I. Basic risks
Changes in the activity of a market economy always influence prices of securities. Prices are fluctuating according to the rhythm of the economic activity. The duration and scope of the economic up and downturns are variable, as are the repercussions of those variations on the different sectors of the economy. In addition, the economic cycles vary depending on the different countries.
Failure to take these factors into account as well as a mistaken analysis of the development of the economy when taking an investment decision may lead to losses.
Devaluation of a currency may cause financial damage to an investor. Therefore, it is important to take into account the real value of the existing wealth of the investor as well as the real yield that ought to be realized through this patrimony. To calculate the yield, the real interest rate should be taken into account, that is the difference between the nominal interest rate and the inflation rate.
It may happen that a debtor, although solvent, happens to be unable to repay his loan and interest at expiration or even may completely default on the loan due to the unavailability of the foreign currency or to currency exchange controls.
Government risk includes the danger of economical as well as political instability. The ensuing unavailability of the foreign currency or currency exchange controls may indeed lead to defaults on payments for the investors.
Concerning securities issued in a foreign currency, the investor risks to receive loan repayments in a currency which turns out not to be convertible anymore because of exchange controls. There is no means to shield oneself against those risks.
Since currency exchange rates fluctuate, there is an exchange rate risk whenever securities are held in a foreign currency. Material elements affecting the exchange rate of a currency are the inflation rate of a country, the gap between domestic interest rates and foreign rates, the assessment of the evolution of the economic activity, the political situation in the world and the safety of the investments.
Additionally, internal political crises may weaken the exchange rate of the domestic currency.
Insufficient market liquidity may prevent investors from selling off securities at market prices. Fundamentally, a distinction has to be made between a lack of liquidity caused by market supply and demand and the lack of liquidity due to the characteristics of the security or the market practice.
A lack of liquidity due to market supply and demand arises when the supply or the demand for one security at a certain price is non-existent or extremely low. Under those circumstances, purchase or sell orders may either not be carried out immediately, or only partly or at unfavorable conditions. In addition, higher transaction costs may apply.
A lack of liquidity due to the inherent characteristics of the security or to market practice may occur, for example, because of a lengthy transcription procedure for a transaction of registered shares, long performance delays because of market practices or other limitations of commerce.
Such insufficient liquidity may also come up due to short-term liquidity needs that cannot be covered quickly enough by the sale of securities.
Irrational factors like, for example, tendencies, opinions or rumors may affect the overall performance of securities on stock exchanges. They may cause important drops in prices although future perspectives of the companies that are hit have not evolved unfavorably.
Credit-financed purchases of securities contain additional risks. On the one hand, supplementary collateral may be required in case the evolution of prices exceeds the credit limit guaranteed by a pledge. If the investor turns out to be unable to present such collateral, the bank may be forced to sell deposited securities at an unfavorable moment.
On the other hand, the loss incurred due to an unfavorable evolution of the price of a security may exceed the initial investment amount. Fluctuations of prices of pledged securities may influence the capacity to repay loans in a negative way. The investor needs to be aware that, as a consequence of the leverage factor accompanying the purchase of credit-financed securities, the sensitivity to price fluctuations of those investments will be proportionally higher. As a consequence, chances of gains increase, as do the risks of losses. Consequently, the risks of such purchases rise according to the importance of the leverage.
Structured products are financial instruments which are composed of two or more financial instruments. The risks associated with structured products are likely to be greater than the risks associated with each of the individual components. The investor must be provided with an adequate description of the financial instruments which are used to create a structured product and of the elevated risks associated with this type of investment.
Certain financial instruments utilize a guarantee which is provided by a third party. Information concerning such a guarantee must supply adequate details on the third party guarantor and the guarantee itself in order to ensure the investor has enough information to correctly evaluate the guarantee.
II. Specific investment risks
A bond is a certificate or evidence of a debt on which the issuing company or governmental body promises to pay the bondholders a specified amount of interest for a specified length of time, and to repay the loan on the expiration date. A bond may be in bearer or registered form. At issuance, the par value of one bond represents a fraction of the total amount of the loan.
The interest payments on bonds may be either fixed or variable. The duration of the loan as well as the terms and conditions of repayment are determined in advance. The purchaser of a bond (the creditor) has a claim against the issuer (the debtor).
The issuer risks becoming temporarily or permanently insolvent; entailing his incapacity to pay back interests or the loan. The solvency of an issuer may change depending on the general evolution of the economy and / or in consequence of changes related to the company, the economic sector of the issuer and / or political developments with economic consequences.
The deterioration of the issuer's cash flow does logically influence the price of the securities issued by the company.
The uncertainty concerning the evolution of market rates entails that the purchaser of a fixed-rate security carries the risk of a decrease of the price of a security in case of a rise in of those interest rates. The longer the duration of the loan and the lower the interest rate, the higher the sensitivity of the bonds to a rise in the market rates.
The issuer of a bond may include a provision allowing him to prematurely reimburse the bondholder in case of a decrease of the market rates. Thus, the expected yields may incur modifications unfavorable to the investor.
