificate is not committed to repay the nominal value but to repay an amount which depends on the performance and devel­opment of a certain underlying. In the course of this, the underlying can be nearly any other financial asset such as stocks, futures, indices, currencies and commodities. Besides that, the certificate also does not provide any regular payments like a coupon bond but only one payment at the end of maturity. Another possibility for the investor to get returns exists in selling the product. (cf. Grill / Perczynski 2014: 270)

Main buyers of certificates are private costumers because institutional investors usually have access to markets for derivative products like EUREX and therefore are not reliant to banks, issuing certificates. Thus, certificates are typically retail products which represent a simple investment possibility for private investors to pursue complex investment strategies by enabling access to markets which usually are not open for private investors (cf. Janos / Hunziker 2010: 47) Certificates can be described as comparably new financial inventions: They were introduced to the markets by Dresdner Bank in June 1990 which at that time issued an index-certificate of which the German DAX was the underlying. (cf. Capek2010: 8)

Certificates are usually buyable over-the-counter (OTC; directly from the issuing bank) or via stock-exchanges which is less common, but still offers huge range of products (cf. fig. 1). The largest market-place in Europe is the European Warrant Exchange (EUWAX) which is part of the Stuttgart Stock Exchange. (cf. Borse Stuttgart n.d.)

illustration not visible in this excerpt

Figure 1: No. of certificates purchasable at Stuttgart Stock Exchange

Source: Own calculation; based on: Borse Stuttgart (ed.) (2017a,b,c,d)

Of course, buying is not free of charge. The investor needs to pay purchase fees when buying the underlying. This fee depends on purchase method. By buying via stock-ex­change, brokerage fees and bid- / ask spreads build the purchase costs. When the investor buys the certificate directly from the issuing bank, normally small issue surcharges become due. Independent of the purchase methods but depending on the type of certificate, some issuers charge management fees. (cf. Gotte 2012: 56-58) Besides the direct costs, there are implied costs for investors which mostly need to be paid for the construction of the certificate. The German derivative association (transl. Deutscher Derivate Verband, DDV) issued a fairness-codex which contains a value, needed to be published by the members: the so called ‘issuer estimates value’ resulting out of the difference between certificate’s price and construction costs/issuer margin plus sales remuneration. This issuer margin var­ies very much between the different types of certificates. (cf. DDV 2012: 12)

2.2 Advantages and disadvantages of certificates

As already indicated, certificates represent a simple option to invest in markets which are typically closed for private investors (e.g. commodities, foreign exchange). But certificates also have more advantages like that they bear the possibility to do precise adjustments of the investment profile with different types of certificates. For example, an investor is able to increase his earnings without increasing risk by using so called outperformance-certificates^[1] or he/she can use bonus, discount or express certificates to generate high returns even in stagnating/sideway markets (cf. Langer2010: 114).

Another important advantage of certificates is the high trading liquidity guaranteed by the issuers. This the high trading liquidity ensures that the investor can terminate his commit­ment and sell his certificate at any time at a price in line with the market. The actual stock exchange turnover does not play a role here, as the issuer always offers a fair redemption price to which it will take back the paper, even for certificates for which there is apparently no stock exchange trading. (cf. Balthazar 2014: 6f.) Also, certificates are mostly issued at small amounts of money which makes them more suitable for private investors. When it comes to certificates with an index as underlying, there often is a subscription ratio used where the index points are transferred in investable portions (mostly 1:100 or 1:10). (cf. ibid.)

Due to the fact that certificates are financial derivatives whose construction also uses option components, they possess a special pay-out profile when they become due. This pay-out profile is clearly defined and usually fixed from the outset. (cf. Sal. Oppenheim, ed. 2007: 2) However, the pricing during the term is less clear. It is often difficult or even impossible for investors to understand it, as the performance of the option components is influenced by many factors which are describes as so called ‘Greeks’. These determinants may be to the benefit of, but also to the disadvantage of the investor. (cf. Rudolph/Schafer 2010:292) In addition to this general disadvantage, there are other specific disadvantages depending on the product type which will be regarded later in this paper.

