Discount Certificates: An Alternative to Stock Investments

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
5.2.1.1 The short maturity strategy combined with the offensive investment strategy
5.2.1.2 The short maturity strategy combined with the neutral strategy
5.2.1.3 The short maturity strategy combined with the defensive strategy
5.2.2 The low volatility strategy

6 Conclusion

Reference List

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

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

1 Introduction

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.

2 The Discount Certificate

2.1 Definition 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.

2.2 Markets 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.

3 Differentiation of Discount Certificates and stocks

3.1 Opportunities and risks

DCs and stocks expose the investor to certain opportunities and risks. Since the DC is derived from the stock (underlying), some are similar. However, there are certain opportunities and risks, which apply only to the DC.

A stock investment offers two ways of making a profit. The first is appreciation. An investor can buy a stock at a certain price and sell it at a much higher value. The difference resembles the profit. The second is dividends paid. A stock owner is entitled to a share of the profit of the particular company of which he owns the stock. If the company is profitable the investor receives a certain amount of money every year - called dividends. Stock investments also give voting rights to investors, which enables them to influence the company’s way of doing business.

As mentioned in Chapter 2.1 the DC does not pay dividends. So the only way of making a profit is selling the DC back to the issuer at a higher price than the investor has bought it. The sale either happens automatically when the DC matures, or during the maturity (Chapter 2.2).

The issuer sells the DC at a discount, which enables to investor to buy the underlying stock at a smaller price. At the end of the maturity the value of the DC equals the value of the stock or cap. So the investor posses the chance to make a profit even if the underlying stock does not performs in a positive way. The discount adds to profit in a positive market scenario. In addition, the investor can use the saved money to buy other investment products, e. g. DCs with a different underlying stock.

Chapter 4 describes the situations in which a DC is more profitable than a direct stock investment.

The economic risk refers to the “risk associated with the overall health of the economy in the locality the investment is made” (Federal Reserve Bank of Atlanta 2009).

For a stock investor the economic risk consists only of the uncertainty about the development of the economy the respective company is located in. If the company performs poorly the value of the underlying stock drops resulting in a loss for the investor (Chapter 5.1). In Addition, expected dividends may not be paid.

The same is true for a person investing in DCs. In addition, the investor interested in buying a DC has to consider the health of the economy in which the issuer operates in. DCs are unsecured bonds. This legal characteristic exposes the investor to the credit default risk. The investor may realize a total loss of his money invested in DCs irrespective to the performance of the underlying. If the issuer of the DCs files bankruptcy, the investor will only be entitled to a small compensation according to value of the issuer after it has been liquidated. The default of Lehman Brothers in 2008 is a prominent example for this risk. (Commerzbank AG 2009 p. 4)

The foreign currency risk describes the risk implied by a change of the exchange rate between two currencies (Organisation for Economic Co-operation and Development [OECD] 2005 p.132). If the investor (located in the Eurozone) buys a stock or other financial product in another currency e.g. Dollar, then the value of the investment can change only due to a change in the exchange rate. If the Dollar decreases in value compared to the Euro, the investor makes a lost on his investment even if the nominal value of the financial product has not changed. A person invested in DCs with an underlying of stocks denominated in a foreign currency, is exposed to the same risk. However the mechanism works in both directions, therefore an investor may use a current weakness of the foreign currency to buy DCs. The currency exchange rate will then work as leverage for the investment. The same chance is also implied in an investment in stocks (denominated in a foreign currency).

An investor interested in DCs faces the problem that the issuer of a DC may quote unfavourable prices. As explained in Chapter 2.2 the issuer of a DC is virtually involved in every transaction of a DC. Wilkens, Erner, and Röder (2003) describe the order flow hypothesis which states that the issuer of a DC orientates the pricing of a DC in accordance to the life cycle of the product. The issuer does not quote a fair price of the DC, but a price according to the risk of redeeming the DC in stocks. As a consequence the price of a DC differs more from the fair price the longer the maturity time is (p. 2 and p. 24-25).

In addition, Baule, Entrop, and Wilkens (2008) point out, that the position as a market maker enables the issuer to realize a margin higher, which is higher than the margin of the components of a DC. The investor is in danger of being put into a disadvantageous position by the market power of the issuing institute (p. 1 and 2).

The fair value of the DC is also determined by its legal structure (Chapter 2.1). The issuer incorporates “its own risk in the payoff structure” (Baule, Entrop et al. 2008 p. 2).

However, for an investor it is also necessary to evaluate the value of a DC not only through evaluating its components, but also to take the transaction costs of reproducing the DC in consideration. Depending on the structure of a DC the transaction costs of buying the single components of a DC individually may exceed the disadvantages in the pricing of a DC by the issuer.

The investor, therefore, has always to consider the both aspects when thinking about investing in DCs. Although the pricing of a DC may be disadvantageous compared to its components, it may still be a better deal than buying them individually (e. g. when considering transaction costs).

An investor in stocks participates in the profit of the respective company by payments of dividends. A DC does not pay dividends. So the only way for the investor to make profit with the DC is by selling it at higher price than he purchased it. If the investor holds the DC until maturity, he will risk to have made less profit than investing directly into a stock. This situation occurs, when the combined profit of value increase and dividends of the stock exceeds the increase in value of the discount certificate including the discount.

In Addition, a change in the expected dividends paid also influences the price of the DC during the time of maturity. If the amount of dividends paid increases the value of the zero-strike-call drops, thereby decreasing the value of the DC. So an increase of dividends may result in a loss for an investor planning to sell the DC before it matures.

The tradability of DCs represents a special risk to potential investors. As described in chapter 2.2, the issuer is virtually the only the only possible trading partner for an investor of DCs.

However an issuer may decide any time to stop taking the role as a trading partner. It can stop quoting bids and asks at the stock market at any point. The OTC-trading may be stopped due to a change in business policies or a lack of liquidity of the issuing institution. An example for such an incident is provided by Commerzbank which declard that it would not act as a market maker for several certificates with an US-bank-share as underlying during the days of the Lehman Brothers bankruptcy. (Mohr 2008)

By investing into DCs the investor has realize that he risks holding illiquid assets. Although a stock may become harder to trade as a company performs very ill or has to file bankruptcy. The stock investor will have always the advantage of having more than one potential trading partner. This reduces the risk of not being able to cash in (even at a low price) when needed.

3.2 Evaluation

An investor faces opportunities and risks when investing in DCs and stocks. It is always important to evaluate both. However, as preceding chapters have shown, the most important risk (issuer’s default risk) of DCs is imminent only in extreme market situations, e.g. a financial crisis. Although the other risks should not be neglected, they are offset in the opportunity of making profits during negative stock market scenarios. Chapter 4 gives a more detailed look at how DCs outperform stocks in different market scenarios and in which stocks are the superior choice of investment.

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^[1] Femals are always included.