The expiration of bonds that are redeemable by lot is difficult to determine. Thus, unexpected changes may take place in the yield of the bonds.
Concerning some kinds of bonds, additional risks may exist: e.g. floating rate notes, reverse floating rate notes, zero coupon bonds, foreign bonds, convertible bonds, indexed bonds, subordinated bonds etc.
For those types of bonds, the investor should make inquiries about the risks by means of the issuance prospectus and not purchase such securities before being certain to master all risks.
For subordinated bonds, investors ought to enquire about the ranking of the debenture compared to other debentures of the issuer. Indeed, in case of a bankruptcy of the issuer, those bonds will only be reimbursed after repayment of all higher ranked creditors.
Reverse convertible bonds include the risk that the investor will not be entirely reimbursed, but will receive only an amount equivalent to the underlying securities at maturity.
A stock certificate represents the rights of the stockholder in a company. Stock may take bearer or registered form. One share of stock represents a fraction of the legal capital of a corporation.
A share purchaser does not lend funds to the company, but makes a capital contribution and, as such, becomes a co-owner of the corporation. He is participating in the development of the company as well as in the chances of profits and losses. Therefore, the precise yield of such investment cannot be easily forecast.
An extreme situation would consist in the bankruptcy of the issuing company, which would have as a consequence the complete loss of the invested amount.
Stock prices may undergo unforeseeable price fluctuations causing risks of losses. Increases and decreases of prices in the short, medium and long-term alternate without it being possible to determine the duration of those cycles.
The general market risk must be distinguished from the specific risk attached to the company itself. Both risks, together or separated, influence the evolution of share prices.
The dividend of a share mainly depends on the profit realized by the issuing company. Therefore, in case of low profits or even losses, it may happen that dividend payments are reduced or that no payments are made.
Bonus certificates represent patrimonial rights as exposed in the terms and conditions of those bonds. In general, they come in the form of par value debt instruments that entitle their holder to a part of the profit of the company.
In case of losses by the issuing company, interest payment may be halted if no minimal interest payment has been provided for. In addition, the repayment of the principal may be reduced.
The bankruptcy of the issuer has as a consequence the complete loss of the invested funds.
An investment fund is a company which is collecting funds from a certain number of investors and which is engaged in reinvesting those funds according to the principle of risk spreading and to make its stockholders or members benefit from the results of its asset management.
Since the yield of investment fund shares depends, among other factors, on the capacities and on the decision-making of the managers, faulty decisions directly lead to losses.
Investment fund shares support the risk of a drop in their prices, this drop reflecting the decrease in value of the securities or currencies that compose the asset portfolio of the fund. The higher the diversification of the fund, the lower the risk of losses. Inversely, risks are more important for more specialized and less diversified investments.
It is therefore important to pay attention to the general and specific risks attached to securities and currencies contained in the fund. The investor may get information about a fund by consulting, among others, its prospectus. Upon request, the investor will be informed where a specific prospectus is available to the public.
Derivatives are securities, the value of which varies according to the value of the underlying asset; the underlying asset may be a market index, an interest rate, a currency, the price of raw materials, another derivative or any instrument described hereabove under II. A to II. D.
Concerning derivatives, a distinction must be made between:
a) option transactions, which give the holder the right, but not the obligation, to enter into a transaction. One party (the seller of the option) is irrevocably bound to perform while the other one (the purchaser of the option) is free to exercise the option or not;
b) forward transactions, where the parties enter into a transaction which will have to be performed at a specified date in the future. In a forward transaction, parties bind themselves irrevocably to perform the transaction as provided for at the specified date.
a) Option transactions
Options are derivative instruments; the value of which evolves proportionally to the evolution of the value of the underlying asset. The purchaser of an option receives, after having paid a premium to his counterpart, the seller of the option, the right to purchase (call) or to sell (put) the underlying asset at maturity or during a certain period for a base price.
Options may be traded at stock exchanges or over-the-counter. They follow the law of offer and demand. An important point for the determination of the price of an option consists, on the one hand in the liquidity of the market, and on the other hand on the real or expected evolution of the price of the underlying asset.
A call option loses value when the price of the underlying asset decreases, whereas the opposite is true for put options. The price of an option does not solely depend on the price modification of the underlying asset. Other factors may come into play, like the duration of the option or the frequency and intensity of the modifications of the value of the underlying asset. Consequently, drops in the option premium may appear although the price of the underlying asset remains unchanged.
Due to the leverage effect, price modifications of the option premium are generally higher than the changes in price of the underlying asset. Thus, the holder of an option may benefit from high gains as well as he may incur high losses. The risk attached to the purchase of an option increases with the importance of the leverage.
The purchase of an option represents a highly volatile investment. The likelihood that an option arrives at maturity without any value is relatively high. In this case, the investor loses the option premium as well as commissions paid for the purchase of the option. The investor has three choices: he may maintain his position until maturity, he may try to get rid of the option before maturity, or, only for "American" options, exercise the option before maturity.
