Basics Of Finance

The Fine Art of Finance

A ready reckoner for the Finance Whiz-on-the-go

CONTENTS 1

Introduction

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Equities

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Fixed Income

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Derivatives

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Alternative Investments

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Investment Funds

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Structured Products

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Glossary

Successful investment advisory starts with better knowledge The main focus for any investor is how to get consistent and sustainable high returns over a long period of time. Investment advisors constantly attempt to ensure optimal returns on their client’s portfolio. There are a lot of views on the different asset classes as expressed by various investment professionals. Only one theoretical approach has been accepted worldwide and proven as effective. Its creator - Harry M. Markowitz who invented the modern portfolio theory more than 50 years ago - got the Nobel Prize in Economic Sciences in 1990 for his pioneering work. How do the different asset classes work together? What is the impact on the portfolio if investment returns on one asset class is volatile? How does the risk–return balance of different asset classes affect the overall portfolio? Does an addition of alternative investments improve the risk – return profile? What is an alternative investment? This is a financial reckoner which will give you an overview of the characteristics of different asset classes. The document delves into why it is important to have more than one asset to invest in and how different asset classes can be used to build optimized portfolios. It will also give you a broad introduction to the modern portfolio theory and show some examples of how to use this theory in every day life. Some basic information about the world of derivatives, investment funds and structured products will round up this reckoner. We hope to give you a basic understanding of how the different asset classes are connected. This reckoner can be used like a lexicon for looking up things from time to time. I hope that this reckoner will help you in getting a good theoretical understanding, which coupled with discussion sessions will aid you in providing more value-added support to your clients. Yours

Torsten Steinbrinker, CIO India

Introduction

Basics Asset Allocation and Diversification Asset Classes Strategic and Tactical Asset Allocation Excursus: Portfolio Theory

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Basics

Any form of investment can be assessed on the basis of three criteria: profitability, safety and liquidity. Profitability The profitability of an investment is determined by the income it generates. This consists of the interest and dividends paid, any other amounts distributed and capital gains (e.g. in the form of changes in the market price of the security). The rate of return is a useful measure to compare the profitability of different investments. It is defined as the annual income earned as a percentage of the capital invested. Safety Safety means preserving the value of the capital invested. The safety of an investment depends on the risks to which it is exposed to. This covers a number of aspects which are discussed in the various sections of this brochure. Safety can be increased by spreading the capital invested over a range of investments, which is known as diversification. This diversification can be based on various criteria such as different categories of investments or investing in different countries, sectors and currencies. Liquidity The liquidity of an investment depends on how quickly an amount invested in a given asset can be realized, in other words converted into cash or an amount in a bank account. In general, securities which are traded on a stock exchange are liquid.

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Capital maintenance, in the sense of protection against inflation, is often cited as a fourth criterion. How these, in part conflicting, target criteria are ultimately weighted and prioritized depends on the investor’s own personal preferences. Basically, all investors want to achieve optimum results in each investment category: high interest rates, attractive dividends and capital gains combined with high safety and the ability to realize the capital invested at any time represents the profile of a “perfect” investment. However, in the real world the three criteria of profitability, safety and liquidity can only be combined by making compromises. The magic triangle of investment illustrates the conflicts: Firstly, there is a conflict between safety and profitability. To obtain a high degree of safety, the investor generally has to accept a lower return. Conversely, above-average returns are normally associated with higher risks. Secondly, there can be a conflict between the targets of liquidity and profitability since more liquid investments often imply disadvantages in terms of return. Each investor therefore has his or her own individual risk preference which follows from the way in which the three criteria mentioned are personally weighted. This preference plays an important role in selecting the optimum portfolio for any given investor.

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Asset Allocation Allocation and Diversification

Once the investor’s investment targets and risk preferences are known, it has to be ascertained with which instruments they can be achieved and what form the investor’s individual asset allocation should take. Asset allocation means the distribution of investor’s funds among different asset classes (e.g. equities, bonds, alternative investments and cash) to reflect his or her investment targets. The term diversification plays a key role here. To spread the portfolio’s overall risk it is necessary to invest in a range of instruments so as to reduce the portfolio’s exposure to individual instruments. As the chart below shows, the portfolio’s overall risk can be reduced by adding new investment instruments. Non-Systemic risks can be minimized by adding new assets Volatility

Non-Systemic risks Systemic risks

Non-systemic risk means the unique “instrument-specific” risk. In the case of equities, for instance, this would be the company-specific risk. This risk can be minimized through diversification so that the investment is then only exposed to systemic risk, which refers to the general market risk.

Asset Classes

To differentiate the investment universe – in other words all possible investments – it has been found useful to divide the universe into asset classes. 4

There is no general definition of asset classes. The classification is usually based on institutional, substantive or pragmatic criteria. The basic division is into equities, bonds, alternative investments and liquid assets. Equities are classed by region, but a division into sectors or industries would also be possible. Bonds can be classified additionally according to the issuer’s credit rating, with a distinction made for instance between government bonds, investment grade bonds and bonds of poorer quality known as high-yield bonds. Asset classes which are neither equities nor bonds are grouped together under the term alternative investments. Cash, or liquidity, is also treated as a separate asset class. This serves as a reserve for transactions but is also important to ensure that payment obligations can be met.

