Discount Certificate

What are discount certificates?

Discount certificates are financial instruments that are traded at a price lower than the market price of the underlying asset, based on the specified issue ratio. Essentially, investors can purchase these certificates at a price below the value of the underlying asset.

Over time, the discount on the certificate diminishes, and its price gradually converges towards the market value of the underlying asset until the maturity date, at which point both prices are expected to be identical. This process of reduction in the discount occurs throughout the certificate's maturity, making it an attractive investment opportunity for profit-seeking investors.

Understanding discount certificates

Discount certificates offer investors the opportunity to acquire a financial instrument at a price lower than the current market value of the underlying security or index. This discounted price, known as the purchase price, provides investors with an initial advantage, commonly referred to as a discount. However, it's important to note that this advantage comes with a limitation on potential profit, known as the cap.

Upon maturity of the certificate, a cash settlement occurs. If the price of the underlying asset at maturity exceeds or matches the predetermined cap, the issuer pays out the maximum amount specified in the certificate. However, if the price of the underlying asset remains below the cap, the issuer has the option to either pay the investor the current price of the certificate in cash or provide the investor with the underlying asset at its current market price. The choice between cash payout and delivering the underlying asset typically depends on the type of underlying asset, with cash payout being mandatory for certificates based on indices, currencies, or interest rates.

The maximum profit potential of a discount certificate is determined by the difference between the purchase price and the cap on the underlying asset. Conversely, any losses incurred by the investor are mitigated by the discount initially received. Losses are only realized if the price of the underlying asset at maturity has declined to the extent that the discount is exhausted. Therefore, the discount acts as a safeguard, buffering against potential risks.

Discount certificates are particularly suitable for conservative investors seeking protection against market volatility, especially those anticipating sideways-moving prices in the medium term. Since investors do not benefit from price gains exceeding the cap, this investment strategy is best suited for medium-term engagements. In the event that the certificate reaches its cap before maturity, investors are advised to consider taking profits.

Features

1. Underlying Asset. Discount certificates are linked to various underlying assets, including shares, indices, or commodities. These underlying assets serve as the basis for the value and performance of the certificate.

2. Discount. The discount represents the extent to which investors can purchase the underlying asset at a lower price compared to its market value. This discount is expressed either in absolute figures or as a percentage and is influenced by the multiplier, which determines the relationship between the certificate and the underlying asset.

3. Cap. The cap is the predetermined maximum limit on the investor's participation in the performance of the underlying asset. It sets a ceiling on the potential gains that investors can realize from the certificate.

4. Multiplier. The multiplier indicates the ratio between the units of the certificate and the units of the underlying asset to which it refers. For instance, if a certificate has a multiplier of 0.01, it means that 100 units of the certificate correspond to 1 unit of the underlying asset. The multiplier plays a significant role in determining the leverage and exposure of the investor to the underlying asset's performance.

Functionality

Functionality of discount certificates revolves around their suitability for investors anticipating specific market movements, coupled with their inherent safety features and potential returns.

Discount certificates serve as an ideal investment product for investors who anticipate slight increases or sideways movements in the underlying asset, typically shares or indices. Even if the underlying asset experiences marginal declines, the discount associated with the certificate acts as a safety buffer, helping to offset potential losses.

Investors may incur losses if the price of the underlying asset falls below the purchase price of the certificate, adjusted by the multiplier. This adjustment ensures that the investor's exposure to losses is limited by the discount initially received.

Upon issuance, investors acquire the discount certificate, which reflects the value of the underlying asset minus the discount. At this point, the certificate is priced lower than a direct investment in the underlying asset. In exchange for the discount, investors accept a capped potential return, representing the maximum payout they can expect.

It's important to note that investors do not participate in price gains of the underlying asset beyond the cap. Therefore, while investors benefit from the discount, they are limited in their potential gains by the cap.

In cases where investors receive a particularly high discount, they may accept a lower maximum payout in return. This trade-off between discount and maximum payout allows investors to tailor their investment strategy based on their risk tolerance and return expectations.

Factors influencing discount certificates

1. Price of Underlying. The value of the underlying asset directly affects the price of the discount certificate. If the price of the underlying asset rises, the value of the discount certificate typically rises as well, and vice versa.

2. Remaining Term. The remaining time until the certificate's maturity also plays a crucial role. Generally, the longer the remaining term, the higher the potential for price fluctuations in response to changes in the underlying asset's value.

3. Underlying's Volatility. Higher volatility in the underlying asset can lead to greater fluctuations in the price of the discount certificate. Increased volatility tends to amplify both upward and downward movements in the certificate's price.

4. Expected Dividend Payments. Anticipated dividend payments from the underlying asset can influence the price of the discount certificate. If investors expect higher dividend payments, it may decrease demand for the certificate, thereby dropping its price.

Example

Telefónica, a telecommunications company, is priced at CZK 540 in the market. However, investors have the opportunity to purchase a discount certificate, TELEDIS, linked to Telefónica, for CZK 52. This represents a discount rate of 3.8%.

The cap for this discount certificate is set at CZK 65.

Scenario 1: At the expiration date, Telefónica's price has increased to CZK 690, while TELEDIS is priced at CZK 69. Despite TELEDIS reaching CZK 69, the investor will only receive the maximum payout, which is capped at CZK 65. This demonstrates the limited profit potential of the discount certificate.

Scenario 2: Conversely, if at the expiration date, Telefónica's price decreases to CZK 480, and TELEDIS is priced at CZK 48, the investor will receive CZK 48 as the payout. In this scenario, the profit is still limited by the cap, but losses are potentially unlimited.