Investors are looking to certificates in tough equity markets

From Archive 02 October 2002

By PWM Editor

As the number of different kinds of listed securitised derivative products increases, these conservative products represent one of the latest successes in the market.

As investors look for different investment alternatives on the risk/reward spectrum to benefit from the current market conditions, they have found interesting alternatives in certificates. Despite difficult conditions in the equity markets, these financial instruments continue to experience strong appetite from investors when compared with traditional listed warrants. In Germany, two types of certificates dominate: discount certificates and index certificates. Discount A discount certificate offers the investor exposure to the relevant underlying, like a stock or an index, but at a discount compared with the spot price of the underlying. In order to obtain this discount, the investor is willing to give up part of the potential upside movement of the underlying, known as the cap. This type of certificate is ideal for investors with a neutral/slightly bullish view on a particular instrument, index or stock. Example At due date SAP stock is at E71.80. A discount certificate with a cap of E100 quotes at E55.90, which represents a discount of 22 per cent versus the SAP stock. At maturity, if SAP stock is unchanged at E71.80, the investor gains 28.44 per cent on the investment; if SAP falls to E60, the discount certificate holder still gains 7.33 per cent, and if the stock rises to E75 a discount holder earns 34.16 per cent. However, the maximum return to the holder of the discount certificate is the pre-defined cap limit (E100). This means that if the SAP stock rises above the cap, the investor only receives the cap amount. Let’s assume that the SAP stock price rises to E120. In this situation the owner of the certificate has a 78.89 per cent return. When compared with an outright holder of the underlying stock, all the previous situations show that a discount certificate investment would result in a better return. Even in the situation where the SAP rises to E120, the investor that bought the stock at E71.80 makes 67.13 per cent compared with the 78.89 per cent of the discount certificate. In other words, the return for the SAP stockholder must exceed 79 per cent before an investment in the relevant stock is more profitable. One could argue that it is always preferable to hold a discount certificate on a stock rather than a straight position in the underlying, except for a situation where the underlying stock rises very strongly in value, from a pure performance point of view. How a discount certificate works An individual purchasing a discount certificate essentially buys a deep “in the money” call option (long call) with a strike price of zero, which is financially equivalent to buying the actual share. He or she then simultaneously sells a call option with a higher strike (cap). The higher the strike of the second option, the greater the maximum performance and the lower the “discount” on the price. As with all options, volatility plays an important role in the performance of a discount certificate before maturity. Although price fluctuations from volatility changes are negligible on the “deep in the money” call portion, the higher strike call option that was sold, earns disproportionate returns when the volatility decreases (the inverse also holds true). As a result, the higher the volatility, the higher the discount for a similar structure. Index Index certificates are suitable for those investors who are looking to have access to a particular market/index on a 1:1 performance basis, ie with no leverage. Although the first index tracker certificate was issued in the early 1990s, the real popularity of these certificates has been seen over the last two years. The turnover in index certificates has been particularly advantaged over the last few months by the outflow from investment funds, as investors are discovering the benefits of this product. There are several reasons for their growing success:

With an index certificate the investor participates 1:1 to an index performance, which means high price transparency
There is full awareness at all times of which stocks underlie the index. The large indices are regularly adjusted, with the result that they are weighted in favour of the successful stocks as the under-performers are replaced. Quite often leading indices like the Dax rise as many of the listed stocks fall.
As with warrants, the major banks issue and act as counterparts, or market makers, in trades on index certificates, which guarantees liquidity.
They are easily traded on the stock exchange, and allow retail investors to invest smaller amounts of money than a straight position in the index.
They are tradeable during stock exchange hours, with some issuers even providing after market liquidity. Compared with an investment in funds, which can outperform or underperform a benchmark, index certificates are often cheaper as there is neither a surcharge involved nor a management fee. There are two main types of index certificates: open ends, without a final maturity; and certificates with a maturity date, often called tracker certificates. The advantages of trackers are that some issuers like Citibank refund part of the dividend, in terms of a discount, for certificates on price indices like the Euro Stoxx. This makes trackers cheaper than a comparable open end certificate. New segments As the range of listed derivative products has dramatically increased, there is a risk that the individual investor may become confused. The sustained success of these new segments is dependent on a complete understanding by the investor of the risks inherent in each product. The investor must thus be helped to distinguish between “high leverage” products on the one hand and “investment-type” products on the other, with the different usage of these products, i.e. hedging, leveraging or investing, clearly explained. “Certificate” is deemed to be the established name for more conservative, longer-term investment products without significant leverage. Unfortunately, however, the use of the certificate label by product issuers is often confusing. For example, in Germany it is often used for highly leveraged products. Product naming by different issuers may also result in some confusion as new product types with similar profiles are being given different names by the issuers. Using the example of knock-out options, in Germany this product is available in the market under a variety of names such as Turbos, Lifs, knock-outs or Waves. Although they might have slight structural variations, they are all in fact knock-out options with very similar risk profiles. It is in favour of market development to establish some standards to avoid confusion among investors over the risk/reward profiles of different products. With discount certificates, discount certificates plus, warrants, turbo warrants, guaranteed Lifs, and so on, it is easier than ever for investors to take advantage of every possible development in the financial markets, and adjust their investments accordingly. This, however, requires knowledge, flexibility and above all, reliance on a complete analysis of the advantages and risks associated with a particular instrument, rather than relying on the product name.