A portfolio should be structured with the help of these asset classes so as to reflect the investment targets of an investor as closely as possible. This has to take into account the minimum investment horizon, the liquidity of the investment instruments as well as the expected return and the risks. As a rule, this is based on the historical performance of the investment instruments considered.

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Government

The portfolio planning is made easier if there is a sufficient base of data available for the asset classes. For many of the common asset classes there are indices which reflect the risks and returns in a transparent and representative way. On the basis of such indices it is possible to simulate the interaction of the asset classes in the portfolio. The aim is to arrive at a combination of asset classes which do not move in unison (correlation) so as to achieve a strong diversification, in other words to spread the risk as far as possible. The weaker the correlation between individual assets, the lower is the portfolio’s overall risk. The movement of commodity prices for instance is largely independent of the equities market – which means that the combination of the two asset classes of equities and commodities will ensure a good diversification.

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The correlation coefficient can be between -1 and 1. A correlation of -1 indicates that the movement of the two asset classes are diametrically opposed to each other. Conversely, a correlation of 1 denotes that the two asset classes move completely in unison. The table above shows for instance that US equities and European equities have a strong correlation, in other words the two markets tend to move in the same direction. By contrast, equities and bonds show a negative correlation, in other words when equity prices are on the rise, bond prices generally fall.

Strategic and Tactical Asset Allocation

The basis for any investment decision is the investment target that has been defined and the investor’s risk profile. The latter reflects the personal weighting of the three criteria of liquidity, safety and profitability discussed in the first section. Depending on the investor’s investment target, one can either seek to maximize income for a given level of risk or seek to minimize risk for a given level of income. The focus of strategic asset allocation is to define an asset mix which is suitable for the investor from a long-term perspective and is the most efficient and balanced as possible from risk and return expectations. A classic case, for instance, is the question of how the capital is to be split between equities, bonds and liquidity, or what proportion of a pure equities or bond portfolio should be invested internationally. Crucial for this decision are the historical data on income and risk, measured in terms of average return and annualized standard deviation (volatility), of the individual asset classes. Since past values cannot automatically be taken as an indication of future values, the figures need to be adjusted according to market expectations and

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perspectives for the future. A strategic asset allocation can be made on the basis of this forecast. The outcome of such an optimization tailored to the investor’s personal risk profile is important for setting a suitable strategic benchmark for portfolios which are oriented to the long term. The investment horizon for strategic asset allocation is very long term, and short-term fluctuations in the risk and return of the individual investment instruments are ignored. As the next step, tactical asset allocation defines the investment instruments or asset combinations the funds are to be invested in and with what weighting Fine Art. Here, it is a question of selecting the actual investments. This selection is based on short to mid-term market forecasts which can differ from the long-term assessments for the purposes of strategic asset allocation. For instance, macroeconomic data and current market developments are considered, which make it necessary to adjust the short to mid-term outlook for returns and volatility. With these tactical decisions it is also attempted to outperform the strategic benchmark which, as discussed, is closely linked to the strategic asset allocation. The following table illustrates the two asset allocation versions with the example of a portfolio based on a “Moderate” strategy. The first column shows a possible strategic asset allocation based on the investor’s risk profile. The second column shows the portfolio’s current weighting (the “tactical asset allocation”), with the current overweighting or underweighting of the various asset classes indicated in the last column.

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Excursus: Portfolio Theory

Once the strategic asset allocation has been defined, the funds can be distributed between various countries and regions, different market segments and individual securities. Thanks to the pioneering study by Markowitz (1952) quantitative portfolio theory provides an answer to this question and is widely accepted in practice. By virtue of its simplicity and clarity it has established itself as a standard model in the financial markets. The optimum portfolio, i.e. the portfolio which delivers the maximum income for a given level of risk, measured in terms of the variance of the returns, or a minimum level of risk for a given income, can be determined by applying standard deviation optimization. The conclusion from Markowitz’s study was that the risk of a portfolio consisting of a number of risk assets is not simply the average of the individual risks of the respective assets but depends on how the individual assets correlate with each other. This leads to an apparent paradox: the overall risk of a conservative portfolio (e.g. bonds) can be reduced in many cases by adding higher-risk assets (e.g. equities). The key factor is how the individual asset classes are weighted in the portfolio. The term “efficient portfolio” is used when the individual elements of the portfolio are combined in such a way as to produce the optimum relationship of return and risk for the given investor. The chart below illustrates how the expected return and the risk of a portfolio can be modified by altering the weighting of equities, bonds and other assets. If all conceivable combinations of these values are plotted on a return-risk matrix, one obtains a number of possible portfolios but not all of them are efficient. In other words, some portfolios offer higher potential returns for the same level of risk while, conversely, others offer less risk for the same expected return. In the chart, the efficient portfolios

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are all located on the upper part of the curve encircling this matrix, the so-called “efficiency curve”. They offer the optimum expected return for a given level of risk. The efficient portfolio with the lowest level of risk is referred to as the “minimum variance” or “safety-first” portfolio (see chart).

