Post by Sapphire Capital on Sept 20, 2008 7:08:38 GMT 4
Knock-out products
Knock-out products is the generic term used for leverage certificates, turbo warrants or for securitised derivatives simply called turbos. These products function in an almost identical manner. However the features specific to the issue should be obtained from the respective issue terms and conditions of the products.
In principle knock-out products can be used to speculate with regard to both increasing as well as falling prices of equities, indices, commodities, currencies and other bases. Products that benefit from increasing prices normally have the word “call”, “long” or “bull” in their description. On the other hand products that benefit from falling prices are highlighted with the words “put”, “short” or “bear”.
Knock-out products belong to the leverage derivative product range and according to their segmentation have a leverage effect feature on the price movement of the respective underlying. The leverage results from the fact that a significantly lower amount of capital is required to be invested in comparison to a direct investment in the respective underlying. The advantage that knock-out products have over classic warrants is the for the most part constant leverage and the associated quasi linear participation in the price movement of the underlying. Normally it is therefore quite easy to calculate the current price of the knock-out product from the current price of an underlying instrument.
A further advantage that knock-out products have over classic warrants is the small and to a large extent negligible effect that volatility has on the price movement of the products.
However the disadvantage of knock-out products is the immediate decline in their price if certain price barriers set out in the issue terms and conditions for the underlying are reached or breached. These price barriers are also called knock-out barriers and can be equivalent to both the strike price of the knock-out products as well as a stop loss barrier that is upstream to the strike prices.
In principle the following factors should be taken into account when investing in knock-out products:
knock-outs are products geared for a speculative and mostly short-term investment, which can result in a total loss under certain conditions
awareness of how the product functions and is structured given the large range of products on offer risk can be reduced by not acquiring any products whose price is close to the knock-out barrier in principle limits should be set (stop loss protection, however not too close to the stop barrier) market developments must be actively tracked the higher the opportunity (leverage) offered by the product, the higher the risk
1. How a knock-out product works:
Benefiting from increasing prices:
Knock-out products based on increases in the price of the underlying normally have the word “call”, “bull” or “turbo” in their name. Underlyings can be for example equities, indices, commodities, currencies or something similar. For example a knock-out call tracks the performance of an equity on a one to one basis; however there is a leverage effect on the equity. For this a price is fixed in a knock-out call below the current price of the equity. In addition to a premium buyers of knock-out calls pay as a result only that part of the respective equity price (the underlying) that is above this strike price.
In simple terms a knock-out call is a type of a quasi loan against a security on the respective underlying. The buyer of a knock-out call purchases an equity and simply finances the difference between the strike price and the current price of the underlying itself. He receives the residual value of the equity from the issuers as if it were a loan against a security. The premium paid for the knock-out call represents the cost of the loan. The bottom line is that the investor now has the opportunity to benefit from the price movement of his underlying on a one to one basis although he has only paid a fraction for this underlying.
If the price of the underlying then falls contrary to all expectations the price losses are also correspondingly reflected in the knock-out call, as is the case with price gains of the underlying, and have a greater impact on a percentage basis due to the lower amount of capital invested compared to a direct investment.
The underlying is lodged at the issuer as if it were collateral for the loan against a security. If the price of the underlying then falls to or below the strike price of the knock-out call the quasi loan against a security would suddenly be no longer covered. In fact the investor would then have to provide extra capital. However, as this is not basically provided for in securitised derivatives, the knock-out call expires at that point in time even though it has not reached its maturity date. The investor can no longer benefit from any future price increases.
Important:
Knock-out products always have a multiplier feature. A multiplier of 10:1 (i.e. an option ratio of 0.1) indicates that a knock-out call tracks a tenth of its underlying.
An example:
Muster AG is currently quoted at Euro 105. A knock-out call with a strike price of Euro 100 Euro, a multiplier of 1:1 and a term of twelve months costs Euro 6. If the equity price of Muster AG increases to Euro 110 by the expiry date of the call, the call securitises the exact difference between the price of the equity and the strike price of the call – i.e. Euro 10. Consequently there is a profit of some 67 percent on the call compared to a price increase in the equity of approximately four percent.
