This Risk Warning Disclosure is provided to you, our Professional Client, in accordance with UK Financial Conduct Authority’s (“FCA”) rules and this document forms part of our terms and conditions in respect of any transactions we undertake on your behalf and may be amended from time to time.
2.1 Different instruments involve different levels of exposure to risk and may therefore be inappropriate to your circumstances, or risk appetite. Please note that this Risk Warning Disclosure may not identify all of the risks and other significant aspects of the financial instruments inwhich we may deal on your behalf. You should not authorise us to deal in any of the in struments described below unless you are satisfied that you understand their nature and the extent of potential risk to your investment.
2.2 As a Professional Client, you are deemed to have the relevant expertise, experience and knowledge to make decisions and understand the risks involved.
If this is not the case, you should let us know immediately by contacting your usual M&G contact. You should also be satisfied that an investment instrument is appropriate in the context of your desired exposure to risk including financial risk. Whilst you may be satisfied that particular instruments do not expose you to risk, you should be aware that certain investment strategies in relation to them may do, for example, taking a “spread” position.
2.3 To assist you in deciding whether to give us authority to deal in instruments on your behalf under our discretionary investment management agreement, we have set out below a list of financial instruments in respect of which we may deal, along with a brief overview of the nature of and inherent risks involved with certain potentially high risk products. It is worth remembering that all investments may be influenced by external risk influences such as political risk and global or local economic trends. Further information on general risks associated with investment products is set out in section 8.
3.1 We will undertake transactions on your behalf in relation to a range of investment products and we have set out a brief summary of such investment products below:
3.3 A share, also known as equity, is the right which a member of a company has to have a certain proportion of the capital. When a share is purchased, the investor becomes a part-owner or shareholder in the company. Most companies are limited by shares, thus an investor’s liability is limited to the amount paid for (or owing on) the shares should the company fail or become insolvent. Many shares are traded on recognised exchanges such as the main market of the London Stock Exchange or AIM. The price of a share can go up or down, in line with market conditions and an investor may therefore lose their capital. The performance of a share may be influenced by a number of factors some of which are outside the control of the company issuing the shares. Such risk factors may include the financial performance and prospects of the company, the performance and prospects for the industry in which the company operates, and general financial and stock market conditions, particularly in the jurisdiction(s) where the company operates or is listed.
There are different classes of shares, including ordinary shares, preference shares and deferred shares. The rights attaching to each class of share depends on the provisions of the memorandum and articles of association, or on the special resolutions of the company in question. The common classes of shares are ordinary shares which have no guaranteed amount of dividend but carry voting rights, and preference shares, the holders of which receive dividends (and/or repayments of capital on winding up of the company) in priority to the holders of ordinary shares but have no voting rights.
Some shares are traded on stock exchanges and their values can go down as well as up in line with market conditions. These shares are termed “quoted”. In respect of unlisted shares or shares in small companies, there is an extra risk of losing money when such shares are bought and sold due to their nature. For example, purchasing and selling unlisted shares is more difficult than with quoted shares as the market is smaller and there are often restrictions on the transferring of unlisted shares.
Shares in companies incorporated in emerging markets may be harder to buy and sell than shares in companies in more developed markets and such companies may also not be regulated as strictly as in more developed markets.
If a company goes into liquidation, its shareholders rank behind the company’s creditors (including its subordinated creditors) in relation to the realisation and distribution of the company’s assets with the result that the shareholder will normally only receive any money from the liquidator if there are remaining proceeds of the liquidation once all of the creditors of the company have been paid in full. You could therefore lose some or all of the money invested.
3.4 Bonds and certificates of deposit
A bond is a loan to a company. It is a debt security in which the authorised issuer (equivalent to the borrower) owes the bond holder (equivalent to the lender) a debt. The issuer is obliged to repay the bond holder the principal at the maturity date and interest at intervals throughout the life of the bond. Certificates of deposit (“CDs”) are negotiable instruments evidencing a deposit with a bank and have similar features to bonds. Consequently the bond/certificate holder is taking a credit risk on the issuer.
After maturity, the bond/CD is redeemed and the issuer has no more obligations to the bond/certificate holders. The maturity can be any length of time, and bonds typically have a term of up to 30 years. An exception to this are perpetuals (bonds with no maturity). By market convention, CDs are normally referred to as short-term marketable instruments and have a maturity of up to 5 years. There is however no reason in principle why longer maturity CDs cannot be issued. The coupon or interest is usually at a fixed rate throughout the life of the bond/CD, although it can also vary with a money market index, such as London Inter Bank Offered rate (“LIBOR”).
The interest rate that the bond/certificate holder receives is influenced by a variety of factors, such as current market interest rates, the length of the term and the credit worthiness of the issuer. These factors are likely to change over time, so the market value of the bond can vary after it is issued. As a result of these differences in market value, bonds are priced as a percentage of their “par” value. As such, the prices of bonds can rise to above par value (in which case you will be trading at a premium) or fall below par value (equivalent to trading at a discount).