The exercise of the option may either entail the payment of the difference between the strike price and the market price or the purchase or the delivery of the underlying asset. In case the option's subject consists in a futures contract, its exercise causes the taking of a position in futures, which supposes the acceptance of some obligations concerning security margins.
The sale of an option requires, generally speaking, higher risk-taking than its purchase.
Indeed, even if the price obtained for an option is fixed, the losses that the vendor incurs may be potentially unlimited.
If market prices of the underlying asset vary in an unfavorable way, the seller of the option will have to adapt his security margins in order to maintain his position. If the sold option is "American" type, performance may be required from the seller at any moment until expiration. If the subject of the option is a futures contract, the seller will take a position in futures and will have to respect his obligations concerning security margins.
The seller's risk exposure may be reduced by keeping a position on the underlying asset (securities, index or other) corresponding to the sold option.
b) Other forward transactions
Futures are contracts traded on a regulated exchange. They are standardized as regards the quantity of the underlying asset and as regards the expiration date of the transaction. Over-the-counter (OTC) or forward contracts are contracts that are not traded at a stock exchange and which may be standardized or individually negotiated between purchaser and seller.
Despite a rise of the price of the contract or the underlying, the forward seller will have to deliver the underlying asset at the initially agreed upon price, which may be a lot lower than the current price. For the seller, the risk equals the difference between the price agreed upon in the contract and the market value at the settlement date. As the market value may theoretically rise in an unlimited manner, the loss potential for the seller is unlimited and may considerably exceed the required margins.
In case the value of the contract or the underlying asset decrease, the forward purchaser will still have to accept the asset at the price agreed upon in the contract which can be potentially very much higher than the current market value. Therefore, the seller's risk consists in the difference between the price agreed upon in the contract and the market value at delivery. Thus, the maximum the purchaser may lose is the initially agreed upon price. This loss may however exceed by far the required margins.
Transactions are regularly evaluated (mark-to-market). The investor will need to have constantly at his disposal a sufficient margin cover. In case the margin becomes insufficient during the forward transaction, a variation margin will be required from the investor at very short notice. If the investor defaults, the transaction will be liquidated before due term.
In order to limit excessive price fluctuations, a stock exchange may fix limits for certain contracts. The investor has to keep in mind that it may be very difficult if not momentarily impossible in such a case to sell off the contract. Thus, every investor should, before entering into a forward contract, make an inquiry concerning the existence of such limits.
It will not always be possible (depending on the market and the terms and conditions of the transaction) to sell off contracts at any moment in order to avoid or to reduce the risks of a current transaction.
Stop-loss transactions, if they are possible, may only be performed during office hours. They do not allow to limit losses to the indicated amount, but they will be performed once the limited amount is attained and they become at that moment at best orders.
To sell an asset without owning it at the conclusion of the contract (short sale) entails the risk that the seller will have to buy the underlying asset in an extremely unfavorable market in order to be able, at settlement, to perform and to effectively deliver the underlying.
The market for standardized OTC transactions is in general liquid and transparent. Therefore, the selling off of contracts can normally be done.
However, no market exists for OTC transactions that are not standardized. That is why the liquidation is only possible with the agreement of the other party.
An "alternative investment" consists in an investment in domestic and foreign investment funds the style of which is completely different from traditional investments in stock and bonds. Hedge funds are the most usual alternative investments. Their investment style often comprehends short sales, leverage effects and derivatives. Investments in private equity funds are also included in this category (venture capital, financing of acquisitions of companies). The word offshore funds points to investment funds located in offshore centers, like for example the Bahamas, Bermuda, the Cayman Islands and Panama.
In this domain, investment strategies may be linked to high risks. For example, by using the leverage effect, a slight change of the market may lead to important gains and losses. In some situations, the entire investment may be lost.
Very often, investors in alternative investments only have very little information at their disposal. The sometimes very complex strategies of the investment funds frequently lack transparency for investors. Strategic changes that may lead to a significant increase of the risks often remain unclear or even completely underestimated by investors.
Alternative investments may be more or less liquid. Sometimes, liquidity is very poor. Thus, share redemption for hedge funds will only either be possible monthly, quarterly or annually. Concerning private equity funds, the lock-up period may last up to 10 years or more.
An important number of funds in this sector are located in offshore centers (offshore funds). Frequently, those offshore centers only impose minimal regulations on the funds. As a consequence, numerous problems or delays may appear during the carrying out of buy or sell orders for which the bank cannot be held liable. The non-violation of the investor's rights is not systematically guaranteed.
The investor interested in alternative investments and notably offshore funds needs to be conscious of those risks. Before proceeding, the actual investment products should be carefully examined.
This document does not pretend to describe all risks inherent to investments in financial instruments. Its objective is rather to give basic information and to caution clients concerning the risks inherent to all investments in financial instruments. The client should not enter into any investment transaction before being sure to master all the risks and having adapted his investments to his assets and needs.
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