However the investor only suffers a loss in the event that the equity price of Muster AG is below Euro 106 on the expiry of the knock-out call. However, if the equity price of Muster AG should fall to or in fact below Euro 100 during the life of the knock-out call, the knock-out call expires at that point in time.
Benefiting from decreasing prices:
Knock-out products based on the decline in price of an underlying are highlighted with the prefix “put”, “short” or “bear”. They function in the same way as the above-described variations used to benefit from an increase in price. Underlyings can be for example equities, indices, commodities, currencies or something similar. For example a knock-out put tracks the performance of an equity on a one to one basis; however there is a leverage feature on the equity. This leverage only has a positive effect for the holder of a knock-out put if the price of the respective underlying falls in value. For this reason the strike price on the knock-out put is set at an amount above the current price of its underlying. As a result the buyer of a knock-out put only pays the difference between the strike price and the current price of its underlying, less a discount.
The buyer will suffer a loss if the price of the underlying increases contrary to the expectations of the buyer of a knock-out put. Due to the lower capital invested these fall proportionately higher than is the case with a direct investment in the underlying. If the price of the underlying increases to or above the strike price of the knock-out put the certificate expires at that point in time. The investor can then no longer benefit from any future decreases in the price of the underlying.
Important:
Knock-out products always have a multiplier feature. A multiplier of 10:1 means that a knock-out put tracks a tenth of its underlying.
An example:
Muster AG is currently quoted at Euro 95. A knock-out put with an strike price of Euro 100 Euro, a multiplier of 1:1 and a term of twelve months costs Euro 6. If the equity of Muster AG falls to Euro 90 by the expiry of the put the put securitises the exact difference between the strike price of the knock-out put and the current price of the equity – i.e. ten Euros. Consequently the buyer of the knock-out put achieves a yield of 67 percent on a decline in the equity price of Muster AG of just under five percent.
The holder of the knock-out put only suffers losses if the equity price of Muster AG is quoted at an amount in excess of Euro 94. However if the equity price increases during the term to Euro 100 or more the knock-out put expires prior to its maturity.
2. Different variations of knock-out products:
The huge demand for knock-out products has led in the meantime to the creation of a wide range of different product variations. Firstly all products can be basically subdivided into products with or without a fixed expiry date. However products without a fixed expiry date also expire as soon as the respective knock-out barrier is reached or breached. Any other differences shall only be addressed in the following comments to the extent that they primarily result from a different knock-out feature, i.e. early expiry:
Knock-out products without a stop loss barrier (type A):
This product variation represents as it were the original type of all the knock-out products: in the beginning they were only issued in the form of products with a fixed expiry date; however perpetual certificates of this type can now be obtained in the market. In this case the knock-out barrier is equivalent to the exact strike price of the knock-out product so that the respective certificate expires without value at the point in time that this barrier is reached or breached.
In the event of a knock-out the issuer only reimburses the investor a remaining balance in the amount of one tenth of a Euro cent (Euro 0.001) for a certificate. The issuer can decide whether this amount is automatically refunded or whether a sell order must be placed by the investor. More detailed information on this can be obtained from the issue terms and conditions of the individual issuers.
Knock-out products with fixed strike prices and stop loss barriers (type B):
Fixed maturity knock-out products with a stop-loss feature are also available in the market. In contrast to knock-out products without a stop loss there is an additional important price barrier that has to be taken into account. In addition to the strike price, which is calculated based on the value of one of these certificates, there is another price level that lies between the current price of the underlying and the strike price of the knock-out product that results in the knock-out of the certificate in the event that it is reached or breached.
In contrast to knock-out products without a stop loss barrier these certificates do not expire without value as a result. In the event of a knock-out the issuer reimburses the holder of a knock-out product with a stop loss barrier the difference between the strike price and the knock-out barrier. The issuer can also decide in this case as to whether this balance is automatically reimbursed or whether a corresponding sell order must be placed. More detailed information on this can be obtained from the issue terms and conditions of the individual issuers.
