Table of contents:
- 1 The universe of certificates
- 1.1 A brief review of the development of certificates
- 1.2 Figures show leverage certificates on the rise
- 1.3 Distribution of market shares for certificates
- 1.4 Types of leverage certificates and their application
- 1.5 Features of the discount certificates
- 1.6 Features of the Bonus Certificates
- 1.7 Features of the Index Certificates
- 1.8 Features of Express Certificates
- 1.9 Characteristics of Outperformance Certificates
- 1.10 Leverage products for risk specialists
- 1.11 But how is the price of the certificate calculated first?
- 1.12 A calculation example for the Turbo Certificate
- 1.13 Tax Aspects for Certificates in Germany
- 1.14 The risks involved in trading with Certificates
- 1.15 A critical view of certificates
- 1.16 Concluding words on trading with certificates
In principle, certificates belong to the so-called structured products, which are often referred to as “strukis” by those who deal with them professionally.
These structured products are always based on one or often several underlying instruments.
They also contain a derivative component
The most widely distributed leverage certificates today are first and foremost:
- Discount certificates
- Bonus certificates
- Index and Express Certificates
These belong to the pure investment products. However, there are also leveraged products such as factor certificates and knock-out certificates, which are probably among the best known among retail and short-term traders.
The universe of certificates
In addition, there are a large number of largely unknown lever certificates with sometimes exotic-sounding names, which are mentioned here incompletely and only for overview purposes.
These include butterfly, win-win, phoenix, basket, strategy, alpha and outperformance certificates.
There are many more types of this product due to the infinite combination possibilities of underlyings and derivative design.
A brief review of the development of certificates
These products first came into existence for the private sector at the end of the 1980s. For the private sector because the actual history goes back much further into the 2nd millennium BC !
The idea had already the old Mesopotamians, who covered the risks of their commercial transactions by sea.
Aristotle also mentioned market manipulation by derivatives in 330 BC.
A first historically known highlight of the development was the speculative bubble with tulip bulbs at the beginning to the middle of the 17th century, the “tulip mania”.
Figures show leverage certificates on the rise
During the Industrial Revolution, the further development of derivatives took full speed and became the fastest growing segment of the modern financial industry.
The Bank for International Settlements estimated the value of OTC derivatives contracts outstanding worldwide at USD 95 trillion in 2000. By the end of 2010, this figure had already reached 601 trillion US dollars.
For the private investor it was not until 1989 that the time had come. Initiated by creative American banks, the then Dresdner Bank first issued an index certificate on the Dax.
Swiss banks took up the example as early as 1990, based on the recognised potential of such “risk-adjusted products”, and subsequently developed the first guarantee and bonus certificates. The rest followed quickly in the first years after 2000.
From 2004 to 2007, the volumes in Germany alone rose from the still almost ridiculous 180 billion euros to almost 540 billion euros.
The financial crisis triggered by the Lehmann bankruptcy caused the market to fall back to 370 billion by 2009 and has currently levelled off somewhat below this level.
Nevertheless, the German retail market for derivatives is still one of the largest in the world with this volume and with over 380,000 products.
The market shares of leading issuers of certificates according to the assets invested by investors currently look like this:
- Deka Bank with around 19.9% market share
- DZ Bank with 17.9
- LBBW (Landesbank Baden-Württemberg) with 12.6
- Helaba with still 12.4%
- Deutsche Bank with 7.9
Large banks only appear in the lower third of providers. Commerzbank, for example, with 4.3%, BNP with 2.9% and Goldmann Sachs, UBS, Citigroup and Morgan Stanley with only 1% or less market share.
Graduated according to pure stock market turnover, however, Commerzbank currently leads the field with 14.1%. It is followed by Deutsche Bank with 12.3%, DZ Bank with 11.7% and BNP with 10.8%.
This reversal may certainly also be due to the orientation of the issuers. While investors invest large assets with Deka, for example, the focus there is more on capital protection or investment products.
However, the pure turnover lies elsewhere. Leverage products dominate here with a whopping 27%, followed by discount certificates with 21%, bonus certificates with 15%, and then index, factor and express certificates in the mid-single-digit % range, far behind.
Capital protection and investment certificates hardly play a role in exchange trading any more.
Types of leverage certificates and their application
In the case of certificates, a distinction is made between investment products and leveraged products.
Investment products are for example bonus, discount or capital protection certificates. There is a wide range of options and variants.
This is different with leverage products. Here, the range is essentially limited (and with the omission of warrants) to factor and classic turbo certificates. For the latter there is an extension, the X-Turbo.
Features of the discount certificates
Discount certificates are intended more for medium to long-term investors.
They can be traded on all exchange-traded underlyings such as indices and commodities.
However, this will mostly be the case with shares. As the name suggests, the investor receives a discount on the underlying instrument. However, the potential returns are limited.
If, for example, the share XY stands at 100.00 Euros and the discount for the issuer is 2%, the certificate on the share costs only 98.00 Euros (in a subscription ratio of 1:1, with indices usually 1:100).
In principle, like an option, it represents the right to delivery of the underlying instrument or to cash settlement at maturity.
