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I N V E S T I N G
A guide for the investor
C ONTENTS
PART I: Investment principles
4
PART II: General risks linked to financial instruments
6
PART III: Presentation of the various financial instruments
9
I Money market instruments
9
II Bonds
12
III Equities
17
IV Mutual funds
(Undertakings for Collective Investment – UCI)
19
V Options and warrants
22
VI Futures
24
VII Structured products
26
GLOSSARY
28
This brochure is published by Banque et Caisse d’Epargne de l’Etat, Luxembourg for its customers. The figures presented
therein are provided purely as an indication.
I N V E S T I N G
A
g u i d e
f o r
t h e
i n v e s t o r
When trading in financial instruments, the importance of potential profits, respectively losses,
is proportional to the risk. It is therefore essential for the investor to be in a position to make
informed investment decisions based on an understanding of the products, their characteristics
and inherent risks.
This brochure aims to give a brief overview of the main types of financial products that Banque et
Caisse d’Epargne de l’Etat, Luxembourg (BCEE) offers its customers, with particular emphasis on the
risks that are inherent to these financial instruments.
The first part of this brochure is dedicated to the risks arising from financial instruments and the
second part presents the main characteristics of the following types of financial assets:
n
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n
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Money market instruments
Bonds
Equities
Mutual funds
Options and warrants
Futures
Structured products
Our branch investment advisers and private bankers are naturally at your entire disposal for further
details and for additional information on any product or financial instrument.
The glossary on page 28 provides definitions of many technical terms used in this
brochure.
Part I
INVESTMENT PRINCIPLES
Define your investor profile and investment horizon
Knowing your investor profile is a prerequisite for determining the type of investment best suited
to your sensitivity towards risk and your performance target. Every investment is characterised by a
risk and an expected return. The higher the risk is, the higher the expected return can be!
Our investor profile system defines five profiles ranging from “security” to “dynamic”. The profile is
determined through a questionnaire designed to identify the level of risk acceptable to the customer and
his investment objectives. This classification is designed to ensure that the advice provided is consistent
for each category of investors.
P erformance
An investment horizon is also defined for the type of investment you have chosen. A short-term
investment, i.e. one to two years, should not be based on a volatile product as you might be obliged to
sell the product under unfavourable market conditions.
Dynamic
Very high risk, requiring very significant investment skills
Growth
High risk, requiring significant investment skills
Balanced
Average risk, requiring some investment skills
Conservative
Low risk, requiring little investment skill
Safe
Very low risk,
requiring very little
investment skill
Short
Ri s k
medium
Investment horizon
long
Diversify your investments
It is not recommended to invest in a too small number of financial instruments due to the specific
risk arising from concentrating on a single security. To reduce this risk, you need to diversify your
investments, i.e. invest preferably in a variety of asset classes (bonds, equities and alternative
instruments). A portfolio is considered to be diversified if it is made up of equities, bonds and
liquid assets, whether held directly or through mutual funds. If you want to invest directly, please
be advised that modern portfolio management theory recommends a minimum of 20 different
positions, with issuers of different economic sectors.
Spread your investments over time
In consideration of the significant and unforeseeable price fluctuations in the financial markets, it
is hard to choose the best time to buy or sell on the market. For this reason, it is preferable not to
invest everything at the same time but to spread your investments over different periods.
The right number of stocks
Investing small amounts in a large number of different stocks multiplies the transaction costs. We
recommend investing similar amounts (EUR 5,000 could be considered a minimum per line) in a
predefined number of stocks, or investing in mutual fund units. Your risks are thus more evenly
spread.
Keep some cash assets available
It is not advisable to invest all your assets in securities as you may be forced to sell them at an
unfortunate moment if you need cash. It is best to maintain some liquidity at all times in order to
retain room for manoeuvre.
Take tax aspects into account
The gross return on an investment may be subject to a withholding tax deducted directly by the
bank, or some other form of tax that means that the return you actually receive is lower than
the gross return on your investment. The tax burden can vary from one type of instrument to
another and according to your personal situation, such as your country of residence. We strongly
recommend that you take the tax aspects of an investment into account before making any
investment decision.
PART II
GENERAL RISKS LINKED TO FINANCIAL INSTRUMENTS*
I. Economic conditions
Changes linked to economic cycles always have an impact on securities prices, and consequently,
with a multiplying effect, on derivatives. Prices fluctuate in line with expectations of recession or
economic growth. The length and scope of economic cycles vary over time, as does the repercussion
on the different sectors of the economy. Moreover, economic cycles can vary from one country to
another. Failure to take this into account or a wrong estimation of future economic trends when
making an investment decision can result in losses. The investor must notably take into account
the impact of economic conditions on interest rate trends and foreign exchange rates as well as on
company earnings in the respective country.
II. Inflation
Inflation is measured by the rise in consumer prices and corresponds to the loss of purchasing
power over time. The investor loses purchasing power whenever inflation (of the investor’s national
economy) exceeds the return on investment (coupons, dividends and capital gains). Investors should
base their decisions on the effective interest rate, i.e. the difference between the interest rate and
inflation.
III. Psychological factors
Irrational factors can influence the prices of financial assets – of commodities as well as of equities
and bonds. Analysts’ reports or rumours can result in significant price swings, either up or down,
even when the fundamental situation has not changed. These psychological factors are way more
pronounced at times of economic crisis or when there is geopolitical tension, and can cause either
stock-market bubbles or slumps.
IV. Sovereign risk
There is a possibility that a country may default and/or suspend foreign exchange of its currency.
This risk includes both economic and political instability. In the event of a foreign currency crunch or
restrictions on foreign transfers, an investor may not receive the payments to which he is entitled.
