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A ready reckoner for the Finance Whiz-on-the-go
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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
Basics Asset Allocation and Diversification Asset Classes Strategic and Tactical Asset Allocation Excursus: Portfolio Theory
sectors and currencies. Safety can be increased by spreading the capital invested over a range of investments. This covers a number of aspects which are discussed in the various sections of this brochure. It is defined as the annual income earned as a percentage of the capital invested.Basics Any form of investment can be assessed on the basis of three criteria: profitability. Liquidity The liquidity of an investment depends on how quickly an amount invested in a given asset can be realized. In general.g. any other amounts distributed and capital gains (e. which is known as diversification. The rate of return is a useful measure to compare the profitability of different investments. in the form of changes in the market price of the security). This diversification can be based on various criteria such as different categories of investments or investing in different countries. securities which are traded on a stock exchange are liquid. in other words converted into cash or an amount in a bank account. This consists of the interest and dividends paid. safety and liquidity. The safety of an investment depends on the risks to which it is exposed to. Safety Safety means preserving the value of the capital invested. Profitability The profitability of an investment is determined by the income it generates. 2 .
all investors want to achieve optimum results in each investment category: high interest rates. above-average returns are normally associated with higher risks. How these. is often cited as a fourth criterion. there can be a conflict between the targets of liquidity and profitability since more liquid investments often imply disadvantages in terms of return. target criteria are ultimately weighted and prioritized depends on the investor’s own personal preferences. in the sense of protection against inflation. the investor generally has to accept a lower return. in the real world the three criteria of profitability. However. 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. 3 . Conversely. Secondly.Capital maintenance. in part conflicting. This preference plays an important role in selecting the optimum portfolio for any given investor. safety and liquidity can only be combined by making compromises. To obtain a high degree of safety. 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. Basically. The magic triangle of investment illustrates the conflicts: Firstly. there is a conflict between safety and profitability.
for instance. Asset allocation means the distribution of investor’s funds among different asset classes (e. This risk can be minimized through diversification so that the investment is then only exposed to systemic risk. alternative investments and cash) to reflect his or her investment targets. this would be the company-specific risk. The term diversification plays a key role here. the portfolio’s overall risk can be reduced by adding new investment instruments. 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. In the case of equities. 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. bonds. equities.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. As the chart below shows. 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. 4 . which refers to the general market risk.g.
bonds. is also treated as a separate asset class. Bonds can be classified additionally according to the issuer’s credit rating.There is no general definition of asset classes. this is based on the historical performance of the investment instruments considered. 5 . Asset classes which are neither equities nor bonds are grouped together under the term alternative investments. 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. investment grade bonds and bonds of poorer quality known as high-yield bonds. Equities are classed by region. The classification is usually based on institutional. This has to take into account the minimum investment horizon. The basic division is into equities. substantive or pragmatic criteria. with a distinction made for instance between government bonds. As a rule. the liquidity of the investment instruments as well as the expected return and the risks. but a division into sectors or industries would also be possible. alternative investments and liquid assets. Cash. or liquidity.
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. 6 . 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. the lower is the portfolio’s overall risk. 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. The weaker the correlation between individual assets.
The table above shows for instance that US equities and European equities have a strong correlation. By contrast. The latter reflects the personal weighting of the three criteria of 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. for instance. is the question of how the capital is to be split between equities. 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. bond prices generally fall. the figures need to be adjusted according to market expectations and 7 . 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. of the individual asset classes. measured in terms of average return and annualized standard deviation (volatility). in other words when equity prices are on the rise. Since past values cannot automatically be taken as an indication of future values. one can either seek to maximize income for a given level of risk or seek to minimize risk for a given level of income. equities and bonds show a negative correlation. A classic case. 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. Conversely.The correlation coefficient can be between -1 and 1. Depending on the investor’s investment target. A correlation of -1 indicates that the movement of the two asset classes are diametrically opposed to each other. safety and profitability discussed in the first section. bonds and liquidity.