How the residual value is determined:
Every issuer that sells a knock-out product to an investor attempts to put himself in a risk neutral position. Thereby he avoids benefiting from the losses of his investors and incurring losses on their profits. These “covering transactions” are known as hedges and can expire at different dates depending on the product. In the event of a knock-out the issuer subsequently sells this hedge without affecting the market again. The proceeds from closing out the hedge are then distributed to each investor that holds a knock-out product with a stop loss barrier. The amount of the resultant proceeds is consequently dependent on how the market, with regard to the respective underlying, has moved since the triggering of the knock-out. Under certain circumstances the proceeds from closing out the hedge can be higher, lower or exactly the same as the calculated difference between the strike price and the knock-out barrier.
Knock-out products with variable strike prices and stop loss barrier (type C and D):
A further subgroup of knock-out products are certificates with variable strike prices. They are available in the market with a fixed maturity as well as with no fixed maturity date. In addition they are also issued with or without stop loss barriers.
The way they function is for the most part identical to the above-described knock-out products with or without stop loss barriers. The decisive difference is the time value that to a large extent is not available in these products but is included in the price of knock-out products with fixed strike prices and knock-out barriers. This time value included in the price in classic products in the form of premiums (call) and discounts (put) is retained in arrears by the issuer in the case of knock-out products with variable strike prices and stop loss barriers. As a result the investor only pays that part of the time value that he has used while holding his certificate. Firstly the strike price is adjusted on a daily basis for this and the stop loss barrier normally once a month. The exact manner in which this adjustment is made depends on the respective issuer and must be obtained from the issue terms and conditions of the products.
As a result a knock-out product with variable strike prices has the greater leverage on the underlying compared to a knock-out product with fixed strike prices.
Rolling turbos (type E):
This is a variation of knock-out products that appears simple at first but is actually complex, which requires an extensive basic understanding of knock-out products. In principle a rolling turbo is first of all a knock-out product with a variable strike price and stop loss barrier without a fixed expiry date. However there are additional important features of the product:
The first significant difference to all other knock-out products is that the leverage is kept constant through daily adjustments made by the issuer. Whereas the leverage in all other product variations only remains constant from the perspective of the investor from the date of purchase the leverage in rolling turbos is constant throughout. The issuer must adjust both the strike prices and the multipliers of the rolling turbo on a daily basis in order to achieve this. As a result the easy transparency that is intrinsic in all other types of knock-out products is lost in this product.
The second significant difference to other products is the fact that the investor is only temporarily knocked out in the event that the stop loss threshold is reached. In fact he can remain invested as the rolling turbo is again reset either on the same or the following day. However the issuer calculates the strike price and the multiplier beforehand in such a way that the leverage specified in the issue terms and conditions is reached again.
Although a rolling turbo has no expiry date the investor should be aware that in some cases he can incur significant losses on a rolling turbo as is the case with all other knock-out products. In addition he should familiarise himself with the exact consequences of the daily adjustment process in different price scenarios.
Prior to purchase he should read the issue terms and conditions to understand how the daily adjustment process works and when a rolling turbo that has been knocked out once is reinstated.
Determination of the leverage
(Index status * option ratio)/selling price = current leverage
Knock out products have at a minimum a knock-out barrier that, similarly to warrants, is called the “strike price” or “strike”. If this knock-out barrier is reached the knock-out product expires without value. Investors, for whom the risk of a total loss is too dangerous, can resort to a knock-out product with a built-in stop loss level. In these the knock-out products are knocked out before the knock-out level is reached and the investor is paid a residual amount.
The selling prospectus of the issuer should also be checked in advance in order to obtain information on the precise features of the stop mark.