The investor could receive payments in a foreign currency that is no longer exchangeable due to
foreign exchange restrictions. In principle there is no protection against such a risk, as can be seen
from the most recent examples of Brazil in 1975, Russia in 1998 and Argentina in 2001.
*These risks apply to all financial products.
V. Currency risk
Foreign exchange risk is the same for all financial instruments, whether they are money market
instruments, bonds, equities or derivative products. An investor that purchases a security of a
currency other than the currency of his national economy (the benchmark currency) is exposed to
foreign exchange risk, i.e. the risk that the foreign currency will depreciate versus the investor’s
national currency.
The purchase of a US or Japanese stock on an European stock exchange does not avoid the foreign
exchange risk. The price variations in Euro take into account the variation in the share price on the
stock’s main market as well as exchange rate fluctuations. Investors can use currency futures and
put options to hedge against foreign exchange risk.
The key factors influencing exchange rates are inflation and interest rate differences between one
country and another, economic forecasts for the country in question, the political situation and
the safety of the investment. In addition, psychological factors, such as lack of confidence in the
government, can trigger speculation on a currency.
VI. Liquidity risk
In the event of a liquidity crunch in a given market, the investor may be unable to sell his securities
at market prices. In principle a distinction should be made between temporary lack of liquidity due
to supply and demand factors (prompted by seasonal factors for example) and structural lack of
liquidity linked to the characteristics of the security, such as low market capitalisation of the issuing
company and consequently low trading volumes.
Inadequate liquidity due to demand/supply factors occurs when there is almost exclusively “supply”
(sell price) of, or almost exclusively “demand” (buy price) for, a security at a given price. In these
circumstances, a sell or buy contract cannot be executed immediately and/or only in part (partial
execution), often on unfavourable terms. Moreover, higher transaction costs are applied in the
event of partial execution.
Lack of liquidity due to the characteristics of the security can occur in the case, for instance, of a
transcription of transactions in registered shares, or execution times linked to market practices.
In the case of mutual funds lack of liquidity can result from suspension of NAV calculation by
the depository bank. This was the case for US equity funds the day after the 11 September 2001
terrorist attacks, when Wall Street remained closed for nearly a week. This was also the case of
German property funds which, faced with massive redemptions, had to suspend NAV calculation
while awaiting to sell part of their property portfolios, which took weeks and even in some cases
months.
VII. Specific risks linked to credit based investment in
financial securities
Financing the purchase of financial assets through borrowing engenders several additional risks.
To begin with, additional collateral may be required if the credit limit is exceeded due to negative
trends in the value of the pledged securities. If the investor is unable to provide said collateral,
the bank may be obliged to sell the deposited securities at an unpropitious moment. Also, the loss
suffered in the event of a negative trend in prices may exceed the initial investment. Fluctuations
in the prices of pledged securities may weigh on the investor’s capacity to repay the debt.
Investors should be aware that the leverage effect of purchasing securities on credit generates a
proportionally greater sensitivity to price fluctuations and thus presents significant opportunities
for gains but also increased risk of losses. The risk is proportional to the amount of the leverage.
VIII. Specific risks arising on investments in derivatives
Warrants and options react with leverage effect to changes in the price of the underlying assets. In
the event of purchase of a warrant or option, the call option loses all its value if at the expiry date,
the price of the underlying asset is lower than the strike price agreed in the contract or, if on the
expiry date of a put option, it is higher than the contractual price.
With regard to “sales” of derivative products or futures transactions, not hedged by underlying
assets, the risk of loss is generally unlimited.
+
+
PUT
pr of i t/ l oss
pr of i t/ l oss
CALL
Strike price
Strike price
0
0
Price of the underlying
Premium
Price of the underlying
Premium
-
-
8
PART III
PRESENTATION OF THE VARIOUS FINANCIAL INSTRUMENTS
I. Money market instruments
1. Definition and characteristics
The money market is an informal market on which financial institutions such as central banks,
commercial banks, insurance companies, fund managers and large companies place their
short-term assets and obtain short-term financing (cash management). Short term refers to a
maturity of less than one year. The main rates that apply in the Eurozone are EONIA, EURIBOR
and LIBOR.
Given that borrowers on the money market are in general financial institutions and large
corporates, the securities issued against these loans are characterised by low risk but also by
low returns. These securities are suitable for investors with a strong aversion to risk.
2. Types of products
a) Treasury Notes
A treasury note is a short or medium-term security issued by the Treasury Department of a sovereign
state and which represents a receivable drawn on the State.
b) Commercial paper
Commercial paper is a negotiable debt security that represents a term investment for a large
amount in a company.
c) Certificates of deposit
A certificate of deposit is a negotiable debt security that represents a term investment for a large
amount in a bank or credit institution.
d) Foreign exchange spot
A foreign exchange spot transaction is an agreement between two parties to exchange on the spot
market a given quantity of one currency against a given quantity of another currency at an exchange
rate agreed on conclusion of the spot transaction. Spot transactions can only be carried out in
currencies that are commonly traded on the foreign exchange market, such as the EUR/USD pair.
e) Currency futures
A currency future is an agreement between two parties to exchange at a future date a given
quantity of one currency against a given quantity of another currency at an exchange rate agreed
when the contract is concluded.
The exchange will take place on an agreed date in the future and each party undertakes to deliver
on that date the quantity of the currency sold and to take delivery on that date of the quantity of
currency purchased.
Currency futures enable investors to protect themselves against future exchange rate fluctuations
or to bet on trends in the exchange rate of one currency against another. In general, a currency
future cannot have a maturity of more than one year. It can only relate to currencies that are
commonly traded on the foreign exchange market.
A forward exchange rate for one currency against another is calculated based on the spot rate of
the two currencies in question and the interest rates of each currency.