Aim of portfolio structuring; a portfolio on/at the efficiency curve

This particularly stable portfolio consists of a mix of weakly correlated assets. The aim of portfolio structuring is to put together a portfolio which comes as close as possible to the efficiency curve. Where the respective portfolio is located on the curve depends entirely on the level of risk the investor is willing to accept. But the principle is always the same: whatever the risk profile – whether conservative or growth-oriented – a combination of various assets can be found which optimally reflects that profile.

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The market portfolio: What we have been saying so far applies to portfolios which consist entirely of risk assets. But what happens if these portfolios are combined with a risk-less investment? This is a question that was investigated by Markowitz‘s colleague James Tobin. He assumed that an investor was able to invest or raise capital at a given interest rate. In our matrix, this risk less investment would be located on the vertical axis of the chart (risk = 0). The higher the investment is on the axis, the higher is the assumed interest rate. A combination of the risk-less investment with any given securities portfolio can then be reproduced by simply drawing a straight line between the two points along which all possible combinations are reflected. Obviously, the steeper the line is, the better the risk-return relationship of the portfolios located along it. The steepest of all possible lines touches the efficiency curve as a tangent at just one point. The line is called the capital market line, and the point at which it touches the efficiency curve is the so-called market portfolio (see chart). Determining the market portfolio

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In this extended model the same principle applies: efficient investor portfolios can be located anywhere along the capital market line – where it lies depends on the level of risk the investor is willing to take. Portfolio theory is an important foundation for concrete asset allocation. With the help of this model, it is possible to develop mathematical models that derive the optimum mix of investor portfolios. However, portfolio theory is based on the assumption that the historical values for the risk (measured in terms of volatility, in other words the degree to which the values fluctuate) and the return of a given asset can be applied to the future. If this were possible on a one-to-one basis and the returns of the respective asset classes were normally distributed, it would indeed be possible, by purely quantitative means, to construct portfolios which always exactly reflect a given investor’s respective expectations with regard to return and risk. But this is not the case, especially since the returns of certain asset categories are not normally distributed. Consequently, the estimation of the future development of values and the volatility of an asset plays an important role. This is taken into account within the framework of strategic asset allocation. In the following sections we describe the individual asset classes and their special features:

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Equities

Definition Classification Measuring Risk Types of Risk

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Definition

Equities or stocks are certificates which document the shareholder’s share of the capital stock of a corporation. The shareholder has an ownership interest in the corporation and shares in its profits in the form of dividends. The market price of the stock, or share price, is determined by supply and demand, and at the same time reflects the rise or fall in the net worth of the corporation.

Classification

Stocks can be assigned to different market sectors, e.g. Financials, Basic Materials, Consumer Goods, Consumer Services, Energy, Healthcare, Technology, etc. Another form of classification is based on the respective corporation’s market capitalization. A distinction is made between Small Cap, Mid Cap and Large Cap companies according to the market value of the corporation’s capital stock. Other terms used to differentiate stocks are “Value” and “Growth”. Value stocks have high book value to market capitalization ratios; growth stocks have low book value to market capitalization ratios. The performance of individual groups of stocks is tracked in the form of indices. The most important and best known international indices are the S&P 500, the Nikkei 225, the Euro Stoxx 50 and the FTSE 100. There are also indices which track the performance of stocks based on specific sectors or market capitalization. One example is the Russell 2000. This index consists of US Small Cap stocks.

Measuring Risk

There are various methods for measuring the risk of equity investments. Volatility and beta are the most commonly used.

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Volatility (historical/implied) The first measure of risk is the standard deviation (volatility) of the returns. A distinction is made between historical volatility and implied volatility. Historical volatility indicates how high the stock’s range of fluctuation was in the past. This measure represents both the positive and negative deviations from the expected value. Implied volatility is the volatility contained in today’s market prices and reflects the market’s expectations regarding the future range of fluctuation in the share price. Beta Another measure of risk is the so-called beta coefficient. Beta measures how strongly the stock reacts to changes in the value of a benchmark, which in most cases is a leading index, and is referred to as systemic risk. If a stock has a beta of 1 relative to the Dow Jones Index, this would mean that the stock has moved in unison (1-to-1) with that index.

Types of risk

The risk of an equity asset can be divided into two main components: the fundamental risk and the market psychology risk. Fundamental risk covers the general market risk (systemic risk) and company-specific risk (non-systemic risk). The former is the risk of a price change that is attributable to the general trend in the equity market and is not directly related to the economic situation of the individual company. The latter denotes the risk of a fall in price due to factors which are directly or indirectly related to the issuing company.