Bonds/CDs are generally viewed as safer investments than equities, however bonds/CDs can carry a number of specific risks, such as:
· Bonds/CDs that carry a fixed rate of interest are subject to interest rate risk, meaning that their market price will decrease in value when the prevailing interest rate rises. Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield. When the markets’ interest rates rise, then the market price for the bonds/CDs will fall, reflecting investors’ improved ability to get a good interest rate for their money elsewhere. Inflation causes the value of money in the future to be worth less than it is today. This means that, except in relation to index linked bonds, the purchasing power of a bond investor’s future interest payments and principal will be reduced over time.
· Prices can become volatile if one of the credit rating agencies (for example Standard & Poor’s or Moody’s) upgrades or downgrades the credit rating of the issuer. As mentioned above, a bond/certificate holder will take a risk on the credit worthiness of the issuer.
· Some bonds/CDs are “callable”.This means that although the issuer has agreed to make payments plus interest towards the debt for a certain period of time, the issuer can choose to pay-off the bond early.This may create re-investment risk for the bond/certificate holder who will need to find a new place for his money, and may not be able to find as good a deal, particularly when interest rates are falling.
If you invest in bonds there is a risk that you will lose some, or all, of the money invested. The value of your investment may be diminished by a number of factors, including increasing interest rates, inflation and default on the part of the bond issuer.
Bonds can be bought and sold in the market and their price can vary from day to day. A rise or fall in the market price of a bond does not affect what you will receive if you hold the bond until it matures. You would only receive the par value of the bond (plus any coupon payment to which you have been entitled during your ownership of the bond), irrespective of what you paid for it.
3.5 Units (collective investment schemes)
Units are rights or interests (however described) of participants in a collective investment scheme. Broadly speaking, a collective investment scheme refers to any arrangement with respect to property, the purpose or effect of which is to enable the participants to receive profits or income out of the property.
One of the main advantages of collective investment is the reduction in investment risk. Collective investments by their nature tend to invest in a range of individual securities and consequently, the capital risk is reduced. However, if the securities are all in a similar type of asset class or market sector then there is a systematic risk that all the securities could be affected by adverse market changes. To minimise or avoid systematic risk, investment manage rs may diversify into different non-perfectly-correlated asset classes. The other advantage of collective investment is that it can reduce the dealing cost-pooling money with that of other investors gives the advantage of buying in bulk, making dealing costs an insignificant part of the investment.
However, there are costs involved in collective investment schemes. It is usual for the fund manager managing the investment decisions on behalf of the investors to expect remuneration. This usually takes the form of an up-front fee or initial charge, and an annual fee taken periodically and which is based on a percentage of the value of the fund. Both charges are included in the price of units or shares of the funds. Sometimes a performance (variable) fee may be charged as well as or instead of the annual fee.
You should be aware that with this type of investment, although you can choose the type of fund to invest in, you have no control over the choice of individual holdings that make up the fund. A further feature of collective investment schemes is that, as an investor, you will usually have none of the rights that someone investing directly in the assets underlying the fund would enjoy (for example, discounts on the company's products and the right to atte nd the company's annual general meeting and vote on important matters).
Some collective investment schemes are open ended ie they have variable capital and are priced and dealt on a regular basis at a net asset value. Others are closed ended ie their capital is fixed. These collective investment schemes are frequently referred to as Investment Trusts and are traded on stock exchanges where the price is dependent on demand. Consequently they may trade at a premium or discount to their net asset value.
The value of an investment in a collective investment product is determined by the value of the underlying investment made by the product's managers. Hence any income received from investing in a collective investment scheme may vary with the dividends or interest paid by the underlying investments and so could fall as well as rise. In the case of open ended funds, such as hedge funds, there may be limits to the ability to redeem units and such funds may also engage in shorting or leveraging techniques. Collective investment products that focus on a country, sector or market index may display greater volatility than the wider market and so should be considered as higher risk than more widely invested collective investment products. It may not be possible to trade units or shares in collective investment products if there is no liquid market.
3.6 Unit Linked life policy
A life policy is a contract of insurance between an insured person and an insurance company which outlines the terms and conditions of the assurance.
The premiums on a life insurance policy may be payable annually, quarterly or monthly depending on the terms of the life policy. The premium may be a single payment, throughout the entire life of the policy or for a specified number of years. An insurance policy can “lapse” if premium payments are not made according to the terms and conditions of the policy.
With a unit linked life policy, the premium is invested by the life assurance company into an investment fund. The insurance company invests premiums in specific funds chosen by the policy holder. The amount payable under the policy will depend on the value of the investments in those funds at the time that the policy matures. Insurance companies offer a range of different funds to which a policy can be linked. You should ask for an explanation of the different funds so that you understand the different risks and opportunities (for example, please see section 3.2 for the risks associated with shares, section 3.4 for the risks associated with bonds and certificates of deposit and section 3.3 for the risks associated with units in collective investment schemes).
It must be noted that there is no guarantee as to the value of the sum that will be paid on maturity as the value of investments can fall as well as rise and the policy may pay out less than you have anticipated. Unit linked life policies have ongoing charges, such as yearly charges for managing the fund and sometimes monthly charges for handling the premiums. These charges could also have the effect of reducing the value of the policy fund.