The volatility effect in knock-out products
The effect of volatility on the price of knock-out products is relatively small compared to its effect on a conventional warrant and can be disregarded to a large extent. However this is not the case if the strike price converges with the respective knock-out threshold. In this situation volatility suddenly has an impact, although still small, on the value of a knock-out product. In contrast to classic warrants the price of knock-out products increases if volatility falls, as the probability that a knock-out will occur now decreases. However the knock-out warrant loses value in periods of increasing volatility as the probability now increases that the knock-out product will hit its knock-out threshold. However this volatility effect is only relevant for the investor if the product is close to a knock-out.
Leverage effect in the event of price declines and the risk of a total loss!
How does the knock-out product move if the equity or index price moves in a direction that is not in line with the intended investment scenario? Of course losses are also incurred in a direct investment. In periods of both rising/falling prices the same leverage effect applies for the then also negative yield of the relevant knock-out product.
The percentage loss on the knock-out product is therefore higher than that on the corresponding direct investment. If the price of the selected underlying falls below or rises above the knock-out barrier the knock-out product expires without value. Provided that there is an additional stop loss barrier the issuer reimburses a residual amount on the product. If the knock-out product once expires the investor can no longer participate in any future price increases or losses. Above all the investor should be aware of the risk in investing in products whose knock-out barrier or stop loss level is close to the current price – the high risk is in effect the price paid for potentially high yield opportunities.
The stop loss threshold or knock-out barrier
In principle knock-out products have a knock-out barrier feature. In some products this threshold is very close to the strike price, in others the stop or knock-out barrier is the same as the strike price.
Knock-out products that only have a knock-out barrier expire prior to their maturity date if the price of the underlying breaches the knock-out barrier. On a long, bull or call knock-out product there is a breach if the barrier is reached or undershot. On a short, bear or put knock-out product early expiry can only be triggered if the knock-out barrier of the underlying is reached or broken through. If a knock-out event occurs the investor can only sell the instrument to the respective issuer at Euro 0.001.
Another variation to the structure of knock-out products is the inclusion of the stop loss threshold in addition to the knock-out barrier. In the event that the stop loss threshold of the underlying is breached the product expires prior to its maturity and a residual amount, including the remaining financing costs, is paid to the investor. Trading in the affected security is ceased as soon as the stop loss barrier of the underlying is breached. Depending on the terms and conditions the traders of the respective issuer now has the time to eliminate his hedge position without affecting the market.
This time period is especially important for less liquid underlyings, as a result the risk that the price is influenced is consciously minimised. The residual value is then determined on the basis of the price realised on the closing out the hedge position. The product can then be sold on the exchange or over the counter at the fixed repayment price. A sale is advisable if the proceeds are to be quickly used for investments in other security transactions. If a decision is made not to sell the residual value is automatically credited to your account. This has the advantage that transaction costs are not incurred again. However this can take several days.
Premiums and discounts on knock-out products
The premium on long, bull or turbo knock-out products is essentially the interest cost paid for investing less capital compared to a direct investment. Knock-out products provide the opportunity to benefit from price movements in the total underlying, however one only has to spend a part of the total investment volume for it. The financing costs that are normally incurred are saved as a result. This interest advantage is reduced by the dividends that are expected to be received over the total life. In addition to the expected dividends the currency impact is also taken account in quanto knock-out products in determining the premium.
In contrast there is a discount in short/bear knock-out products as the underlying is sold but only a part of the total value is received immediately. In this case interest is not received. However these costs are again offset by the discount.
When are investments in knock-out products worthwhile?
Similarly to warrants an investment in knock-out products is worthwhile in periods of both rising and falling prices due to the so-called leverage effect. In periods of both rising and falling prices higher yields can be achieved through this leverage compared to a direct investment.
On the other hand there is however a risk of a higher percentage loss up to a total loss of the capital invested. The price of knock-out products is always better than that of the underlying instrument. If the price of the underlying increases or falls the price of the product increases by approximately the same amount. Consequently less capital has to be invested to achieve the same absolute increase in value. As less capital is invested in a knock-out product compared to a direct investment the security achieves a higher performance on a percentage basis than the underlying. Consequently the leverage indicates by what factor the yield on the knock-out product is higher than that of the underlying.
source: www.mojnovac.net/forumi/showthread.php?t=4443
Knock-out products is the generic term used for leverage certificates, turbo warrants or for securitised derivatives simply called turbos. These products function in an almost identical manner. However the features specific to the issue should be obtained from the respective issue terms and conditions of the products.