A forward foreign exchange transaction can be carried out:
- to hedge foreign exchange risk incurred by the customer;
- for speculative purposes.
In the latter case, the customer must:
-
-
10
reverse (repurchase or resell) the position taken at least two days before the contract expires and realise the respective gain or loss.
carry over his position to a new maturity date. In this case, it is a forward foreign exchange swap transaction.
3. Additional risks linked to money market instruments
The money market is reserved to investments of significant size made by professional investors. The
majority of individual investors have access to it only through money market mutual funds.
The credit risk consists in the possibility of non-payment of interest and non-repayment of part of
the capital. In addition to rating issuers’ long-term debt, the rating agencies Standard & Poor’s and
Moody’s also publish ratings that assess the credit risk for short-term debt. These ratings can be
divided into investment grade and speculative grade.
Systemic risk on money markets of OECD countries can only materialise in the extreme case of a
severe banking crisis, such as the default of a major financial institution resulting in contagion of
the international banking system.
As money market instruments are short-term products, the investor bears the risk of reinvestment,
i.e. the risk that at expiration of the instrument, the reinvestment possibilities will yield a lower
rate of interest than his initial investment.
II. Bonds
1. Definition
A bond is a security that certifies that the owner, called the bondholder, has granted a loan to
the issuer and has creditor’s rights on the issuer. These rights include entitlement to interest,
coupon and the right to receive repayment of the capital lent on a predetermined date and on
predetermined terms and conditions. A bond is a negotiable debt security, representing a part
of the long-term debt of a sovereign State, a government agency, a supra-national body or a
private company.
The coupon, representing the remuneration of the capital lent in the form of interest, can be
fixed or floating. At the end of each predetermined period, the borrower pays the interest,
corresponding to the nominal value of the bonds multiplied by the interest rate, to the investor.
On the final maturity date, the borrower repays the capital at the redemption price.
In the event of issuer default (insolvency, bankruptcy), the bondholder bears the risk of
non-repayment of the capital. In general, the risk inherent in bonds is lower than that
incurred on an investment in shares.
2. Main characteristics of bonds
a) Nominal or ‘face’ value
The nominal or face value of a bond represents the total amount of a loan divided by the total
number of bonds issued. It is used as the basis for calculating interest.
b) Issue/redemption price
The issue/redemption price can differ from the face value (also known as the par value). When the
issue price is higher than the par value, the difference is the subscription premium (against the
investor). When the redemption price is higher than the par value, the difference is the redemption
premium (in favour of the investor).
c) Market price or fair value
The fair value of a bond is the listed price on the market. Both the theoretical value of a bond and
its fair value can differ significantly from its face value.
Generally speaking, when interest rates rise the price of existing bonds drops. This is explained by
the fact that past issues at lower interest rates lose their appeal compared with more recent issues
at higher rates. This reverse relationship between bond prices and interest rates is the interest rate
risk.
12
When an investor purchases a bond he pays the market price plus the accrued interest, i.e. the
fraction of interest attached to the bond since the issue date or since the last coupon cut off
up to the purchase date. When he sells a bond, the investor receives the market price plus the
accrued interest up to the sale date.
d) Coupon rate
This is the interest rate at which the bond was issued and which provides the basis for calculating
the interest to be paid. The basis for calculation most commonly applied to bonds is ACT/ACT
(where ACT corresponds to the exact number of days) or the 30/360 method.
As an example, a bond with a face value of EUR 10,000 held over an uninterrupted period
of one year and paying annual interest of 6%, will pay the holder a coupon of EUR 600 (EUR
10,000 x 6%).
e) Yield
The rate of return on a bond, also known as yield-to-maturity, is a percentage that measures the
annual return on an investment over a given period and generally until the bond end date. It
takes into account the purchase and redemption price, the coupon rate and the bond’s residual
maturity. Only when the price is equal to 100% the yield is identical to the coupon.
f) Redemption of bonds
There are several types of redemption:
-
redemption at maturity;
bonds that can be redeemed early, either at the holder’s request (put), or at the issuing company’s request if it has reserved this possibility (call) ;
bonds redeemable by draw, i.e. the issuer has reserved the right to repay a given portion of its loan, determined by a draw, each year;
loan convertible into shares
13
g) Rating
The table below describes the way the two main rating agencies, Standard & Poors and Moody’s,
assess the quality of bond issuers and of medium and long-term debt when they assign a rating.
Quality
S&P Moodys Comment
Investment grade AAA Aaa Credit risk
First grade issuers, with stable and reliable financial structures
Very low
AA+
AA AA -
Aa1
Aa2
Aa3
Good quality issuers, slightly more risky than triple-A issuers
Low
A+
A
A -
A1
A2
A3
Quality issuers whose financial situation could be affected by economic conditions
Low
BBB+
BBB
BBB -
Baa1
Baa2
Baa3
Average quality issuer with satisfactory repayment capacity
Average
Speculative grade
BB+
BB
BB -
Ba1
Ba2
Ba3
Reliant on economic trends
High
B+
B
B -
B1
B2
B3
Significant changes in financial situation according to economic trends
High
CCC+
CCC
CCC -
Caa
Caa
Caa
Financially vulnerable, capacity to repay linked to favourable economic conditions
Very high
CC
Ca
Extremely vulnerable financial situation -> very speculative positions
Very high
C
C
Payment default is foreseeable
Excessive
C
Payment default is a reality
Default
D
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Excessive
3. Types of bonds
In legal terms there are several types of bonds:
-
-
-
-
mortgage bonds, backed by mortgages on one or several of the company’s property assets;
preference bonds, backed by the company’s transferable assets;
straight bonds, which have no additional guarantee attached;
subordinated bonds, which in the event of failure of the issuer are repaid only after all the other creditors have been repaid.