Other types of life policies include endowment insurance, with-profits insurance and term insurance.
3.7 Real estate
Investing in real estate is considered by some as an alternative investment. Investors in real estate generally look to ach ieve rental income from tenants (such as rental from the letting of a commercial property) as well as capital growth as the value of the property increases.
There are risks associated with investing in real estate as property prices may go down as well as up and the original investment may be lost. If an investor borrows to invest in property, interest rate rises may mean that interest payments on a loan exceed the amounts that are received in rentals and the investor will have to cover the difference. Real estate is not a liquid investment and selling a property may take many weeks or months, therefore redemption of capital may take time. Investing in property will involve associated costs (for example legal fees, estate agent fees and insurance). There are also costs associated with the upkeep and maintenance of an investment property. From time to time it is likely that an investment property will be vacant, in which case rental income will not be received. If there are any problems with the tenants of a property this may lead to a reduction or cessation of rental payments and legal and other costs may be incurred in dealing with the matter.
Commercial properties are often let out to companies and tend to be on long leases. As a result, the value of the property will often be increased as a result of the length of the remaining lease and the perception of the financial strength of the company paying the rent. The length of the lease and the standing of the tenant can have a significant effect on the value of a commercial property investment.
3.8 Real Estate Investment Trusts
A Real Estate Investment Trust (“REIT”) is an investment trust (please also refer to collective investment schemes at section 3.3) in which investors can buy shares.
REITs are however subject to certain additional risks. For example, an oversupply of capital may lead to over-development of the market. As investment into REITs is via the purchase of shares, the share price will likely be influenced by what is happening in the wider equity market and subject to the related risks (for further detail on this, please see section 3.2 above). The share price will also be influenced by what is happening in the underlying property market and investors who have separately invested in property should not generally consider an investment in a REIT as a way of diversifying investment risk. A REIT may invest in property where demand for rentals falls and the property market as a whole may suffer a downturn which would likely affect the value of your investment. In addition, the yields obtained from REITs may be relatively low compared to that obtained from other investments.
3.9 Property Related Debt Assets
Property related debt assets are subject to the general risks associated with any mortgage loan in that they are in the ordinary course dependant on the successful operation of the underlying properties, including the sufficiency of the rental income from the underlying properties. Further, there is the risk of default by the borrower in which case an investor is reliant on the value of the property being sufficient to repay the loan.
The borrowers' ability to make payments due under a property related debt asset will also be subject to the risks generally associated with investment in real property and may be beyond the control of the borrower. These and other factors may make it impossible for a mortgaged property to generate sufficient income to make full and timely payments on the related loan.
In the event of default, enforcement of the relevant related security may not be immediate, resulting in a significant delay in recovery of amounts owed by the relevant borrower under a loan. In certain circumstances, a moratorium may apply to prevent or delay enforcement in a relevant jurisdiction. Additionally, in each relevant jurisdiction, there may be certain classes of creditors entitled to receive the proceeds of secured assets before the investor (for example, unpaid salaries, enforcement costs and taxes).
The security given in respect of property related debt assets (if any is given) is usually referable to a property or a pool of properties and not given over all the assets of the obligor (borrower).
3.10 Asset Backed Securities and Structured Products
Asset Backed Securities and Structured Products are typically investments that entitle the holders to receive payments that depend primarily on the cash flow from a specified pool of assets, that by their terms convert into cash within a finite time period , together with rights or other assets designated to assure the servicing or timely distribution of proceeds to holders of the Asset Backed Securities or Structured Products.
The term ‘Structured Product’ may cover a number of different product types wth different features which vary in complexity. It is important that you understand the risk profile of a particular Structured Product, as it may vary. Asset Backed Securities and Structured Products generally are created by the transfer of assets and/or collateral to a special purpose vehicle (which may be a trust, limited liability company, corporation or other entity), which becomes the issuer of the Asset Backed Securities and Structured Products. The sponsor or originator usually establishes the special purpose vehicle as an entity outside of its corporate structure (often referred to as an “orphan entity”). Thus, in case of default, there is usually no recourse against the originator’s other assets. The special purpose entity may issue securities in the form of debt secured by the underlying assets or securities in the form of ownership interests in the underlying assets. With certain types of Asset Backed Securities and Structured Products, primarily securitisations, a servicer (often the originator) is responsible for collecting the cash flow generated by the underlying assets and distributing such cash flow to security holders in accordance with the terms of the issued securities. In certain transactions a party unrelated to the originator will perform these functions.
The structure of Asset Backed Securities and Structured Products and the terms of the security holders' interest in the underlying assets may vary widely depending on the type of collateral, whether the collateral is fixed or revolving, the tax, accounting or regulatory treatment desired by the originator, investor preferences, and the use of credit enhancement including the process by which principal and interest payments are allocated and distributed to investors, how credit losses affect the Asset Backed Securities and Structured Products and the return to holders in such Asset Backed Securities and Structured Products.
