Financial instruments and related risks

Transcription

1 Financial instruments and related risks Foreign exchange products Money Market products Capital Market products Interest Rate products Equity products Version 1.0 August 2007

2 Index Introduction... 1 Definitions... 2 Risk definition... 2 General... 2 Option-related features... 3 List of abbreviations... 4 Risk of losing entire investment... 4 Tax Treatment... 4 of financial instruments: FX... 5 Complexity Commercial Paper (CP)... 5 Certificate of Deposit (CD)... 6 Bills... 7 Bonds... 8 Complexity Floating Rate Certificate of Deposit Floating Rate Bills Futures Options Callable/Putable Bond Convertible bond Reverse convertible bond Linked bond Floater Complexity Target Redemption Note (TARN) Snowball Interest Rate products...22 Complexity MM Loans MM Deposit Complexity Forward Rate Agreement (FRA) Interest Rate Future Interest Rate Swap (IRS) Cross-Currency Interest Rate Swap (CCIRS) Cap/Floor (plain vanilla) Complexity Interest Rate Swap Complex variants Barrier Options Financial instruments and related risks

3 Linked products (equity, commodities, credits, )...36 Complexity Share Basket Index Funds Complexity Warrant Cliquet Average Rate Option (ARO) Commodity swap Commodity Forward Commodity option (plain vanilla) Complexity Knock-in/Knock-Out Average Rate Option (equity linked) Barrier Option (equity linked) Digital Option (equity linked) Barrier Option (commodity linked) CDS: Credit Default Swap (credit linked structure) CDO: Collateralised Debt Obligation (credit linked structure) Foreign exchange on Money Market products...52 Complexity FX Spot Trade FX Swap FX Forward Complexity FX option (plain vanilla) Average Rate Option (ARO) Complexity Barrier option Digital option Trigger Reset Forward (structure) Transatlantic forward (structure) Financial instruments and related risks

4 Introduction This document describes the nature of the financial products that are distributed by KBC, and their associated risks, in order to enable the client to take investment decisions on an informed basis. It is first and foremost intended for hedgers and investors that are in direct contact with the KBC Bank Ireland Plc dealing room. The financial instruments are grouped in different product classes based on the type of underlying asset: Foreign Exchange products (FX) Interest Rate products (IR) Fixed Income instruments (FI) Other (including credit, equity and commodity related products) For each type of financial instrument, the brochure describes the main features, the risk profile and also provides an overview of the variants of the basic products. The financial products are grouped in levels of complexity, ranging from 1 (non-complex dealing room products) to 3 (structures). The more complex financial instruments are linked to a higher level of complexity. Please note, however, that a higher level of complexity does not automatically mean that the risk associated with the financial instrument is higher. KBC Bank Ireland Plc has defined three levels of complexity in order to make it possible to assess the knowledge and experience a client requires for every possible combination of product class and complexity. Product Class\Complexity Level 1 Level 2 Level 3 FX IR FI Other The volatility and leverage of the financial instruments have been assessed from the perspective of a hedger. These risk profiles may differ considerably if seen from a speculative point of view. This brochure defines three types of investment: 1) Hedging: the conclusion of a contract with the same amounts and duration as a predetermined underlying risk. The purpose of the use of financial instruments is to eliminate the possible negative impact on the results of that risk. The use of financial instruments like options has a cost (premium), but from the point of view of the entire position of a hedger, there is no risk of losing the entire underlying amount. 2) Active risk management: the managing of underlying risk positions by keeping them temporarily open or hedging them partially or by concluding hedging contracts with durations and amounts that exceed the underlying risk. The risk related to active risk management lies between the risks associated with hedging and speculation. 3) Speculation: the conclusion of contracts that have little or no relation to the underlying risk positions, intended to make profit on the respective market. The investor runs the risk of making significant losses. Additionally, the premium paid for setting up the trade can be entirely lost if the contract is not exercised. Financial instruments and related risks 1