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The market psychology risk results from irrational opinion-forming among investors and mass psychological behaviour. The share price also reflects the hopes and fears, assumptions and sentiment of buyers and sellers. In so far, the stock market is a market of expectations on which it is not possible to draw a clear-cut dividing line between objectively justified and more emotionally driven behaviour.

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Fixed Income Securities

Definition Types of Bonds Risks

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Definition

Fixed income securities, often also referred to as bonds, notes or debentures, are debt certificates which are made out to the respective (anonymous) bearer or registered in the name of a specific holder. They carry a fixed or variable rate of interest and have a specified life and specific repayment terms. The buyer of a fixed income security (=creditor) has a monetary claim against the issuer.

Types of Bonds

There are a wide range of fixed income securities which differ with regard to the payment of interest, repayment options and other features such as protection against exchange rate changes. Classic straight bonds have a constant rate of interest (nominal interest rate or coupon) over their entire life. In most countries the interest coupons are paid half-yearly in arrears. In the case of floating rate notes the nominal interest rate is variable and is based on a reference rate, usually money market rates such as EURIBOR or LIBOR. Depending on the terms of the issue, the respective interest rate is fixed three, six or twelve months in advance. There are two basic variants of these floating rate notes: floaters with a minimum interest rate (“floors”) and floaters with a maximum interest rate (“caps”). With “floors” the investor is guaranteed a minimum interest rate regardless of the level of the reference rate. With “caps” there is a ceiling on the rate of interest paid so the buyer never receives a coupon payment above the maximum rate.

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Another type of fixed income security is zero bonds, which do not carry an interest coupon. In this case, there are no periodic payments. The difference between the purchase price and the repayment amount on maturity represents the interest income over the life of the bond to maturity. When selecting fixed income securities one needs to differentiate between bonds denominated in local currency and foreign currency. Another important distinction is between government bonds and corporate bonds. Corporate bonds normally carry a higher yield or premium versus government bonds, referred to as the “spread”, which reflects the additional risk normally associated with an investment in corporate bonds.

Risks

Although fixed income securities are considered to be relatively safe investments compared with other types of security, they still present a number of major sources of risk. Investors should be familiar with these risks before they invest, in order to be able to make a reliable assessment of the potential returns. Credit Risk Credit risk denotes the risk of the issuer’s bankruptcy or insolvency, in other words the possibility that it might be unable, either temporarily or permanently, to meet its interest and/or repayment obligations as agreed. Alternative terms for credit risk are borrower risk or issuer risk. An issuer’s credit quality can change during the life of a bond as a result of macroeconomic or company-specific developments. Deterioration in credit quality therefore has an adverse effect on the price of the respective securities (risk discount). Generally, credit risk tends to be higher, the longer the bond’s remaining life to maturity is.

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Rating Ratings are used as a means of assessing the probability that an issuer will discharge the obligations to pay interest and repay principal related to the securities it has issued punctually and in full. The two best known rating agencies are Moody’s and Standard & Poor’s. The rating has an influence above all on the level of the yield: the better the rating the lower the yield. Interest rate Interest rate risk is one of the central risks of a fixed income security. Interest rate levels on the money and capital market constantly fluctuate and can cause the market price of the securities to change daily. Interest rate risks arise as a result of the uncertainty surrounding future changes in market rates. If the market rate rises, the price of the bond normally falls until its yield is roughly in line with the market rate. Conversely, if the market rate falls, the price of the bond rises until its yield is roughly in line with the market rate. Yield denotes the effective rate of return, which represents the nominal interest rate (coupon), the price at which the bond was issued or purchased, the repayment amount and the (remaining) period to maturity of the fixed income security. Currency Risk Investors are exposed to a currency risk if they hold securities denominated in a foreign currency and the underlying exchange rate fluctuations. This is an important factor particularly in the case of fixed income securities. Foreign bonds might have an attractive coupon but this is generally associated with a higher currency risk. A country’s exchange rate is influenced by fundamental factors such as the country’s rate of inflation, differences in the level of interest rates in relation to other countries, how the country’s economic outlook is assessed, the geopolitical situation and investment safety. If a currency’s exchange rate moves in the wrong direction, this can quickly erode any yield advantage and diminish the return achieved to such an extent that, with hindsight, it would have been better to have invested in a fixed income security denominated in one’s own local currency. 20

Derivatives

Definition Financial Futures Options Possibilities Risks

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Definition

Derivatives are not straightforward cash or spot market transactions which are settled immediately but are a “derived“ form of transaction in equities, fixed income securities or foreign exchange. A distinction is made between conditional (options) and unconditional (futures) transactions.