A distinction can also be made between the following:
a) Zero coupon bonds
Bonds with a 0% coupon and which pay no interest until maturity. This type of bond is generally
issued at a low subscription price and entitles the holder to a high redemption premium, following
capitalisation of the interest.
b) Fixed rate bonds
Bonds whose interest rate (annual or half-yearly) remains unchanged until maturity.
c) Floating rate bonds
Bonds with variable interest rate, generally computed each quarter, up to the maturity date,
according to a predetermined money-market rate (3-month EURIBOR or LIBOR) or bond rate. The
rate is often linked to inflation or to an index.
d) Step up/step down bonds
A bond whose interest rate increases or decreases during its lifetime at fixed dates, determined
when the bond was issued.
e) Convertible bonds
These are ordinary bonds that can, if the investor wishes so and on the terms and conditions defined
in the issue contract, be converted into new shares of the issuing company. If the share price rises,
the bond price rises identically. Conversely, if the share price falls, the price of the convertible bond
stabilises at a floor corresponding to the price of a bond of the same quality and residual maturity.
Convertible bonds therefore offer better protection against a fall of the price of the underlying
shares than a direct investment in the equities.
15
f) Reverse convertible bond
These are bonds that pay a higher coupon than conventional bonds but for which repayment of
the capital depends on the benchmark share price determined in advance. If on maturity of the
convertible bond, the price of the benchmark share is lower than the price initially set, the investor
will be repaid in reference shares. Conversely, if the price of the reference share is higher than
the predetermined price, the investor will be repaid his capital. In all cases, the investor receives a
coupon.
g) Special types of bonds: savings certificates or bank bills
These are “bonds” issued by a financial institution. In exchange for an amount (even relatively
small) lent to a financial institution for a given period (the range of maturities is relatively wide), the
institution issues an acknowledgement of the debt called a savings certificate or bank bill.
For this category, there exist also “step-up bonds” (the rate increases over the lifetime), capitalisation
bonds (the interest is not paid annually, instead it is added to the capital) and floating rate bonds,
where the interest rate changes at regular intervals.
Financial institutions generally offer the possibility of direct repurchase, even before the maturity
date.
4. Additional risks linked to bonds
The low credit risk on investment grade bonds and high credit risk on speculative grade bonds
explains the difference in yield between a German government bond and a bond issued by a US
carmaker or by the Argentinean government.
The risk varies in line with the economic fundamentals of a country (deficits, growth etc.) and/or a
company (balance sheet and cash flows). If the risk materialises, the interest is no longer paid and
the invested capital will not be repaid, totally or in part. Specific risks are borne by the investor
when a bond contains a conditional element.
Bond prices vary in accordance with yield curve fluctuations (resulting in interest rate risk), i.e.
changes in short- and long-term rates and according to the duration of the bond, or more simply
to the residual life of the bonds. The market rates vary according to the level of liquidity in the
financial markets, to aversion or lack of aversion to risk, forecasts of economic cycle and central
bank monetary policy. A systemic risk arises in the event of default on payment by a sovereign
state, as it was the case for Argentina at the beginning of this century.
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III. SHARES
1. Definition
A share is a transferable security that represents a part of the capital of a company, listed or not.
The share is a deed of property delivered to the shareholder to testify to his entitlements and
can be in registered or bearer form. The share gives the holder pecuniary rights and rights of
participation. It entitles the holder to attend general meetings and to vote as well as the right to
receive, in the form of dividends, part of the profit generated by the company. The shareholder is
also entitled to information about the company (financial results, earnings, annual reports, etc.).
In exchange the shareholder participates fully in the company’s risks.
2. Main characteristics of a share
a) Shareholder’s rights
These rights are determined by law and by the issuing company’s by-laws. The rights consist
essentially of entitlement to a part of the company’s profit, in the form of dividends, as well as the
right to vote at shareholder meetings, the right to receive information and the right to repayment
in the event of the company’s liquidation.
b) Return
The return on an investment in shares consists of the capital gain, or loss, realised on sale of the
share together with the dividends received. Dividends are paid out as decided by the general
meeting of shareholders. The share price rises or falls according to whether the company achieves
its targets in terms of sales and/or margins, i.e. earnings, which are reflected by the market in the
share price.
c) Sale of a share
Barring legal provisions to the contrary, bearer shares can be sold without any specific formalities
whereas there are often limitations or administrative constraints on sales of registered shares,
which are registered in the company’s register of shareholders.
3. Types of shares
a) Bearer/registered shares
The share is a registered share when the name of the owner is registered in the company register
of shareholders, resulting in the need for certain formalities upon sale of the security. The owner
of a bearer share is not registered and the share can be sold with no formalities.
17
b) Ordinary or preference shares
Depending on the issuing company’s by-laws, some shares may carry advantages in terms of dividends in exchange for loss/reduction of voting rights at general meetings.
c) Share certificates
As its name implies, a share certificate is a certificate representing one or more shares of an issuer.
They can be traded instead of shares. Share certificates comprise Fiduciary Depositary Receipts
(FDR), American Depositary Receipts (ADR) and Global Depositary Receipts (GDR).
4. Additional risks linked to shares
The main risk are price fluctuations. Share prices react to any improvement or deterioration in the
company’s fundamentals (balance sheet and income statement, notably sales and margins). The
market anticipates these changes in fundamentals and share prices react to news relating to the
company, such as profit warnings, in what may seem a sometimes irrational manner.
Each share is valued based on a core scenario, reflected in the stock market ratios (notably Price/
Earnings), that factor in market expectations with regard to the company’s fundamentals. Failure
to fulfil the market’s expectations results in a fall in the share price. As long as the company needs
financing, it can decide not to pay a dividend.