5 Definitions Risk definition Liquidity risk/limitations on the available market Risk that a financial counterparty will fail to fulfill its obligations. In most cases, this will be because of its poor financial status or imminent bankruptcy. Risk that an instrument may prove difficult to be dealt in at a reasonable price (prior to maturity). Risk that the value of an investment or product is impacted by currency movements. Risk that the value of an investment or product is impacted by interest rate fluctuations. Risk that the value of an investment or product is impacted by inflation. Risk that the value of an investment or product is impacted by external factors, such as the tax regime, etc. General OTC ( over the counter ) Financial instruments traded over the counter are instruments that are traded outside a regulated market. Leverage The degree that the price of a financial instrument changes due to a change in the price of the underlying assets. The variability of the price of a security, fund, market or index over a given period of time. Deliverable The contract is settled through delivery of the underlying assets (physical settlement). Cash settled The contract is settled in cash (in a major currency), as opposed to being physically delivered. Non-deliverable The contract is settled in cash (in a major currency), because the underlying currency is non-convertible. Financial instruments and related risks 2

6 Option-related features The features are typical properties of optional financial instruments ( 2 or above). European A property of a contract or feature meaning that it can be exercised only at maturity. American A property of a contract or feature meaning that it can be exercised during the entire duration of the contract. Barrier A barrier is a predetermined boundary or limit in the market, potentially impacting the outcome of a contract. By using barriers, different contract features can be defined: Single: the outcome of the contract is potentially impacted by one barrier Double: the outcome of the contract is potentially impacted by two barriers Standard: the barrier is applicable during the entire life of the contract Partial: the barrier is only applicable during part of the life of the contract (window) Knock-in A feature where a provision is included in a contract suspending its operation until a specific condition is fulfilled (suspensive condition). Knock-out A feature where a provision is included in a contract suspending its operation at the moment that a specific condition is fulfilled (dissolving condition). One touch A feature of a contract where a predetermined payout will be made, provided that a certain predetermined level is hit. No-touch A feature of a contract where a predetermined payout will be made, provided that a certain predetermined level is not hit. Range A feature of a contract where the outcome of the contract depends on the market rate either staying within predetermined levels or exceeding those levels in either direction. Financial instruments and related risks 3

7 List of abbreviations FX FI IR MM CM OTC Foreign exchange Fixed Income Interest Rate Money Market Capital Market Over The Counter Risk of losing entire investment Depending on the perspectives of the client, the risk of losing the entire investment should be considered in light of the risks associated with the underlying positions (see Introduction ). Tax Treatment The tax treatment of financial instruments depends on the characteristics of the financial product, the individual circumstances of each client and may differ from one country to another. Clients who are in any doubt as to their tax position should consult their financial or own independent tax advisers. In addition, potential purchasers should be aware that tax regulations and their application by the relevant tax authorities change from time to time. Accordingly, it is not possible to predict the precise tax treatment that will apply at any given time. Financial instruments and related risks 4

8 of financial instruments: FX Complexity 1 Commercial Paper (CP) Commercial paper is a short-term, unsecured, debt instrument, issued by large companies (institutional borrowers) in order to satisfy immediate cash needs or to finance accounts receivable, inventories, etc. Companies, which issue commercial paper, must fulfill the relevant statutory financial requirements. Depending on the CP, a guarantee can be included (see prospectus) (depending on interest-rate trends and supply and demand) 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Depending on the rating of the issuer) (linked to FX transactions) Financial instruments and related risks 5

9 Certificate of Deposit (CD) A Certificate of Deposit is a short- or medium-term, interest-bearing, debt instrument issued by credit institutions. In exchange for the deposit, credit institutions offer higher rates than most comparable investments. Depending on the CD, a guarantee can be included (see prospectus), depending on interest-rate trends and supply and demand 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Depending on the rating of the issuer) (linked to FX transactions) Financial instruments and related risks 6

10 Bills A Bill is a short- or medium-term, interest-bearing, debt instrument issued by a government. In exchange for the deposit, interest is paid to the lender. 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) There are many examples of bills, all issued by governments. Some include: Treasury Bills (T-bills) A treasury bill is a negotiable security issued by the US government, at a discount from face value, with a maturity of one year or less. Treasury certificates Treasury certificates are short-term debt securities issued by the Belgian Treasury. Financial instruments and related risks 7

11 Bonds A bond is a debt instrument where the bond holder lends money to the issuer (company or government) for a predetermined period of time and at a predetermined interest rate. The issuer pays interest (coupon) on predetermined dates and repays the principal amount on the maturity date. (for some exceptions there is no mandatory prospectus) 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the rating of the issuer) Financial instruments and related risks 8