Financial Futures

Financial futures are standardized, exchange-traded futures contracts. Futures constitute an agreement which places an unconditional obligation on both parties – both seller and buyer. Such contracts can be based on a variety of financial products (underlying): for instance there are financial futures contracts based on interest rates (interest rate futures), on stock indices (stock index futures) and on foreign currencies (foreign exchange futures). Futures have a symmetrical risk profile. This means that the buyer and the seller have the same profit or loss potential. With the purchase/sale of the futures contract the buyer undertakes to take/deliver a specified quantity of a specified asset (underlying) at a future date (delivery, performance, maturity date) at a predetermined price. The purchase of the futures contract gives rise to a long/short futures position. The buyer/seller expects the price of the underlying to rise/fall during the life of the futures contract. As a rule, the difference in gain or loss arising as a result of a change in the price of the traded futures contract during its life is realized by liquidating or closing out the position (making an offsetting contract). The difference between the buying price and the selling price of the futures contract determines what

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gains or losses are made on the transaction, whereby other costs (such as transaction costs) have also to be taken into account. In the area of commodity futures physical delivery of the commodity is usual, which can make this type of futures contract unattractive for the private investor. Moreover, these futures have high contract values and are therefore not suitable for investors with small to medium amounts to invest.

Options

An option is an agreement under which the buyer (option holder) has the right, but not the obligation, to buy or sell a specified quantity of a given underlying asset within a specified time period (American-style option) or on a specified date (European-style option) at a predetermined price (strike price). In exchange for this right the buyer pays a price (option premium) to the seller of the option. There are two types of option. An option to buy is referred to as a call and an option to sell is referred to as a put. The reference asset (underlying) is the asset to which the option right relates. This can be individual stocks or bonds, specific foreign currencies or indices and futures contracts. There are two forms in which option contracts can be settled: the underlying can be physically delivered (physical settlement) or the contract terms can provide for payment in cash (cash settlement).

Possibilities

Depending on their strategy, investors can use futures and options to pursue different objectives. Both can be used for hedging purposes i.e. to protect against risk. Market risks arising from existing or planned positions in the underlying asset (cash or spot market position) can be largely neutralized by taking up offsetting positions in

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the respective futures or options. If a loss arises on the cash or spot market position, it is theoretically possible to achieve a gain of roughly the same magnitude with a previously sold futures contract or a put option. If prices move in the opposite direction, a gain is made on the cash or spot market position, while a loss is made on the futures/options position. Besides hedging strategies, it is also possible to use futures and options as a speculative instrument. Based on subjective expectations and assessments of how the price of the underlying asset will move, positions are deliberately entered into with a view to making a profit. In this case, the leverage effect, which arises because less capital needs to be invested, plays an important role. This effect causes the price of the derivative to react more than proportionally to changes in the price of the underlying asset.

Risks

For futures and options the biggest risk lies in a. the risk presented by the leverage effect and b. that the risk of loss is not limited The higher the derivative’s leverage, the riskier the position is. Another danger is the greater risk of total loss. Owing to the small amount of capital invested compared with other investments and the high leverage, small market movements can lead to considerable losses. A total loss is also possible (and in the case of short positions a loss even beyond the capital invested). Futures and options should therefore only be used by investors with long capital market experience. Derivatives are also exposed to the same general risks as the underlying assets discussed in the earlier sections since their performance is linked to the performance of the underlying.

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Alternative Investments

Alternative Products / Investments Hedge Funds Private Equity Funds Venture Capital Funds Commodities Real Estate Currencies

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Alternative Products/ Investments

Alternative products and investments are assets which do not count among the traditional investments (equities and fixed income securities). Generally, a distinction is made between unregulated - in other words not subject to special regulatory supervision - partnerships or corporations which serve the purpose of collective investment (hedge funds, real estate, private equity and venture capital funds), and non-homogeneous asset classes. Non-homogeneous asset classes include commodities and currency investments which do not relate to classic asset classes such as equities and fixed income securities. The aim of Alternative Investments is to offer opportunities for capital appreciation independently of the equity and fixed-income markets. They are therefore suitable for portfolio diversification. This modifies the overall return and risk profile.

Hedge funds

Hedge fund managers pursue an investment style of their own. The basic idea is to generate a positive absolute return irrespective of market trends. They can use the whole spectrum of financial instruments including futures contracts, options and securities of diverse asset classes. Most managers concentrate on specific investment strategies and processes. To simplify matters, the investment strategies can be divided into five broad categories: Relative Value, Event Driven, Global Macro, Equity Hedge and Short Selling.

Private equity funds

Investments in private equity funds represent entrepreneurial equity stakes in portfolios of young, usually unlisted companies. The equity stakes serve to finance the growth of young companies or special situations such as restructuring measures. By subscribing a specific sum, investors acquire an ownership interest in the private equity company and share in the assets of

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the fund. The income, which mainly represents gains realized upon the sale of the equity stakes, is usually distributed to the individual investor after it is received by the fund and after deducting the investment manager’s success fee and is not reinvested.

Venture capital funds

Venture capital funds are very similar to private equity funds. The main difference is that for the most part they invest in companies which are at a very early stage of development. They are mainly active in growth sectors such as the internet, information technology and biotechnology. Portfolio constructions (so-called funds of funds and special index certificates) provide an opportunity for investing indirectly in hedge funds, private equity funds and venture capital funds. In the case of funds of funds, investors acquire units in a fund which in turn invests in funds. This gives the investor access to a diversified investment, whose individual assets may require high minimum investment sums. However in such cases there is very limited public information available in such cases.