Asset Backed Securities and Structured Products are often subject to extension and prepayment risks which may have a substantial impact on the timing of their cashflows. The average life of each individual security may be affected by a large number of factors such as structural features (including the existence and frequency of exercise of any optional redemption, mandatory redemption or prepayment or sinking fund features), the payment or the prepayment rate of the underlying assets, the prevailing level of interest rates, the actual default rate of the underlying assets, the timing of recoveries and the level of rot ation in the underlying assets. As a result, no assurance can be made as to the exact timing of cashflows from the portfolio or on the notes. This uncertainty may substantially affect the returns on each class of notes.
Some Asset Backed Securities and Structured Products are subordinated in right of payment and rank junior to other securities that are secured by or represent an ownership interest in the same pool of assets. In addition, the underlying documentation for certain of such Asset Backed Securities and Structured Products provide for the diversion of payments of interest and/or principal to more senior classes when the delinquency or loss experience of the pool of assets underlying such Asset Backed Securities and Structured Products exceeds cert ain levels or applicable over-collateralisation or interest coverage tests are not satisfied. In certain circumstances, payments of interest on certain Asset Backed Securities and Structured Products in the Portfolio may be reduced, deferred or eliminated for one or more payment dates, which may adversely affect the ability of the Issuer to pay principal and interest in respect of the Notes.
Some subordinated Asset Backed Securities and Structured Products have a higher risk of loss and a lower degree of control and/or decision-making rights compared to more senior classes of such securities. Additionally, as a result of the diversion of cash flow to more senior classes, the average life of such subordinated Asset Backed Securities and Structured Products may lengthen. Subordinated Asset Backed Securities and Structured Products generally do not have the right to trigger an event of default or vote on or direct remedies following a default until the more senior securities are paid in full. As a result, a shortfall in payments to holders of subordinated Asset Backed Securities and Structured Products will generally not result in a default being declared on the transaction and the restructuring of the same.
3.11 Mortgage-Backed Securities
Mortgage-backed securities (“MBS”) are debt instruments secured by a pool of mortgages. The market value of MBS may vary with changes in interest rates. Falling interest rates may result in borrowers pre-paying their mortgages. This can reduce the returns as the re-investment of the proceeds is likely to occur at the lower prevailing interest rate. Conversely, rising interest rates may extend the likely maturity date.
The pooling of mortgages mitigates the risks associated with the default of a particular mortgagee but there may still be residual exposure for investors related to the general credit quality of particular classes of mortgagee . MBS are also subject to the credit risk of the issuer.
3.12 Repurchase Agreements and Reverse Repurchase Agreements
A repurchase agreement is an agreement between a seller and buyer for the sale of securities, under which the seller agrees to repurchase the securities, or equivalent securities, at an agreed date and, usually, at a stated price. A reverse repurchase agreement is the opposite.
In the event of a default, there may be exposure to losses from a decline in the value of the underlying asset. There may also be exposure to the loss of all or part of the income from the agreement.
3.13 Index Linked Obligations
Index linked bonds are securities the coupon and/or principal of which may be linked to the prices of other securities, currencies or statistics. Usually index-linked bonds are “linked” to inflation. The performance of the security varies with the performance of the underlying index. Index-linked bonds are subject to the credit risk of the issuer and their value may fall in the event that the issuer’s credit worthiness deteriorates.
3.14 Distressed Debt
Distressed debt describes debt issued by companies that are already in default , are in distress or are heading toward such condition. Historically, distressed debt has traded at discounts to a rational assessment of their risk-adjusted value for a number of reasons. For example, banks or institutional investors often have constraints that prevent them from investing in such circumstances. In some circumstances this has led to above average returns (adjusted for risk) for investors in this asset class.
When companies enter a period of financial distress, the original holders often sell the debt to a new set of buyers. Investors in distressed securities often try to influence the process by which the issuer restructures its debt, narrows its focus, or implements a plan to turnaround its operations. Investors may also invest new money into a distressed company in the form of debt or equity. Investors in distressed securities typically must make an assessment not only of the issuer's ability to improve its operations but also whether the restructuring process (which frequently requires court supervision) might benefit one class of securities more than another.
3.15 Government and public securities
Government and public securities are bonds issued by the government and are a form of long-term government borrowing. They usually have a fixed term and pay a fixed level of interest. Their value varies inversely with changes in the interest rates, and the intention is that they are always redeemed at the end of their term for their original face value. They are generally considered relatively safe investments as they are backed by the government of a country (and thus by its treasury) which is unlikely to go bust or to default on the interest payments. However, recent events in the Eurozone, and in Greece in particular, highlight the fact that government and public securities are susceptible to the same risks as other financial instruments.
Government and public securities are bought and sold on the stock market where their price can go up or down depending on supply and demand. An investor may therefore not get back the full face value. Inflation may also have an effect on gilt prices as rising inflation is damaging to gilt prices because, unless the gilt is index linked, the income it generates will fail to maintain its buying power. If an investor then decided to sell their gilt, they may find that its market value is not as high as when it was bought.