In principle knock-out products can be used to speculate with regard to both increasing as well as falling prices of equities, indices, commodities, currencies and other bases. Products that benefit from increasing prices normally have the word “call”, “long” or “bull” in their description. On the other hand products that benefit from falling prices are highlighted with the words “put”, “short” or “bear”.
Knock-out products belong to the leverage derivative product range and according to their segmentation have a leverage effect feature on the price movement of the respective underlying. The leverage results from the fact that a significantly lower amount of capital is required to be invested in comparison to a direct investment in the respective underlying. The advantage that knock-out products have over classic warrants is the for the most part constant leverage and the associated quasi linear participation in the price movement of the underlying. Normally it is therefore quite easy to calculate the current price of the knock-out product from the current price of an underlying instrument.
A further advantage that knock-out products have over classic warrants is the small and to a large extent negligible effect that volatility has on the price movement of the products.
However the disadvantage of knock-out products is the immediate decline in their price if certain price barriers set out in the issue terms and conditions for the underlying are reached or breached. These price barriers are also called knock-out barriers and can be equivalent to both the strike price of the knock-out products as well as a stop loss barrier that is upstream to the strike prices.
In principle the following factors should be taken into account when investing in knock-out products:
knock-outs are products geared for a speculative and mostly short-term investment, which can result in a total loss under certain conditions
awareness of how the product functions and is structured given the large range of products on offer risk can be reduced by not acquiring any products whose price is close to the knock-out barrier in principle limits should be set (stop loss protection, however not too close to the stop barrier) market developments must be actively tracked the higher the opportunity (leverage) offered by the product, the higher the risk
1. How a knock-out product works:
Benefiting from increasing prices:
Knock-out products based on increases in the price of the underlying normally have the word “call”, “bull” or “turbo” in their name. Underlyings can be for example equities, indices, commodities, currencies or something similar. For example a knock-out call tracks the performance of an equity on a one to one basis; however there is a leverage effect on the equity. For this a price is fixed in a knock-out call below the current price of the equity. In addition to a premium buyers of knock-out calls pay as a result only that part of the respective equity price (the underlying) that is above this strike price.
In simple terms a knock-out call is a type of a quasi loan against a security on the respective underlying. The buyer of a knock-out call purchases an equity and simply finances the difference between the strike price and the current price of the underlying itself. He receives the residual value of the equity from the issuers as if it were a loan against a security. The premium paid for the knock-out call represents the cost of the loan. The bottom line is that the investor now has the opportunity to benefit from the price movement of his underlying on a one to one basis although he has only paid a fraction for this underlying.
If the price of the underlying then falls contrary to all expectations the price losses are also correspondingly reflected in the knock-out call, as is the case with price gains of the underlying, and have a greater impact on a percentage basis due to the lower amount of capital invested compared to a direct investment.
The underlying is lodged at the issuer as if it were collateral for the loan against a security. If the price of the underlying then falls to or below the strike price of the knock-out call the quasi loan against a security would suddenly be no longer covered. In fact the investor would then have to provide extra capital. However, as this is not basically provided for in securitised derivatives, the knock-out call expires at that point in time even though it has not reached its maturity date. The investor can no longer benefit from any future price increases.
Important:
Knock-out products always have a multiplier feature. A multiplier of 10:1 (i.e. an option ratio of 0.1) indicates that a knock-out call tracks a tenth of its underlying.
An example:
Muster AG is currently quoted at Euro 105. A knock-out call with a strike price of Euro 100 Euro, a multiplier of 1:1 and a term of twelve months costs Euro 6. If the equity price of Muster AG increases to Euro 110 by the expiry date of the call, the call securitises the exact difference between the price of the equity and the strike price of the call – i.e. Euro 10. Consequently there is a profit of some 67 percent on the call compared to a price increase in the equity of approximately four percent.
