L17 - Certificates: Strategies and Portfolio Combinations

Question 1

What are certificates?

Answer 1

• They are securitised derivatives usually issued by investment banks to provide investors with instruments that are flexible and suitable for satisfying different investment needs in different market scenarios. •
• Most of them can be traded on the Markets.
• In their simplest version, certificates are investment products which passively replicate the movements of the underlying asset without any active management contribution
• They do not entitle investors to receive the dividends paid by the underlying asset (except for Total Return indices)
• They are subject to credit risk. In the event of default of the issuer, certificates and unsecured non-preferred senior bonds are ranked at the same level.

Question 2

What is the third way to create a structured product with equity protection?

Answer 2

• underlying + a put
  
  • buy underlying —> have participation but don’t like the negative downside which you hedge with a put
    
    • underlying is sometimes called a call with strike 0 –> if underlying is worth 8 the call is then worth 8 –> same as the underlying
      
      • but don’t dividends so its 8- PV of the expected dividend
  • Total cost = call strike zero + put option premium
  • Usually, these products are sold in batches of a 100
    
    • so the multiple is 100/stock price ==> how many stocks can I buy with 100
  • equity protection = multiple x total cost
• Cost of option = 97.35
• Sold for 100 (implied fee of 2.65)

Question 3

What are the two macro strategies around certificates?

Answer 3

• INVESTMENT CERTIFICATES They are suitable for the investment of capital and are characterized by an underlying combination of options. There are three main types of investment certificates:
  
  • • certificates with capital protection;
  • • certificates with conditional capital protection;
  • • certificates without capital protection.
• 2. LEVERAGE CERTIFICATES They are characterized by leverage effect and are appropriate for more speculative investments as well as for trading or hedging purposes.

Question 4

Example of the different capital protections?

Answer 4

Question 5

What are bonus certificates?

Answer 5

The monitoring activity should focus on:

• initial price of the underlying asset
• multiple equal to the rate of the issue price to the initial value of the underlying asset. It represents the quantity of the asset controlled by each certificate;
• – barrier level;
• – bonus level

Question 6

How do you build a bonus certificate?

Answer 6

• purchase of a zero-strike call option (equivalent to the underlying)
• the purchase of a down and out put option with strike equal to the bonus level and knock-out level equal to the barrier level of the certificate

Question 7

Example of a bonus certificate cap?

Answer 7

Question 8

how flexible are bonuses?

Answer 8

Question 9

What are express autocallables?

Answer 9

• Express certificates are characterized by an autocallable feature which allows early redemption, i.e. redemption before the pre-set maturity of the instrument. Early redemption occurs only if the price of the underlying asset observed on predetermined dates is not lower than a pre-set level (Trigger Level) which is usually equal to the strike.
• In the event of early redemption, Express certificates provide investors with the notional value and an additional amount which is equal to the premium or to the sum of all the premiums that have not been paid on the previous observation dates (memory effect).
• Express certificates may feature unconditional capital protection. These certificates are known as Express Protection.

Question 10

What are phoenix autocallable with coupons?

Answer 10

• If the underlying does not lose more than 40% you will receive the coupon of 5.6%
• only receive the autocallable if the underlying has not lost value or even gained
• memorising means that if you don’t receive the first coupon the next time you could potential get the current coupon and the one previously

Question 11

why are phoenix autocallable with coupons so widely used?

Answer 11

• issuer –> implied fee and no management costs
• investors like the autocallable function as in the best case scenario you invest 1000 in 9 months you get a lot of coupon payments plus your initial investment

Question 12

What are certificates without capital protection?

Answer 12

• Certificates without capital protection are very simple products which replicate linearly the movements of the underlying asset. They do not ensure the repayment of the initial capital at maturity.
• Some of these instruments allow for a more than or less than proportional participation to the performance of the underlying asset.

Question 13

What are benchmark certificates?