For instance. which make it necessary to adjust the short to mid-term outlook for returns and volatility. The first column shows a possible strategic asset allocation based on the investor’s risk profile.perspectives for the future. 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. macroeconomic data and current market developments are considered. and short-term fluctuations in the risk and return of the individual investment instruments are ignored. is closely linked to the strategic asset allocation. 8 . With these tactical decisions it is also attempted to outperform the strategic benchmark which. A strategic asset allocation can be made on the basis of this forecast. as discussed. tactical asset allocation defines the investment instruments or asset combinations the funds are to be invested in and with what weighting Fine Art. with the current overweighting or underweighting of the various asset classes indicated in the last column. The investment horizon for strategic asset allocation is very long term. Here. As the next step. it is a question of selecting the actual investments. 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 second column shows the portfolio’s current weighting (the “tactical asset allocation”). The following table illustrates the two asset allocation versions with the example of a portfolio based on a “Moderate” strategy.
The optimum portfolio. If all conceivable combinations of these values are plotted on a return-risk matrix.g. bonds and other assets. i. different market segments and individual securities. others offer less risk for the same expected return.e. bonds) can be reduced in many cases by adding higher-risk assets (e. or a minimum level of risk for a given income. This leads to an apparent paradox: the overall risk of a conservative portfolio (e. By virtue of its simplicity and clarity it has established itself as a standard model in the financial markets. the portfolio which delivers the maximum income for a given level of risk. The chart below illustrates how the expected return and the risk of a portfolio can be modified by altering the weighting of equities. conversely. In the chart. measured in terms of the variance of the returns.Excursus: Portfolio Theory Once the strategic asset allocation has been defined.g. can be determined by applying standard deviation optimization. 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 efficient portfolios 9 . In other words. one obtains a number of possible portfolios but not all of them are efficient. 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. Thanks to the pioneering study by Markowitz (1952) quantitative portfolio theory provides an answer to this question and is widely accepted in practice. the funds can be distributed between various countries and regions. some portfolios offer higher potential returns for the same level of risk while. equities). The key factor is how the individual asset classes are weighted in the portfolio.
They offer the optimum expected return for a given level of risk. 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). the so-called “efficiency curve”. 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. Aim of portfolio structuring. 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 aim of portfolio structuring is to put together a portfolio which comes as close as possible to the efficiency curve.
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 market portfolio: What we have been saying so far applies to portfolios which consist entirely of risk assets. the better the risk-return relationship of the portfolios located along it. He assumed that an investor was able to invest or raise capital at a given interest rate. In our matrix. The line is called the capital market line. the steeper the line is. Determining the market portfolio 11 . this risk less investment would be located on the vertical axis of the chart (risk = 0). the higher is the assumed interest rate. The higher the investment is on the axis. 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). 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. Obviously.
Consequently. If this were possible on a one-to-one basis and the returns of the respective asset classes were normally distributed.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. 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. by purely quantitative means. especially since the returns of certain asset categories are not normally distributed. it is possible to develop mathematical models that derive the optimum mix of investor portfolios. in other words the degree to which the values fluctuate) and the return of a given asset can be applied to the future. 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. With the help of this model. However. In the following sections we describe the individual asset classes and their special features: 12 . portfolio theory is based on the assumption that the historical values for the risk (measured in terms of volatility. Portfolio theory is an important foundation for concrete asset allocation. it would indeed be possible.
Equities Definition Classification Measuring Risk Types of Risk 13 .
14 .g. Measuring Risk There are various methods for measuring the risk of equity investments. Financials. growth stocks have low book value to market capitalization ratios. Technology. This index consists of US Small Cap stocks. There are also indices which track the performance of stocks based on specific sectors or market capitalization. Other terms used to differentiate stocks are “Value” and “Growth”. Consumer Goods. The shareholder has an ownership interest in the corporation and shares in its profits in the form of dividends. One example is the Russell 2000. and at the same time reflects the rise or fall in the net worth of the corporation. e. Volatility and beta are the most commonly used. etc. Healthcare. Another form of classification is based on the respective corporation’s market capitalization. The market price of the stock. Value stocks have high book value to market capitalization ratios. the Nikkei 225. is determined by supply and demand. Energy. Consumer Services. Basic Materials. or share price.Definition Equities or stocks are certificates which document the shareholder’s share of the capital stock of a corporation. A distinction is made between Small Cap. The performance of individual groups of stocks is tracked in the form of indices. Classification Stocks can be assigned to different market sectors. the Euro Stoxx 50 and the FTSE 100. The most important and best known international indices are the S&P 500. Mid Cap and Large Cap companies according to the market value of the corporation’s capital stock.
