1 FINANCIAL INSTRUMENTS AND RELATED RISKS This description of investment risks is intended for you. The professionals of AB bank Finasta have strived to understandably introduce you the main financial instruments and the risks related to them. We kindly recommend to review any part, which might be of interest to you, and to consider the list of risks provided in the end. Financial instruments differ by their risk and potential return. The greater the return potential is, the higher the risk that a significant part of the initial value of the investments may be lost. Shares Mutual funds Structured bonds Bonds Cash money, deposits Repurchase agreements Derivative financial instruments This description was prepared following item 33 of the rules confirmed by the Securities Commission of the Republic of Lithuania of providing investment services and accepting and executing of the customers orders. The description is designed both for professional and nonprofessional investors. The used notions and their definitions are stated in corresponding legal acts. I. DEPOSITS Deposit is an easy and secure way to invest, save and keep money in order to distribute the investment risks. Deposits are considered to be the simplest investment instrument for protecting funds from depreciation and for obtaining the agreed return in the end of the agreed period. Types of deposits: Term deposit is a way to keep and accumulate money for a chosen period of time and to obtain the determined interest for that. Accumulative deposit is a way to save money and replenish your account without any restrictions; at the same time, the interest calculated every month is transferred into the deposit account and reinvested (the interest is paid every month to the same term deposit account).
2 Investor s benefit fixed return agreed in advance, i.e. interest. low probability of losing of the invested funds. Deposits, as financial instruments, are distinguished by relatively the lowest risk and by the smallest definable return. Actually, the only case when the risk of not recovering of the deposit amount may arise is the case of insolvency of the financial institution (bank or credit union) that has accepted the deposit. However, usually financial institutions are strictly supervised by corresponding organisations, which determine certain criteria to be observed. All the deposits kept in AB bank Finasta are insured according to the Law on insurance of deposits and liabilities to investors. II. BONDS Bonds are securities, confirming the company s (issuer s, which has issued the bonds) debt to you (investor). Investment making by lending the funds to a business is one of the main and very often less risky investment methods than that of purchasing of a part of a business (shares). Obviously, very often due to this very reason, the possible return is also lower. When investing into bonds, you in advance agree to the subject of the debt interest rate (bond coupon), the method of payment, the frequency and the debt recovery term (bond repurchase). The interest for bonds is usually paid in two ways: In the course of the entire bonds validity period, the coupon is paid at the determined frequency or in the end of the period. Bonds are sold with discount (discount bonds) and repurchased for a nominal value. Thus, if you have purchased bonds and wish to keep them until repurchase, then the return is known in advance. Should you require the money earlier than it has to be repurchased, whether you will earn or lose a part of the invested money depends on the current yield of bonds. The yield of bonds is reflected in their market price expressed in percentage at a certain moment of time and depends on the current interest rate, investors expectations, general economic situation etc. Example. Let us assume that the coupon of your bond is 5%. And at the moment when you required money, the market interest reached 8%. It means that the bonds analogous to yours at that moment would be issued with the coupon of 8%. It is clear that your bonds, for which the coupon of 5% was paid, are less attractive to the investors; that is why their price decreases. Thus, if you do not intend to keep bonds until repurchase, you should pay attention to the fact that in case of a change in the market conditions both return and loss may be bidirectional.