12 The list of variants below is not exhaustive: Public A public bond is a bond issued for a large number of investors (a prospectus is issued). It is also accessible to small investors. Private A private bond is a bond issued to a limited number of investors (no prospectus) Government bond A government bond is a bond issued and fully guaranteed by a government Zero (coupon) bond A zero coupon bond is a bond where there are no interest rate payments. The bond is traded at a discount price and the full principal amount is repaid on the maturity date. Capital guaranteed A capital guaranteed bond is a bond where the principal and sometimes the interest payments are guaranteed by a third party. Floating rate bond See Structures - Floaters (Complexity 2) Step-up/Step-down A step-up bond is a bond where the interest rate increases/decreases over the life of the bond. Different coupon frequency A bond with different coupon frequency is one where interest is not paid on a regular basis. Perpetual A perpetual bond is a bond with no maturity date. Coupons are paid forever and the principal amount is not paid back. In most cases, a perpetual bond includes a call option for the issuer to terminate the contract. Senior/subordinated bonds Senior bonds have higher priority in case of liquidation. The holders of senior bonds are paid before the holder of subordinated bonds. Because of the higher risk, subordinated bonds usually have a lower credit rating than senior bonds. Linked bonds See Structures Linked bonds (Complexity 2) Financial instruments and related risks 9

13 Complexity 2 Floating Rate Commercial Paper Floating Rate Commercial Paper is a debt instrument whose interest rate is adjusted periodically based on a selected index. Depending on the CP, a guarantee can be included (see prospectus) (depending on interest-rate trends and supply and demand) 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Depending on the rating of the issuer) (linked to FX transactions) Financial instruments and related risks 10

14 Floating Rate Certificate of Deposit A Floating Rate Certificate of Deposit is a certificate of deposit whose interest rate is adjusted periodically based on a selected index. Depending on the CD, a guarantee can be included (see prospectus), depending on interest-rate trends and supply and demand 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Depending on the rating of the issuer) (linked to FX transactions) Financial instruments and related risks 11

15 Floating Rate Bills A Floating Rate Bill is a bill whose interest rate is adjusted periodically based on a selected index. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) See standard bills Financial instruments and related risks 12

16 Futures A bond future is an agreement between two parties to purchase/sell (on an organised exchange) a certain amount of bonds at a predetermined price on a specified date in the future., depending on the nature and volatility of the underlying bonds. No 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 13

17 Options A bond option gives the buyer the right, but not the obligation to buy (call) or to sell (put) an agreed amount of bonds at a predetermined price on a specific date (European type option) or up to a specific date (American type option). The seller (or writer) of a bond option has the obligation, if the buyer of the option exercises his right, to deliver or to buy the agreed amount of bonds at the predetermined bond price. To obtain this right, the buyer of the bond option pays a premium to the seller. Costs may be attached to trading the underlying assets. These cost can be avoided by closing the market positions with closing transactions (close sale), which is caused by developments in, and speculation on, the price of the underlying assets. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 14

18 Callable/Putable Bond A bond with a call option is one where the issuer retains the right, but not the obligation, to redeem the bond at a predetermined date prior to the original maturity date of the bond. The issuer has a call option on the bond. A bond with a put option is one where the holder has the right, but not the obligation, to have the bond redeemed at a predetermined date prior to the original maturity date of the bond. The holder effectively has the right to sell the bond back to the issuer, i.e. a put option. - in line with interest rate trends 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) The risk is higher than the risk associated with a normal bond (risk proportional to embedded option) Financial instruments and related risks 15

19 Convertible bond A convertible bond is a bond that may, at the request of the holder, be converted into shares in the company concerned, within a certain period and at conditions determined in advance. The conversion price (i.e. the price at which bonds may be converted into shares) is fixed in advance and is not affected by changes in the price of the underlying shares. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) No heightened risk of losing invested money if the share value drops below the bond value Financial instruments and related risks 16

20 Reverse convertible bond A reverse convertible bond is a bond which may, at the request of the issuer, be converted into cash or shares in the company concerned, at maturity at the price agreed at the time of issue. Issuers will take the latter option if shares are quoted below the conversion price at maturity. To offset this risk of a capital loss, investors receive a high rate of annual interest. Reverse convertible bonds have a short term to maturity. The conversion price (i.e. the price at which bonds may be converted into shares) is fixed in advance and is not affected by changes in the price of the underlying shares., since investors will face a capital loss if the price of the underlying shares falls. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) As the bond can be converted into shares, the risk of losing invested money is higher if the share value dropped below the bond value Financial instruments and related risks 17