this would mean that the stock has moved in unison (1-to-1) with that index. and is referred to as systemic risk.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. 15 . The latter denotes the risk of a fall in price due to factors which are directly or indirectly related to the issuing company. which in most cases is a leading index. 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. This measure represents both the positive and negative deviations from the expected value. Historical volatility indicates how high the stock’s range of fluctuation was in the past. Beta Another measure of risk is the so-called beta coefficient. 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. If a stock has a beta of 1 relative to the Dow Jones Index. Fundamental risk covers the general market risk (systemic risk) and company-specific risk (non-systemic risk). Beta measures how strongly the stock reacts to changes in the value of a benchmark. Types of risk The risk of an equity asset can be divided into two main components: the fundamental risk and the market psychology risk.
16 . assumptions and sentiment of buyers and sellers. 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. The share price also reflects the hopes and fears. In so far.The market psychology risk results from irrational opinion-forming among investors and mass psychological behaviour.
Fixed Income Securities Definition Types of Bonds Risks 17 .
In most countries the interest coupons are paid half-yearly in arrears. are debt certificates which are made out to the respective (anonymous) bearer or registered in the name of a specific holder. six or twelve months in advance. the respective interest rate is fixed three. With “floors” the investor is guaranteed a minimum interest rate regardless of the level of the reference rate. 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 “caps” there is a ceiling on the rate of interest paid so the buyer never receives a coupon payment above the maximum rate. Types of Bonds There are a wide range of fixed income securities which differ with regard to the payment of interest. The buyer of a fixed income security (=creditor) has a monetary claim against the issuer. Classic straight bonds have a constant rate of interest (nominal interest rate or coupon) over their entire life. often also referred to as bonds. notes or debentures. repayment options and other features such as protection against exchange rate changes. Depending on the terms of the issue. 18 .Definition Fixed income securities. They carry a fixed or variable rate of interest and have a specified life and specific repayment terms. 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.
either temporarily or permanently. An issuer’s credit quality can change during the life of a bond as a result of macroeconomic or company-specific developments. they still present a number of major sources of risk. Risks Although fixed income securities are considered to be relatively safe investments compared with other types of security. which do not carry an interest coupon. The difference between the purchase price and the repayment amount on maturity represents the interest income over the life of the bond to maturity. in order to be able to make a reliable assessment of the potential returns. credit risk tends to be higher. to meet its interest and/or repayment obligations as agreed. Deterioration in credit quality therefore has an adverse effect on the price of the respective securities (risk discount). there are no periodic payments. Corporate bonds normally carry a higher yield or premium versus government bonds. Investors should be familiar with these risks before they invest. Generally. in other words the possibility that it might be unable. In this case. When selecting fixed income securities one needs to differentiate between bonds denominated in local currency and foreign currency. referred to as the “spread”. the longer the bond’s remaining life to maturity is. which reflects the additional risk normally associated with an investment in corporate bonds. Another important distinction is between government bonds and corporate bonds.Another type of fixed income security is zero bonds. Credit Risk Credit risk denotes the risk of the issuer’s bankruptcy or insolvency. Alternative terms for credit risk are borrower risk or issuer risk. 19 .
which represents the nominal interest rate (coupon). Interest rate risks arise as a result of the uncertainty surrounding future changes in market rates. Interest rate levels on the money and capital market constantly fluctuate and can cause the market price of the securities to change daily. Foreign bonds might have an attractive coupon but this is generally associated with a higher currency risk. the price at which the bond was issued or purchased. with hindsight. if the market rate falls. 20 . Yield denotes the effective rate of return. 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. This is an important factor particularly in the case of fixed income securities. A country’s exchange rate is influenced by fundamental factors such as the country’s rate of inflation. the repayment amount and the (remaining) period to maturity of the fixed income security. this can quickly erode any yield advantage and diminish the return achieved to such an extent that.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. If a currency’s exchange rate moves in the wrong direction. If the market rate rises. Interest rate Interest rate risk is one of the central risks of a fixed income security. it would have been better to have invested in a fixed income security denominated in one’s own local currency. the geopolitical situation and investment safety. differences in the level of interest rates in relation to other countries. Conversely. the price of the bond normally falls until its yield is roughly in line with the market rate. the price of the bond rises until its yield is roughly in line with the market rate. how the country’s economic outlook is assessed. Currency Risk Investors are exposed to a currency risk if they hold securities denominated in a foreign currency and the underlying exchange rate fluctuations.
