Leveraged certificates or knock-out products were introduced in Europe about four years ago and contribute to a substantial part of the total daily volume of structured product trading. Having gained popularity in Italy, Germany and the Netherlands, the first Asian leveraged certificate was introduced in Hong Kong early last year, better known as Callable Bull-Bear Certificates. Given their simplicity and transparency, leveraged certificates are expected to become commonplace in the region.
Turbo Certificates
Turbo certificates are one of the most popular versions of leveraged certificates, which combine the simplicity of open-ended index-tracking certificates with the leverage effect of warrants.
Turbo certificates do not have a fixed maturity date, which means that they offer leveraged exposure to an underlying without any maturity restriction. The price of a turbo certificate is always equal to its intrinsic value, i.e. the underlying spot minus financing level (plus the prevailing bid/offer spread). The financing costs associated with establishing the leverage are offset against the certificate value on a daily basis, thereby doing away with the premium. Thus the investor only pays the financing costs for the leverage he actually uses, thereby increasing both transparency and the leverage effect. Unlike both warrants and knock-out options, esoteric factors like volatility have no effect on the price of turbo certificates.
While futures, options and derivative warrants are classic trading and hedging vehicles, the complexity and opaque nature of these instruments puts them at a disadvantage. Turbo certificates allow the investor--as with futures, options and warrants--to choose from a variety of strikes but because they mirror the movement of the underlying one-to-one they do not have the volatility exposure of the other instruments.
Turbo long certificates enable leveraged participation in rising markets and turbo short certificates enable leveraged participation in falling markets. One of the advantages over a future or a warrant is a theoretically unlimited time to maturity, so that the investor does not constantly have to roll into the next contract or any new product. In addition, turbo certificates are securities, which means that there is never any obligation to pay further capital--there are no margin calls. If the investor has at any time misjudged the market, the stop loss of the product protects against large losses mounting up, in which case the turbo's remaining value is automatically credited to the investor.
Leverage
A turbo certificate can be easily explained by comparison with a classic index-tracking certificate or exchange-traded fund. While investing in an index certificate or exchange-traded fund means paying the full index to participate in its movement, a turbo certificate investor would only need to invest a portion of his capital to track the index performance. The reduced capital outlay results in a leverage effect. The smaller the capital outlay, the higher the leverage effect. Every intraday movement in the underlying is exactly tracked by the turbo certificate taking into account the bid/offer spread.
Zero Interest For Day Traders
What makes turbo certificates special is that financing costs only apply when they are used. This means there is no upfront premium. Each day that a turbo certificate is held, the capital outlay falls or rises by the financing costs for the financing level. As a result, the leverage is virtually free of charge for day traders.
Turbo Long, Turbo Short
With a turbo long, the investor bets on a rise in the underlying. If the underlying rises by 10 points, the turbo long also rises by 10 points. With a turbo short, on the other hand, the investor participates in the falling price of the underlying.
Wide Range Of Underlyings
Turbo certificates can be issued on many different kinds of asset classes, including indices, equities, currencies and commodities. From common equity indices such as the Standard & Poor's 500, through various currencies and government bond futures, to the less easily accessible commodity futures like live cattle futures, turbo certificates offer a way for investors to participate in all these markets.
Example: Turbo Certificates On Commodities
Turbo certificates on commodities enable the investor to participate in the movement of the respective commodity futures contract with reduced capital outlay. A leverage effect on the invested capital results from the reduced capital outlay. Turbo certificates on commodity futures contracts are particularly suitable for hedging existing commodity positions. When compared with those on other underlyings, turbo certificates on commodities and other futures offer one more benefit: they avoid the complication of rolling over futures near expiry.
Rollover
Turbo certificates on commodities relate to the respective futures contract. Shortly before the respective futures contract expires, the certificate is automatically rolled over into the next contract. The price differences between the contracts make it necessary to reset the financing levels and stop-loss levels on the rollover day, but this does not affect the price of turbo certificates.
This week's Learning Curve was written by Miles Ashton, head of private investor product sales for Asia at ABN AMROin Hong Kong.