A debenture is a form of debt instrument, usually given by an incorporated company as a deed in favour of a creditor, and which provides the creditor with security over the whole or substantially the whole of a company's assets and undertaking. There are two main types of debentures: fixed charge debentures and floating charge debentures. Fixed charge debentures are secured against the fixed assets of the company, such as buildings, machinery and other equipment. On the other hand, a floating charge is a charge taken over all the assets or a class of assets owned by a company from time to time as security for borrowings or other indebtedness. With a floating charge, charged assets can be bought and sold during the course of a company’s business without reference to the debenture holder. A floating charge crystallises if there is a default or similar event by the company. At that stage the floating charge is converted to a fixed charge over the assets which it covers at that time.
Whether an investor decides to take as security for a debenture a fixed or floating charge becomes a significant risk in a company’s insolvency proceedings. A liquidator is under a duty to distribute assets to the creditors in a set order of priority; therefore, creditors with registered fixed charges are entitled to payment from the secured assets before thos e assets are used for any other purpose. Creditors with registered floating charges would rank after the payment of secured fixed creditors, after the payment of the costs of winding up and after preferred creditors. Priority between holders of floating charges over the same assets is similarly determined by the dates of execution and registration.
3.17 Certificates representing certain securities
Certificates representing certain securities are certificates or other instruments which confer contractual or prop rietary rights in securities held by a person, for example shares (please see section 3.2 ), government and public securities (please see section 3.13 ), debentures (please see section 3.16 ) or warrants (please see section 4.5 ) and whose ownership may be represented by a physical document. There are two main types of certificated securities: bearer securities and registered securities.
Bearer securities are completely negotiable and entitle the holder to the rights under the security (e.g. to payment if it is a debt security, and voting if it is an equity security). They are transferred by delivering the instrument from person to person. In some cases, transfer is by endorsement, or signing the back of the instrument, and delivery. In the case of registered securities, certificates bearing the name of the holder are issued, but these merely represent an economic interest in the securities rather than giving rights in the securities. A person does not automatically acquire legal ownership by having possession of the certificate. Instead, the issuer (or its appointed agent) maintains a register in which details of the holder of the securities are entered and updated as appropriate. A transfer of registered securities is effected by amending the register.
The risks associated with the underlying security in question will apply. For example, the risks associated with warrants will apply to a certif icated security in relation to a warrant. Certain securities are however excluded from the certificated security category, including options.
3.18 Private Debt
Due to the unique and customised nature of the documentation evidencing private debt assets and the private syndication thereof, these assets are not as easily purchased or sold as liquid publicly traded securities. Although the range of investors in private debt has broadened in recent years, there can be no assurance that future levels of supply and demand for the asset will provide the degree of liquidity which currently exists in the market. Credit risk affects liquidity which may be reduced further if the asset is impaired. In addition, the terms of these assets may restrict their transferability without borrower consent. We will consider any such restriction, along with all other factors, in determining whether or not to acquire participation in each asset.
Private debt assets are subject to unique risks, including the possible invalidation of an investment as a fraudulent conveyance under relevant creditors' rights laws. Further, where exposure to these assets is gained by purchase of Sub-Participations there is the additional credit and bankruptcy risk of the direct participant and its failure for whatever reason to account to the sub-participant for monies received in respect of assets directly held by it. In analysing each asset or Sub-Participation, the Investment Manager will compare the relative significance of the risks against the expected benefits of the investment.
Subordinated private debt assets may defer the payment of current interest in cash such that all or a part of the interest may be deferred or capitalised and added to principal. This interest structure postpones burdening a borrower with the full interest cost of such a loan until the due date. To the extent that a Fund acquires assets with a payment in kind (“PIK”) element, a Fund will be exposed to the risk of deferred interest collections. PIK is in addition to cash intere st and accrues period after period, thus increasing the underlying principal (e.g. compound interest). The PIK part is due on maturity of the principal.
Neither an investor nor an Investment Manager will have any control over the activities of companies in whose private debt you may be invested. Managers of companies in whose loans you have been invested may manage those companies in a manner not anticipated by you or us.
4.1 A derivative is a financial instrument, the value of which is derived from the value of an underlying asset. Rather than trade or exchange the asset itself, an agreement is entered into to exchange money, assets or some mother value at some future date based on the underlying asset. A premium may also be payable to acquire the derivative instrument.
An investor in derivatives often assumes a high level of risk, and therefore investments in derivatives should be made with caution, especially for less experienced investors or investors with a limited amount of capital to invest.
An option is a derivative contract which gives the investor the right to perform a specified transaction with the other party to the contract, but does not place an obligation on the holder to perform the transaction. The future payoffs relating to an option are determined by the price of another security.
A “call” option gives the investor the right to buy at the agreed price at any time between the date of the option and its expiry date. A “put” option gives the investor the rig ht to sell at the agreed price between the date of the option and its expiry date. Buying options is generally less risky than selling them as a decision can be made to simply allow the option to lapse if the price of the underlying asset becomes unfavourable. The maximum loss to an investor is the premium on the option and any commission or other transaction charges. However, if a call option is bought on a futures contract and later exercised, the future will be acquired, which will in turn leave an exposure to risks associated with Futures (please see section 4.2).