Derivatives Definition Financial Futures Options Possibilities Risks 21 .
Futures have a symmetrical risk profile. exchange-traded futures contracts. 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. 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). Futures constitute an agreement which places an unconditional obligation on both parties – both seller and buyer. As a rule. The buyer/seller expects the price of the underlying to rise/fall during the life of the futures contract. This means that the buyer and the seller have the same profit or loss potential. maturity date) at a predetermined price. Financial Futures Financial futures are standardized. The difference between the buying price and the selling price of the futures contract determines what 22 . on stock indices (stock index futures) and on foreign currencies (foreign exchange futures).Definition Derivatives are not straightforward cash or spot market transactions which are settled immediately but are a “derived“ form of transaction in equities. 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). A distinction is made between conditional (options) and unconditional (futures) transactions. The purchase of the futures contract gives rise to a long/short futures position. fixed income securities or foreign exchange. performance.
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). Options An option is an agreement under which the buyer (option holder) has the right. Possibilities Depending on their strategy. Moreover. Both can be used for hedging purposes i. This can be individual stocks or bonds. investors can use futures and options to pursue different objectives. There are two types of option. which can make this type of futures contract unattractive for the private investor. In exchange for this right the buyer pays a price (option premium) to the seller of the option. 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).e. An option to buy is referred to as a call and an option to sell is referred to as a put. whereby other costs (such as transaction costs) have also to be taken into account.gains or losses are made on the transaction. these futures have high contract values and are therefore not suitable for investors with small to medium amounts to invest. specific foreign currencies or indices and futures contracts. In the area of commodity futures physical delivery of the commodity is usual. 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 23 . The reference asset (underlying) is the asset to which the option right relates. but not the obligation.
Owing to the small amount of capital invested compared with other investments and the high leverage.the respective futures or options. it is theoretically possible to achieve a gain of roughly the same magnitude with a previously sold futures contract or a put option. that the risk of loss is not limited The higher the derivative’s leverage. positions are deliberately entered into with a view to making a profit. In this case. Futures and options should therefore only be used by investors with long capital market experience. A total loss is also possible (and in the case of short positions a loss even beyond the capital invested). Besides hedging strategies. 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. it is also possible to use futures and options as a speculative instrument. while a loss is made on the futures/options position. a gain is made on the cash or spot market position. the riskier the position is. the leverage effect. 24 . Another danger is the greater risk of total loss. Risks For futures and options the biggest risk lies in a. Based on subjective expectations and assessments of how the price of the underlying asset will move. If prices move in the opposite direction. which arises because less capital needs to be invested. small market movements can lead to considerable losses. the risk presented by the leverage effect and b. This effect causes the price of the derivative to react more than proportionally to changes in the price of the underlying asset. If a loss arises on the cash or spot market position. plays an important role.
Alternative Investments Alternative Products / Investments Hedge Funds Private Equity Funds Venture Capital Funds Commodities Real Estate Currencies 25 .
partnerships or corporations which serve the purpose of collective investment (hedge funds. and non-homogeneous asset classes. Private equity funds Investments in private equity funds represent entrepreneurial equity stakes in portfolios of young. Non-homogeneous asset classes include commodities and currency investments which do not relate to classic asset classes such as equities and fixed income securities. real estate. By subscribing a specific sum. 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.Alternative Products/ Investments Alternative products and investments are assets which do not count among the traditional investments (equities and fixed income securities). Most managers concentrate on specific investment strategies and processes.in other words not subject to special regulatory supervision . Event Driven. Global Macro. The equity stakes serve to finance the growth of young companies or special situations such as restructuring measures. investors acquire an ownership interest in the private equity company and share in the assets of 26 . The aim of Alternative Investments is to offer opportunities for capital appreciation independently of the equity and fixed-income markets. To simplify matters. private equity and venture capital funds). Hedge funds Hedge fund managers pursue an investment style of their own. Generally. usually unlisted companies. This modifies the overall return and risk profile. Equity Hedge and Short Selling. the investment strategies can be divided into five broad categories: Relative Value. They are therefore suitable for portfolio diversification. The basic idea is to generate a positive absolute return irrespective of market trends.