3 Investor s benefit clear investment return, if bonds are kept until repurchase. a possibility to sell bonds in the secondary market until repurchase. the price of bonds in the secondary market changes depending on the current market interest rate, thus, there is a possibility to obtain a return without keeping the bonds until repurchase. When buying bonds, contrary to what is thought, it is required to comprehensively evaluate the risk of the company, issuing these bonds, in the way you would consider buying the shares of that company. Government bonds make an exception of this rule, because governments bankrupt much rarer than companies do. The price of secondary market s bonds (yield) similarly to the price of shares depends on their liquidity. Liquidity is a possibility of the available assets to be within the shortest possible time and with the least possible expenses to be converted into cash money. Thus, the greater the liquidity of bonds is, the more probable is that they will be traded easier without significant expenses. III. MUTUAL FUNDS Mutual fund is money collected from the majority of investors for investing into shares, bonds, money market instruments, or other securities or their combinations. On having chosen the mutual fund, you trust your funds to the fund management company, which invests them into various financial instruments. The fund investment strategy determines where the trusted funds will be invested. It should be marked out that the fund s assets are separated from the assets of the management company, thus, even if the latter bankrupts, the assets of the fund remain to the investors. Usually, the available investment units may be sold to the fund management company, and certain fund units are traded on the stock-exchange. Investor s benefit the funds are trusted to be managed by professionals, thus you will not have to persistently follow the events on the market. you may choose a fund with the strategy, which correspond to the profile of your risk the best. you get a diversified portfolio of financial instruments. As it has already been mentioned, when investing into mutual funds, the funds are trusted to the manager; that is why, first of all, we strongly recommend you evaluating the manager s competence, i.e. whether you, as an investor, find the fund manager reliable and competent, and whether he/she has the required licenses etc. It is also important to bear in mind that even the mutual funds of the smallest risk, for example, money markets or bonds, at a change in the market conditions may lose a part of their value, and as a result, you may get less than you have invested. Before purchasing units of mutual fund, it is also important to evaluate their liquidity.
4 The risk of the mutual funds is usually smaller than that of single shares, because they are diversified according to assets classes, sectors, regions and other aspects. In other words, the mutual funds assets may be invested into shares of different companies, thus, the risk of one company decreases. If such the mutual fund invests into several companies of different countries and sectors, then the risk reduces even more. Should the same fund supplement its strategy and invest into bonds or other assets types, then the risk would reduce in terms of the assets classes as well. Thus, before making an investment decision, we recommend to carefully study the strategy and the rules of the mutual fund. IV. EXCHANGE TRADED FUNDS Exchange traded funds (ETFs) are mutual funds, which are traded on the stock-exchange and which by their essence resemble index funds. Usually these funds are managed passively, thus they are distinguished by lower management fees, i.e. the exchange traded fund may trace composition of a certain stock-exchange index (for example, S&P 500), as well as of a share index of a specific sector (for example, banks or pharmaceutical companies shares) or prices of the assets class (for example, currency or bonds). Apart from the ETFs, tracing the index value, there also may be constructed more complex ETFs: inversed ETFs their price is moving in different directions than that of the financial instrument, with which it is related to or leveraged ETFs the price of a such ETF unit would increase much more comparing to the basic financial instrument. inversed leveraged ETFs the ETFs, having properties of the both earlier mentioned ETFs. Investor s benefit you do not have to invest yourself into separate financial instruments for having a possibility to relate the investments with the selected market index. an exchange traded fund is easier to sell than the available package of financial instruments. a passively managed fund may be purchased at a relatively smaller price due to smaller costs of such fund management. after having chosen a suitable ETF, there is a possibility to earn not only the instruments that are getting more expensive, but also those that are getting cheaper. The price of an ETF unit as that of other financial instruments may rise as well as fall depending on the current situation on the markets. However, due to ETF management features, its unit s return during the investment period may depend not only on the situation on the markets, but also on other parameters, which may determine a different return than that of the traced index. Risk of index tracking error due to the investment specifics, the price of an ETF unit does not always accurately reflect the change of the traced index price. The ETF price may change in both directions comparing to the benchmark. Usually ETF best of all reflects the change of the price of the basic basket during a short period, thus, it is not suitable for long-term investments. In order to learn more about fund investment, it is always necessary to carefully get familiarised with the ETF prospectus where information on a specific investment object, risks, fees etc. is stated.