Share prices vary according to factors specific to each company but also according to macroeconomic
factors, such as inflation, growth rates, public deficit, etc. If expectations are for an economic
recession, the market can experience a slump known as a “bear market”, i.e. a period of negative
stock market returns. If expectations are for an upturn, equity markets can experience a period
of significant rises in share prices, a situation that is particularly favourable to cyclical shares, i.e.
shares in companies that operate in sectors that are sensitive to economic conditions, such as steel,
technology, etc. Generally speaking share prices benefit during periods of economic growth.
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IV. MUTUAL FUNDS (UNDERTAKINGS FOR COLLECTIVE INVESTMENT - UCI)
1. Definition
An Undertaking for Collective Investment (UCI) or mutual fund is an investment vehicle whose
sole purpose is to collect funds from the public and invest these in transferable securities or other
financial assets, according to the risk spreading principle.
Shares in mutual funds, often known as units, can be in the form of capitalisation shares or
distribution shares. If the investor opts for a capitalisation share, the revenues earned by the fund
will be reinvested and no dividend is paid out to investors in the fund. This explains why the Net
Asset Value (NAV) of a capitalisation share differs from that of a distribution share in the same
fund. Distribution shares give rise to payment of revenues in the form of an annual dividend.
An investment fund is classified as a closed-end fund when the number of shares it can issue is
limited to a fixed number defined in its Articles of association. An investor can only purchase shares
in a closed-end fund if an existing shareholder sells his shares or if the fund increases its capital. The
majority of funds are open-ended investment funds, for which the number of shares that can be
issued is not defined or limited in the Articles of association and to which investors can subscribe
according to the frequency determined in the fund’s prospectus.
Each fund or sub-fund manages its investments on behalf and in the interests of the subscribers/
shareholders and, in accordance with applicable law, based on an investment policy defined when
the fund is created. The sub-fund’s investment policy is always described in the fund prospectus.
A mutual fund:
-
-
-
gathers funds from the public;
is managed by a management company or by a board of directors (self-managed fund) responsible for managing the fund’s assets;
is divided into units or shares, which each represent a share in the capital of the fund and are allocated pro rata to the amount invested by the subscriber.
The value of a share is the Net Asset Value or NAV determined on basis of the calculation methods
set out in the prospectus.
The investor is advised to refer to the fund’s prospectus for further information about how the
fund is operating.
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2. Legal forms
Luxembourg law provides for two legal forms of funds: contractual undertakings (Fonds Commun
de Placement) and statutory undertakings (investment companies).
a) Contractual common undertaking or Fonds Commun de Placement (FCP)
An FCP is defined as an undivided mass of marketable securities put together and managed according
to the risk spreading principle and on behalf of undivided owners, each with a commitment equal
to the amount invested.
As a joint or common ownership structure, the FCP does not have a legal identity of its own and is
managed by a management company, according to the fund investment rules and in the exclusive
interest of the unit holders.
The investment rules (described in the prospectus) established by the management company must
be accepted by the investor when he subscribes to units in the fund. The depository bank supervises
application of the investment rules.
Given the voluntary allocation of assets to a common purpose, the investor renounces on ownership
rights such as voting rights. General meetings are not held.
b) Investment Company
Statutory funds are investment companies. Unlike FCPs, investment companies have a legal
identity that is distinct from that of the investors. Under UCITS III (see glossary) these companies
are managed by a board of directors (self-managed open-ended investment company) or by a fund
manager authorised by the Luxembourg financial markets authority, Commission de Surveillance
du Secteur Financier (CSSF).
There are two types of investment companies:
-
-
Open-ended investment companies (Société d’Investissement à Capital Variable – SICAV);
Closed-ended investment companies (Société d’Investissement à Capital Fixe – SICAF).
3. Umbrella funds
Under Luxembourg law, a fund (the so-called umbrella fund) can divide its assets into several
distinct sub-funds according to investment policy, currency or type of investor. Switching from one
sub-fund to another within a fund is generally free of transaction charges.
20
4.Type of fund according to investment policy
Funds can be divided into several categories based on their investment policies:
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
Money-market funds (funds invested in money-market instruments in the fund’s currency)
Bond funds (funds invested in bonds denominated in a single currency or in several currencies)
Equity funds (funds invested in shares, whether according to a geographic strategy or sector strategy)
Mixed or balanced funds (funds invested mainly in both bonds and shares)
Funds of funds (funds invested in other funds)
Funds with guaranteed capital or guaranteed returns (a product structured in the form of a fund rather than an EMTN, offering certain guarantees)
Real estate funds (funds invested in property assets)
Hedge funds (funds that seek to achieve absolute returns, decorrelated from stock market trends)
Institutional funds or SIF which reserve the issue of shares to one or several institutional investors as defined in the fund’s by-laws
Private equity funds (Sicar - Société d’Investissement en Capital à Risque), which invest in unlisted companies.
Access to the last three types of funds in the list is generally reserved to investors with significant
financial assets.
5. Specific risks linked to mutual funds
For retail investment funds marketed to the general public, notably those governed by part
I of the 2002 UCITS III law, the risks specific to a sovereign country and/or a company are so
widely spread that the impact of a default would be small. Generally speaking, investment
in a mutual fund offers the advantage of diversifying specific risks through professional
management of the assets, documented in the prospectus and in the half-yearly financial reports.
The fund’s investment policy is such that the investor incurs no specific risk and the sole risk is market
risk relating to the markets defined in the prospectus. Consequently, once the investor has made his
choice of allocation for a given financial asset, a given geographic region or a specific investment
theme (healthcare, environment, etc), the return is largely dependent on the performance of the
underlying market. Conventional funds generally follow a benchmark.