Another class are so-called soft commodities such as coffee. investors acquire units in a fund which in turn invests in funds. palladium and platinum). This gives the investor access to a diversified investment. Venture capital funds Venture capital funds are very similar to private equity funds.the fund. gas. The income. Portfolio constructions (so-called funds of funds and special index certificates) provide an opportunity for investing indirectly in hedge funds.g. 27 . The main difference is that for the most part they invest in companies which are at a very early stage of development. which mainly represents gains realized upon the sale of the equity stakes. Commodities The term commodities relates to commercial products traded on the markets. agricultural products (e. “New” commodities include electricity. private equity funds and venture capital funds.g. aluminium and copper). oil. They are mainly active in growth sectors such as the internet. sugar or orange juice concentrate. wheat and maize) and precious metals (e. gold. Commodities are divided into three broad categories: minerals (e. information technology and biotechnology.g. weather and catastrophe derivatives. In the case of funds of funds. cocoa. 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. whose individual assets may require high minimum investment sums. However in such cases there is very limited public information available in such cases.
The oil price reacts quickly and sharply to supply shocks and geopolitical events. plays the most important role among the precious metals. Most commodities are traded on specialized exchanges. 28 . 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. This class also includes cyclically-sensitive metals such as aluminium and copper whose price development is strongly correlated with economic cycles. 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. Gold. However. which is still regarded as a crisis currency and “safe haven”. 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.Oil is the most important asset class among the mineral commodities.g. and is therefore regarded as a crisis barometer. switch from vegetarian foods to non-vegetarian foods as people become more affluent). 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. or directly between market players around the globe in the form of OTC (over-the-counter) transactions.
and open and closed-end real estate funds – whereby the individual categories differ widely from country to country. this mostly requires a large amount of capital to be invested. mortgage loans. including Real-estate Investment Trusts (REITs). Directly owned real estate assets are investments in apartments or office properties. Finally. The main forms of indirectly owned real estate are real estate company stocks. 29 . securitized forms such as mortgage backed securities and mezzanine capital. a distinction can be made between directly and indirectly owned real estate. which is a hybrid form of debt and equity capital. 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. On a broad definition real estate investments also include property finance. Real estate assets can also be differentiated according to regional focus or different types of use. 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. However. Basically. it is customary to categorise real estate investments according to different investment styles based on their risk-return profile.Real Estate Real estate is an asset class which offers a wide variety of investment opportunities. and is therefore not attractive for most investors. and is a less liquid form of investment compared with traded instruments and fund units. Currencies The prices traded in the foreign exchange market are rates of exchange between two currencies.
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.Another possibility is so-called “carry trades” where the investor seeks to exploit the interest rate spread between two currencies. 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. 30 . the international foreign exchange market is the world’s biggest market.
Investment Funds Characteristics of Investment Funds Performance Possibilities 31 .
Characteristics of Investment Funds Investment funds gather money from different investors and. Although funds have a better risk profile. in the home market or internationally) or in real estate. The value of an investment fund unit (= the buying price. 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. Funds also make it possible to invest in markets which require considerable market expertise. in equities or fixed income securities. or to which small investors do not have access owing to market restrictions. The resultant risk spreading reduces the overall risk of this kind of investment. 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 . The advantage lies in the fact that the risk is diversified. so the portfolio is under constant review and the various markets are analyzed. depending on the fund’s terms of reference.g. The portfolio is adjusted according to the respective market situation (tactical asset allocation). Performance The value of the investment certificate changes as the market price of the securities in which the fund is invested changes. the potential return is still exposed to the same risks as a direct investment in individual asset classes. invest them in specific securities (e. Investment funds are professionally managed. where asset values are highly volatile.
