The Fine Art of Finance

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

CONTENTS
1 2 3 4 5 6 7 8

Introduction Equities Fixed Income Derivatives Alternative Investments Investment Funds Structured Products 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

1

Profitability The profitability of an investment is determined by the income it generates. any other amounts distributed and capital gains (e. Safety Safety means preserving the value of the capital invested. 2 . safety and liquidity. Safety can be increased by spreading the capital invested over a range of investments. in the form of changes in the market price of the security).g. which is known as diversification. Liquidity The liquidity of an investment depends on how quickly an amount invested in a given asset can be realized. The rate of return is a useful measure to compare the profitability of different investments. securities which are traded on a stock exchange are liquid. This diversification can be based on various criteria such as different categories of investments or investing in different countries. sectors and currencies.Basics Any form of investment can be assessed on the basis of three criteria: profitability. in other words converted into cash or an amount in a bank account. This covers a number of aspects which are discussed in the various sections of this brochure. This consists of the interest and dividends paid. It is defined as the annual income earned as a percentage of the capital invested. The safety of an investment depends on the risks to which it is exposed to. In general.

above-average returns are normally associated with higher risks. safety and liquidity can only be combined by making compromises. 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. there is a conflict between safety and profitability. all investors want to achieve optimum results in each investment category: high interest rates. there can be a conflict between the targets of liquidity and profitability since more liquid investments often imply disadvantages in terms of return. Secondly. 3 . is often cited as a fourth criterion. in the sense of protection against inflation. This preference plays an important role in selecting the optimum portfolio for any given investor. target criteria are ultimately weighted and prioritized depends on the investor’s own personal preferences. the investor generally has to accept a lower return. However. in part conflicting. Basically. How these. Conversely. in the real world the three criteria of profitability. 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.Capital maintenance. The magic triangle of investment illustrates the conflicts: Firstly. To obtain a high degree of safety.

This risk can be minimized through diversification so that the investment is then only exposed to systemic risk. bonds. 4 . 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.g. which refers to the general market risk. equities. In the case of equities. alternative investments and cash) to reflect his or her investment targets. it has to be ascertained with which instruments they can be achieved and what form the investor’s individual asset allocation should take. this would be the company-specific risk.Asset Allocation Allocation and Diversification Once the investor’s investment targets and risk preferences are known. 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. 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. the portfolio’s overall risk can be reduced by adding new investment instruments. for instance. The term diversification plays a key role here. As the chart below shows. Asset allocation means the distribution of investor’s funds among different asset classes (e.

As a rule.There is no general definition of asset classes. This serves as a reserve for transactions but is also important to ensure that payment obligations can be met. alternative investments and liquid assets. Asset classes which are neither equities nor bonds are grouped together under the term alternative investments. Cash. The basic division is into equities. The classification is usually based on institutional. substantive or pragmatic criteria. with a distinction made for instance between government bonds. This has to take into account the minimum investment horizon. 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. the liquidity of the investment instruments as well as the expected return and the risks. Equities are classed by region. investment grade bonds and bonds of poorer quality known as high-yield bonds. but a division into sectors or industries would also be possible. or liquidity. is also treated as a separate asset class. 5 . this is based on the historical performance of the investment instruments considered. bonds. Bonds can be classified additionally according to the issuer’s credit rating.

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. For many of the common asset classes there are indices which reflect the risks and returns in a transparent and representative way. 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.Government The portfolio planning is made easier if there is a sufficient base of data available for the asset classes. in other words to spread the risk as far as possible. the lower is the portfolio’s overall risk. 6 . The weaker the correlation between individual assets.

in other words when equity prices are on the rise. A classic case.The correlation coefficient can be between -1 and 1. or what proportion of a pure equities or bond portfolio should be invested internationally. for instance. one can either seek to maximize income for a given level of risk or seek to minimize risk for a given level of income. 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. bond prices generally fall. Depending on the investor’s investment target. equities and bonds show a negative correlation. bonds and liquidity. The latter reflects the personal weighting of the three criteria of liquidity. of the individual asset classes. measured in terms of average return and annualized standard deviation (volatility). A correlation of -1 indicates that the movement of the two asset classes are diametrically opposed to each other. is the question of how the capital is to be split between equities. 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. The table above shows for instance that US equities and European equities have a strong correlation. Conversely. By contrast. Crucial for this decision are the historical data on income and risk. Since past values cannot automatically be taken as an indication of future values. a correlation of 1 denotes that the two asset classes move completely in unison. in other words the two markets tend to move in the same direction. safety and profitability discussed in the first section. the figures need to be adjusted according to market expectations and 7 .