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V. Options and warrants
1. Definition and characteristics
Options are derivative products. The purchase of an option gives the right (but not the obligation)
to buy (call) or sell (put) an underlying asset. A call option gives the buyer the right to purchase a
given quantity of the underlying asset at a set price (known as the strike price) on a predetermined
date, called the maturity date. A put option gives the buyer the right to sell a given quantity of the
underlying asset at a predetermined price on the maturity date.
In all cases, the seller of an option contract is subordinate to the buyer’s decision.
The buyer of a call option realizes a gain at maturity if the price of the underlying asset is higher
than the strike price. The buyer of a put option gains at the maturity date if the price of the
underlying asset is lower than the strike price.
A call option is said to be “in the money” as soon as the price of the underlying exceeds the strike
price. A put option is said to be “in the money” whenever the price of the underlying falls below
the strike price. As soon as an option is “in the money” it has an intrinsic value. A call option is
said to be “out of the money” whenever the price of the underlying falls below the strike price.
A put option is said to be “out of the money” as soon as the price of the underlying exceeds the
strike price. When the price of the underlying is the same as the strike price, the option is said to
be “at the money”.
Option contracts offer strong leverage effect in so far as the capital invested is much lower than
that of the underlying asset. The risk of capital loss is also much higher.
The value of an option depends on several factors, namely the price and volatility of the underlying
asset, the exercise price, time remaining to maturity and interest rates.
A combination of options can give rise to very complex strategies and to high risk, particularly in
the case of sale of options.
2. Types of option
a) European/American style options
A European style option can only be exercised on a set date, usually the maturity date. This does
not prevent it from being traded on the secondary market. American style options can be exercised
at any time from the issue date to maturity.
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b) Exotic options
Unlike conventional call and put options, exotic options are subject to additional conditions and
agreements. As a result, they present payment and risk structures that cannot result solely from the
combination of various conventional options. Exotic options can be in the form of over-the-counter
options or warrants. There is an unlimited variety of exotic options. It is therefore essential that
the investor informs himself as to the risks likely to be incurred and has these explained to him on
a one by one basis.
c) Distinction by type of underlying
Some option contracts relate directly to an underlying asset such as a share, a commodity or a
precious metal. Other option contracts relate to underlyings such as forward bond contracts,
interest rates, foreign exchange rates or stock market indices.
d) Physical delivery/cash settlement
In the case of a call option with physical delivery, the investor can ask for delivery of the underlying
asset on exercise of the option. In the case of a put option, the issuer must accept the possibility of
having to receive delivery of the underlying if the purchaser exercises his option.
When an option provides for cash settlement, the beneficiary receives a payment corresponding
to the difference between the strike price and the market price of the underlying assets on the
maturity date.
e) Warrants
Warrants are a form of option traded as transferable securities on the stock markets and generally
issued by financial institutions.
A warrant represents neither a part of the issuer’s capital as a share does, nor a part of the issuer’s
debt, as a bond does. It represents the right to buy or sell a financial asset under predefined
conditions in terms of price and duration. It is a derivative product.
Like an option, it gives the right (and not the obligation) to buy or sell a given asset at a
predetermined price over a predetermined period. A warrant must refer to a specific asset, called
the underlying, which can be shares, indices, commodities or exchange rates or baskets of shares,
indices or commodities.
Warrants are financial products with leverage effect, which means that the exposure to fluctuations
in the price of the underlying asset can have a multiplying effect on the initial investment. They
are therefore particularly suitable for speculating on rises or falls in price of the underlyings but
the investor runs the risk of the loss of the entire initial investment on maturity.
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Warrants are also used to hedge a portfolio against unfavourable market movements. Put warrants are
frequently used as hedging instruments to protect a portfolio against market downturns. For example,
if the investor has a portfolio of German equities, he can use put warrants on the DAX to protect
himself against a fall in the German market. If the fall never occurs, the put warrant expires without
any value in the same way as unused insurance cover. Like an option, a call warrant gives the right to
buy a given asset at a predetermined price over a predetermined period.
Also included in this category of financial instruments are allocation rights and and subscription
rights that entitle the holder to subscribe to a share or bond over a given period at a predetermined
price. Subscription warrants differ from subscription rights by their longer duration. Lastly, allocation
rights enable a shareholder in the company to receive bonus shares, for example following a
capital increase. These rights are freely tradable on the stock market.
Warrants are sometimes issued at the same time as bonds or during capital increases. In general,
these securities have a duration of several years and are traded separately from the bond or share
to which they were attached on issue.
Warrants can be traded from the issue date up to five trading days prior to their expiry date.
VI. FUTURES
1. Definition and characteristics
Futures, like options, are derivative products. These are forward contracts under which two parties
give a firm commitment (unlike in the case of options) to buy or sell a given quantity of the
underlying asset at a fixed price on a set date in the future (the maturity date). One feature of
futures contracts is their high level of standardisation (amount, predetermined maturity, tick size,
precise definition of eligible underlying assets, etc.).
If the price of the underlying asset is higher than the fixed price on the maturity date, the buyer
of the contract makes a gain. If it is lower, he makes a loss. It is the other way round for the seller
of a contract.
Like all derivative products, futures have leverage effect to the extent that the capital invested
is lower than the price of the corresponding asset, which has a multiplying effect on the rate of
return, and goes hand in hand with a much higher risk on the invested capital.
24
The majority of contracts are settled in cash on the last listing day. It is very unusual for futures
contracts to be exercised via physical delivery on the maturity date.
Investing in such products requires a good understanding of the mechanisms underpinning these
products as well as regular monitoring. Futures can give rise to specific financial risks. These
transactions are therefore reserved to highly experienced investors with enough liquid assets to
bear any possible losses.