However the investor only suffers a loss in the event that the equity price of Muster AG is below Euro 106 on the expiry of the knock-out call. However, if the equity price of Muster AG should fall to or in fact below Euro 100 during the life of the knock-out call, the knock-out call expires at that point in time.
Benefiting from decreasing prices:
Knock-out products based on the decline in price of an underlying are highlighted with the prefix “put”, “short” or “bear”. They function in the same way as the above-described variations used to benefit from an increase in price. Underlyings can be for example equities, indices, commodities, currencies or something similar. For example a knock-out put tracks the performance of an equity on a one to one basis; however there is a leverage feature on the equity. This leverage only has a positive effect for the holder of a knock-out put if the price of the respective underlying falls in value. For this reason the strike price on the knock-out put is set at an amount above the current price of its underlying. As a result the buyer of a knock-out put only pays the difference between the strike price and the current price of its underlying, less a discount.
The buyer will suffer a loss if the price of the underlying increases contrary to the expectations of the buyer of a knock-out put. Due to the lower capital invested these fall proportionately higher than is the case with a direct investment in the underlying. If the price of the underlying increases to or above the strike price of the knock-out put the certificate expires at that point in time. The investor can then no longer benefit from any future decreases in the price of the underlying.
Important:
Knock-out products always have a multiplier feature. A multiplier of 10:1 means that a knock-out put tracks a tenth of its underlying.
An example:
Muster AG is currently quoted at Euro 95. A knock-out put with an strike price of Euro 100 Euro, a multiplier of 1:1 and a term of twelve months costs Euro 6. If the equity of Muster AG falls to Euro 90 by the expiry of the put the put securitises the exact difference between the strike price of the knock-out put and the current price of the equity – i.e. ten Euros. Consequently the buyer of the knock-out put achieves a yield of 67 percent on a decline in the equity price of Muster AG of just under five percent.
The holder of the knock-out put only suffers losses if the equity price of Muster AG is quoted at an amount in excess of Euro 94. However if the equity price increases during the term to Euro 100 or more the knock-out put expires prior to its maturity.
2. Different variations of knock-out products:
The huge demand for knock-out products has led in the meantime to the creation of a wide range of different product variations. Firstly all products can be basically subdivided into products with or without a fixed expiry date. However products without a fixed expiry date also expire as soon as the respective knock-out barrier is reached or breached. Any other differences shall only be addressed in the following comments to the extent that they primarily result from a different knock-out feature, i.e. early expiry:
Knock-out products without a stop loss barrier (type A):
This product variation represents as it were the original type of all the knock-out products: in the beginning they were only issued in the form of products with a fixed expiry date; however perpetual certificates of this type can now be obtained in the market. In this case the knock-out barrier is equivalent to the exact strike price of the knock-out product so that the respective certificate expires without value at the point in time that this barrier is reached or breached.
In the event of a knock-out the issuer only reimburses the investor a remaining balance in the amount of one tenth of a Euro cent (Euro 0.001) for a certificate. The issuer can decide whether this amount is automatically refunded or whether a sell order must be placed by the investor. More detailed information on this can be obtained from the issue terms and conditions of the individual issuers.
Knock-out products with fixed strike prices and stop loss barriers (type B):
Fixed maturity knock-out products with a stop-loss feature are also available in the market. In contrast to knock-out products without a stop loss there is an additional important price barrier that has to be taken into account. In addition to the strike price, which is calculated based on the value of one of these certificates, there is another price level that lies between the current price of the underlying and the strike price of the knock-out product that results in the knock-out of the certificate in the event that it is reached or breached.
In contrast to knock-out products without a stop loss barrier these certificates do not expire without value as a result. In the event of a knock-out the issuer reimburses the holder of a knock-out product with a stop loss barrier the difference between the strike price and the knock-out barrier. The issuer can also decide in this case as to whether this balance is automatically reimbursed or whether a corresponding sell order must be placed. More detailed information on this can be obtained from the issue terms and conditions of the individual issuers.