Answer 13

Benchmark certificates are derivative instruments which replicate linearly the performance of the underlying asset, without any leverage effect. As a result, at any point in time, the price of these instruments reflects the value of the underlying index. More precisely, the price of a benchmark certificate is always equal to: Multiple * Price of the underlying asset •

If the underlying asset is denominated in a foreign currency, it is necessary to take the exchange rate between that currency and the euro into consideration, unless the certificate features a Quanto option

Question 14

What are outperformance certificates?

Answer 14

• These instruments allow investors to participate in the upward movements of the underlying asset with a leverage effect. On the expiration date, if the price of the underlying asset is above the strike, the certificate provides investors with the notional amount plus the entire positive performance of the underlying asset adjusted for the leverage effect.
• Outperformance certificates, as specified in the latest version of ACEPI’s certificates map, may offer conditional capital protection and feature a cap. These instruments are known as Outperformance Protected Cap
• certificate amplifies upwards movement by in the case of a downtrend the certificate replicates linearly the performance of the underlying

Question 15

Some investment needs that can be met with certificates?

Answer 15

Question 16

What are digital certificates?

Answer 16

• Characteristics
  
  • Periodic coupons if the underlying is above the coupon level (i.e. the pre-set threshold which triggers the payments if reached). •
  • Total or partial capital protection.
• Implicit strategy
  
  • Purchase of a zero-coupon bond; •
  • Purchase of a series of digital call options with strike equal to the coupon level and maturities that coincide with the intermediate payment dates and maturity date;
  • Sale of a put spread at maturity (in case of partial capital protection)

Question 17

How can certificates benefit bond investors?

Answer 17

• Since the bond market is no longer able to provide the yields traditionally offered in the past, investors apparently have no choice but to turn to the stock market and in particular to those stocks with high dividend yield.
• However, if investors decide to invest in the stock market they become exposed to capital losses.
• Investment certificates, thanks to their nature, enable investors to access asymmetric payoffs so as to satisfy their changing financial needs.
• In order to ensure a substantial stream of periodic coupon payments, there are two types of products available to investors which reflect two different risk exposures:
  
  • 1) certificates with unconditional capital protection; e.g. target coupon?
  • 2) certificates with conditional capital protection.

Question 18

What is a target coupon certificate?

Answer 18

• The certificate guarantees not only the protection of the entire capital at maturity but also the payment of periodic coupons as long as, on preset observation dates (with annual frequency), the underlying asset is not lower than the initial value.
• • The only risk has to do with the opportunity cost of capital.

Question 19

What is the advantages of a monthly coupon in certificates?

Answer 19

• The creation of a Phoenix certificate with monthly observation dates allows investors to receive a stream of periodic payments.
• Even if one or more coupons are not paid during the year, investors may still achieve a substantial return at the end of the year.
• The observation of the subsequent coupon on each coupon payment date, allows the price to be supported in the secondary market

Question 20

What are cash collect certificates?

Answer 20

• In the same way as Bonus certificates, Cash Collect certificates offer conditional capital protection. In fact, capital protection is guaranteed as long as the underlying asset does not violate a pre-set level which is the Barrier level.
• The violation of the barrier, typically at maturity, causes Cash Collect certificates to replicate linearly the performance of the underlying asset, thus becoming Benchmark certificates.
• Unlike Bonus certificates, the return of Cash Collect certificates derives from a stream of periodic coupons with payment frequency ranging from monthly to annual.

Question 21

What are bonus cap recovery certificates?

Answer 21

• Say an investor had significant losses on a portfolio
• There is a particular type of investment certificates that allows investors to accelerate the recovery process.
• • These instruments are called Bonus Cap Recovery and are issued at a price below 100 euro in order to make it easier, also from a psychological point of view, to bear the losses from closing the position
• • The payoff profile is the same as standard Bonus Certificates
• . • If the barrier level is not violated throughout the lifetime of the certificate or only at maturity, the investor will receive a premium

Question 22

How can certificates help when investors want to lock in profits?

Answer 22

Certificates can meet the needs of investors who are in a dilemma about whether they should close their market position to lock-in profits.

Certificates with unconditional and conditional capital protection offer many different opportunities.