The Fine Art

of Finance
A ready reckoner for the Finance Whiz-on-the-go
CONTENTS
1 Introduction
2 Equities
3 Fixed Income
4 Derivatives
5 Alternative Investments
6 Investment Funds
7 Structured Products
8 Glossary
Successful investment advisory starts with better knowledge
The main focus for any investor is how to get consistent and sustainable high returns
over a long period of time. Investment advisors constantly attempt to ensure optimal
returns on their client’s portfolio. There are a lot of views on the different asset classes as
expressed by various investment professionals. Only one theoretical approach has been
accepted worldwide and proven as effective. Its creator - Harry M. Markowitz who
invented the modern portfolio theory more than 50 years ago - got the Nobel Prize in
Economic Sciences in 1990 for his pioneering work.

How do the different asset classes work together? What is the impact on the portfolio if
investment returns on one asset class is volatile? How does the risk–return balance of
different asset classes affect the overall portfolio? Does an addition of alternative
investments improve the risk – return profile? What is an alternative investment?

This is a financial reckoner which will give you an overview of the characteristics of
different asset classes. The document delves into why it is important to have more than
one asset to invest in and how different asset classes can be used to build optimized
portfolios. It will also give you a broad introduction to the modern portfolio theory and
show some examples of how to use this theory in every day life.

Some basic information about the world of derivatives, investment funds and structured
products will round up this reckoner. We hope to give you a basic understanding of how
the different asset classes are connected. This reckoner can be used like a lexicon for
looking up things from time to time.

I hope that this reckoner will help you in getting a good theoretical understanding, which
coupled with discussion sessions will aid you in providing more value-added support to
your clients.

Yours

Torsten Steinbrinker, CIO India

 Introduction

Basics
Asset Allocation and
Diversification

Asset Classes
Strategic and Tactical
Asset Allocation
Excursus: Portfolio Theory

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Basics Any form of investment can be assessed on the basis of three
criteria: profitability, safety and liquidity.

Profitability
The profitability of an investment is determined by the income
it generates. This consists of the interest and dividends paid,
any other amounts distributed and capital gains (e.g. in the
form of changes in the market price of the security). The rate
of return is a useful measure to compare the profitability of
different investments. It is defined as the annual income
earned as a percentage of the capital invested.

Safety
Safety means preserving the value of the capital invested. The
safety of an investment depends on the risks to which it is
exposed to. This covers a number of aspects which are
discussed in the various sections of this brochure. Safety can
be increased by spreading the capital invested over a range of
investments, which is known as diversification. This
diversification can be based on various criteria such as
different categories of investments or investing in different
countries, sectors and currencies.

Liquidity
The liquidity of an investment depends on how quickly an
amount invested in a given asset can be realized, in other
words converted into cash or an amount in a bank account.
In general, securities which are traded on a stock exchange
are liquid.

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 Capital maintenance, in the sense of protection against
inflation, is often cited as a fourth criterion.

How these, in part conflicting, target criteria are ultimately

weighted and prioritized depends on the investor’s own
personal preferences. Basically, all investors want to
achieve optimum results in each investment category: high
interest rates, attractive dividends and capital gains
combined with high safety and the ability to realize the
capital invested at any time represents the profile of a
“perfect” investment.

However, in the real world the three criteria of profitability,

safety and liquidity can only be combined by making
compromises. The magic triangle of investment illustrates
the conflicts:
Firstly, there is a conflict between safety and profitability.
To obtain a high degree of safety, the investor generally has
to accept a lower return. Conversely, above-average returns
are normally associated with higher risks.
Secondly, there can be a conflict between the targets of
liquidity and profitability since more liquid investments
often imply disadvantages in terms of return.

Each investor therefore has his or her own individual risk

preference which follows from the way in which the three
criteria mentioned are personally weighted. This preference
plays an important role in selecting the optimum portfolio
for any given investor.