How the residual value is determined:
Every issuer that sells a knock-out product to an investor attempts to put himself in a risk neutral position. Thereby he avoids benefiting from the losses of his investors and incurring losses on their profits. These “covering transactions” are known as hedges and can expire at different dates depending on the product. In the event of a knock-out the issuer subsequently sells this hedge without affecting the market again. The proceeds from closing out the hedge are then distributed to each investor that holds a knock-out product with a stop loss barrier. The amount of the resultant proceeds is consequently dependent on how the market, with regard to the respective underlying, has moved since the triggering of the knock-out. Under certain circumstances the proceeds from closing out the hedge can be higher, lower or exactly the same as the calculated difference between the strike price and the knock-out barrier.
Knock-out products with variable strike prices and stop loss barrier (type C and D):
A further subgroup of knock-out products are certificates with variable strike prices. They are available in the market with a fixed maturity as well as with no fixed maturity date. In addition they are also issued with or without stop loss barriers.
The way they function is for the most part identical to the above-described knock-out products with or without stop loss barriers. The decisive difference is the time value that to a large extent is not available in these products but is included in the price of knock-out products with fixed strike prices and knock-out barriers. This time value included in the price in classic products in the form of premiums (call) and discounts (put) is retained in arrears by the issuer in the case of knock-out products with variable strike prices and stop loss barriers. As a result the investor only pays that part of the time value that he has used while holding his certificate. Firstly the strike price is adjusted on a daily basis for this and the stop loss barrier normally once a month. The exact manner in which this adjustment is made depends on the respective issuer and must be obtained from the issue terms and conditions of the products.
As a result a knock-out product with variable strike prices has the greater leverage on the underlying compared to a knock-out product with fixed strike prices.
Rolling turbos (type E):
This is a variation of knock-out products that appears simple at first but is actually complex, which requires an extensive basic understanding of knock-out products. In principle a rolling turbo is first of all a knock-out product with a variable strike price and stop loss barrier without a fixed expiry date. However there are additional important features of the product:
The first significant difference to all other knock-out products is that the leverage is kept constant through daily adjustments made by the issuer. Whereas the leverage in all other product variations only remains constant from the perspective of the investor from the date of purchase the leverage in rolling turbos is constant throughout. The issuer must adjust both the strike prices and the multipliers of the rolling turbo on a daily basis in order to achieve this. As a result the easy transparency that is intrinsic in all other types of knock-out products is lost in this product.
The second significant difference to other products is the fact that the investor is only temporarily knocked out in the event that the stop loss threshold is reached. In fact he can remain invested as the rolling turbo is again reset either on the same or the following day. However the issuer calculates the strike price and the multiplier beforehand in such a way that the leverage specified in the issue terms and conditions is reached again.
Although a rolling turbo has no expiry date the investor should be aware that in some cases he can incur significant losses on a rolling turbo as is the case with all other knock-out products. In addition he should familiarise himself with the exact consequences of the daily adjustment process in different price scenarios.
Prior to purchase he should read the issue terms and conditions to understand how the daily adjustment process works and when a rolling turbo that has been knocked out once is reinstated.
Determination of the leverage
(Index status * option ratio)/selling price = current leverage
Knock out products have at a minimum a knock-out barrier that, similarly to warrants, is called the “strike price” or “strike”. If this knock-out barrier is reached the knock-out product expires without value. Investors, for whom the risk of a total loss is too dangerous, can resort to a knock-out product with a built-in stop loss level. In these the knock-out products are knocked out before the knock-out level is reached and the investor is paid a residual amount.
The selling prospectus of the issuer should also be checked in advance in order to obtain information on the precise features of the stop mark.
