Outperformance Certificate

What is an Outperformance Certificate?

An outperformance certificate is a financial instrument that offers disproportional participation and allows investors to potentially gain disproportionately from the price appreciation of an underlying asset, provided it trades above a predetermined threshold value. These certificates feature a strike price and a participation factor. The participation factor becomes active once the underlying instrument surpasses the strike price and typically ranges between 120 and 200 percent, depending on factors such as the maturity term and the specific underlying asset.

Outperformance Certificates Explained

Outperformance certificates, within the realm of investment products, cater to investors anticipating a rise in the price of an underlying asset over a specific timeframe. These certificates offer a means to enhance potential returns by enabling disproportionate participation in price increases once a predetermined price level is achieved. Typically, they are issued on individual stocks or stock indices.

At the core, an outperformance certificate embodies three fundamental elements: the strike price, the participation rate, and the term. The strike price is pivotal, dictating the level at which participation begins. The participation rate, set upon issuance, determines the extent of this participation. Additionally, outperformance certificates always carry a fixed term. Upon the term's conclusion, if the underlying asset's price exceeds the strike price, the certificate benefits from enhanced participation in the price increase beyond the strike price.

How are Outperformance Certificates Created?

Outperformance certificates are crafted through the integration of two primary option components. Firstly, a Call option with a strike price close to zero, often referred to as a LEPO (Low-Exercise-Price Option), forms the foundation. This Call option grants the holder the privilege to purchase the underlying asset at maturity for a nominal amount, typically negligible. Consequently, the intrinsic value of the Call option reflects the price of the underlying asset, mirroring its performance. Essentially, a LEPO behaves akin to a stock without the entitlement to receive dividends.

In addition to the LEPO, a Call option with a strike price aligned with the prevailing price of the underlying asset at the point of initial fixing is essential. Should the price of the underlying asset surpass the strike price upon maturity, the option holder has the ability to procure the underlying asset at a lower cost than its prevailing market value, thereby yielding a profit. In such instances, a higher return potential is achievable compared to the value of the LEPO or the stock, contingent upon the participation rate. Conversely, if the price of the underlying asset remains below the strike price at term's end, the Call option lapses without value, leaving solely the LEPO intact for the delivery of shares to the investor.

As explained, options play a pivotal role in the formulation and valuation of outperformance certificates. The pricing of an option hinges not solely on the price of the underlying asset throughout the term but also on variables such as the volatility of the underlying asset, time until maturity, and prevailing interest rates. These parameters collectively influence the pricing dynamics of outperformance certificates over their tenure. Consequently, investors must recognize that the application of the participation rate may not invariably coincide with the specified threshold value during the term. The payout structure described herein solely materializes at term's culmination, given that the price of the underlying asset singularly dictates the repayment.

Risks and Benefits of Outperformance Certificates

Benefits

1. Disproportionate Participation in Rising Prices Above the Strike Price. Investors have the opportunity to participate disproportionately in price gains of the underlying asset once it surpasses the strike price. This allows for potentially enhanced returns compared to a direct investment in the underlying asset.

2. No Disproportionate Losses Below the Strike Price. Unlike some investment products, outperformance certificates typically do not expose investors to disproportionate losses below the strike price. This provides a level of downside protection, limiting potential losses in case of falling prices.

Risks

1. Significant Losses Can Occur. While outperformance certificates offer potential benefits in rising markets, they do not shield investors from losses if the price of the underlying asset declines. Investors face the risk of losing a significant portion of their investment if the price of the underlying asset falls below the strike price.

2. Pricing During the Term. The pricing of outperformance certificates during the term is influenced by the performance of the options components, including factors such as the volatility of the underlying asset, time to maturity, and interest rates. Changes in these factors can impact the value of the certificate and the potential returns for investors.

3. Issuer Risk. Investors are exposed to the risk of default or insolvency of the issuer of the outperformance certificates. If the issuer fails to meet its obligations, investors may lose all or a portion of their investment.

Sub-Types

1. Protect Outperformance Certificates. These certificates include additional safety levels to protect investors from potential losses in case of adverse price movements in the underlying asset. They typically offer a level of downside protection while still allowing investors to participate in the upside potential.

2. Spread Certificates. Spread certificates, also known as range certificates, involve betting on the price movement of an underlying asset within a specified range or spread. They offer investors the opportunity to profit if the price of the underlying asset remains within the predetermined range throughout the term of the certificate.

Why Invest in Outperformance Certificates?

Investing in outperformance certificates is attractive for investors who anticipate positive performance and further gains in the underlying asset. These certificates offer the opportunity for disproportionate participation in price advances above the defined price level. Additionally, certain types, like outperformance bonus certificates, provide the potential for even higher returns through features such as bonus levels or higher participation rates. Furthermore, outperformance certificates often feature additional safety levels, making them appealing to investors seeking to manage risk while still capitalizing on potential price advances. Overall, for investors expecting positive performance and seeking a structured product with the potential for higher gains, outperformance certificates play an important role in their investment strategy.

Example

Consider an outperformance certificate on a stock with the following specifications:

• Exercise price: CHF 100

• Participation rate: 2

• Ratio: 1

At the end of the term, let's assume the stock's price stands at CHF 110, which is above the exercise price of CHF 100. Since the certificate participates in the price increase above the exercise price with a factor of 2, the investor receives CHF 120 at the end of the term. Here's the breakdown of the calculation:

• Price increase above exercise price: CHF 110 - CHF 100 = CHF 10

• Participation in price increase: CHF 10 * 2 = CHF 20

• Total payout: CHF 20 (participation) + CHF 100 (repayment of nominal value) = CHF 120

So, in this example, the investor receives CHF 120 at the end of the term for their outperformance certificate, reflecting the price increase of the underlying stock above the exercise price.