21 Linked bond A linked bond is a bond where the payment of interest (coupons) is linked to the value of another asset. (in some cases, there is no mandatory prospectus) 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the rating of the issuer) Inflation linked bond A bond whose return is indexed to inflation. Index linked bond A bond whose return is indexed to a specific index. Equity linked bond A bond whose return is determined by a single equity security, a basket of equity securities or an equity index. Financial instruments and related risks 18

22 Floater A floating rate bond is a bond with a variable interest rate, which is calculated based on a money market reference rate (like EURIBOR) and a predetermined spread. (in some cases, there is no mandatory prospectus) 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the rating of the issuer) Range floater/range note A bond whose coupon rate depends on the number of days that a reference rate stays within a predetermined rate. Reverse floater A bond whose coupon rate has an inverse relationship with market conditions (short-term interest rates). If the underlying interest rate increases/decreases, the coupon rate decreases/increases. Also known as an "inverse floater". Financial instruments and related risks 19

23 Complexity 3 Target Redemption Note (TARN) A target redemption note is a note where the coupons are based on a floating index. The contract terminates on the maturity date or can be terminated early when the accumulated coupon has reached a predetermined target cap (= guaranteed sum of coupons). Term sheet 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 20

24 Snowball A snowball is a bond where consecutive coupons are calculated based on the previous coupon plus (bullish) or minus (bearish) a floating index spread. Term sheet 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) Callable The contract can be terminated by the issuer. Combined with TARN feature See above. Financial instruments and related risks 21

25 Interest Rate products Complexity 1 MM Loans With a MM loan, a lender provides funds to a borrower who agrees to repay these funds, along with interest, at a predetermined date in the future. (Not within the scope of the MiFID) Depending on the contract, the lender can request for a guarantee 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Forward forward loan A forward forward loan is an arrangement by one party to lend an amount of money to another party at an agreed rate and date in the future for a specified period of time. Fixed-rate loan A fixed-rate loan offers a fixed rate of interest. Variable-rate loans With a variable-rate loan, the interest rate is adjusted periodically based on a selected index (such as LIBOR, EURIBOR, etc.). Amortising loan An amortising loan is a loan where the principal or notional amount (and interest payments) decreases in steps over the duration of the loan. Financial instruments and related risks 22

26 MM Deposit A MM deposit is a transaction involving a placement of funds. The depositor receives interest on the deposited amount. (Not within the scope of MiFID) 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Forward forward deposit A forward forward deposit is an arrangement by one party to place a deposit with another party at an agreed rate and date in the future for a specified period of time. Fixed-rate deposit A fixed rate deposit offers a fixed rate of interest. Variable-rate deposit With variable rate deposits, the interest rate is adjusted periodically based on a selected index (such as LIBOR, EURIBOR, etc.). Amortising deposit An amortising loan is a loan where the principal or notional amount (and interest payments) decreases in steps over the duration of the loan. Financial instruments and related risks 23

27 Complexity 2 Repo A repurchase transaction (a repo) is a transaction where one party (the Seller ) agrees to sell securities and financial instruments ( Securities ) to the other party (the Buyer ) securities and financial instruments ( Securities ) against payment of an agreed price. The Buyer agrees to resell to the Seller Securities equivalent to the original Securities at a certain date or on demand against payment of the original value of the Securities, plus a return on the use of the cash (the repo rate ). 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Financial instruments and related risks 24

28 Standard Standard variant Tri-party agreement A tri-party agreement involves a third party (a clearing house or custodian bank) which handles the administrative aspects of the repo between Seller and Buyer. Reverse standard This is a reverse repo agreement that involves a third party (a clearing house or custodian bank) which handles the administrative aspects of the repo between Seller and Buyer. Reverse tri-party A tri-party is a reverse repo agreement that involves a third party (a clearing house or custodian bank) acting as custodian between the cash borrower and the cash lender. Buy/Sellback A buy/sellback transaction is similar to a repo, i.e. an agreement between two parties first to sell securities and then to buy them back at an agreed future date. The main differences with a repo are that: (1) a buy/sellback transactions combines 2 transactions executed simultaneously and (2) the buyer keeps the income (coupon) payment on the securities, but takes it into account when calculating the sellback price. Financial instruments and related risks 25