Commodities

The term commodities relates to commercial products traded on the markets. Commodities are divided into three broad categories: minerals (e.g. oil, gas, aluminium and copper), agricultural products (e.g. wheat and maize) and precious metals (e.g. gold, palladium and platinum). Another class are so-called soft commodities such as coffee, cocoa, sugar or orange juice concentrate. “New” commodities include electricity, weather and catastrophe derivatives.

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Oil is the most important asset class among the mineral commodities. The oil price reacts quickly and sharply to supply shocks and geopolitical events, and is therefore regarded as a crisis barometer. This class also includes cyclically-sensitive metals such as aluminium and copper whose price development is strongly correlated with economic cycles. Demand for agricultural products is less cyclical and price fluctuations are mainly due to changes in supply conditions which are difficult to predict such as weather factors. However, prices can also be influenced by long-term factors such as increase in demand as a result of population growth or changes in eating habits (e.g. switch from vegetarian foods to non-vegetarian foods as people become more affluent). Gold, which is still regarded as a crisis currency and “safe haven”, plays the most important role among the precious metals. Soft commodities are acquiring greater importance in the international markets in recent times as they are being used more and more as substitutes for the traditional commodity classes. Most commodities are traded on specialized exchanges, or directly between market players around the globe in the form of OTC (over-the-counter) transactions, as largely standardized contracts. Commodities are mainly added to portfolios to improve the risk structure as they are only weakly or negatively correlated with traditional asset classes such as equities or fixed income securities.

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Real Estate

Real estate is an asset class which offers a wide variety of investment opportunities. Basically, a distinction can be made between directly and indirectly owned real estate. The main forms of indirectly owned real estate are real estate company stocks, including Real-estate Investment Trusts (REITs), and open and closed-end real estate funds – whereby the individual categories differ widely from country to country. Directly owned real estate assets are investments in apartments or office properties. However, this mostly requires a large amount of capital to be invested, and is therefore not attractive for most investors, and is a less liquid form of investment compared with traded instruments and fund units. Real estate assets can also be differentiated according to regional focus or different types of use. Finally, it is customary to categorise real estate investments according to different investment styles based on their risk-return profile. On a broad definition real estate investments also include property finance, mortgage loans, securitized forms such as mortgage backed securities and mezzanine capital, which is a hybrid form of debt and equity capital.

Currencies

The prices traded in the foreign exchange market are rates of exchange between two currencies. The motivation for investors to engage in the foreign exchange market is usually to make a profit as a result of short to mid-term fluctuations in exchange rates. It should be noted that in this case the gains are generally achieved from short-term changes in value and not in the form of interest income.

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Another possibility is so-called “carry trades” where the investor seeks to exploit the interest rate spread between two currencies, in other words borrowing money in a low-interest currency and reinvesting it in a high-interest currency. Currencies can be traded in a number of ways. The most common are trading on a cash or spot market basis (with settlement following as a rule two business days later) in the form of currency futures contracts (settlement at a future date) or a currency option. With a daily trading volume of more than 1 trillion US dollars, the international foreign exchange market is the world’s biggest market.

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Investment Funds

Characteristics of Investment Funds Performance Possibilities

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Characteristics of Investment Funds

Investment funds gather money from different investors and, depending on the fund’s terms of reference, invest them in specific securities (e.g. in equities or fixed income securities, in the home market or internationally) or in real estate. Investment funds are professionally managed, so the portfolio is under constant review and the various markets are analyzed. The portfolio is adjusted according to the respective market situation (tactical asset allocation). Investment funds are able to practice the diversification described in portfolio theory very well since they have the necessary capital and are therefore able to invest in a range of asset classes. The resultant risk spreading reduces the overall risk of this kind of investment. Funds also make it possible to invest in markets which require considerable market expertise, where asset values are highly volatile, or to which small investors do not have access owing to market restrictions. Although funds have a better risk profile, the potential return is still exposed to the same risks as a direct investment in individual asset classes. The advantage lies in the fact that the risk is diversified.

Performance

The value of the investment certificate changes as the market price of the securities in which the fund is invested changes. The value of an investment fund unit (= the buying price, or the price at which the unit is bought back by the investment fund) is calculated on the basis of the fund’s total net asset value

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divided by the number of units in circulation. The so-called “buying price” is fixed once a day. When the units are purchased, a premium is usually charged. The issue price paid thus represents the buying price plus the premium. Funds which offer units for sale without a premium are referred to as no-load funds. Exchange traded funds (ETFs) are another type of fund. ETFs can be traded continuously on a stock exchange and are mostly index funds or actively managed no-load funds.

