Discount Certificates: How they work
Discount certificates feature a discount compared to the underlying asset at the time of issue. The reduced issue price shows its strengths when the market environment is stagnant or slightly positive, as it cushions possible price losses. However, the profit potential is limited by the cap. The level of the cap determines the price discount compared to the price of the underlying and can be set below, at or above the current price of the underlying. Here, the level of the cap determines whether the discount certificate is defensive, neutral or offensive.
How Discount Certificates work
Discount certificates are particularly well suited to stagnating or moderately rising market phases. In such a market environment, investors can achieve higher returns with discount certificates than with a direct investment in the underlying asset. At the end of the term, discount certificates pay out at most the cap determined at the beginning of the term.
The redemption conditions depend on the price of the underlying asset at the time of the final fixing. If the price of the underlying asset of a discount certificate is above or at the strike price at the time of the final fixing, the certificate is redeemed at its nominal value. In this case, the investor achieves the maximum return in the amount of the cap.
Conversely, if the price of the underlying closes below the strike price, a defined number of shares in the underlying are physically delivered or a cash settlement corresponding to the final fixing price of the underlying is paid.
Structure of a discount certificate
A discount certificate can be constructed with the purchase of a Low Exercise Price Option (LEPO) and the sale of a call option. The construction of such a position corresponds to a covered call writing strategy in which the purchase of a share is combined with the simultaneous sale of a call option on the same share.
Factors influencing pricing
It is not only the level of the cap that determines the discount, but also the factors that influence the level of the option price. These include, in particular, implied volatility (the range of fluctuation expected in the market) and the duration. Higher implied volatility tends to have a positive effect on the option price (for both call and put options). For this reason, higher discounts and therefore higher maximum returns can be granted by selling the call option with higher implied volatility. At the same time, however, changes in volatility have an impact on the price performance of discount certificates that have already been issued.
Advantages and risks
Advantages
- In the event of a sideways movement or moderate price losses in the underlying asset, investors can achieve better results with a discount certificate than with a direct investment
- The discount serves as a buffer against price losses
Risks
- Investors only participate in positive price performance up to the maximum return (cap)
- No participation in dividends or other payouts on the underlying asset
- Issuer risk
FAQ
How is the discount financed?
The reduced issue price (discount) is created by the components contained in a discount certificate. The discount on the Low Exercise Price Option (LEPO) and the option premium received from the call option sold provide the necessary funds to finance the discount. A LEPO is an option whose exercise price is very low (close to zero).
What is the relationship between maximum return and discount?
There is a negative connection between the level of the discount and the maximum yield (cap) that can be achieved with the certificate - this means that the higher the strike price is set, the higher the maximum yield that can be achieved, whereby the discount is lower. High discounts, on the other hand, require a correspondingly low maximum return.