Some options operate on a margined basis which carries additional risks. Margin trading means that the investor may not pay the full premium on the option at the time it was bought but the investor may be subsequently called upon to make a series of payments against the purchase price. If the market moves against an investor, they may be called on to pay substantial additional margin at short notice in addition to the margin which was paid to establish or maintain the position. If margin is not paid within the time required, the position may be liquidated and the investor will be responsible for the shortfall. Non-margined transactions may, in certain circumstances, still require the investor to make further payments in addition to the purchase price that was paid upon entering into the option contract.
Writing an option carries with it a higher level of risk than buying options as the investor may be required to provide a margin (described a bove) to maintain the position. The investor will ultimately risk losing a greater sum than the premium received. In addition, writing an option means accepting a legal obligation to purchase or sell the underlying asset if the option is exercised against the investor, however-much the market price has changed in relation to the exercise price. If the investor already owns the underlying asset which they have agreed to sell, the risk is reduced. If the underlying asset is not owned, the risk can be unlimited.
Examples of options include index future options, single stock options (both equity and bond), swaptions, (i.e. an option giving the investor the right but not the obligation to engage in a swap see 4.5 for more information on risks relating to credit default swaps) over-the-counter (“OTC”) equity and bond options (both including index), commodity options and currency options.
4.4 Futures contracts are standardised contracts to buy or sell an underlying instrument or asset at a certain date in the future (the delivery date), at a specified price (the futures price). Once in place, the contract obliges the parties to buy/sell in accordance with the terms of the contract. Whilst considerable financial gains can be made on futures contracts, they carry a high degree of risk:
· If the investor purchases a future to sell an investment, it is possible that the investor may suffer considerable losses should the settlement price (the price of the underlying asset on the delivery date) of the underlying instrument have risen over the pre-set futures price through potentially unforeseen circumstances. Contingent orders may be placed, such as “stop-loss” or “stop-limit” orders which will not necessarily limit losses to the intended amounts, since market conditions on the exchange where the order is placed may make it impossible to execute such orders.
· Futures contracts have a contingent liability and carry margin risks. The high degree of leverage that is often obtainable in futures trading because of small margin requirements can work against as well as for the investor. In particular, an investor may be required to pay a series of payments against the purchase price instead of paying the whole purchase price immediately.
Examples of futures include index futures, bond futures, interest rate futures and commodity futures.
A warrant is a derivative security that gives the holder a time-limited contractual right (but not the obligation) to purchase securities from the issuer at a specific price and within a certain time frame. The securities subject to the right may be equity shares, in which case the warrants are known as equity warrants. For debt securities, the warrants are known as debt warrants.
It is important for anyone considering purchasing warrants to understand that the right to subscribe which a warrant confers is invariably limited in time. The consequence of this is that if there is a failure to exercise this right within the pre-determined time-scale then the investment will become worthless. Another risk associated with warrants is that a relatively small movement in the price of the underlying security may result in a disproportionately large movement in the price of the warrant which may be favourable or unfavourable. The prices of warrants can therefore be volatile.
Warrants should not be purchased unless the investor is prepared to sustain a total loss of the money that has been invested plus any commission or other transaction charges.
Transactions in off-exchange warrants may involve greater risk than dealing in exchange traded warrants because there is no exchange market through which to liquidate a position, or to assess the value of the warrant or the exposure to risk. Bid and offer prices need not be quoted, and even where they are, they will be established by dealers in these instruments and consequently it may be difficult to establish what a fair price is.
4.6 Contracts for difference
4.7 A contract for difference (“CFD”) is an agreement between two parties to exchange the difference between the opening price and the closing price of the contract at the close of the contract, multiplied by the number of underlying units specified in the contract. Such a contract is a derivative that will allow an investor to speculate on price mo vements, without the need to own the underlying assets. The fluctuation can be in the value or price of an asset, or an index. Settlement of these contracts is made through cash payments, rather than the delivery of physical goods or securities.
4.8 4.9 CFDs carry a high level of risk to investor capital, and capital and income are not guaranteed. As the financial outcome is determined by the price movement of the total trade value, profits and losses can quickly exceed the initial deposit. In particular, an investor may lose more than the sum of money which was originally invested, as there will be a liability to pay the total amount of the “difference” not just the sum originally invested.
4.10 4.11 If you adopt a highly leveraged strategy in relation to CFDs (i.e. as maller commitment of capital is ‘leveraged’ to achieve a larger investment exposure), this can result in a higher probability of trades being closed at a loss to the investor due to ordinary intra-day market volatility.
4.12 4.13 The investor will be required to maintain a certain amount of margin, and they may need to make further margin payments at short notice if the positions move against them. If there is a failure to do so within the time required, the position may be liquidated at a loss and the investor will be responsible for the resulting deficit. The risks associated with futures and options, which we have outlined above, will also apply to CFDs. As a result CFDs carry an increased risk of rapid, large and unexpected losses.
Examples of CFDs include interest rate swaps, cross-currency swaps, inflation rate swaps, total return swaps for bonds, property and equity, credit default swaps and spread bets. Credit default swaps and spread bets are two of the most widely used derivatives, and we have provided further detail of these below.