A strategic asset allocation can be made on the basis of this forecast. and short-term fluctuations in the risk and return of the individual investment instruments are ignored. 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. With these tactical decisions it is also attempted to outperform the strategic benchmark which. tactical asset allocation defines the investment instruments or asset combinations the funds are to be invested in and with what weighting Fine Art. The investment horizon for strategic asset allocation is very long term. The following table illustrates the two asset allocation versions with the example of a portfolio based on a “Moderate” strategy. macroeconomic data and current market developments are considered. as discussed. is closely linked to the strategic asset allocation. The second column shows the portfolio’s current weighting (the “tactical asset allocation”). which make it necessary to adjust the short to mid-term outlook for returns and volatility. For instance. 8 . The first column shows a possible strategic asset allocation based on the investor’s risk profile. As the next step. 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.perspectives for the future. with the current overweighting or underweighting of the various asset classes indicated in the last column. Here. it is a question of selecting the actual investments.

g. equities). others offer less risk for the same expected return. The key factor is how the individual asset classes are weighted in the portfolio. bonds and other assets. different market segments and individual securities. 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 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. the portfolio which delivers the maximum income for a given level of risk. i. In the chart. the funds can be distributed between various countries and regions. measured in terms of the variance of the returns. or a minimum level of risk for a given income. This leads to an apparent paradox: the overall risk of a conservative portfolio (e. some portfolios offer higher potential returns for the same level of risk while.g. conversely. In other words.Excursus: Portfolio Theory Once the strategic asset allocation has been defined. If all conceivable combinations of these values are plotted on a return-risk matrix. The chart below illustrates how the expected return and the risk of a portfolio can be modified by altering the weighting of equities. can be determined by applying standard deviation optimization. The optimum portfolio. Thanks to the pioneering study by Markowitz (1952) quantitative portfolio theory provides an answer to this question and is widely accepted in practice. the efficient portfolios 9 . bonds) can be reduced in many cases by adding higher-risk assets (e. one obtains a number of possible portfolios but not all of them are efficient. By virtue of its simplicity and clarity it has established itself as a standard model in the financial markets.e.

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. 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. 10 . a portfolio on/at the efficiency curve This particularly stable portfolio consists of a mix of weakly correlated assets.are all located on the upper part of the curve encircling this matrix. They offer the optimum expected return for a given level of risk. 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. the so-called “efficiency curve”.

The steepest of all possible lines touches the efficiency curve as a tangent at just one point. and the point at which it touches the efficiency curve is the so-called market portfolio (see chart). 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. the higher is the assumed interest rate. He assumed that an investor was able to invest or raise capital at a given interest rate. the better the risk-return relationship of the portfolios located along it.The market portfolio: What we have been saying so far applies to portfolios which consist entirely of risk assets. this risk less investment would be located on the vertical axis of the chart (risk = 0). The higher the investment is on the axis. 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. the steeper the line is. The line is called the capital market line. Obviously. In our matrix. Determining the market portfolio 11 .

Portfolio theory is an important foundation for concrete asset allocation.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. in other words the degree to which the values fluctuate) and the return of a given asset can be applied to the future. portfolio theory is based on the assumption that the historical values for the risk (measured in terms of volatility. If this were possible on a one-to-one basis and the returns of the respective asset classes were normally distributed. especially since the returns of certain asset categories are not normally distributed. the estimation of the future development of values and the volatility of an asset plays an important role. With the help of this model. Consequently. it is possible to develop mathematical models that derive the optimum mix of investor portfolios. to construct portfolios which always exactly reflect a given investor’s respective expectations with regard to return and risk. However. In the following sections we describe the individual asset classes and their special features: 12 . This is taken into account within the framework of strategic asset allocation. by purely quantitative means. it would indeed be possible. But this is not the case.