2.3 Categorisation of certificates

Certificates can be distinguished by several attributes. The most common distinctions are maturity, underlying and risk which is illustrated in the following figure:

illustration not visible in this excerpt

Figure 2: Categorisation of certificates by different factors

Source: Own, illustration, following: Grill Perczynski. (2014): 271

As with the previous figure already indicated, the willingness to take risks is determined by the pursued objectives while investing in certificates and like with any other investment op­portunity also certificates usually offer higher (expected) returns for higher risk (cf. Brechmann et al. 2008: 26f). In general, one can distinguish between three major objectives (cf. fig. 3; protecting, investing, speculating): firstly, risk-aware investors are seeking for possibilities to limit their potential losses and are therefore accepting lower returns. Inves­tors trying to follow the investing aim choose certificates which typically possess a lower risk compared to the underlying and thus, only limited participation in positive development of the underlying. The third investment aim - speculating - is also achievable by investing in certificates, namely by using e.g. factor certificates which multiply the development of the underlying which enables high potential gains but which also comes along with a high risk- potential. (cf. ibid./fig. 3)

As common knowledge, higher-risk-usually offers higher returns. This fact needs to be con­sidered to use the in 2.2 described advantage of possible precise investment adjustments by using the right certificates. The certificates regarded in this term paper can be ranged in as follows, compared with common asset classes:

illustration not visible in this excerpt

Figure 3: Return- and risk expectation of certificates

Source: Own, illustration, following: Brechmann et al. (2008): 26

2.4 Risk for all types of certificates

Whereas in the following chapters the specific risk of the different types of certificates will be analysed, this part intends to provide an overview on risks which count for all certificates. The essential risk which has needs to be mentioned in connection with certificates is the so called ‘issuer risk'.

Due to their legal nature as bonds, the money invested in certificates is - in contrast to money invested in investment funds - not protected by their legal status as special assets in the event of the issuing company's insolvency. Thus, the issuer risk describes the risk of losing (parts of) the invested capital due to an insolvency of the issuer or negative changes in its credit-worthiness. (cf. Brechmann et. al. 2008: 27). This type of risk was moving into focus of investors during the subprime crisis in 2007 and the following struggles of banks especially Lehmann Brothers which back then, was one of the key issuers for certificates. (cf. Capek 2010: 19f.) Another fact which needs to be considered regarding the issuer risk, is the fact that most banks do not issue certificates by themselves but by subsidiaries like “Goldman, Sachs & Co. Wertpapier GmbH” which acts as a subsidiary of “The Goldman Sachs Group, Inc.” (cf. Goldman Sachs (ed) 2018: 1)

Investors might reduce the issuer risk by keeping an eye on the issuer ratings, choosing certificates with a guarantee of the parent enterprise and by buying certificates from different issuers and thus, diversifying the risk of default of the certificates’ issuers. Besides that, some issuers offer securitisation of the invested capital by at least partly holding the under­lying. (cf. cf. Brechmann et. al. 2008: 27)

3 Discount certificates

3.1 Definition, functionality and construction

Key principle behind this investment vehicle is that the derivative component of the discount certificate causes a capped participation in the performance of the underlying, meaning buyers of discount certificates participate in the performance of the underlying asset, but at the same time, they waive gains when the price of the underlying increases above a spec­ified level (‘cap’). For this waiver he receives a discount so that the certificate is always slightly cheaper than the underlying. (cf. Balthazar 2014: 22) The invention of discount cer­tificates goes back to 1995 where Thomas Zwirner, employee of HSBC Trinkhaus had the idea of copying an investment strategy previously only used by professional investors and securitising it in a paper for the first time. However, Zwirner did not have the name Discount Certificate registered as a trademark. (cf. Schmidt 2011: 9)

In order to construct a discount certificate, the issuer either acquires the base value directly or a zero strike call on it. At the same time, it sells a call option on the underlying (= short call), whereby the strike price of the call corresponds to the cap of the certificate. Since the call option is covered by the underlying or the zero-strike call, this is also referred to as a covered call. The sale proceeds generated by the sold call option are largely the amount or discount by which the discount certificate is cheaper than the underlying. (cf. HSBC, ed. 2016: 175)

3.2 Application fields and investment aims

According to fig. 3, discount certificates can typically be filed as investment vehicles. But by choosing different caps, different investment approaches can be realised. These ap­proaches differ in terms of attainable yields and incurred risk and can be summarised as follows:

illustration not visible in this excerpt

A conservative strategy ex­ists when the cap is clearly under the underlying’s cur­rent price so that the buffer for loss absorption is very high.

Offensive:

illustration not visible in this excerpt

An offensive strategy was chosen if the cap is clearly above the underlying’s cur­rent price so that the dis­count is low but the return potential is high.

illustration not visible in this excerpt

Neutral strategy requires the cap to be just slightly under the underlying’s cur­rent price. This causes a balance between discount and cap.

