Tutorial: Discount-certificates

What are discount certificates?

Discount certificate are debentures through which the investor acquires an underlying instrument at a discount to the direct investment. At the beginning of the term a cap is set which limits the potential return. At the end of maturity the current price of the underlying instrument is paid out, with the cap representing the upper limit of the payout.

This is the advantage of discount certificates – since the buyer of a discount certificate buys the share at a discount to its current price but gets the full share price (limited by the cap) paid out at the end of maturity, s/he can earn the so-called sideways yield. Please keep in mind the respective exchange ratio.

How do discount certificates work?

The potential return from discount certificates is capped. In return for this cap (and thus, for the unlimited potential return), the investor gets to buy the specific underlying at a discount. This means that you pay a lower price for the discount certificate than you would pay for investing directly in the underlying. At the end of maturity the current price of the underlying instrument is paid out (while bearing in mind the exchange ratio), with the cap representing the upper limit of the payout. The cap is set at the beginning of the term, remains constant over time, and marks the maximum return potential.

Your benefits

Discount certificates bring a little more safety to your portfolio. The discount at the time of acquisition means that you have a safety cushion and can make attractive profits even if markets do not move. This is the so-called sideways yield: the underlying has not moved, but you are still making a profit.

Your advantages

You may achieve a positive return at the end of maturity even if the underlying comes out below the initial price (sideways yield).
The difference between the price of the underlying and your initial acquisition price serves as cushion against losses.
Short maturities minimise your risk further and allow you to change your investment strategy in the medium run.

Details you should be aware of

With a discount certificates, your potential return is capped.
If the underlying falls, you may incur losses.
Between issue date and maturity, price fluctuations are possible, which means that the sale of the discount certificates prior to maturity may result in a loss.

How do discount certificates react to…

… rising markets?
In rising markets the discount certificate tends to rise as well, with the cap marking the maximum possible return. This means that in the case of rising markets, the discount certificate gradually approaches its cap.

… stable markets?
In stable markets, discount certificates rise over the course of time while approaching the end of maturity. This happens because the discount of the certificate decreases until the end of maturity, at which point the price of the certificate equals the price of the underlying. This is a prime example of the sideways yield.

… falling markets?
In falling markets, the certificates fall as well. However, since the discount certificate was bought at a discount to the underlying, the loss is lower by the amount of the discount then it would be for the underlying.

Payoff-Chart

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