Equities Definition Classification Measuring Risk Types of Risk 13 .

Measuring Risk There are various methods for measuring the risk of equity investments. Another form of classification is based on the respective corporation’s market capitalization. The shareholder has an ownership interest in the corporation and shares in its profits in the form of dividends. is determined by supply and demand. A distinction is made between Small Cap. Financials. Technology. One example is the Russell 2000. Energy. There are also indices which track the performance of stocks based on specific sectors or market capitalization. Consumer Goods. or share price.Definition Equities or stocks are certificates which document the shareholder’s share of the capital stock of a corporation. Classification Stocks can be assigned to different market sectors. growth stocks have low book value to market capitalization ratios. Value stocks have high book value to market capitalization ratios. The performance of individual groups of stocks is tracked in the form of indices. etc. Basic Materials. This index consists of US Small Cap stocks. the Euro Stoxx 50 and the FTSE 100. The market price of the stock. Mid Cap and Large Cap companies according to the market value of the corporation’s capital stock. e. The most important and best known international indices are the S&P 500. Healthcare. and at the same time reflects the rise or fall in the net worth of the corporation. 14 .g. the Nikkei 225. Consumer Services. Other terms used to differentiate stocks are “Value” and “Growth”. Volatility and beta are the most commonly used.

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. Historical volatility indicates how high the stock’s range of fluctuation was in the past. The latter denotes the risk of a fall in price due to factors which are directly or indirectly related to the issuing company. This measure represents both the positive and negative deviations from the expected value. this would mean that the stock has moved in unison (1-to-1) with that index.Volatility (historical/implied) The first measure of risk is the standard deviation (volatility) of the returns. and is referred to as 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. Beta measures how strongly the stock reacts to changes in the value of a benchmark. If a stock has a beta of 1 relative to the Dow Jones Index. which in most cases is a leading index. Fundamental risk covers the general market risk (systemic risk) and company-specific risk (non-systemic risk). A distinction is made between historical volatility and implied volatility. Types of risk The risk of an equity asset can be divided into two main components: the fundamental risk and the market psychology risk. 15 .

In so far.The market psychology risk results from irrational opinion-forming among investors and mass psychological behaviour. 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. assumptions and sentiment of buyers and sellers. The share price also reflects the hopes and fears. 16 .

Fixed Income Securities Definition Types of Bonds Risks 17 .

The buyer of a fixed income security (=creditor) has a monetary claim against the issuer. 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”). repayment options and other features such as protection against exchange rate changes. the respective interest rate is fixed three. Classic straight bonds have a constant rate of interest (nominal interest rate or coupon) over their entire life. Depending on the terms of the issue. often also referred to as bonds. They carry a fixed or variable rate of interest and have a specified life and specific repayment terms.Definition Fixed income securities. notes or debentures. With “floors” the investor is guaranteed a minimum interest rate regardless of the level of the reference rate. are debt certificates which are made out to the respective (anonymous) bearer or registered in the name of a specific holder. In the case of floating rate notes the nominal interest rate is variable and is based on a reference rate. In most countries the interest coupons are paid half-yearly in arrears. With “caps” there is a ceiling on the rate of interest paid so the buyer never receives a coupon payment above the maximum rate. six or twelve months in advance. usually money market rates such as EURIBOR or LIBOR. Types of Bonds There are a wide range of fixed income securities which differ with regard to the payment of interest. 18 .