4.14 Credit Default Swaps
A credit default swap is an agreement which enables one party (the credit protection buyer) to buy protection from another party (the credit protection seller) against the risk of default by a company. The purpose of credit default swaps is to allow credit risks to be traded and managed in much the same way as market risks, and the agreement is similar to a contract of insurance against a default by a particular company. It is not however, in law, a contract of insurance. The company is known as the “reference entity” and a default by the company is known as a “credit event”. The reference entity is not a party to the transaction and is usually unaware of the existence of the credit default swap. The parties choose which credit events are applicable to the reference entity (for example bankruptcy, failure to pay and restructuring).
The credit protection buyer pays a regular fee or premium for the cover until a credit event occurs or otherwise until maturity. Following a credit event, the credit protection buyer will receive compensation for the loss of the reference asset. Most credit default swap contracts are physically settled and on a credit event the credit protection seller must pay the par amount of the contract against the credit protection buyer's obligation to deliver an agreed security of the company. As credit default swaps are a type of CFD, the risks associated with CFDs which we have outlined above will apply. In particular, dealing in credit default swaps carry the risk of losing more than was invested, and the risk that losses may be magnified due to margin trading.
A forward is a contract between two parties who agree that at a certain time in the future one party will deliver a pre-agreed quantity of some underlying asset (or its cash equivalent in the case of non-tradable underlyings) and the other party will pay a pre-agreed amount of money for it. This amount of money is called the forward price. Once the contract is signed, the two parties are legally bound by its conditions: the time of delivery, the quantity of the underlying and the forward price. Forward contracts are instruments traded over-the-counter.
Securities lending describes the market practice by which, for a fee, securities are transferred tempora rily from one party, the lender, to another, the borrower; the borrower is obliged to return them either on demand or at the end of any agreed term.
However, the word “lending” is in some ways misleading. In law, the transaction is in fact an absolute tra nsfer of title (sale) against an understanding to return equivalent securities. Usually the borrower will collateralise the transaction with cash or other securities of equal or greater value than the lent securities in order to protect the lender against counterpart credit risk.
Some important consequences arise from the nature of securities lending transactions:
· Absolute title over both lent and collateral securities passes between the parties, therefore these securities can be sold outright and “on lent”. Both practices are commonplace and an intrinsic part of the functioning market.
· Once securities have been acquired, the new owner of them has certain rights. For example it has the right to sell or lend them to another buyer and, vote in AGMs.
· The borrower is entitled to the economic benefits of owning the lent securities (e.g. dividends) but the agreement with the lender will oblige it to make (“manufacture”) equivalent payments back to the lender.
· A lender of equities no longer owns them and has no entitlement to vote. But it is still exposed to price movements on them since the borrower can return them at a pre-agreed price. Lenders typically reserve the right to recall equivalent securities from the borrower and will exercise this option if the y wish to vote. However, borrowing securities for the specific purpose of influencing a shareholder vote is not regarded as acceptable market practice.
6.1 Currency Spot and forward trades All currency transactions have a counterparty risk in that the counterparty to the trade might default before settlement. In the case of a forward currency trade (anything over two days) this risk is greater than spot trades (which typically settle in two days).
7.1 Non-readily Realisable Investments
7.2 Where the investments include any investments which are (i) government or public securities (ii) securities other than those which are or will be admitted to official listing in an EEA state or securities which are or will be regularly traded on or under the rules of an exchange in an EEA state or recognised investment exchange or designated investment exchange, there is no certainty that market makers will be prepared to deal or that adequate information for determining current value of the relevant investment will be available.
7.3 Foreign Markets
7.4 Investments which are directly linked to, or have exposures in foreign markets are likely to involve different risks from investments in your home markets. In some cases the risks will be greater and could involve wider geopolitical and economic risks . The potential for profit or loss from transactions on foreign markets or in foreign denominated contracts may also be affected by fluctuations in foreign exchange rates outlined in section 7.5 below.
7.5 Foreign Exchange Risk
7.6 If a liability in one currency is to be matched by an asset in a different currency, a movement in exchange rates may have an effect, favourable or unfavourable, on the gain or loss attributable to an investment, separate from and additional to a gain or loss in the currency in which the investment is denominated.
7.7 Off-exchange Transactions in Derivatives
7.8 It may not always be apparent whether or not a particular derivative is arranged on exchange or in an off-exchange derivative transaction. While some off-exchange markets are highly liquid, transactions in off-exchange or “non transferable” derivatives may involve greater risk than investing in on-exchange derivatives because there is no exchange market on which to close out an open position. It may be impossible to liquidate an existing position, to assess the value of the position arising from an off-exchange transaction or to assess the exposure to risk. Bid prices and offer prices need not be quoted, and, even where they are, they will be established by dealers in these instruments and consequently it may be difficult to establish what a fair price is.
7.9 Margin trading
7.10 Contingent liability inve stment transactions, which are margined, require an investor to make a series of payments against the purchase price, instead of paying the whole purchase price immediately. If an investor deals in futures, contracts for differences or sells options, they may sustain a total loss of the margin. If the market moves against them, they may be called upon to pay substantial additional margin at short notice to maintain the position. If there is a failure to do so within the time required, the position may be li quidated at a loss and the investor will be responsible for the resulting deficit. Even if a transaction is not margined, it may still carry an obligation to make further payments in certain circumstances over and above any amount paid when the contract was entered into.
