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Loss threshold exceeded with a constant leverage certificate

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Vontobel Markets
11/01/20223 min read
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Have you sustained losses with a constant leverage certificate? Would you like to know why the constant leverage certificate is seeing disproportionate losses compared with the underlying reference instrument (for example, equities, indices, currencies or commodities) when there are strong price movements in the opposite direction? Why did you sustain losses although you bet on the right market movement? What does an intra-day index adjustment do? Here you can find out what an intra-day index adjustment means for you after the loss threshold (or barrier) has been exceeded.

By their nature, price fluctuations of underlying reference instrument have a much stronger effect on leverage products, which intensify movements through a built-in leverage or factor. This leads to disproportionate losses for you as an investor if you bet on the “wrong direction.”

As an example, we will assume that the price of a reference instrument (benchmark) falls by 10 percent within one day. As an investor in a constant leverage certificate with a 10x factor index related to this underlying reference instrument, you would suffer a complete loss of the invested capital as 10x 10% = 100%. To prevent this from happening, factor certificates are provided with a price threshold, which also is called barrier. It describes the maximum permissible negative price change of the reference instrument compared to its last valuation price before an intra-day index adjustment is made. A new valuation price is determined, and a new (assumed) index calculation day begins.

Even though a total loss can be avoided, it is important to note that an intra-day adjustment is equivalent to realizing the losses have occurred, since further participation in the price changes of the reference instrument now takes place from the new level of the factor index. A recovery to the original price is difficult to achieve.

Despite the fact that a total loss can be avoided, it is important to note that an intra-day adjustment is equivalent to realizing the losses have occurred, since further participation in the price changes of the reference instrument now takes place from the new level of the factor index. A recovery to the original price is difficult to achieve.

A fictitious example

A Bull (long) constant leverage certificate a leverage factor of x8 on an underlying share (the reference instrument). The threshold is at 90 percent - a 10 percent difference.

Day 0:

The share price and the price of the factor index are initially at EUR 100.00. This puts the threshold at EUR 90.00.

Day 1a:

The price of the share initially falls (intra-day) by 12.5 percent to EUR 87.50 during the trading day. Because of the integrated 8x leverage, the factor index would fall to EUR 0.00 (8 x 12.5%) without the loss threshold and would lose its entire value. The threshold of a 10 percent difference effectively ensures that when the threshold is exceeded, the loss in the reference instrument is realized by an intra-day index adjustment, namely the factor index initially falls by this adjustment from EUR 100.00 to EUR 20.00 (8x 10%), and the new reference instrument threshold (barrier) is now at EUR 81.00 (90 percent of the new share price at the time of index adjustment). The further 2.5 percent losses of the benchmark continue to reduce the value of the factor index without, however, triggering another intra-day index adjustment.

Day 1b:

After the share has suffered a 12.5 percent loss, it recovers on the same day and closes at EUR 94.50. Starting at the last valuation price of EUR 90.00 for the share, this is an increase of 5 percent. For constant leverage certificates, this performance is also multiplied with the factor and, starting at the new valuation price of EUR 94.50, the certificate rises by 40 percent to EUR 28.00.

Day 2:

On the following day, the share price rises from EUR 94.50 to its original price of EUR 100.00, recording a 5.82 percent increase. The constant leverage certificate rises from EUR 28.00 to EUR 41.04.

Illustration of an intra-day index adjustment

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Summary:

The certificate is substantially lower than at the beginning, although the share price did not change over the period. The reason is that the share price fell below the barrier even though it only fell temporarily. Consequently, the performance of the constant leverage certificate was calculated based on the new valuation price and traded lower at the end than at the beginning.

Constant leverage certificates allow you to benefit in a simple, efficient way from stable rising or falling price trends. They can offer interesting opportunities to short-term investors with an affinity to risk. Not only the opportunities but also the high risks should always be taken into account before making a decision to invest in constant leverage certificates.

Risks

Important Notice

Investors in the products are exposed to the risk that the Issuer or the Guarantor may not be able to meet its obligations under the products. A total loss of the invested capital is possible. The products are not subject to any deposit protection.

The value of the products can fall significantly below the purchase price due to changes in market factors, especially if the value of the underlying asset falls. The products are not capital-protected

Due to the leverage effect, there is an increased risk of loss (risk of total loss) with leverage products, e.g. Bull & Bear Certificates, Warrants and Mini Futures.

Product and possible financing costs reduce the value of the products.

If the product currency differs from the currency of the underlying asset, the value of a product will also depend on the exchange rate between the respective currencies. As a result, the value of a product can fluctuate significantly.