Table 1: Overview on the three main discount-certificate strategies

Source: Own illustration, following: Societe Generale (ed.) (2016): 40-41

3.3 Return and risk

Regarding the possible return out of a discount-certificate investment, there are two possi­ble cases at the due date:

1) The underlying is quoted under the cap: If the price of the underlying asset is below the cap, the buyer of the option will not exercise this and the underlying asset will either be tendered to the buyer of the certificate, who is indirectly the seller of the call option, or the investor will receive a cash settlement. (cf. HSBC 2016: 174)
2) The underlying is quoted on or above the cap: If the market value of the underlying is on or above the strike price (‘cap’), the buyer of the call option will exercise the option and demand the shares. Thus, the buyer of the certificate receives the maximum possible profit through cash settlement. (cf. ibid.)

Because of its short call position, the discount certificate is a covered option. The investor benefits from the pure expiration of time even without price movement because the time

Discount certificates value of the call option lapses over time due to a positive theta^[2] of the short call option, (cf. Rudolph / Schafer 2010: 305) The most noticeable difference compared to direct investment is the profit and loss profile. In contrast to the underlying, the discount certificates possess an asymmetric profile (cf. fig. 4)

illustration not visible in this excerpt

Figure 4: Exemplary Profit & Loss Profile of a discount certificate

Source: Own calculation; cf. Appendix, Table No. 4

The upwards limited earning potentials causes a risk buffer of the discount certificates com­pared to its underlying because the market value of the underlying can fall to the discounted purchase price before the investor suffers losses. But in extreme market movements, e.g. due to the event of insolvency, discount certificates can also end in a total loss (cf. fig. 4).

3.4 Assessment as an investment possibility 3.4.1 Advantages

The main advantage of discount certificates is already named in the product name, namely the 'discount' on the market value of the underlying, which means that even if the market value of the underlying falls, profits can still be made to a certain extent due to the cap. Another advantage exists in the yield, caused by time lapse due to the short position. Fur­thermore, decreasing implicit volatility in the underlying asset leads to an increase in value in the certificate as well. These facts and the fact that a discount certificate generates an excess return over the underlying, if the underlying is above the certificate's purchase price and below the cap at maturity, makes discount certificates recommendable for a scenario

Bonus certificates in which investors expect only slight price changes at maturity (‘sideway markets’), (cf. Bock/Mack 2016: 20)

3.4.2 Disadvantages

By purchasing a discount certificate, the buyer does not actually acquire the underlying but, depending on terms and conditions, sometimes the right to tender the underlying and oth­erwise a cash settlement at maturity. As a result, investors do not receive any dividend payments on a discount certificate and no voting rights. But the dividend is usually returned indirectly to the certificate through the proceeds from the sale of the call. One disadvantage of discount certificates is the asymmetric risk-reward profile and the fact that no participation is possible in prices that rise above the cap. Besides that, vice versa to the advantage, an increasing implicit volatility in the underlying leads to a loss in the certificate. (cf. ibid.)

4 Bonus certificates

4.1 Definition, functionality and construction

Bonus certificates always have a fixed agreed term and are characterised by two parame­ters, the barrier, also called security level, and the bonus level. Depending on the choice of these parameters, the value of the certificate reacts to the development of its underlying. (cf. Rieger 2009: 188f.) One important role plays the security level because, if the base value touches or breaks through the barrier even once during the term, the bonus certificate becomes a normal tracker certificate^[3] and the bonus is irrevocably lost, even if the underly­ing is above the barrier on the maturity date (cf. ibid / fig. 5).

Comparable to discount certificates, one component while constructing a bonus certificate is the purchase of a zero strike call on the base value and taking a long position in a down- and-out put option (barrier option) at the same time. The strike price of the option corre­sponds to the bonus level and the knock-out equals the threshold above which the option expires and the bonus certificate only corresponds to the zero-strike call. The fair, meaning arbitrage-free price of a bonus certificate can be calculated as the sum of the prices of these two components. (cf. Brechtmann, et. al 2008: 104)

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^[1] Outperformance certificate: A certificate which combines the desire of investors for a higher return with the same risk. This gives investors the opportunity to participate more in the positive perfor­mance of an underlying than with the underlying. In the event of a loss, however, this is no higher than the loss for a direct investment in the underlying. (cf. Winkler 2008: 71f.)

^[2] Theta is one of the .Greeks'. It describes the time value loss of the option with reference to a decreasing remaining term. (cf. Rudolph / Schafer 2010: 305)

^[3] Tracker certificates simply replicate (or ‘track’) the underlying’s performance without any caps or protection (cf. Bluemke 2009: 54)