29 Forward Rate Agreement (FRA) The FRA is an agreement between two parties about the interest rate for a specified period of time in the future. It is similar to a forward forward, but no actual loan or deposit is made on the start date of the contract. Instead the parties will settle at the starting date of the hypothetical deposit or loan. The gain or loss in cash is the discounted value of the difference between the contracted forward interest rate and a reference rate, calculated on the notional amount of the FRA. The contract will determine the rates to be used along with the termination date and notional value. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Financial instruments and related risks 26

30 Interest Rate Future An IR future is an agreement between two parties to purchase/sell a specific amount of an interest bearing instrument at a predetermined price and date in the future. No 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Short-term Interest Rate Future (STIR Future) A short-term interest rate future is a futures contract written on an underlying interest-rate instrument with a short-term maturity. STIR Futures are cash settled. Bond futures A futures contract on a bond (cash or physically settled) Financial instruments and related risks 27

31 Interest Rate Swap (IRS) An interest rate swap is a financial contract between two parties that wish to exchange two interest rate payments. Generally, a fixed interest rate payment is exchanged for a variable interest rate payment ('fixed against floating'), but both interest rate payments can also be variable ('floating against floating ). Interest payments are made in the same currency. No exchange of principal occurs and the parties contractually agree to meet or exchange each other's interest payments. (Proportional to maturity) 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) if the frequency is not the same for the two interest rate payments (Proportional to maturity) Financial instruments and related risks 28

32 Forward start A forward start IRS is a swap transaction which is entered into today, but does not start until some future date, e.g., a three year two year forward interest rate swap begins two years from now and ends five years from now. Zero coupon A zero coupon swap is an IRS where the fixed rate payments are not made periodically throughout the life of the swap. Instead, only one fixed payment is made on the expiry date of the swap, whereas floating payments are made periodically throughout the life of the swap. Zero coupon swaps have a high credit risk for the party that receives the fixed payment. Year on year A zero coupon swap is an IRS where the fixed rate payments are made on a yearly basis. Compounding swap A compounding swap is an IRS where the fixed rate payments are not made on every fixing date, but where a number of payments are capitalised. Payments are made on predetermined dates during the life of the contract. Fixing up front The fixing of the floating Interest rate is done at the beginning of the contract. In arrears The fixing of the floating rate is not made at the beginning, but at the end of the fixing period. Amortising IRS An amortising IRS is an IRS where the principal or notional amount (and interest payments) decreases in steps over the duration of the swap. Constant Maturity Swap (CMS) A Constant Maturity Swap is a variation of the regular interest rate swap, where the floating interest portion is reset periodically according to a fixed maturity market rate of a product with a duration extending beyond that of the swap's reset period. Financial instruments and related risks 29

33 Cross-Currency Interest Rate Swap (CCIRS) A cross-currency interest rate swap is an interest rate swap in which the cash flows are in different currencies. Upon initiation of a cross-currency swap, the counterparties can make an initial exchange of notional principal amounts in the two currencies. During the life of the swap, each party pays interest (in the currency of the principal received) to the other. And when the swap matures, the parties make a final exchange of the initial principal amounts, reversing the initial exchange at the same spot rate. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) to (Depending on specifications/characteristics of the contract) (Proportional to maturity) Financial instruments and related risks 30

34 With initial and final exchange This variant has a low currency risk. Without initial exchange This variant has a high currency risk (as it is a long-term outright forward contract). Forward start A forward start CCIRS is a swap transaction which is entered into today, but does not start until some future date, e.g., a three year two year forward interest rate swap begins two years from now and ends five years from now. Fixing up front The fixing of the floating Interest rate is done at the beginning of the contract. In arrears The fixing of the floating rate is not made at the beginning, but at the end of the fixing period. Amortising CCIRS An amortising CCIRS is a CCIRS where the principal or notional amount (and interest payments) decreases in steps over the duration of the swap. FX reset An FX Reset is a CCIRS where - in each reset period - the amount of the floating leg is reset to the actual FX spot rate. As a result, the credit risk is lower than with a normal CCIRS. Financial instruments and related risks 31