Corporate bonds normally carry a higher yield or premium versus government bonds. to meet its interest and/or repayment obligations as agreed. referred to as the “spread”. there are no periodic payments. which reflects the additional risk normally associated with an investment in corporate bonds. Another important distinction is between government bonds and corporate bonds. Deterioration in credit quality therefore has an adverse effect on the price of the respective securities (risk discount). 19 . In this case. the longer the bond’s remaining life to maturity is. An issuer’s credit quality can change during the life of a bond as a result of macroeconomic or company-specific developments. Alternative terms for credit risk are borrower risk or issuer risk. in other words the possibility that it might be unable. in order to be able to make a reliable assessment of the potential returns. Investors should be familiar with these risks before they invest. When selecting fixed income securities one needs to differentiate between bonds denominated in local currency and foreign currency. either temporarily or permanently. Credit Risk Credit risk denotes the risk of the issuer’s bankruptcy or insolvency. credit risk tends to be higher.Another type of fixed income security is zero bonds. they still present a number of major sources of risk. Generally. which do not carry an interest coupon. Risks Although fixed income securities are considered to be relatively safe investments compared with other types of security. The difference between the purchase price and the repayment amount on maturity represents the interest income over the life of the bond to maturity.

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

Derivatives Definition Financial Futures Options Possibilities Risks 21 .

maturity date) at a predetermined price. The buyer/seller expects the price of the underlying to rise/fall during the life of the futures contract. performance. Futures constitute an agreement which places an unconditional obligation on both parties – both seller and buyer.Definition Derivatives are not straightforward cash or spot market transactions which are settled immediately but are a “derived“ form of transaction in equities. As a rule. A distinction is made between conditional (options) and unconditional (futures) transactions. The difference between the buying price and the selling price of the futures contract determines what 22 . Financial Futures Financial futures are standardized. Futures have a symmetrical risk profile. 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). This means that the buyer and the seller have the same profit or loss potential. on stock indices (stock index futures) and on foreign currencies (foreign exchange futures). The purchase of the futures contract gives rise to a long/short futures position. 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). exchange-traded futures contracts. fixed income securities or foreign exchange. 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.

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). 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 23 . In the area of commodity futures physical delivery of the commodity is usual. investors can use futures and options to pursue different objectives. In exchange for this right the buyer pays a price (option premium) to the seller of the option. but not the obligation. There are two types of option. Moreover. Possibilities Depending on their strategy. specific foreign currencies or indices and futures contracts. This can be individual stocks or bonds. whereby other costs (such as transaction costs) have also to be taken into account.gains or losses are made on the transaction. The reference asset (underlying) is the asset to which the option right relates. these futures have high contract values and are therefore not suitable for investors with small to medium amounts to invest. An option to buy is referred to as a call and an option to sell is referred to as a put. Both can be used for hedging purposes i. Options An option is an agreement under which the buyer (option holder) has the right. to protect against risk. which can make this type of futures contract unattractive for the private investor.e. 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).

A total loss is also possible (and in the case of short positions a loss even beyond the capital invested). that the risk of loss is not limited The higher the derivative’s leverage. Owing to the small amount of capital invested compared with other investments and the high leverage. the riskier the position is. which arises because less capital needs to be invested. If prices move in the opposite direction.the respective futures or options. Risks For futures and options the biggest risk lies in a. 24 . the leverage effect. 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. This effect causes the price of the derivative to react more than proportionally to changes in the price of the underlying asset. while a loss is made on the futures/options position. Another danger is the greater risk of total loss. Based on subjective expectations and assessments of how the price of the underlying asset will move. the risk presented by the leverage effect and b. In this case. Besides hedging strategies. small market movements can lead to considerable losses. plays an important role. Futures and options should therefore only be used by investors with long capital market experience. a gain is made on the cash or spot market position. If a loss arises on the cash or spot market position. positions are deliberately entered into with a view to making a profit. it is theoretically possible to achieve a gain of roughly the same magnitude with a previously sold futures contract or a put option. it is also possible to use futures and options as a speculative instrument.

Alternative Investments Alternative Products / Investments Hedge Funds Private Equity Funds Venture Capital Funds Commodities Real Estate Currencies 25 .