Therefore, the discount certificate is also regarded as a forward transaction.
For this discount, however, the investor must accept a limited return.
This is determined by a cap in the certificate.
Accordingly, if the cap is around 105.00 euros, the maximum yield is 5%.
If the price of share XY is higher at maturity, the investor no longer benefits from this.
The advantage is the discount.
If the share price falls to EUR 98.00 at maturity, i.e. the purchase price of the certificate, the investor does not incur any losses up to this value. Only below this value does a 1:1 price loss come into effect.
Even if the price of the share has fallen to 99.00 euros at the end of the term, this still means a profit of 1.00 euro per certificate for the certificate holder in principle, i.e. without taking trading costs into account.
Due to its option-heavy nature, however, the value of the certificate is also measured by the remaining term and the implied volatility.
The longer the remaining term and the more the implicit volatility decreases, the more the value of the certificate increases, and vice versa.
Features of the Bonus Certificates
Sideways markets or ranges are predestined for bonus certificates. These contain a so-called “lower barrier” (also known as “safety level” or “hedging level”) and a “bonus level”.
If the price of the underlying asset moves above the lower barrier and at the same time below the bonus level during the entire term of the certificate, the specified value of the bonus level is paid out at the end of the term.
However, if the price touches or falls below the barrier at any time during the term of the certificate, the type of certificate changes significantly.
In this case it becomes a normal participation certificate. At the end of the term, only the current share price is paid out 1:1. This does not change even if the price should again be above the barrier at the end of the term.
If the price at the end of the term has exceeded the bonus level without touching or falling below the barrier beforehand, the current price is also paid out 1:1 (or accordingly in the subscription ratio).
The advantage is therefore clearly a guaranteed minimum return, provided the barrier is never touched.
If the bonus level is breached at maturity, however, the stock yield would not differ from that of a physical purchase of the underlying asset.
An alternative to the bonus certificate is the cap bonus certificate. Here, the bonus level marks the maximum achievable profit.
If the underlying asset is above this level at maturity, the investor no longer participates. In return, however, this certificate allows a greater distance to the lower barrier.
Features of the Index Certificates
In principle, the simplest variant is the index certificate. These ultimately reflect the development of any index, usually 1:1. They can have a limited term or be designed endlessly.
Their main advantage is that they involve lower costs for diversifying investors than a comparable investment in an index fund, for example.
With some stock indices, such as the Dax, it makes sense to ensure that the underlying is a performance index.
Only then can you also benefit from dividend payments of the stocks contained in it, which can amount to several percent per year.
Furthermore, one should always pay close attention to the structure.
Some index certificates may contain several indices, composed of countries, regions or industries or entire sectors.
In addition, indices can also be traded short with “bear” or “reverse index” certificates.
In this case, however, the all too often deviating subscription ratio, which is usually less than 1:100 (e.g. 1:95,1017 etc.), must be taken into account.
Features of Express Certificates
Investors who are primarily interested in returns, but not necessarily in their maximum amount, like to use this type of certificate.
However, the name is usually not necessarily program. This is because express certificates usually have a term of several years, at least in the case of shares.
The principle is simple:
An underlying asset, for example a share XY has a “redemption” or “redemption threshold” of 100.00 euros (strike price) as well as a “protective barrier” or also “threshold value” of 60.00 euros.
The term is three years, and there is a fixed valuation date in each year.
On the first valuation day, the system checks whether the current price is above or equal to the redemption threshold. If this is the case, the invested capital plus a fixed interest rate would be paid out immediately by means of a drawn coupon, in which case the certificate expires.
If the redemption threshold has not been reached, the certificate continues to run until the next valuation day. If the price is reached here, the invested capital plus twice the interest income is paid out immediately and the certificate expires, etc.
If the redemption threshold is not touched during the entire term and the lower threshold value is not reached either, the investor receives back the invested capital without interest income.
However, if the threshold value has fallen below on one of the valuation days or at maturity, the investor bears 100% of the loss, i.e. exactly as if he had been directly invested in the underlying instrument.
Certain advantages in sideways markets are therefore only offset by opportunities for low returns and a relatively high risk of loss if a market or share falls below the threshold value for a short period of time, especially shortly before or on the respective valuation days, due to strong fluctuations.
Characteristics of Outperformance Certificates
These certificates are more for something for investors who are less afraid of risk and have an eye on a higher return. There is no downward barrier here.
The Outperformance Certificate only specifies a strike price that must be exceeded during the term.
If the price on the final valuation day is higher, the return achieved is multiplied 1:1 by a factor which is usually 1.5.
An outperformance certificate on the Dax with a strike price of 10,000 thus generates a profit of 150.00 euros if the Dax has risen to 10,100 on the valuation day (subscription ratio 1:100).
However, if the price is lower at maturity, the loss must be borne by the investor 1:1.
Leverage products for risk specialists
The next level for somewhat more risk-conscious investors are the so-called leverage certificates.
These primarily include the classic turbo certificates, which are also called knock-outs due to their construction.
They are tradable on indices, FX pairs, stocks and commodities and can have a fixed term or be endless.
What primarily distinguishes these certificates is the famous lever, which will be explained briefly here.
