The majority of structured products (80%) available in the German market account for the three highest risk categories under the European Securities & Markets Authority (Esma) rules, according to a research paper by software as a service (SaaS) provider Smart Trade.

The German firm calculated the Summary Risk Indicator (SRI) of 40,975 bonus, bonus capped and discount certificates linked to the Dax, following Esma's risk methodology. According to the research, for almost every twelfth certificate linked to the Dax the calculation placed them in the lowest risk category (one) while none of the almost 16,000 discount certificates felt under the highest risk category (seven).

"These results are very relevant for providers and for the distributors of financial products to retail investors," said Andre Fischer (pictured), director at Smart Trade. "The more risky the product is, the lower number of investors for whom it will be appropriate for, and [will also carry] higher consulting expenses."

Smart Trade's research calculated the SRI on the certificates by combining the credit risk of the issuer with the value-at-risk approach (bootstrapping method) for the determination of market risk. "We ran extensive simulation on more than 10,000 possible return scenarios mapped," said Fischer. "From the distribution of these scenarios, the so-called value-at-risk can be determined, and represents the return scenario that is undershot in only 2.5% of the simulations."

The research found that one in twelve certificate has an SRI of one and would therefore be suitable solutions for conservative and 'security-conscious' investors under Esma's guidelines, said Fischer. The research also found that Dax-linked discount certificates risk categories five and six dominate with none of the almost 16,000 discount certificates reviewed falling under the highest risk category (seven).

According to Smart Trade, the reason for this is that the Dax is a 'diversified equity investment' which already has a low variability in expected return scenarios and thus a lower risk than an equity investment in a single stock. "In addition, investors will receive a discount," said Fischer. "[which means] that they invest less capital for the same risk. However, it is also striking that 563 discount certificates fell in the risk category 1 and qualify as a very safe investment under Esma's guidelines."

The explanation for this result is that discount certificates with an SRI of one relate exclusively to products which have a very low residual maturity of sometimes only a few days and, secondly, a cap which was well below the Dax level at the time of evaluation (9,001 points), according to Fischer.

"These two characteristics limit drastically the simulation spectrum of potential losses for investors," said Fischer. "The vast majority of products that are at the time of evaluation (02/09/2016) in the risk category one, were launched at a time when the Dax was still below the cap, but the Dax has now risen above the cap level."

According to the research, investors in these products, therefore will suffer losses only if the Dax falls below the sometimes thousands of points distant cap again.

The research also calculated the SRI on more than 8,600 classic bonus certificates that have never touched their barrier or have fallen short, and found that the majority (over 80%) fall in the risk categories (SRIs) five, six and seven. However, approximately one in ten certificates is in the risk category one with only a handful of bonus certificates falling under risk categories two to four.

"Unlike discount certificates, bonus certificates account for over 15 % of the risk category seven," said Fischer. "Bonus certificates, in which a barrier breach is very likely, face a one-to-one participation in the losses of the underlying. However, because investors pay an additional option premium as part of the bonus certificate, their risk is higher than with a direct investment. Therefore in the case of a barrier breach they are worse off than if they had invested directly in the underlying and therefore the value- at-risk is correspondingly higher."

The research also found that a high proportion of bonus certificates fell under SRI category one and the explanation for this result is similar to discount certificates. "All bonus certificates have low residual maturities and significant room around their barriers (the current Dax level is well above the barrier). Both features together reduce the loss probability dramatically."

In addition, the calculation of approximately 16,500 bonus capped certificates unveiled a similar picture. More than 85% of the products have an SRI of five or higher. "The risk categories two to four remain virtually unused with nearly 12 % of the products falling in the lowest risk profile category." Similar to classic bonus certificates, the capped certificates with SRI five and above have an average distance to the barrier of 15% and less. "For certificates with SRI one, however, the likelihood of barrier breaches are correspondingly lower because the distance to the barrier is almost double, and have low residual maturities."

Smart Trade is a Berlin-based FinTech company providing independent valuation of financial instruments and the calculation of risk indicators to institutional investors, banks and asset managers. The firm has also developed web-based analysis and selection tools particularly in the area of structured products aimed at investment banks, financial portals and online brokers.

Click the link to read the full research (In German)

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