Most managers concentrate on specific investment strategies and processes. By subscribing a specific sum. Equity Hedge and Short Selling. Global Macro. The equity stakes serve to finance the growth of young companies or special situations such as restructuring measures. The basic idea is to generate a positive absolute return irrespective of market trends. To simplify matters. the investment strategies can be divided into five broad categories: Relative Value. Event Driven. Generally. usually unlisted companies. The aim of Alternative Investments is to offer opportunities for capital appreciation independently of the equity and fixed-income markets. private equity and venture capital funds).partnerships or corporations which serve the purpose of collective investment (hedge funds. Private equity funds Investments in private equity funds represent entrepreneurial equity stakes in portfolios of young. Hedge funds Hedge fund managers pursue an investment style of their own. a distinction is made between unregulated . options and securities of diverse asset classes. They can use the whole spectrum of financial instruments including futures contracts. Non-homogeneous asset classes include commodities and currency investments which do not relate to classic asset classes such as equities and fixed income securities. This modifies the overall return and risk profile. real estate. investors acquire an ownership interest in the private equity company and share in the assets of 26 . and non-homogeneous asset classes. They are therefore suitable for portfolio diversification.Alternative Products/ Investments Alternative products and investments are assets which do not count among the traditional investments (equities and fixed income securities).in other words not subject to special regulatory supervision .

gas. In the case of funds of funds. “New” commodities include electricity. whose individual assets may require high minimum investment sums. agricultural products (e. This gives the investor access to a diversified investment. Another class are so-called soft commodities such as coffee. aluminium and copper). gold. information technology and biotechnology. sugar or orange juice concentrate. The income. which mainly represents gains realized upon the sale of the equity stakes.g.g. wheat and maize) and precious metals (e. weather and catastrophe derivatives. 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. Commodities The term commodities relates to commercial products traded on the markets. palladium and platinum). investors acquire units in a fund which in turn invests in funds.g. 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. 27 . However in such cases there is very limited public information available in such cases. Venture capital funds Venture capital funds are very similar to private equity funds. private equity funds and venture capital funds. Portfolio constructions (so-called funds of funds and special index certificates) provide an opportunity for investing indirectly in hedge funds. cocoa. Commodities are divided into three broad categories: minerals (e. oil.the fund.

This class also includes cyclically-sensitive metals such as aluminium and copper whose price development is strongly correlated with economic cycles. 28 . Gold. 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. Most commodities are traded on specialized exchanges.Oil is the most important asset class among the mineral commodities. or directly between market players around the globe in the form of OTC (over-the-counter) transactions. switch from vegetarian foods to non-vegetarian foods as people become more affluent). However. 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. which is still regarded as a crisis currency and “safe haven”. and is therefore regarded as a crisis barometer. 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. The oil price reacts quickly and sharply to supply shocks and geopolitical events.g. 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. as largely standardized contracts.

mortgage loans. Real estate assets can also be differentiated according to regional focus or different types of use. which is a hybrid form of debt and equity capital. and is a less liquid form of investment compared with traded instruments and fund units. However. securitized forms such as mortgage backed securities and mezzanine capital. Basically. and open and closed-end real estate funds – whereby the individual categories differ widely from country to country. it is customary to categorise real estate investments according to different investment styles based on their risk-return profile. a distinction can be made between directly and indirectly owned real estate. On a broad definition real estate investments also include property finance.Real Estate Real estate is an asset class which offers a wide variety of investment opportunities. Directly owned real estate assets are investments in apartments or office properties. Currencies The prices traded in the foreign exchange market are rates of exchange between two currencies. and is therefore not attractive for most investors. 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. including Real-estate Investment Trusts (REITs). this mostly requires a large amount of capital to be invested. 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. Finally. 29 . The main forms of indirectly owned real estate are real estate company stocks.

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. in other words borrowing money in a low-interest currency and reinvesting it in a high-interest currency.Another possibility is so-called “carry trades” where the investor seeks to exploit the interest rate spread between two currencies. 30 . the international foreign exchange market is the world’s biggest market.