In CFD trading, the classic leverage is calculated by comparing the capital outlay for a direct investment with the outlay for reduced capital.
For example, the Dax at 12,000 points and with one Euro per point would cost around 12,000 Euro.
With CFD trading, however, the cost per point is around 600 euros, which corresponds to a leverage of 1:20.
With leverage certificates, however, the calculation is somewhat different, as here some components are added.
In addition to the price of the underlying asset, the price of the certificate and the subscription ratio also play a role.
But how is the price of the certificate calculated first?
The decisive factor is the so-called “strike” or even the “knock out”.
If this threshold is ever touched or undercut, the certificate expires and the invested capital is lost.
As a rule, only EUR 0.001 per certificate is credited on final maturity. In some cases, however, the issuer offers an additional stop-loss barrier to avoid total loss.
A calculation example for the Turbo Certificate
If, for example, we buy a bull-turbo certificate (long) on the Dax at 12,000 points with a standard subscription ratio of 1:100 and the strike is 11,500 points, the calculation would be as follows (premiums not included):
From this we can now simultaneously calculate the leverage of the certificate by replacing the strike with its value in the above formula and thereby dividing the current price:
The attraction of the leverage now lies in the disproportionate participation in price increases. For if the Dax rises from 12,000 points to 12,600, this would correspond to 5%. However, the price of the certificate would develop in this way:
So while the price increases only amounted to 5%, the price of the certificate rose by 120%, i.e. more than doubled. This can also be calculated in this way:
If the Dax falls to 11,600 (above mentioned threshold not yet touched), the price of the certificate would fall by 80% to 1.00 Euro.
Another problem with some certificates is the leverage effect, if the certificate continues to be held and the Dax subsequently falls back to 12,000.
The decline would correspond to around -4.76%, which is around 114% for the certificate with the leverage of 24. Its price would thus be only EUR 4.30, although the underlying instrument has remained virtually unchanged.
However, this effect usually only occurs with highly speculative factor certificates where the leverage remains constant.
The levers of classic turbos, on the other hand, are adjusted daily, as they depend on the distance between the current price and the strike.
First and foremost, the costs of order fees must be taken into account, which can arise when buying and selling.
Whether and how high these fees are depends on whether certificates are traded on the stock exchange or directly with the issuer.
In addition, some certificates are subject to issue surcharges (premium). Others, due to their credit character, are financed by a regular adjustment of the strike price, which is also referred to as the financing level in this context. This is particularly the case with leveraged products to the disadvantage of the investor.
In addition, the spread is of course a cost factor. It often also depends on the liquidity of a certificate.
As a rule, the higher the turnover, the lower the spread. For a relative benchmark, those that account for a maximum of 0.5% of the certificate price are considered cheap.
Last but not least, the issuer charges a so-called premium, which is added to the actual issue price. Specified premiums provide information on how much more one pays than if one would buy the underlying asset directly.
For certificates that can be replicated with options (e.g. discount or bonus certificates), the possible loss in fair value and the implied volatility also play a role. These can have both positive and negative effects on the price adjustment of the certificate.
Tax Aspects for Certificates in Germany
The same applies to Certificates as to all other income from financial market transactions.
All profits generated with them are subject to the final withholding tax if the purchase took place after 01.01.2009.
The taxes are usually paid to the tax office by the custodian bank or broker.
The risks involved in trading with Certificates
Depending on its design, each certificate contains specific risks that are subject to the so-called market risk. These can be disproportionately high or low. In addition, however, there is the less calculable issuer risk.
Since certificates are among the derivatives, they are in principle considered OTC (over-the-counter) transactions between investor and issuer.
If the issuer files for insolvency, the money invested is usually lost.
A critical view of certificates
In addition to the issuer risk, which has demanded a certain amount of attention at the latest since the Lehmann bankruptcy, the question of cost transparency is also a major issue.
For the simple private trader or investor, who is ultimately the target group for most certificates, the structure of the costs to be generated and their inclusion in the price is hardly comprehensible.
The only remedy here would be to take a look at the issuer’s “basic information sheets”, if one can find them at all. But let’s be honest: who reads through it every time before deciding to buy a certificate?
Furthermore, the price of the certificates is often criticised by the issuers. Since they are not exchange-traded products and are therefore not subject to any supervision, both prices and spreads can in principle be set and changed arbitrarily.
This question arises in particular when certificates are, for example, close to a knock-out threshold and their spread suddenly increases 20 to 50 times.
Concluding words on trading with certificates
The use of certificates can make sense depending on motivation or risk profile.
They can be used with low financial investment to protect capital or existing positions from other influences such as inflation or opposing market movements.
Or even to profit from markets or individual underlyings that are in less profitable sideways movements.
And, of course, speculatively in order to participate with low or increased risk in both rising and falling prices.
All this is possible if one is aware of the risk that certificates carry beyond the normal market risk.
This includes not only the issuer risk, but also that of the costs, which are not always obvious, but can be generated first.
Finally, one should know which certificate product is suitable for which purpose. For this purpose, it is necessary to know the respective product and its mode of operation exactly. If these prerequisites are met, nothing stands in the way of trading.