Specialized equity funds concentrate on specific segments of the equity market. 33 . and mostly in stocks which are regarded as “blue chips” owing to their generally accepted quality. The so-called “buying price” is fixed once a day. for instance sector funds which invest in stocks in specific industries or business sectors. The fund’s assets are widely spread and are not confined to specific sectors. and almost entirely in issuers of good or very good credit quality. Standard equity funds invest in stocks. The issue price paid thus represents the buying price plus the premium. ETFs can be traded continuously on a stock exchange and are mostly index funds or actively managed no-load funds. a premium is usually charged. Funds which offer units for sale without a premium are referred to as no-load funds.divided by the number of units in circulation. small cap funds which hold small and mid-sized companies (second-tier stocks) in their portfolios. Standard bond funds invest mostly in fixed income securities with different coupon rates and maturities. or stock index funds which track specific stock indices. Exchange traded funds (ETFs) are another type of fund. 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. When the units are purchased.
34 . North America or Asia-Pacific). Europe. for instance low-coupon bond funds (bonds with low interest rates). These speciality funds might also pursue specific investment styles such as “value” or “growth” strategies. There are also funds which concentrate their investments on specific markets.g.Specialized bond funds concentrate. Hybrid funds are mixed funds which use both equity and fixed income market instruments. 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. high-yield funds (high-yielding bonds of mixed credit quality). instruments or combinations thereof (speciality funds). junk bond funds (high-yielding bonds of low credit quality) and short bond funds (securities with short periods to maturity). Examples are warrants funds and futures funds. like specialized equity funds. on specific segments of the fixed income market. regional funds which only consist of assets of the given region (e. international funds which invest in the capital markets worldwide and emerging markets funds which invest in one or more emerging market countries.
Structured Products Characteristics Safety / Risk Price performance Certificates 35 .
The value of a structured product is normally determined and published several times on each trading day. They derive mostly from equities. 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. Price Performance The value of the structured product changes as the market prices of the underlying investment instruments change. real estate and specific strategies. 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 have an asymmetrical risk/reward relationship. 36 . there are a whole range of products on offer in the certificates market with different terms and modalities.Characteristics Structured products are products whose risk/reward profile is tailored to specific market situations. Certificates Certificates are a good example of structured products. they can offer protection against falling prices but this is at the price of a lower potential return. Structured products can also be used as a hedging instrument. There is no clear-cut definition. derivatives. For instance. Depending on the issuer. The most common types are index. fixed income securities.
the issuer continuously quotes bid and asked prices for the certificates every trading day throughout the certificate’s life. As a rule. In return for this the discount certificate is cheaper than the underlying so there is a buffer against risk on the downside. the amount of which depends on the value of the underlying index on the maturity date. The certificates normally run for several years.Index Certificates Index certificates document a right to the payment of a sum of money or other settlement. On a specified date there is an upper limit on the amount disbursed. 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. throughout the life of the certificate. dividends) during the life of the certificate. 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. By buying an index certificate. stocks or indices). If 37 .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. As a rule.g. the investor can participate in the performance of the underlying index without having to buy the securities contained in the index individually. the so-called barrier. Certificates are traded on and/or off the exchange. there are no periodic payments of interest or other distributions (e.
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.the barrier is touched during the life of the certificate. when the certificate matures. the function of the risk buffer is cancelled. 38 .
then we expect. but not the obligation.5 means that a stock’s excess return is expected to move 1. if market excess return is 10 percent. 39 . Such sets may be based on published indexes or may be customized to suit an investment strategy. REITs. profitability and market uncertainty. Call option A call option is the right. money markets. For example. securities grouped into the same asset class will tend to respond similarly to changes in economic climate. bonds. Beta is referred to as an index of the systematic risk due to general market conditions that cannot be diversified away. to buy an asset at a pre-specified price on or before a pre-specified date in the future.. used for comparison purposes.g. equities. water districts. though this will not always be the case. Benchmarks The performance of a predetermined set of securities. companies. Interest-bearing bonds pay interest periodically. the stock return to be 15 percent. Asset allocation The decision regarding how an investor’s funds should be distributed among the major assets (e. Bonds A bond is debt issued for a period of more than one year.Glossary Asset Any possession that has value.g. Asset class An investment category that groups all securities sharing certain defined attributes into that grouping (e. The asset classes are generally defined so that every security will fall into one and only one asset class. commodities). etc. A beta of 1. In general. on average. and many other types of institutions sell bonds. When an investor buys bonds. The seller of the bond agrees to repay the principal amount of the loan at a specified time.. US large cap. local governments. or an alternative benchmark.. The government.5 times the market excess return. Beta The measure of a fund’s or stock’s risk in relation to the market. he or she is lending money.). US bonds.