2. Types of future contracts
The most common futures contracts concern goods and commodities (oil, orange juice, etc),
currencies, interest rates (money market rates and bond yields) and stock market indices.
VII. STRUCTURED PRODUCTS
1. Definition and characteristics
Structured products are financial instruments combining various other financial products and which
therefore have the same risk and return characteristics as the constituent products.
Generally speaking, a structured product is composed of two main elements:
-
-
an element of capital protection (often a fixed-income product that also determines the investment horizon) and
a risk element that enables the investment to achieve high performances (such as a share, an index, commodities, etc).
The almost unlimited number of possible risk/protection combinations means that the structured
product market is very broad and requires in-depth knowledge of this field.
26
2. Types of structured products
A “defensive” structured product is generally characterised by the allocation of a large part of
the capital to the bond element. One example is the zero coupon strategy. This gives the investor
access to asset classes with high potential risk/return without losing his protection.
An “aggressive” structured product, offering little capital protection, will have a larger proportion
of the risky element. These products have only a limited basic protection that provides some
protection against downside risk. One example is leveraged products, which increase the possibility
of gains as well as the possibility of losses.
There are structured products based on shares and indices that enable the investor to take a
position on trends in the global markets and hope to achieve a return higher than that of the
money market or traditional bond market.
The most common structured products guarantee all or part of the capital on maturity.
Structured Products
Structured Products
Capital Protection
Capital Exposure
Interest rate structured
products
Equities and/or indices
structured products
Foreign exchange or
commodities structured
products
Hybrid products
(combining the preceding
categories)
27
GLOSSARY
The glossary that follows, which is not exhaustive, provides definitions for some of the terms used in
this brochure.
Bear and Bull markets
A bear market corresponds to a downtrend in the
market whereas a bull market corresponds to an
upward trend in the market.
Benchmark
An index used as a benchmark to measure the
performance of an investment fund. Money market
and hedge funds are generally measured against a
money market index, bond funds against a bond index
and equity funds against a stock market index. Asset
allocation or mixed funds are generally measured
against a composite or tailor-made index composed
of bond and equity indices.
Calculation basis
In the case of simple interest, interest is calculated
by multiplying the capital by the interest rate and
by a conventional basis for calculation. The basis sets
out the methods for calculation of time between
payments and the number of days in the full year. The
basis takes the form of a fraction where the numerator
is the number of days between payments and the
denominator is the number of days in a year.
- ACT/ACT: Exact number of days/number of days in
the year.
- 30/360: This basis obeys the same principle as the
basis above. By convention, the month has 30 days
and the year 360 which allows regular payments
(180/360; 90/360; 30/360).
Call
Purchase option. A contract between two parties (the
buyer and the seller) under which the buyer pays the
seller a premium in exchange for the right, and not the
obligation, to buy a given quantity of the underlying
asset at one or several predetermined dates or over
a given period at a predetermined price (the strike
price).
Currency future
A foreign exchange transaction at a given date in the
future for a predetermined nominal amount, currency
pair and exchange rate.
Currency swap
Contract whereby two parties swap, over a fixed
period, two flows of interest denominated in two
different currencies on a nominal amount determined
in advance. The principal is always exchanged on expiry
and sometimes at the start date.
Delta (sensitivity)
Difference between the variation in the premium
and the variation in the price of the underlying asset.
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Mathematically, delta is therefore the deviation in the
option price as a function of the value of the underlying.
Expressed as a percentage, a delta of 50 means that for
a change of EUR 1 in the value of the underlying, the
price of the option varies by EUR 0.50. Delta can be
construed as the likelihood that the option will expire
in the money. An ‘at the money option’ will have a
delta of close to 50, which means that the option has
a 50/50 chance of expiring in the money. Delta will be
proportionally higher in absolute terms when an option
is in the money. Delta also enables the calculation of
the quantity of the underlying that needs to be held to
cover the optional portion.
Diversification
The diversification or risk spreading rule of modern
portfolio management is better known as the proverb
“don’t put all your eggs in the same basket”. This
fundamental portfolio management rule is the key to
the success of mutual funds. Mutual funds offer the
investor the possibility of diversifying his investment
even for small amounts.
EMTN (Euro Medium Term Note) programme
This is an extremely flexible bond issuance vehicle that
enables the issuance, using standard documentation,
of a wide variety of investment products. An EMTN
programme is a refinancing vehicle that enables the
issuer to raise cash from investors and remunerate it or
invest it in accordance with the terms and conditions
set out in the contract (Pricing Supplement).
EMTN
A bond issued under an EMTN programme. Such
bonds are frequently created to respond to the specific
requirements of one or more investors. They therefore
offer access to a wide variety of markets (interest
rates, equities, commodities, etc.) and respond to
needs ranging from the most simple (fixed coupon
bond) to the most sophisticated (reverse convertible,
non-directional products, etc.). It is always absolutely
necessary to know the issuer of an ETMN and to assess
its reliability (through its rating) as it is the entity that
ensures the proper execution of the transaction. The
exact terms and conditions applicable to the bond
(currency of issue, maturity, basis for redemption, etc.)
are described in the Pricing Supplement.
EONIA (Euro Overnight Index Average)
EONIA is the European overnight rate. It is
calculated based on the amounts and rates applied
for all credit transactions on a day to day basis for a
sample of around fifty European credit institutions.
This a posteriori rate is calculated for the previous
day by the European Central Bank (ECB) the next
morning at 7 am and published by the European
Banking Federation.
EURIBOR (European Interbank Offered Rate)
EURIBOR is the interbank rate used as a reference
by European banks. The quotation is made after
consulting a selection of banks representative of
the euro zone. EURIBOR is calculated and published
daily by the European Banking Federation for
different maturities. The most commonly used
duration is 3-month EURIBOR. This predetermined
rate is fixed on D at 11 am, with a starting date
of D+2 for settlement of interest at the end of the
period on the interbank market.