Possibilities

The following describes the different variants in terms of investment focus: The first distinguishing feature is the composition of the fund’s assets in terms of investment instruments. Standard equity funds invest in stocks, and mostly in stocks which are regarded as “blue chips” owing to their generally accepted quality. The fund’s assets are widely spread and are not confined to specific sectors. Specialized equity funds concentrate on specific segments of the equity market, for instance sector funds which invest in stocks in specific industries or business sectors, small cap funds which hold small and mid-sized companies (second-tier stocks) in their portfolios, or stock index funds which track specific stock indices. Standard bond funds invest mostly in fixed income securities with different coupon rates and maturities, and almost entirely in issuers of good or very good credit quality.

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Specialized bond funds concentrate, like specialized equity funds, on specific segments of the fixed income market, for instance low-coupon bond funds (bonds with low interest rates), high-yield funds (high-yielding bonds of mixed credit quality), junk bond funds (high-yielding bonds of low credit quality) and short bond funds (securities with short periods to maturity). Hybrid funds are mixed funds which use both equity and fixed income market instruments. There are also funds which concentrate their investments on specific markets, instruments or combinations thereof (speciality funds). Examples are warrants funds and futures funds. These speciality funds might also pursue specific investment styles such as “value” or “growth” strategies. The following types of fund can be distinguished on the basis of their geographical investment horizon: country funds which only invest in financial assets of issuers based in one specific country; regional funds which only consist of assets of the given region (e.g. Europe, North America or Asia-Pacific); international funds which invest in the capital markets worldwide and emerging markets funds which invest in one or more emerging market countries.

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Structured Products

Characteristics Safety / Risk Price performance Certificates

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Characteristics

Structured products are products whose risk/reward profile is tailored to specific market situations. There is no clear-cut definition. They derive mostly from equities, fixed income securities, derivatives, real estate and specific strategies.

Safety / Risk

By investing in structured products it is possible to combine the characteristics of different asset classes in terms of return and risk so that a specific return and risk profile can be generated according to how the market outlook is assessed. Structured products have an asymmetrical risk/reward relationship, in other words the buyer and the seller do not have the same profit or loss potential owing to their different rights and obligations. Structured products can also be used as a hedging instrument. For instance, they can offer protection against falling prices but this is at the price of a lower potential return.

Price Performance

The value of the structured product changes as the market prices of the underlying investment instruments change. The value of a structured product is normally determined and published several times on each trading day.

Certificates

Certificates are a good example of structured products. Depending on the issuer, there are a whole range of products on offer in the certificates market with different terms and modalities. The most common types are index, discount and bonus certificates.

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Index Certificates Index certificates document a right to the payment of a sum of money or other settlement, the amount of which depends on the value of the underlying index on the maturity date. The certificates normally run for several years. As a rule, there are no periodic payments of interest or other distributions (e.g. dividends) during the life of the certificate. By buying an index certificate, the investor can participate in the performance of the underlying index without having to buy the securities contained in the index individually. Certificates are traded on and/or off the exchange. As a rule, the issuer continuously quotes bid and asked prices for the certificates every trading day throughout the certificate’s life. Discount Certificates Discount certificates are securities with a fixed life where the manner of repayment on maturity depends on the price of the reference underlying (e.g. stocks or indices). On a specified date there is an upper limit on the amount disbursed. In return for this the discount certificate is cheaper than the underlying so there is a buffer against risk on the downside. Bonus Certificates Bonus certificates are instruments which enable the investor to profit from rising prices without any limit while benefiting additionally from a buffer against the risk of falling prices. This takes the form of the payment of a bonus amount (on top of the value of the certificate) at the end of the certificate’s life if the value of the underlying has always traded above a specified level, the so-called barrier, throughout the life of the certificate. If

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the barrier is touched during the life of the certificate, the function of the risk buffer is cancelled. If the price of the underlying rises and the barrier is not touched, the investor either receives the nominal value of the certificate plus the bonus amount or the value of the underlying, whichever is higher, when the certificate matures.

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Glossary Asset Any possession that has value. Asset allocation The decision regarding how an investor’s funds should be distributed among the major assets (e.g., equities, bonds, money markets, commodities). Asset class An investment category that groups all securities sharing certain defined attributes into that grouping (e.g., US large cap., US bonds, REITs, etc.). In general, securities grouped into the same asset class will tend to respond similarly to changes in economic climate, profitability and market uncertainty, though this will not always be the case. The asset classes are generally defined so that every security will fall into one and only one asset class. Benchmarks The performance of a predetermined set of securities, used for comparison purposes. Such sets may be based on published indexes or may be customized to suit an investment strategy. Beta The measure of a fund’s or stock’s risk in relation to the market, or an alternative benchmark. A beta of 1.5 means that a stock’s excess return is expected to move 1.5 times the market excess return. For example, if market excess return is 10 percent, then we expect, on average, the stock return to be 15 percent. Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away. Bonds A bond is debt issued for a period of more than one year. The government, local governments, water districts, companies, and many other types of institutions sell bonds. When an investor buys bonds, he or she is lending money. The seller of the bond agrees to repay the principal amount of the loan at a specified time. Interest-bearing bonds pay interest periodically. Call option A call option is the right, but not the obligation, to buy an asset at a pre-specified price on or before a pre-specified date in the future.

