Discount Certificates

Table of Contents

Executive Summary

Table of Contents

List of Abbreviations

List of Figures

List of Tables

1 Introduction

2 The Discount Certificate
2.1.. Definition and General Information
2.2.. Markets for Discount Certificates

3 Differentiation of Discount Certificates and stocks
3.1.. Opportunities and risks
3.2.. Evaluation

4 Behavior of Discount Certificates in Different Market Scenarios
4.1.. Assumptions
4.2.. Five Market Scenarios
4.2.1.. The Growth Scenario
4.2.2.. The Moderate Growth Scenarios
4.2.3.. The Stagnation Scenario
4.2.4.. The Moderate Decline Scenarios
4.2.5.. The Decline Scenario
4.3.. Special considerations when investing in discount certificates
4.4.. Evaluation and Critical Review

5 Strategies for investing into Discount Certificates
5.1.. Classic Strategies
5.2.. Unconventional Strategies
5.2.1.. The short maturity strategy
5.2.2.. The low volatility strategy

6 Conclusion

Reference List

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1: Growth

Figure 2: Growth I

Figure 3: Moderate Growth II

Figure 4: Stagnation I

Figure 5: Stagnation II

Figure 6: Moderate Decline I

Figure 7: Moderate Decline II

Figure 8: Decline

List of Tables

Table 1: List of Variables

Table 2: Payout Growth

Table 3: Payout Moderate Growth I

Table 4: Payout Moderate Growth II

Table 5: Payout Stagnation I

Table 6: Payout Stagnation II

Table 7: Payout Moderate Decline I

Table 8: Payout Moderate Decline II

Table 9: Payout Decline.

Executive Summary

This work evaluates investments in discount certificates as an alternative to stock investments and shows that discount certificates must be taken into consideration when choosing an investment.

It gives general information on the construction of discount certificates and the markets they can be traded in.

In Addition, it describes and compares the opportunities and risks of stock investments and investments in discount certificates. It evaluates the development in value of both investments in different market environments. Using a fictive example it shows that discount certificates outperform stocks in most market situations.

The paper provides strategies for investments in discount certificates and evaluates them.

1Introduction

In 1985 Thomas Zwirner of HSBC Trinkaus invented the Discount Certificate by copying an investment strategy of professional investors (Schmidt 2008).

Now there are over 100,000 certificates traded on the European Warrant Exchange (EUWAX). About 80% are discount certificates (Boerse Stuttgart AG 2010). Many Banks promote discount certificates as a safer and more profitable investment than a direct investment in stocks. However, when Lehman Brothers has filed bankruptcy in 2008 many investors lost their money invested in Lehman certificates (London Stock Exchange plc. 2008). Investors may now ask themselves the question if certificates and especially discount certificates are a true alternative to a stock investment.

The following work will answer this question. It is structured as follows: Chapter 2 describes basic information about discount certificates; it also provides information on the markets for discount certificates. Chapter 3 will identify and evaluate the risks and opportunities of a direct stock investment and a investment in discount certificates. Chapter 4 evaluates the behavior of discount certificates and stocks in different market scenarios by using a fictive example.

In chapter 5 possible strategies for an investment in discount certificates are given by the author and evaluated on their risk and opportunities, while chapter 6 concludes.

Since there are many different types of discount certificates, this work will focus on the discount certificates with an underlying of one share of the respective company.

2The Discount Certificate

2.1Definition and General Information

A Discount Certificate (DC) is a financial product, which is set up by banks and sold to private and institutional investors. The structure of a DC locates it in the product family called derivatives. A Derivative is “a contract that derives most of its value from some underlying asset, reference rate, or index” (Kolb, Overdahl 2003). A DC has usually on share of the respective company as an underlying.

A DC is a contract between the investor and the issuing bank which allows the investor to participate in the value development of an underlying stock with a lower initial investment than investing directly into the underlying. In the legal perspective this resembles an unsecured bond. The participation is limited in time – maturity (Commerzbank AG 2009). There is, however, no call for additional cover implied by investing in DCs.