The volatility effect in knock-out products
The effect of volatility on the price of knock-out products is relatively small compared to its effect on a conventional warrant and can be disregarded to a large extent. However this is not the case if the strike price converges with the respective knock-out threshold. In this situation volatility suddenly has an impact, although still small, on the value of a knock-out product. In contrast to classic warrants the price of knock-out products increases if volatility falls, as the probability that a knock-out will occur now decreases. However the knock-out warrant loses value in periods of increasing volatility as the probability now increases that the knock-out product will hit its knock-out threshold. However this volatility effect is only relevant for the investor if the product is close to a knock-out.
Leverage effect in the event of price declines and the risk of a total loss!
How does the knock-out product move if the equity or index price moves in a direction that is not in line with the intended investment scenario? Of course losses are also incurred in a direct investment. In periods of both rising/falling prices the same leverage effect applies for the then also negative yield of the relevant knock-out product.
The percentage loss on the knock-out product is therefore higher than that on the corresponding direct investment. If the price of the selected underlying falls below or rises above the knock-out barrier the knock-out product expires without value. Provided that there is an additional stop loss barrier the issuer reimburses a residual amount on the product. If the knock-out product once expires the investor can no longer participate in any future price increases or losses. Above all the investor should be aware of the risk in investing in products whose knock-out barrier or stop loss level is close to the current price – the high risk is in effect the price paid for potentially high yield opportunities.
The stop loss threshold or knock-out barrier
In principle knock-out products have a knock-out barrier feature. In some products this threshold is very close to the strike price, in others the stop or knock-out barrier is the same as the strike price.
Knock-out products that only have a knock-out barrier expire prior to their maturity date if the price of the underlying breaches the knock-out barrier. On a long, bull or call knock-out product there is a breach if the barrier is reached or undershot. On a short, bear or put knock-out product early expiry can only be triggered if the knock-out barrier of the underlying is reached or broken through. If a knock-out event occurs the investor can only sell the instrument to the respective issuer at Euro 0.001.
Another variation to the structure of knock-out products is the inclusion of the stop loss threshold in addition to the knock-out barrier. In the event that the stop loss threshold of the underlying is breached the product expires prior to its maturity and a residual amount, including the remaining financing costs, is paid to the investor. Trading in the affected security is ceased as soon as the stop loss barrier of the underlying is breached. Depending on the terms and conditions the traders of the respective issuer now has the time to eliminate his hedge position without affecting the market.
This time period is especially important for less liquid underlyings, as a result the risk that the price is influenced is consciously minimised. The residual value is then determined on the basis of the price realised on the closing out the hedge position. The product can then be sold on the exchange or over the counter at the fixed repayment price. A sale is advisable if the proceeds are to be quickly used for investments in other security transactions. If a decision is made not to sell the residual value is automatically credited to your account. This has the advantage that transaction costs are not incurred again. However this can take several days.
Premiums and discounts on knock-out products
The premium on long, bull or turbo knock-out products is essentially the interest cost paid for investing less capital compared to a direct investment. Knock-out products provide the opportunity to benefit from price movements in the total underlying, however one only has to spend a part of the total investment volume for it. The financing costs that are normally incurred are saved as a result. This interest advantage is reduced by the dividends that are expected to be received over the total life. In addition to the expected dividends the currency impact is also taken account in quanto knock-out products in determining the premium.
In contrast there is a discount in short/bear knock-out products as the underlying is sold but only a part of the total value is received immediately. In this case interest is not received. However these costs are again offset by the discount.
When are investments in knock-out products worthwhile?
Similarly to warrants an investment in knock-out products is worthwhile in periods of both rising and falling prices due to the so-called leverage effect. In periods of both rising and falling prices higher yields can be achieved through this leverage compared to a direct investment.
On the other hand there is however a risk of a higher percentage loss up to a total loss of the capital invested. The price of knock-out products is always better than that of the underlying instrument. If the price of the underlying increases or falls the price of the product increases by approximately the same amount. Consequently less capital has to be invested to achieve the same absolute increase in value. As less capital is invested in a knock-out product compared to a direct investment the security achieves a higher performance on a percentage basis than the underlying. Consequently the leverage indicates by what factor the yield on the knock-out product is higher than that of the underlying.
source: www.mojnovac.net/forumi/showthread.php?t=4443