Synthetic products

Synthetic products are financial instruments. Synthetic products – essentially covered options and certificates – are characterised by their identical or similar profit and loss structures when compared with specific traditional financial instruments (shares or bonds). They result from the combination of two or several financial instruments in the same product. Basket certificates, based on a specific number of selected shares, are one typical example. Synthetic products

Synthetic products
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Synthetic products can be traded either on a stock-exchange or over-the-counter. Due to the important number of possible combinations, each synthetic product has its own risks. Synthetic products

However, generally, the risks associated to synthetic products are not always the same as the risks associated to the financial instruments they contain. Consequently, before an investment in such products, the investor must make thorough inquiries about these specific risks, for instance by consulting the product description. Synthetic products

1. Covered options (e.g. BLOC1 warrants, DOCUs2, GOALs3)

1.1. Characteristics: Synthetic products Synthetic products

  • Limited loss: when purchasing a covered option, the investor purchases an underlying asset (share, bond or currency) and, at the same time, writes a call option on that same asset. In return, the investor is paid a premium. The latter limits his loss in case the price of the underlying falls;
  • Limited potential gain: the potential return from any increase in the underlying asset’s market value is limited to gains up to the option’s strike price;
  • Collateral: for traditional covered options, the investor must lodge the underlying asset as collateral, thus becoming a passive investor;
  • Synthetic covered options: this type of product is based on the idea of duplicating or reproducing traditional covered options. But this duplication is achieved by means of a single transaction. Both the purchase of the underlying asset and the writing of the call option are carried out synthetically using derivatives. The purchase price of such a product is identical to that of the underlying minus the premium received for the sale of the call option. Hence, the synthetic product is sold more cheaply than its underlying;
  • Settlement: either cash settlement or physical delivery of the underlying are possible upon maturity: If the market value of the underlying is higher than the strike price, the investor is paid a specified cash amount as settlement. If, however, it is lower than the strike price, the investor receives physical delivery of the underlying asset.
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1.2. Advantages:

By writing a call option (traditional covered option) or by the return from the sale of a call option included into the product price (synthetic covered option), any loss in the price of the underlying triggers a lower loss than that which could be suffered in case of a direct investment in the underlying asset.

1.3. Risks:

Unlike structured products with capital protection, synthetic covered options do not contain a hedge against losses in the market value of the underlying.

Therefore, if the price of the underlying increases and that, upon maturity, it is higher than the strike price of the option, the investor will receive the price originally agreed upon in the form of a cash payment. If the price of the underlying upon maturity is lower than the price contemplated by the investor when purchasing the product, the yield of such product may be lower than the return of an investment on the monetary market with the same maturity.

If the price of the underlying, upon maturity, is equal or lower than the strike price of the option, the investor will receive the underlying. The potential loss that may be suffered by the investor is thus linked to a possible drop in the market value of the underlying until maturity. The risk of loss is therefore unlimited, as if the investor had invested directly in the underlying asset.

However, the premium of the option mitigates the consequences of a potential loss of profit in relation to the underlying.

2. Certificates/EMTN4 (e.g. PERLES5)

2.1. Characteristics:

  • Diversification: a certificate entitles an investor to purchase a right which is based on several underlyings or has a value derived from several indicators;
  • Main types of certificates: Synthetic products
    • index certificates: these reflect a whole market being based on an official index (e.g. DAX, CAC, etc…);
    • region certificates: these are derived from a series of indexes or companies from a certain region (e.g. Eastern Europe, Pacific area, etc…);
    • basket certificates: these are derived from a selection of national or international companies active in the same sector (e.g. biotechnology, telecoms, etc..), indexes, bonds or other underlyings; Synthetic products
  • Guarantee: these certificates are securitised; Synthetic products
  • Maturity and trading: the maturity of these certificates usually ranges between one to three years. However, these certificates can be traded at any time;
  • Limited duration: they are incorporated in an instrument and thus these certificates have a limited duration;
  • Investor’s rights: no voting right and no right to dividend/interests in relation to the underlying assets;
  • Repayment: repayment occurs upon maturity and equals:
    • a set amount per index point for an index certificate;
    • the difference between the market value upon maturity and the strike price for a region or basket certificate.
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2.2. Advantages:

For a minimum of capital investment, the investor can achieve diversification over a broad range of instruments or risk factors and thus mitigate the latter.

This type of product offers the same potential of gains or losses than a similar direct investment in the underlying assets but, due to the diversification of the index, it is possible to limit or even eliminate the risks specific to the companies composing this index and thus to limit the risk of loss of the full amount invested.

They are usually low-cost products (in particular because they have no rights to dividends/interests or voting rights vested in them).

2.3. Risks:

2.3.1. Transfer of risk

Investments in index, region or basket certificates basically involve the same level of potential loss as direct investments in the corresponding shares themselves. However, they offer greater risk diversification.

However, this does not mean the risks are eliminated – they may simply be transposed onto the market or sector on which the certificate is based.

2.3.2. Absence of rights

In contrast to direct investments, certificates do not confer any voting rights nor do they entitle the investor to payments of dividends or interests in relation to the underlying assets.

Therefore, a drop in the price of the certificate cannot be counterbalanced by payments of dividends or interests.

2.3.3. Issuer risk

In addition to the risk of insolvency of the companies constituting the underlyings of the certificate, the investor is exposed to the issuer risk, that is to say, the risk of insolvency of the credit institution issuing the certificate.

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2.3.4. Leverage risk

Due to the leverage effect, price modifications of the value of the certificate are generally higher than the changes in the price of the underlying assets. Thus, during the lifetime of the certificate, chances of gains, as well as the risks of losses, are higher. The risk attached to the purchase of a certificate increases with the importance of the leverage effect of the relevant certificate.

Such certificates are usually more volatile instruments than normal certificates and can lose their entire value very quickly.

Synthetic products

Synthetic products

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