The discount acts like an airbag, which decreases the loss of an investment if the underlying decreases in value and increases the profit, which the investor makes if the underlying increases in value.

However, every advantage comes with a price. In the case of the DC the price for the discount is called cap. The cap resembles a barrier which limits the participation in value development and thereby limiting the maximum profit for the investor.

A DC consists of a zero-strike-call and a sold call-option (short call). The zero-strike-call is a call-option for the underlying with a base price of zero. It represents the price of the underlying excluding the anticipated dividends paid within its maturity. With buying a DC the investor indirectly sells a call-option for the underlying. The value of the DC is the price of the zero-strike-bond less the value of the call-option. The base price of the call-option represents the cap of the DC (Maaß 2007). The DC changes its value according to the change of these two components in different market environments (Chapter 4). The level of the cap compared to the price of the underlying, the maturity of the DC, and the implicit volatility of the underlying influence the price of the DC as well. The time of maturity is determined by the maturity of the zero-strike-call and the maturity of the short call. During the maturity the DC does not pay dividends like a stock. The profit of the investor is only determined by the increase in value. When the DC matures it will have the value of the zero-strike-call.

The DC has two payout possibilities. If the underlying notes above or on the cap, the investor will receive the value of the cap in cash. If the underlying notes below the cap he^[1] will receive the stock.

2.2Markets for Discount Certificates

DCs are traded on the primary and the secondary market (Alexander, Sheedy 2008 p. 111). The primary market describes the first offering of a stock (initial public offering) or another financial product (e. g. DC). “The secondary market consists of the buying and selling of already issued [financial products]” (Alexander, Sheedy 2008 p.113).

The secondary market for DCs can be divided into an unregulated market (over-the-counter-trading) and a regulated market (stock exchange).

On the primary market the issuer sells a fixed number of DCs to investors. This selling process takes place in a limited time span. The investor does not have to pay stock market fees and is able to participate in gaining of the DC immediately. However, some conditions of the DC sold, may be fixed after the investors has purchased them. Some issuers will also charge an issuing fee undo the advantage of not paying stock market fees. (Brechmann, Röder et al. 2008 p. 75-76)

All further buys and sales take place in the secondary market. There are always to prices quoted on the secondary market. The difference between the price of buying and selling a DC is called spread and resembles the profit margin of the trading partner in the secondary market.

A DC can be traded over-the-counter (OTC). In an OTC-trade the investor conducts the transaction directly with the issuer of the DC by cutting out the middle man (exchange). One advantage for an investor in trading OTC is the extension of trading hours, which enables the investor to buy or sell DCs even if the stock market is closed. Another advantages is the smaller cost of transaction, since the investors has not to pay any stock market fees.

There are two exchanges in Germany which have specialist in certificate investing – EUWAX (Stuttgart) and Scoach (Frankfurt). Both exchanges offer the investor the regulatory measures including the best-price-principle, miss-trade-rules, and a limit-control-system. The first ensures that a transaction is conducted at the best price within the spread. The second defines what a miss-trade is and how to reverse it. The last measure ensures that an order placed by an investor is executable (Brechmann, Röder et al. 2008 p. 76 – 77). However, the investor has to pay this security by paying a market fee. Although the exchange is designed to bring bids and asks of private investors together, the extreme high number of DCs traded makes it very improbable that to investors will pair in a trade. For that reason the stock market requires the issuers of DCs to act as market makers constantly prompting bids and asks quotes. An investor will most certainly have the issuer of the DC as a trading partner in the warrant exchange (Baule, Entrop et al. 2008 p1). This results in the dangerous position for the investor. He is dependable on one counterpart in the trading. This limits the advantages of a stock exchange and introduces risks to a DC investor which are further discussed in chapter 3.2.

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^[1] Femals are always included.