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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 n n n n n n 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 14 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. 16 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. 18 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. 19 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. 21 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. 22 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. 23 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. 28 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