Future
A firm forward buy or sell contract that enables the
parties to fix immediately the price of a financial
product at a given date in the future. Financial
futures transactions relate to standard contracts and
fixed amounts for each instrument traded.
Leverage effect
A multiplying or amplifying effect.
LIBOR (London Interbank Offered Rate)
is the interbank lending rate in the London euro market.
Net asset value (NAV)
The Net Asset Value corresponds to the value of a fund
unit or share as published by the fund administrator
and approved by the depository bank. The net asset
value corresponds to the fund’s assets divided by the
number of shares or units. It is calculated according
to the frequency set out in the fund prospectus (daily,
weekly or monthly). The net assets correspond to
the value of the fund’s assets (securities, dividends,
coupons and cash) after deduction of charges, such
as subscription taxes and management fees.
Option
Contract under which the buyer pays a premium for
the right, on or before a given date, to request the
seller to sell (Call) or buy (Put) the assets concerned
at the exercise (strike) price determined when
the contract was signed. The buyer may choose
not to exercise the option if the exercise does not
generate a gain. The seller must fulfil his obligation
if the option is exercised and retains the premium
regardless of whether the option is exercised or not.
Options can be divided into European-style options ,
American-style options and exotic options.
Exotic options, relative to ordinary or plain vanilla
options, are options for which calculation of the pay
off is more complex than for a European or American
style plain vanilla options. The exotic component can
relate to a very wide variety of elements: method of
calculating the strike price or value of the underlying,
conditions relating to the value of the pay off, etc.
PAY-OFF
Amount received by the buyer of an option upon
exercise of the option.
Premium
Amount the buyer must pay to the seller of an option
or interest rate guarantee for the buyer’s right to
exercise the option or for the seller’s undertaking
to pay the difference in the case of an interest rate
guarantee. The premium is payable in one or more
payments according to the terms agreed in the
contract. It is definitively acquired by the seller.
Premium (options)
Gain, frequently expressed as a percentage,
corresponding to the difference between the
nominal value of a security and its market value.
In forward markets, the “premium” means that the
price of the future contract is higher than the spot
price of the underlying asset or that the premium
on an option is higher than its intrinsic value.
Price earnings ratio
The Price/Earnings Ratio is the ratio of a company’s
share price to net earnings for a single share (earnings
per share). In other words, it expresses the multiple
of earnings reflected in the share price. It reflects
the cost of a share based on present earnings and
not on estimated future earnings. The price earnings
ratio is therefore a sort of reverse return, between
the share’s potential earnings and its price. The price
earnings ratio generally published in the financial
press is based on the most recent published annual
earnings. In principle, the higher the price earnings
ratio is, the higher are investors’ expectations of
future earnings growth.
Put
Sell option. A contract between two parties (the
buyer and the seller) under which the buyer pays the
seller a premium in exchange for the right, and not
the obligation, to sell him a given quantity of the
underlying asset at one or several predetermined
dates or over a given period at a predetermined
price (the strike price).
Rating
Rating agencies such as Standard & Poors and Moody’s
are independent companies charged by the financial
community to assess the solvency and financial risk
29
of debt issuers. The highest rating assigned to any
company or country is AAA/Aaa. The rate paid by the
borrower on its debt depends on its ability to repay
the debt, i.e. on its credit rating.
Return
The return is the performance achieved by a financial
asset over a given period of time taking into account
price trends and financial flows.
Risk
Investments are subject to market law and therefore to
price fluctuations according to market conditions. The
risk measures the possibility of loss on an investment.
Investors can protect themselves against the risk of
loss by choosing a longer investment horizon or less
risky assets.
Spot market
Market for immediate settlement and delivery.
Start date (Value date)
Date agreed between the parties as being the starting
date of the transaction for the calculation of amounts to
be paid or received.
Strike price
Interest rate, exchange rate or price at which the
underlying asset of an option can be bought or sold
on maturity.
Structured product
Product (bond or mutual fund) composed of various
“elementary bricks” (zero bond, options, swaps, etc.)
grouped within a single easily accessible product.
Investors can use structured products to access a great
variety of markets (interest rates, equities, commodities,
etc), to define the acceptable level of risk (partial or
total capital protection, no capital protection, etc.)
and express the most complex market trends (nondirectional, equity/interest rate correlation, etc). A
structured product can take a number of legal forms:
EMTN, certificate, etc. The price of structured products,
which are very rarely actively traded on the market, is
calculated using complex pricing models.
UCITS III
UCITS III is the law of 20 December 2002, modifying
the law of 30 March 1988, relating to undertakings
for collective investment in transferable securities
(UCITS). This law comprises two parts, part 1 which
defines investment funds as provided for under EC
30
Directive 85/611/CE, which can be freely marketed
throughout the European Union. Part 2 defines the
investment funds that do not meet UCITS criteria.
Volatility
Volatility measures fluctuations in the price of
an asset over a given period. Volatility can be
expressed as historical volatility – i.e. volatility
calculated based on the price history of the
underlying asset and expressed as a percentage
of the average price over a given period – or
implied volatility, i.e. market expectation of
price volatility of an underlying asset. Volatility
therefore measures the possible extent of the
fluctuation in a fund’s net asset value.
Yield to maturity
The yield to maturity corresponds to the annual
return on a bond from the moment the investor
holds the bond until the maturity date.
11/07PDF
Banque et Caisse d’Epargne de l’Etat, Luxembourg
Etablissement Public Autonome
Siège Central: 1, Place de Metz L-2954 Luxembourg
BIC: BCEELULL R.C.S. Luxembourg B 30775
www.bcee.lu