Investment Funds Characteristics of Investment Funds Performance Possibilities 31 .

so the portfolio is under constant review and the various markets are analyzed. in equities or fixed income securities. The advantage lies in the fact that the risk is diversified.g. 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 portfolio is adjusted according to the respective market situation (tactical asset allocation). the potential return is still exposed to the same risks as a direct investment in individual asset classes. Performance The value of the investment certificate changes as the market price of the securities in which the fund is invested changes.Characteristics of Investment Funds Investment funds gather money from different investors and. The resultant risk spreading reduces the overall risk of this kind of investment. The value of an investment fund unit (= the buying price. Investment funds are professionally managed. depending on the fund’s terms of reference. Although funds have a better risk profile. or to which small investors do not have access owing to market restrictions. in the home market or internationally) or in real estate. invest them in specific securities (e. 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 32 . where asset values are highly volatile. Funds also make it possible to invest in markets which require considerable market expertise.

Standard equity funds invest in stocks. When the units are purchased. Specialized equity funds concentrate on specific segments of the equity market. The so-called “buying price” is fixed once a day. Exchange traded funds (ETFs) are another type of fund.divided by the number of units in circulation. 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. 33 . a premium is usually charged. ETFs can be traded continuously on a stock exchange and are mostly index funds or actively managed no-load funds. Funds which offer units for sale without a premium are referred to as no-load funds. for instance sector funds which invest in stocks in specific industries or business sectors. Standard bond funds invest mostly in fixed income securities with different coupon rates and maturities. small cap funds which hold small and mid-sized companies (second-tier stocks) in their portfolios. The fund’s assets are widely spread and are not confined to specific sectors. The issue price paid thus represents the buying price plus the premium. and mostly in stocks which are regarded as “blue chips” owing to their generally accepted quality. or stock index funds which track specific stock indices. and almost entirely in issuers of good or very good credit quality.

Hybrid funds are mixed funds which use both equity and fixed income market instruments. Examples are warrants funds and futures funds. on specific segments of the fixed income market. like specialized equity funds. 34 . These speciality funds might also pursue specific investment styles such as “value” or “growth” strategies. North America or Asia-Pacific). for instance low-coupon bond funds (bonds with low interest rates). high-yield funds (high-yielding bonds of mixed credit quality). instruments or combinations thereof (speciality funds). Europe. 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. international funds which invest in the capital markets worldwide and emerging markets funds which invest in one or more emerging market countries. regional funds which only consist of assets of the given region (e. junk bond funds (high-yielding bonds of low credit quality) and short bond funds (securities with short periods to maturity).g.Specialized bond funds concentrate. There are also funds which concentrate their investments on specific markets.

Structured Products Characteristics Safety / Risk Price performance Certificates 35 .

They derive mostly from equities. derivatives. There is no clear-cut definition. 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. discount and bonus certificates. For instance. Depending on the issuer. Structured products can also be used as a hedging instrument. Certificates Certificates are a good example of structured products. fixed income securities. in other words the buyer and the seller do not have the same profit or loss potential owing to their different rights and obligations. they can offer protection against falling prices but this is at the price of a lower potential return. there are a whole range of products on offer in the certificates market with different terms and modalities. Price Performance The value of the structured product changes as the market prices of the underlying investment instruments change. The most common types are index. Structured products have an asymmetrical risk/reward relationship.Characteristics Structured products are products whose risk/reward profile is tailored to specific market situations. real estate and specific strategies. The value of a structured product is normally determined and published several times on each trading day. 36 .

the so-called barrier. As a rule. 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.g. the issuer continuously quotes bid and asked prices for the certificates every trading day throughout the certificate’s life. stocks or indices). By buying an index certificate. Certificates are traded on and/or off the exchange. dividends) during the life of the certificate. As a rule. the amount of which depends on the value of the underlying index on the maturity date. there are no periodic payments of interest or other distributions (e. In return for this the discount certificate is cheaper than the underlying so there is a buffer against risk on the downside. 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 certificates normally run for several years. throughout the life of the certificate.g. 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. On a specified date there is an upper limit on the amount disbursed. the investor can participate in the performance of the underlying index without having to buy the securities contained in the index individually.Index Certificates Index certificates document a right to the payment of a sum of money or other settlement. If 37 .

the function of the risk buffer is cancelled. whichever is higher. when the certificate matures. If the price of the underlying rises and the barrier is not touched.the barrier is touched during the life of the certificate. 38 . the investor either receives the nominal value of the certificate plus the bonus amount or the value of the underlying.

Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away.5 times the market excess return. Call option A call option is the right. Asset class An investment category that groups all securities sharing certain defined attributes into that grouping (e. REITs. equities.g. though this will not always be the case. In general. and many other types of institutions sell bonds. local governments. but not the obligation. 39 . The seller of the bond agrees to repay the principal amount of the loan at a specified time. The government. etc.Glossary Asset Any possession that has value. US large cap. companies. The asset classes are generally defined so that every security will fall into one and only one asset class. water districts.. Benchmarks The performance of a predetermined set of securities. to buy an asset at a pre-specified price on or before a pre-specified date in the future. profitability and market uncertainty. US bonds.g. For example. Asset allocation The decision regarding how an investor’s funds should be distributed among the major assets (e.. he or she is lending money.).. When an investor buys bonds.5 means that a stock’s excess return is expected to move 1. A beta of 1. securities grouped into the same asset class will tend to respond similarly to changes in economic climate. commodities). 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. if market excess return is 10 percent. Interest-bearing bonds pay interest periodically. or an alternative benchmark. the stock return to be 15 percent. money markets. Bonds A bond is debt issued for a period of more than one year. on average. bonds. used for comparison purposes. then we expect.

Floors are a lower limit on interest rates (if you buy a floor. Caps are an upper limit on interest rates (if you buy a cap. Currency risk Risk of loss due to movements in currency rates. such as options. you make money if interest rates move above cap strike level). Default Failure of a debtor to make timely payments of principal and interest or to meet other provisions of a bond indenture. target return by moving towards the efficient frontier. 40 . Diversification Holding a large collection of independent assets to reduce overall risk.0 to +1. More risk does not always imply greater estimated returns. futures. Foreign exchange risk Risk of loss due to movements in foreign exchange rates. international equity markets rising and falling together show positive correlation. whose value is derived in part from the value and characteristics of another underlying security. Derivatives Securities. or even increasing.Caps and floors Interest rate options.0. clumps of firms defaulting together by industry or geographically show positive correlation of default events. A correlation will range from -1. Coupon The periodic interest payment made to the bondholders during the life of bond. In credit risk. Correlation A linear statistical measure of the degree to which two random variables are related. you make money if interest rates move below floor strike level). Efficient frontier The efficient frontier is a set of allocations that delivers the highest estimated return for a range of estimated risk levels. and swaps. Please note that if an allocation is not on the efficient frontier it may be possible to reduce risk while preserving. For market risk.

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

a short position in a stock will benefit from the stock price falling.g. Systemic risk The risk of a portfolio after all unique risk has been diversified away. Unique risk Exposure to a particular company sometimes referred to as firm-specific risk. If returns followed a normal distribution.) Underlying An asset that may be bought or sold is referred to as the underlying. For example. (Also known as systematic risk. It does not describe other forms of risk.uncertainty of the year-to-year performance relative to the expected return. Short position Opposite of long position—a bet that prices will fall. war) and can influence the whole market’s well-being. Stock Ownership interest possessed by shareholders in a corporation (i. Standard deviation A statistical measure that indicates the width of a distribution around the mean. More generally. 42 . market and economic factors.. stocks as opposed to bonds). natural disasters.. 66% of the possible return values would fall within one standard deviation of the control (or expected) value. Systemic risks may arise from common driving factors (e. Volatility Portfolio volatility is a measure of deviation from that portfolio’s mean return over the period in question. it is a measure of the extent to which numbers are spread around their average.e. A standard deviation is the square root of the second moment of a distribution. 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.

Master the fine art of financial markets and asset classes Financial consultancy is an art. accordingly. during negotiations and even in day-to-day situations. Deutsche Bank AG has not verified the contents hereof. 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. and. This compilation aims at equipping you with fundamental financial terminologies and nomenclature. Deutsche Bank states: The opinions. 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. expectations and other information contained herein are entirely those of Deutsche Bank AG. Deutsche Bank does not in any manner guarantee any returns on any of the investment products. to help you master this art. . 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. 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.

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