5 V. SHARES Shares make up a part of the company s assets, in other words, assets securities, confirming the right of their owner (shareholder) to participate in the company s management, to obtain dividends as well as confirming other rights stipulated by the law. There are two main investment methods: lending funds to business (i.e. buying bonds) or purchasing a part of business (i.e. buying shares). The latter is considered to be more risky, because accesses to management and corresponding responsibilities are acquired; however, there appear more possibilities to earn. By investing into shares you become a business co-owner (even upon having purchased one share. Depository receipts are designed for investment into foreign companies, because they confirm the availability of shares of these companies. They provide the same rights as those that are acquired after having directly purchased shares of foreign companies. Before investing, it is necessary to pay attention to the fact that shares are divided into several types and classes, and they determine what rights you obtain. The two main types: preferred stocks usually they do not give the vote right at the shareholders meeting, however guarantee higher dividends generally at the rate set in advance. ordinary shares they comprise the main part of the company s shares; all the ordinary shares grant the vote right and the right to dividends, if such are paid. Also shares may be divided according to classes, which grant shareholders a certain number of rights. When evaluating investments to shares and their return, it is important to make difference between the following notions share value and share price: share value shows the value of the company s assets minus the value of the company s liabilities and plus the value of the expected return. share price (an amount, for which you sell or buy shares) reflects the share value and the investors expectations, general tendencies of the economy etc. Thus, the share value determined by analysts does not indicate that their market price should be the same. Investor s benefit partial company s assets and the vote right are acquired (in the case of ordinary shares) for participation in the company s management. the right to obtain a part of the company s assets is acquired in the form of dividends. when investing into shares of a perspective company there also is acquired a potential to obtain positive investment return. Apart from the mentioned factors, the share price also depends on their liquidity. Usually the more liquid the shares are, the less their price volatility will be and it is more probable that less selling and purchasing expenses will be. The liquidity becomes especially important, when many shares are being sold or bought, since if it is small, the process of selling or buying may take up some time and demand additional expenses.
6 Since one of the most important stages is supervision of investments, it is important to verify in advance, what information on share prices, company s results etc. may be obtained, it is also important to clear out the frequency and methods of obtaining information. Obviously, the risk of investments into shares is great if the company bankrupts, the entire investment amount may be lost. However, the possibilities of return are also quite impressive the return may be obtained from dividends, if the company pays them, and from the increase of the share price, if the business of the company goes well. The risks of shares are as follows: risks of choice of credit, equity, market, investment moment, risks of currency, liquidity, legal market regulation and the like. VI. DERIVATIVE, STRUCTURED FINANCIAL INSTRUMENTS Derivative financial instruments comprise an entire group of financial products, whose value depends on the value of other financial instruments, to which they are related. They are created and sold by those market participants, who are inclined to take up a certain risk to the subject of the change of the price hidden behind the main assets. The derivative financial instruments are often used by other market participants to secure against the risk of an unfavourable change of some of the assets prices, e.g. the company may secure against the rise of the currency price, when in future it will have to settle from abroad for goods with the provider. They also help to create a market for objects, which are actually difficult or impossible to trade, e.g. those, which depend on the weather conditions. Very often derivative financial instruments are used by investors for the speculative purpose. According to the agreement object, the derivative financial instruments are usually associated by currencies, share prices, interest rates, raw material prices or fulfilment of debt obligations. The derivative financial instruments may be traded both on as well as off the stock-exchange. Forwards are deals, which determine that after the expiry of the set period of time, one of the deal parties will buy and the other party will sell financial or material assets (the deal s object) for the price, determined on the deal day. On the day, when the deal has to be fulfilled, depending on the actual price of the deal s object, one of the deal parties may gain return, and the other may sustain loss. Swaps are deals concluded between two parties to the subject of exchange money flows in some period of time, which, for example, may depend on the interest rate or currency rate difference in different countries. Derivative financial instruments of a standard form traded on the stock-exchange: futures are future deals, which by their content resemble forward deals, however, they differ from the latter by having standard characteristics; they are traded on the stock-exchange and they have a secondary market, i.e. future deals may be bought or sold on stock-exchange earlier than their validity period expires. options are more complex future deal, when one of the parties participating in the deal, on the day of the period expiry may choose whether to fulfil the conditions of the deal. The options may be concluded both for buying (call options) and selling (put options) of material or financial assets at a certain period of time for a certain price. Investor s benefit allows redistributing the risk of possible unfavourable change of the price among the participants, who would like to take up a smaller or a greater risk. one of the ways to invest, speculate in the dominating market.