35 Cap/Floor (plain vanilla) Cap A Cap is an interest rate option where, in the event that the market reference rate (e.g., EURIBOR, LIBOR) is higher than the cap rate, the holder receives the difference between both on the settlement date. When the market rate is lower than the cap rate, the seller makes no payment. Floor A Floor is an interest rate option where, in the event that the market reference rate (e.g., EURIBOR, LIBOR) is lower than the cap rate, the holder receives the difference between both on the settlement date. When the market rate is higher than the cap rate, the seller makes no payment. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Financial instruments and related risks 32

36 Swaption A swaption is an option, which gives the buyer the right, but not the obligation, to enter into an Interest Rate Swap. The buyer and seller agree on the strike rate, the length of the option period, the term of the swap, notional amount, amortisation and frequency of settlement. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Cash settled/delivery See definitions European/American See definitions Knock-in/Knock-out See definitions Double knock-in/double knock-out See definitions Financial instruments and related risks 33

37 Complexity 3 Interest Rate Swap Complex variants For the definition of an Interest Rate Swap, see the standard Interest Rate Swap description ( 2) Based on their specifications/characteristics, some IRS variants are categorised as Complexity 3 products. (Proportional to maturity) 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) if the frequency is not the same for the two interest rate payments (Proportional to maturity) Callable IRS A callable IRS is an IRS that can be cancelled, on predetermined dates, by one of the parties as specified in the contract at no additional cost when the call is exercised. Inflation-linked swap An inflation-linked swap is a swap where the exchanged cash flows are dependent on the price of underlying inflation indices. Quanto A Quanto swap is an interest rate swap between two interest rates in different currencies, but where the payments are settled in the same currency. Leveraged swap A leveraged swap is a swap where the interest on 1 of the legs is calculated as a multiple of a notional amount or index. The leverage is proportional to the multiple. Financial instruments and related risks 34

38 Barrier Options A barrier option is an option where the buyer can exercise its right depending on whether or not the underlying interest rate has hit or exceeded a predetermined price ( barrier ) either during the life of the contract or on the maturity date. 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Knock-in/Knock-out See definitions Financial instruments and related risks 35

39 Linked products (equity, commodities, credits, ) Complexity 1 Share A share is a certificate representing a portion of ownership in a corporation, mutual fund or limited partnership. No 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the rating of the share) (depending on the applicable market) Financial instruments and related risks 36

40 Basket A basket is a collection of different securities in one tradable package. 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the applicable market) The risk of the structure is lower than the risk of the underlying building blocks Financial instruments and related risks 37

41 Index An index is an adjustable basket, either equally weighted or weighted according to market capitalisation. (depending of the applicable index) No 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the applicable market) Financial instruments and related risks 38

42 Funds A fund is a collective investment scheme which solicits funds from the public and invests them collectively. Depends on underlying assets Depends on underlying assets No 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the rating of the issuer) (depending on the applicable market) The risk of the structure is lower than the risk of the underlying building blocks Financial instruments and related risks 39

43 Complexity 2 Warrant A warrant is a financial instrument which gives the holder the right, but not the obligation, to acquire (call option) or to sell (put option) an underlying asset at predetermined conditions during a specified period or on a pre-arranged date. The main difference between a warrant and an option is that a warrant is exchange traded. (depending on overall option strategy) (depending on overall option strategy) No 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) European/American See Definitions Financial instruments and related risks 40

44 Cliquet A cliquet is an option with periodic settlement, where the strike price is reset based on the value of the underlying equities. At the time of periodic settlement, the option locks in the difference between the old and new strike and pays out the profit (if any). 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 41

45 Average Rate Option (ARO) An Average Rate Option is an option whose value is determined by an average spot rate for the underlying equity(ies) over the life of the option or over a preset period of time. Also referred to as an "Asian option" 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 42

46 Commodity swap A commodity swap is a swap where two parties exchange cash flows which are dependent on the price of an underlying commodity for an agreed period in the future. One party agrees to pay a fixed price to another in return for receiving payments based on the market price of the underlying commodity. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the underlying commodities and external factors) Financial instruments and related risks 43

47 Commodity Forward A commodity forward is a contract where two parties exchange cash flows which are dependent on the price of an underlying commodity at an agreed date in the future. The price at which the buying and selling occurs is the forward price. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the underlying commodities and external factors) Financial instruments and related risks 44

48 Commodity option (plain vanilla) A commodity option gives the buyer the right, but not the obligation, to buy (call) or to sell (put) an agreed amount in a specific commodity at a predetermined price on a specific date (European type option) or up to a specific date (American type option). 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 45

