Constant Leverage Certificates: How they work
Constant Leverage Certificates allow investors to participate disproportionately in the performance of a reference instrument. The special feature of this product type is the constant leverage. For rising prices of the reference instrument, Long Constant Leverage Certificates are relevant, while for falling prices, Short Constant Leverage Certificates can be considered. This product type is suitable for short-term investment horizons, but not for a Buy and Hold strategy. Constant Leverage Certificates provide access to many different asset classes, such as: stocks, indices, precious metals, commodities, currencies, interest instruments and volatility.
How they work
With Constant Leverage Certificates, short-term oriented investors can participate disproportionately in the daily performance of a reference instrument. Compared to a direct investment, Constant Leverage Certificates requires less capital, which leads to leverage.
A distinctive feature of this product type is the constant leverage. While the leverage of other product types like Warrants, Warrants with Knock-Out and Mini-Futures can change, leverage for Constant Leverage Certificates remains unchanged. By what factor an investor participates in the performance of the reference instrument, depends on the leverage.
Leverage describes how strongly a product reacts to changes in the value of the reference value. This allows for a disproportionate participation. The higher the leverage, the lower the investor's capital investment measured against the value of the reference instrument.
To understand the product, it is important to mention that the tradable Constant Leverage Certificate is not directly linked to the reference instrument but requires a step in-between to allow for the constant leverage. Every Constant Leverage Certificate is linked to a Factor Index. Factor Indices replicate a theoretical investment in a reference instrument, with the performance of the reference instrument multiplied by the leverage. The Constant Leverage Certificate reflects the performance of the Factor Index, while considering the trading currency and ratio of the product. The relevant Factor Index is shown on the product page.
For the calculation of the Factor Index Level, the change from the current reference instrument level to the last reference instrument valuation price. The reference instrument valuation price is determined daily and depending on the asset class or reference instrument category at different times. For stocks and equity indices, the valuation period usually takes place at market close. The exact valuation periods are provided on the product page under «Valuation Time».
The relation of these three components is illustrated in the following diagram.
Characteristics of Constant Leverage Certificates
The products enable a disproportionate participation in the performance of the reference instrument, by multiplying the daily percentage price movement by the leverage value. «Long» products are for rising, «Short» for falling prices.
Volatility does not have a direct influence on the price. Furthermore, Constant Leverage Certificates do not have a fixed maturity, they are «Open-End».
It is important to mention that leverage works in both directions. This means that disproportionate gains as well as losses (up to a total loss) are possible. A particularly relevant feature of Constant Leverage Certificates is the so called «barrier». The barrier refers to the reference instrument. It indicates the maximum permitted negative change in price of the Reference Instrument compared with its most recent Valuation Price before an intraday index adjustment takes place. The barrier is given in percent, its current, absolute value is determined at every reference instrument valuation time. For Long products, the barrier describes the maximum negative change of the reference instrument compared to with its most recent valuation price before an intraday index adjustment takes place. For Short products, the barrier describes the maximum positive change of the reference instrument compared to with its most recent valuation price before an intraday index adjustment takes place. When the barrier is reached, an intraday index adjustment takes place. A new reference instrument valuation price and a new (absolute) barrier level are set. The absolute value of the barrier is set after a regular daily index valuation and in the case of an intraday index adjustment. The barrier exists to avoid an immediate total loss.
A Constant Leverage Certificate leverages daily performance. Therefore, the long-term performance of the reference instrument cannot simply be multiplied with the leverage factor to compare the performance of the Constant Leverage Certificate. The correct calculation involves determining each individual daily returns of the reference instrument relative to the last valuation price. The relation of these daily returns results in path dependence.
The significance of clear, steady price trend or sideways movement on performance is illustrated in the following two examples. Additionally, the two examples also demonstrate the characteristic of path dependence.
Note: Only the Leverage component is used in the calculation
Costs of Constant Leverage Certificates
The strategy of a factor index (Long) involves multiple investments in the reference value according to the leverage factor. The costs of a Constant Leverage Certificate consist of two components.
The financing costs for a Long Factor Index are composed of the current daily interest rate plus a financing spread. As a result, the financing costs have a negative impact on the price of the product.
For a Short product, the reference value is sold short in accordance with its leverage factor. Combined with the financing spread, this amount is invested at the current daily interest rate, generating a return.
The second financing component, the index fee, is applicable to both long and short products.
Wide range of asset classes available
Constant Leverage Certificates are available for a variety of reference instruments from different asset classes. The represented asset classes span from stocks, stock indices, commodities, precious metals, interest instruments, currencies to volatility.
Advantages and Risks of Constant Leverage Certificates
Advantages of Constant Leverage Certificates
- Participation with constant leverage
- Volatility does not influence the price
- No fixed maturity (Open-End), issuer with right to terminate
- Simplified product selection, leverage as differentiator
Risks of Constant Leverage Certificates
- Market risk of reference instrument
- Leverage works in both directions
- Disproportionate losses up to total loss possible
- Not suitable for sideways moving markets and markets without steady price trends
- Intraday index adjustment during significant adverse performance of the reference instrument is akin to an immediate realization of losses. Any potential recovery in the future is thus hindered
- Issuer's right of termination: The issuer can terminate the products with a specific notice period, thereby ending the term and resulting in the repayment of the current value at the specified date.
- Currency risk, if the currency of the reference value differs from the products trading currency
- Issuer risk (issuer default)
FAQs
For what market expectation are Constant Leverage Certificates suitable?
The product works best if the reference instrument follows a clear, steady trend. Additionally, they are suitable for a short investment horizon (intraday or a few days).
Do the valuation times differ?
The valuation time depends on the asset class and the reference instrument. Therefore, there are different valuation times. An overview of the various valuation times can be found here.
What happens when the barrier is reached?
If the reference instrument reaches the barrier, an intraday index adjustment occurs. This results in a new reference instrument valuation price and a new barrier level in absolute values. This new valuation price serves as the basis for determining the subsequent performance.
In such a case, the intraday index adjustment occurs in addition to the regular daily valuation.
Why is path dependence an important feature of a Constant Leverage Certificate?
A factor index leverages the daily returns of a reference instrument. To calculate the factor index, the change in the reference value's price relative to the last valuation price of the reference instrument is relevant. Essentially, a new valuation price is determined on each trading day, serving as the basis for calculating the change in value for the following period.
Path dependence arises because the daily returns are linked together. The performance of a Constant Leverage Certificate is determined not only by the performance of the reference value at a specific point in time but also how that performance is achieved on the "path" to that point in different periods.