7 Derivative financial instruments give a possibility to earn much even from insignificant changes of assets prices. However, in the case of an unfavourable situation, especially if while investing into derivative financial instruments the borrowed funds were used, the losses may also be quite sustainable. That is why usually only those persons, who are well aware of the financial markets, are recommended to invest into derivative financial instruments. Other structured financial instruments: Structured bonds these securities are comprised of bonds and other financial assets; thus, they differ from ordinary structured bonds by the fact that the interest paid for them depends on the return of other financial assets (shares, raw materials etc. markets). Example. If structured bonds are kept until repurchase, a part of their bonds secure the invested amount. For example, you have purchased two years structured bonds of 100 LTL nominal value, whose interest depend on the volatility of oil prices, i.e. if oil gets more expensive, you earn. If you decide to keep these bonds until repurchase, after two years you will definitely return the invested 100 LTL and, if oil prices grew, you will be paid the interest. The investment coefficient helps to understand how the return of structured bonds is generated. Let us say that the coefficient of your purchased structured bonds is equal to 100%. Thus, if after a year the price of oil has grown by 20%, your earnings have also to be 20%, or 20 LTL, however it also depends on the price of bonds. The price of a bond is equal to the price of an annual discount bond according to the current market yield (more detailed description may be found in the Bonds part). Let us assume that the yield of annual bonds is equal to 5%, then the price of your structured bonds is equal to the sum of the bond price (95.24 LTL (100 LTL / (1 + 5%) = 95.24) and the financial assets (oil) part price (20 LTL), i.e LTL ( = ). Whether you will be able to sell your structured bonds for such a price also depends on their liquidity. The greater the liquidity of the structured bonds is, the greater the probability that you will manage to sell them for a price similar to the one calculated. Otherwise, if the price of the oil fell by 20%, your structured bonds would cost the same as the discount annual bond, i.e LTL. Due to that reason, structured bonds are more risky than the ordinary ones, because they acquire not only the good properties of several financial assets, but also their risks. To conclude, structured bonds are more risky than the ordinary ones, because if you decide to sell them until repurchase, and the market conditions change, you may not receive the interest and may sustain loss. Anyhow, the risk is less than that of the part of financial assets comprising the structured bonds (for example, oil), because if you keep the structured bonds until repurchase, the invested amount is returned. Contract for difference (CFD) is an agreement between two parties to pay after a defined term the price difference between the current and the future assets prices. In such a case, investors have the right to speculate the change of the desired financial instrument price even without purchasing it themselves.
8 Thus, the investor takes up a risk that the price of a financial instrument may turn in an unfavourable direction and due to that a loss may be sustained. VII. INVESTENT AND BORROWED FUNDS Short selling is an action when the investor borrows financial instruments from a third party and promises to return them after the agreed period. The investors do so when they expect that the borrowed financial instruments price on the agreed day will be less. Then it will be possible to return the borrowed financial instruments at a lower price and to earn from the price difference. In such a case, the investor must take into consideration the probability that the borrowed financial instrument may get more expensive during the agreed period. In such a case the investor on the market will have to repurchase and return the borrowed financial instruments at a higher price. Repurchase deal is one of the methods of short-term borrowing of funds; by such a deal a loan is extended with pledging of the available financial instruments. If, for instance, you have bonds and wish to keep them until repurchase, but suppose if you require money, you may conclude a repurchase deal, i.e. to borrow the money from the bank by pledging the available bonds. On the one hand, it is a quite easy way to get a loan; on the other hand, it may be a complex financial instrument, resulting in a greater risk than that of an ordinary loan. What kind of a repurchase deal will be concluded depends on the purpose of your borrowing. If you borrow for everyday expenses In such a case, the repurchase deal s risk is similar to that of a loan; however, it is greater due to the pledge. For example, when taking a mortgage loan, you pledge a house. The main risk in such a case is the decrease of your earnings. And on having pledged the mentioned bonds, there appears one more significant risk that of the pledge value. The value of the house, comparing to the value of bonds, changes less, and rarer, and the change lasts for a longer period of time. The price of the mentioned bonds changes every day and may change significantly, thus, if it falls lower than the bank s set limit, you will have to additionally pay in (to pay a guarantee fee) or to pledge more of the available financial instruments in order to secure recovery of the loan. The bigger the volatility of the value of the mentioned bonds is, the greater the risk is that you will have to pay a guarantee fee. Example. Let us assume that you have bonds at the value of LTL, you pledge them and get a loan of 900 LTL. The bank sets a limit of the value of 80%. On the next day, the value of your bonds decreases by 30% to 700 LTL. The bank demands to additionally pay in 100 LTL in order to achieve the set value. If you borrow for investing Example. Let us assume that you borrow because you want to invest more into the mentioned bonds. You immediately invest the borrowed money into the same bonds. In such a case you have bonds of the value of LTL and a loan of 900 LTL. If the value of the bonds decreases on the next day by 30%, you have bonds of the value of x (100% 30%) = LTL and a loan of 900 LTL, you are also obliged to pay in 100 LTL of a guarantee fee. If the value of the mentioned bonds decreases and you have not concluded a repurchase deal, your assets will comprise x (100% 30%) = 700 LTL. On having concluded a repurchase deal for the investment purposes, your assets will be x (100% 30%) 900 = 430 LTL.