49 Complexity 3 Knock-in/Knock-Out Average Rate Option (equity linked) Knock in An ARO that is triggered ("knocks in") only when a certain price level is hit before expiration. The contract pays a benefit only if a specified event occurs (for instance, a certain change in the price of the underlying asset). Knock-out An ARO that expires ("knocks out") when a certain price level is hit. The contract pays a benefit only if a specified event does not occur (for instance, a certain change in the price of underlying asset). 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 46

50 Barrier Option (equity linked) A barrier option is an option where the buyer can exercise his right depending on whether or not the spot price has hit or exceeded a predetermined price (trigger) either during the life of the contract or on the maturity date. 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) European/American See definitions Knock-in/Knock-out See definitions Double knock-in/double knock-out See definitions Financial instruments and related risks 47

51 Digital Option (equity linked) A digital option is an option which has a fixed, predetermined payout if the price of the underlying equity price reaches (or does not reach) a predetermined level, the strike price. Term sheet 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) European/American See definitions Knock-in/Knock-out See definitions One Touch/No-touch See definitions Financial instruments and related risks 48

52 Barrier Option (commodity linked) A barrier option is an option where the buyer can exercise his right depending on whether or not the underlying commodity price has hit or exceeded a predetermined price (trigger) either during the life of the contract or on the maturity date Term sheet 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) Knock-in/Knock-out See Definitions Financial instruments and related risks 49

53 CDS: Credit Default Swap (credit linked structure) A Credit Default Swap is a swap where the seller of credit protection receives a periodic coupon in return for the obligation to buy the underlying credit debt (corporate, sovereign or asset-backed) in the case of a credit event (bankruptcy, failure to pay, restructuring, modified restructuring). The underlying credit debt is settled physically or in cash. The buyer of the credit protection receives the notional par value in the case of a credit event. Term sheet Depends on the level of the market Depends on the level of the market 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) CDS Basket A CDS basket is a collection of different Credit Default Swaps in one tradable package. Nothing-to-default CDS The seller of protection on a nothing-to-default CDS is exposed only until the specific (nothing) event on which protection has been sold takes place. CDS on Asset-Backed Securities A Credit Default Swap on Asset-Backed Securities is a swap designed to transfer the credit exposure of bonds or notes backed by financial assets - mostly loans that are not first mortgages - between parties. CDS on CDO A Credit Default Swap on a Collateralised Debt Obligation is a swap designed to transfer the credit exposure of a CDO between parties. The protection seller in the credit swap guarantees the credit worthiness of the CDO concerned, whereas the protection buyer receives credit protection. The risk of a credit event on the CDO is transferred from the holder of the CDO/buyer of the protection to the seller of the protection in order to set up a synthetic participation in a CDO. Financial instruments and related risks 50

54 CDO: Collateralised Debt Obligation (credit linked structure) A CDO is a typical credit structure where the investor only assumes a credit risk on a specific portfolio of corporate names, asset-backed securities or other CDOs. The investor can chose his risk profile by buying either the lower rated notes (mezzanine) or the higher rated notes., for full capital structure No, for mono tranche No 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) (depending on the rating of the issuer) er Financial instruments and related risks 51

55 Foreign exchange on Money Market products Complexity 1 FX Spot Trade An FX spot trade is an agreement between two parties to purchase/sell a certain amount of foreign currency for immediate delivery. The exchange rate at which the buying and selling occurs is the spot rate. (Not within the scope of the MiFID) 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) Financial instruments and related risks 52

56 FX Swap A foreign exchange swap is a transaction where two parties exchange a given amount of one currency for another with two different value dates (normally spot to forward). The two parties agree a currency exchange on one day and simultaneously agree to reverse that deal on a date in the future (typically less than 12 months). (Depending on the nature and volatility of the underlying currencies) 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportionate with maturity) Financial instruments and related risks 53

57 FX Forward A FX forward is an agreement between two parties to purchase/sell a certain amount of foreign currency, whereby the due date (or term) of the exchange transaction lies in the future (generally within a time scale of less than 12 months). The exchange rate at which the buying and selling occurs is the forward rate. (Depending on the nature and volatility of the underlying currencies) 1 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) OTC Standard variant Exchange (FX futures) Standardised FX Forward contract on an exchange market. Non-deliverable An FX forward where one of the currencies is a non-convertible foreign currency. The profit or loss at the time of the settlement date is calculated by taking the difference between the agreed exchange rate and the spot rate at the time of settlement (normally a fixing). Financial instruments and related risks 54