7.11 Suspensions of Trading
7.12 Under certain trading conditions it may be difficult or impossible to liquidate a position. This may occur, for example, at times of rapid price movement if the price rises or falls in one trading session to such an extent that under the rules of the relevant exchange trading is suspended or restricted. Placing a stop-loss order will not necessarily limit losses to the intended amounts, because market conditions may make it impossible to execute such an order at the stipulated price.
8.1 Credit risk
8.2 Credit risk is the risk due to uncertainty in the counterparty’s ability to meet its obligations. Because there are many types of counterparties from individuals to sovereign governments and many different types of obligations from auto loans to derivatives transactions credit risk takes many forms. Institutions manage credit risk in many different ways. You should be aware that the credit risk of the counterparty is closely l inked to the counterparty’s default probability, the credit exposure and the recovery rate of the counterparty.
8.3 Clearing house protections
On many exchanges, the performance of a transaction by us (or third party with whom we are dealing on your behalf) is “guaranteed” by the exchange or clearing house. However, this guarantee is unlikely in most circumstances to cover you and may not protect you if we or another party were to default on obligations owed to you.
8.4 Market risk
Markets can be developed in ma ny different ways and so the price for investments in each market is dependent on several factors such as supply and demand, and other economic variables. In emerging markets social, economic and political changes can also influence these factors and as such the profitability of any investment in this market.
You should also be aware that trading conditions may differ in every market. Under certain trading conditions it may be difficult or impossible to liquidate a position. This may occur, for example, at times of rapid price movement if the price rises or falls in one trading session to such an extent that under the rules of the relevant exchange trading is suspended or restricted.
Placing a stop-loss order or limit order will not necessarily limit your losses to the intended amounts, because market conditions may make it impossible to execute such an order at the stipulated price.
8.5 Liquidity risk
Liquidity risk is the risk that you will not always be able to obtain an appropriate price for your investment when you sell it. When certain securities and derivatives are impossible to sell, or can only be sold with difficulty and at a sharply reduced price, the market is said to be illiquid. Liquidity risk occurs especially with shares in unlisted or poorly capitalised companies, investments with sale restrictions and certain structured products.
8.6 Interest rate risk
Interest rate risk is risk to the earnings or market value of a portfolio due to uncertain future interest rates. Interest rates can go up or down and may not work in your favour. Generally, bonds and shares are exposed to this risk. When you invest in shares , it is important to be aware of this risk to enable you to take appropriate action should future interest rates not be favourable to you.
8.7 Settlement risk
There exists the risk that one party may perform its obligation upon settlement of a financial in strument but the other might not, leaving the non-defaulting party in the position of having paid out under the contract and received nothing in return.
This arises mainly in transactions where there is a time lag between the parties performing their obligations under the contract. The most common example is in foreign exchange markets because each currency must be delivered in its home country. Due to time zone differences, several hours can elapse between a payment being made in one currency and the off setting payment being made in another currency.
8.8 Insolvency risk
A firm’s insolvency, or that of any other brokers involved with the transaction, may lead to positions being liquidated or closed out without your consent. In certain circumstances, you may not get back the actual assets which you lodged as collateral and you may have to accept any available payments in cash.
8.9 Contingent liability risk
Contingent liability transactions, which are margined, require you to make a series of payments against the purchase price, instead of paying the whole purchase price immediately. If you trade in future contracts for differences or sell options, you may sustain a total loss of the margin you deposit with your firm to establish or maintain a position. If the market moves against you, you may be called upon to pay substantial additional margin at short notice to maintain the position. If you fail to do so within the time required, your position may be liquidated at a loss and you will be responsible for the resulting deficit.
Even if a transaction is not margined, it may still carry an obligation to make further payments in certain circumstances over and above any amount paid when you entered into the contract.
8.10 Securities lending risk
Please see section 5 above.
8.11 Stabilisation risk
Stabilisation is the process of providing support for the price of an issue of securities for a limited time period in accordance with the FCA’s rules. The purpose of stabilisation is to alleviate sales pressure on the issued securities which is generated by short term investors and to maintain an orderly market in the securities. The effect of stabilisation is to make the market price of the securities artificially higher than would be the case if their value was determined solely by mark et forces. The risk is that investors may purchase securities at an inflated price during the stabilisation period.
8.12 Electronic trading
We carry out trading of designated investments, including the investments set out in this risk warning, on an electronic trading system. Undertaking transactions on an electronic trading system carries inherent risks such as hardware and software failure. The result of a system failure may be that orders are not executed according to instructions, or is not executed at all.
8.13 8.14 Regulatory and legal risk
The risk that a change in laws and regulations will materially impact a security and investments in a particular sector or market. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape and as such alter the profit potential of an investment. This risk is unpredictable and may vary from market to market. In emerging markets, such risk may be higher than in more developed markets. For example in emerging markets the inadequacy or absence of regulatory measures can give rise to an increased danger of market manipulation, insider trading. In addition, the absence of effective financial market supervision can affect the enforceability of legal rights.
8.15 Should you have any queries in relation to the contents of this document, you should contact your usual M&G contact.