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Caps and floors Interest rate options. Caps are an upper limit on interest rates (if you buy a cap, you make money if interest rates move above cap strike level). Floors are a lower limit on interest rates (if you buy a floor, you make money if interest rates move below floor strike level). Correlation A linear statistical measure of the degree to which two random variables are related. A correlation will range from -1.0 to +1.0. For market risk, international equity markets rising and falling together show positive correlation. In credit risk, clumps of firms defaulting together by industry or geographically show positive correlation of default events. Coupon The periodic interest payment made to the bondholders during the life of bond. Currency risk Risk of loss due to movements in currency rates. Default Failure of a debtor to make timely payments of principal and interest or to meet other provisions of a bond indenture. Derivatives Securities, such as options, futures, and swaps, whose value is derived in part from the value and characteristics of another underlying security. Diversification Holding a large collection of independent assets to reduce overall risk. Efficient frontier The efficient frontier is a set of allocations that delivers the highest estimated return for a range of estimated risk levels. More risk does not always imply greater estimated returns. Please note that if an allocation is not on the efficient frontier it may be possible to reduce risk while preserving, or even increasing, target return by moving towards the efficient frontier. Foreign exchange risk Risk of loss due to movements in foreign exchange rates.

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Futures A term used to designate contracts covering the sale of financial instruments or physical commodities for future delivery on an exchange. Hedge fund A fund targeted to sophisticated investors that may use a wide range of strategies to earn returns, such as taking long and short positions based on statistical models. Hedging Eliminating an exposure by entering into an offsetting position. For example, a gold mine can hedge exposure to falling prices by selling gold futures. When hedging, we look for highly correlated substitute securities. Inflation The rate at which the price that consumers pay for goods and services rises over time. Interest rate risk Risk arising from fluctuating interest rates. For example, a bond’s price drops as interest rates rise. Interest rate Cost of using money, expressed as a percentage rate per annum. Long position Opposite of short position, a bet that prices will rise. For example, you have a long position when you buy a stock and will benefit from prices rising. Market risk Risk that arises from the fluctuating prices of investments as they are traded in the global markets. Market risk is highest for securities with above-average price volatility and lowest for stable securities such as Treasury bills. Modern portfolio theory Investment decision approach that permits an investor to classify, estimate, and control both the kind and the amount of expected risk and return. Option An option is the right, but not the obligation, to buy or sell a reference asset at a pre-specified strike price on or before a pre-specified future date. A European-style option can be exercised only at maturity, whereas an American-style option may be exercised any day before or on maturity. Risk Uncertainty about or exposure to loss or damage. The risk of a security or an asset allocation describes its volatility, or the 41

uncertainty of the year-to-year performance relative to the expected return. It does not describe other forms of risk. Short position Opposite of long position—a bet that prices will fall. For example, a short position in a stock will benefit from the stock price falling. Standard deviation A statistical measure that indicates the width of a distribution around the mean. A standard deviation is the square root of the second moment of a distribution. More generally, it is a measure of the extent to which numbers are spread around their average. If returns followed a normal distribution, 66% of the possible return values would fall within one standard deviation of the control (or expected) value. Stock Ownership interest possessed by shareholders in a corporation (i.e., stocks as opposed to bonds). Strike price The stated price for which an underlying asset may be purchased (in case of a call) or sold (in the case of a put) by the option holder upon exercise of the option contract. Systemic risk The risk of a portfolio after all unique risk has been diversified away. Systemic risks may arise from common driving factors (e.g., market and economic factors, natural disasters, war) and can influence the whole market’s well-being. (Also known as systematic risk.) Underlying An asset that may be bought or sold is referred to as the underlying. Unique risk Exposure to a particular company sometimes referred to as firm-specific risk. Volatility Portfolio volatility is a measure of deviation from that portfolio’s mean return over the period in question.

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Master the fine art of financial markets and asset classes Financial consultancy is an art. This compilation aims at equipping you with fundamental financial terminologies and nomenclature, to help you master this art. It explains the basics of financial markets and asset classes in clear and simple terms with the aim of helping you in pre-meeting preparations, during negotiations and even in day-to-day situations.

Deutsche Bank states: The opinions, expectations and other information contained herein are entirely those of Deutsche Bank AG. Whilst all reasonable care has been taken to ensure that the facts stated herein are accurate and that forecasts, opinions and expectations contained herein are fair and reasonable, Deutsche Bank AG has not verified the contents hereof, and, accordingly, neither Deutsche Bank AG nor any members of the Deutsche Bank Group nor any of their respective Directors, officers or employees shall be in anyway responsible for the contents hereof. All decisions to sell or purchase units / securities shall be on the basis of the own personal judgement of the Customer consulting his / her / their own external investment consultant. Deutsche Bank does not in any manner guarantee any returns on any of the investment products.