0. Derivatives Securities. Floors are a lower limit on interest rates (if you buy a floor. or even increasing. A correlation will range from -1. such as options. Coupon The periodic interest payment made to the bondholders during the life of bond. whose value is derived in part from the value and characteristics of another underlying security. Currency risk Risk of loss due to movements in currency rates. futures. Default Failure of a debtor to make timely payments of principal and interest or to meet other provisions of a bond indenture. More risk does not always imply greater estimated returns. Correlation A linear statistical measure of the degree to which two random variables are related. clumps of firms defaulting together by industry or geographically show positive correlation of default events. In credit risk. For market risk. 40 . Please note that if an allocation is not on the efficient frontier it may be possible to reduce risk while preserving. Efficient frontier The efficient frontier is a set of allocations that delivers the highest estimated return for a range of estimated risk levels. Diversification Holding a large collection of independent assets to reduce overall risk. and swaps. target return by moving towards the efficient frontier. you make money if interest rates move above cap strike level). international equity markets rising and falling together show positive correlation.0 to +1. you make money if interest rates move below floor strike level).Caps and floors Interest rate options. Caps are an upper limit on interest rates (if you buy a cap. Foreign exchange risk Risk of loss due to movements in foreign exchange rates.
Futures A term used to designate contracts covering the sale of financial instruments or physical commodities for future delivery on an exchange. estimate. a bond’s price drops as interest rates rise. When hedging. Hedging Eliminating an exposure by entering into an offsetting position. whereas an American-style option may be exercised any day before or on maturity. a bet that prices will rise. we look for highly correlated substitute securities. Option An option is the right. Modern portfolio theory Investment decision approach that permits an investor to classify. but not the obligation. such as taking long and short positions based on statistical models. A European-style option can be exercised only at maturity. you have a long position when you buy a stock and will benefit from prices rising. Risk Uncertainty about or exposure to loss or damage. Inflation The rate at which the price that consumers pay for goods and services rises over time. The risk of a security or an asset allocation describes its volatility. Market risk is highest for securities with above-average price volatility and lowest for stable securities such as Treasury bills. Interest rate risk Risk arising from fluctuating interest rates. For example. to buy or sell a reference asset at a pre-specified strike price on or before a pre-specified future date. Market risk Risk that arises from the fluctuating prices of investments as they are traded in the global markets. a gold mine can hedge exposure to falling prices by selling gold futures. For example. Long position Opposite of short position. expressed as a percentage rate per annum. and control both the kind and the amount of expected risk and return. For example. Hedge fund A fund targeted to sophisticated investors that may use a wide range of strategies to earn returns. or the 41 . Interest rate Cost of using money.
It does not describe other forms of risk. 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. market and economic factors. stocks as opposed to bonds). For example. (Also known as systematic risk. 42 . natural disasters. Unique risk Exposure to a particular company sometimes referred to as firm-specific risk.. Stock Ownership interest possessed by shareholders in a corporation (i.g. a short position in a stock will benefit from the stock price falling. Short position Opposite of long position—a bet that prices will fall.uncertainty of the year-to-year performance relative to the expected return. 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..) Underlying An asset that may be bought or sold is referred to as the underlying. war) and can influence the whole market’s well-being. 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. Systemic risk The risk of a portfolio after all unique risk has been diversified away. If returns followed a normal distribution.e. 66% of the possible return values would fall within one standard deviation of the control (or expected) value. Standard deviation A statistical measure that indicates the width of a distribution around the mean.
Deutsche Bank states: The opinions.Master the fine art of financial markets and asset classes Financial consultancy is an art. expectations and other information contained herein are entirely those of Deutsche Bank AG. . This compilation aims at equipping you with fundamental financial terminologies and nomenclature. opinions and expectations contained herein are fair and reasonable. officers or employees shall be in anyway responsible for the contents hereof. accordingly. 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. to help you master this art. Deutsche Bank does not in any manner guarantee any returns on any of the investment products. during negotiations and even in day-to-day situations. Deutsche Bank AG has not verified the contents hereof. Whilst all reasonable care has been taken to ensure that the facts stated herein are accurate and that forecasts. 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.
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