58 Complexity 2 FX option (plain vanilla) An FX option gives the buyer the right, but not the obligation, to buy (call) or to sell (put) an agreed amount in a specific currency at a predetermined exchange rate on a specific date (European type option) or up to a specific date (American type option). The seller (or writer) of a foreign exchange option has the obligation, if the buyer of the foreign exchange option exercises his right, to deliver or to buy the amount in the agreed currency at the predetermined exchange rate. To obtain this right, the buyer of the foreign exchange option pays a premium to the seller. 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) European/American See definitions OTC Standard variant Exchange Standardised FX Option on an exchange market Deliverable Standard Non-deliverable An FX option where one of the currencies is a non-convertible foreign currency. The profit or loss at the time of the settlement date is calculated by taking the difference between the agreed exchange rate and the spot rate at the time of settlement (normally a fixing). Financial instruments and related risks 55

59 Average Rate Option (ARO) An Average Rate Option is an option where the payoff is determined according to the average spot rate over the life of the option and a strike price. Also referred to as an "Asian option" 2 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) Financial instruments and related risks 56

60 Complexity 3 Barrier option A barrier option is an option where the buyer can exercise his right depending on whether or not the underlying FX rate has hit or exceeded a predetermined price (trigger) either during the life of the contract or on the maturity date. 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) (Proportional to maturity) European/American See definitions Knock-in/Knock-out See definitions Knock-in/Knock-out barrier options have a higher leverage than standard barrier options. Double knock-in/double knock out See definitions Window (Partial) See definitions Financial instruments and related risks 57

61 Digital option A digital option is an option which has a fixed, predetermined payout if the price of the underlying FX rate reaches (or does not reach) a predetermined level, the strike price. 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) Digitals can be highly illiquid when close to maturity. (Proportional to maturity) European/American See definitions Knock-in/Knock-out See definitions One-touch/Double One-touch See definitions No-touch/Double No-touch See definitions Financial instruments and related risks 58

62 Trigger Reset Forward (structure) A Trigger Rest Forward (TRF) behaves like a hybrid of a forward and vanilla option. Its behaviour (as an option or as a forward) depends on whether one (of two) predetermined barriers is hit or not. The TRF has 3 possible outcomes: 1) If neither barrier is hit during the life of the contract, the TRF behaves as though the client has a vanilla option at a predetermined strike. 2) If the barrier in the direction in which the client protects himself is hit during the life of the contract, the TRF behaves like a forward option at the same predetermined strike. The strike under 1) and 2) is the worst-case scenario. 3) If the barrier in the other direction is hit during the life of the contract, the TRF behaves like a forward option at the reset strike, generally equal to the forward price at the moment the contract is set up. Premium: zero cost. Term sheet 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) The structure is less risky than the combination of the building blocks Financial instruments and related risks 59

63 Transatlantic forward (structure) A Transatlantic forward behaves like a hybrid of a forward and vanilla option. If the contract expires in the money (i.e. in the direction in which the client has protected himself), the client is always hedged at a predetermined strike. In case the contract expires out-of the-money (in the other direction), the contract will only be exercised as a forward option at the same predetermined strike (worst-case scenario), if both of the following conditions are met: 1. The market at no time has hit a predetermined barrier ("American barrier ). 2. At the expiry, the market has hit a predetermined barrier ("European barrier"). If one of these conditions has not been met, the client cannot comply with the obligations of the forward option. Term sheet 3 on a scale of 1 (non-complex dealing room products) to 3 (structures) The structure is less risky than the combination of the building blocks Financial instruments and related risks 60

64 The information provided in this document is general in nature and may in no way be regarded as an offer in respect of any financial instrument mentioned, or as investment advice. More detailed information and specific, personal investment advice may be obtained from your personal adviser. This document is the property of KBC Bank Ireland Plc and is protected by intellectual property law. It may not, in whole or in part, be reproduced, published, distributed or otherwise used in any way by anyone other than KBC Bank Ireland Plc without KBC Bank Ireland Plc's express authorisation. KBC Bank Ireland Plc, Sandwith Street, Dublin 2 A member of the KBC Group NV. KBC Bank Ireland Plc is Registered in the Republic of Ireland. Number