9 In the case of a repurchase deal, if the investor keeps borrowing and investing the obtained funds into the same financial instruments, he/she may create such a financial structure where even very small volatilities of the price of the available financial instruments may impact the loss of the entire invested assets. When the borrowed funds or financial instruments are participating, you risk not only to lose your own money, but the borrowed money as well, which has to be returned anyway. In any case, before creating a repurchase deal, you should exactly clarify with the investment consultant all the deal conditions and to evaluate your possibilities of taking up such a risk. GROUPS OF RISKS All or a part of the below enumerated risks are applicable to the above described financial instruments: Equity risk is a risk that the investor will lose all his/her invested funds or a part of them. This kind of risk is directly related to specific properties of a financial instrument market (liquidity, supply and demand ratio and the like). This risk is not directly related to the issuer (see credit risk), rather to investment circumstances. Inflation risk is a risk that due to rising prices of different consumer goods and services, the purchasing power of money will decrease, i.e. for a certain amount of money you will buy less. Risk of choice even at the availability of especially favourable conditions on the market as well as promising and positive characteristics of investment objects, there still remains a probability that the investment made into a chosen financial instrument will not live up to your expectations. Credit risk is a risk, arising due to possible worsening of the issuer s financial situation. This risk is directly related to the issuer. Price difference risk a risk that there will appear a difference between the prices of buying and selling, which may cause that the financial instruments will be sold at a lower price (or bought at a higher price) and this will reduce or change the potential investment return. Market risk a risk related to general factors having impact on the entire financial instruments market, e.g. economic situation of the country, instability of national currency rates, basic interest rate changes and the like. Risk of choice of investment moment is a risk to choose an unfavourable moment to buy and sell a financial instrument (i.e. at volatility of financial instruments market prices, at buying for a higher price than it could be done, at selling at a lower price than it could be sold). Reinvestment risk is a risk when the investors into bonds strive to get constant income for a period of a year or several years, as a result, they risk that at a particular moment they will not have a possibility to reinvest from the funds obtained from investments even into the investments of the same yield. Liquidity risk is a risk that you will not have a possibility to withdraw the invested funds at a preferred time, e.g. due to the circumstance that at that time there will be no persons, wishing to buy shares. In this respect it is recommended to invest o a liquid market. Currency risk is a risk that due to unfavourable currency rate, a general investment return may worsen, when it is invested into financial instruments of a foreign country, whose currency rate is floating. Systematic risk is a probability that insolvency of one financial broker s company, credit institution or investor will have a negative impact to the majority of financial brokers companies, credit institutions or investors.
10 Risk of legal regulation is a risk to sustain losses, occurring due to unexpected legal acts regulations. Thus, before making investments, it is important to find out about the legal regulation of the market, into which you are planning to invest, especially when you invest into a market of a country you know little about. Other notions Financial instruments are understood as it is stated in the law on financial instruments markets of the Republic of Lithuania. Those investing into financial instruments, expect to obtain earnings from dividends or interest as well as equity growth, when the value of financial instruments during the period of investment increases. Portfolio of financial instruments is a set of investor s available financial instruments. General investment return is a relation of the received earnings or sustained losses from a financial instrument (paid out dividends or interest, change of financial instrument s market value during the investment period) and the initial amount of the invested money. Derivative instruments are certain chosen deals (forwards, swaps, futures etc.), whose volatility of prices depend on various types of assets (shares, bonds, precious metals, currency etc.)). Derivative instruments may be used in order to reduce the investment risk or to secure a greater return.