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Asset Allocation Once the investor’s investment targets and risk
Allocation preferences are known, it has to be ascertained with
and which instruments they can be achieved and what form
Diversification the investor’s individual asset allocation should take. Asset
allocation means the distribution of investor’s funds
among different asset classes (e.g. equities, bonds,
alternative investments and cash) to reflect his or her
investment targets. The term diversification plays a key
role here. To spread the portfolio’s overall risk it is
necessary to invest in a range of instruments so as to
reduce the portfolio’s exposure to individual instruments.
As the chart below shows, the portfolio’s overall risk can
be reduced by adding new investment instruments.

Non-Systemic risks can be minimized

by adding new assets

Volatility

Non-Systemic risks
Systemic risks

Non-systemic risk means the unique “instrument-specific”

risk. In the case of equities, for instance, this would be the
company-specific risk. This risk can be minimized through
diversification so that the investment is then only exposed
to systemic risk, which refers to the general market risk.

Asset Classes To differentiate the investment universe – in other words

all possible investments – it has been found useful to
divide the universe into asset classes.

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 There is no general definition of asset classes. The
classification is usually based on institutional, substantive
or pragmatic criteria. The basic division is into equities,
bonds, alternative investments and liquid assets.

Equities are classed by region, but a division into sectors

or industries would also be possible. Bonds can be
classified additionally according to the issuer’s credit
rating, with a distinction made for instance between
government bonds, investment grade bonds and bonds of
poorer quality known as high-yield bonds. Asset classes
which are neither equities nor bonds are grouped together
under the term alternative investments. Cash, or liquidity,
is also treated as a separate asset class. This serves as a
reserve for transactions but is also important to ensure
that payment obligations can be met.

A portfolio should be structured with the help of these

asset classes so as to reflect the investment targets of an
investor as closely as possible. This has to take into
account the minimum investment horizon, the liquidity of
the investment instruments as well as the expected return
and the risks. As a rule, this is based on the historical
performance of the investment instruments considered.

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 Government

The portfolio planning is made easier if there is a sufficient

base of data available for the asset classes. For many of
the common asset classes there are indices which reflect
the risks and returns in a transparent and representative
way. On the basis of such indices it is possible to simulate
the interaction of the asset classes in the portfolio. The
aim is to arrive at a combination of asset classes which do
not move in unison (correlation) so as to achieve a strong
diversification, in other words to spread the risk as far as
possible. The weaker the correlation between individual
assets, the lower is the portfolio’s overall risk. The
movement of commodity prices for instance is largely
independent of the equities market – which means that
the combination of the two asset classes of equities and
commodities will ensure a good diversification.

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 The correlation coefficient can be between -1 and 1. A
correlation of -1 indicates that the movement of the two
asset classes are diametrically opposed to each other.
Conversely, a correlation of 1 denotes that the two asset
classes move completely in unison. The table above
shows for instance that US equities and European
equities have a strong correlation, in other words the two
markets tend to move in the same direction. By contrast,
equities and bonds show a negative correlation, in other
words when equity prices are on the rise, bond prices
generally fall.

Strategic The basis for any investment decision is the investment

and target that has been defined and the investor’s risk
Tactical profile. The latter reflects the personal weighting of the
Asset Allocation three criteria of liquidity, safety and profitability
discussed in the first section. Depending on the
investor’s investment target, one can either seek to
maximize income for a given level of risk or seek to
minimize risk for a given level of income. The focus of
strategic asset allocation is to define an asset mix which
is suitable for the investor from a long-term perspective
and is the most efficient and balanced as possible from
risk and return expectations. A classic case, for instance,
is the question of how the capital is to be split
between equities, bonds and liquidity, or what proportion
of a pure equities or bond portfolio should be
invested internationally.

Crucial for this decision are the historical data on income

and risk, measured in terms of average return and
annualized standard deviation (volatility), of the individual
asset classes. Since past values cannot automatically be
taken as an indication of future values, the figures need
to be adjusted according to market expectations and

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perspectives for the future. A strategic asset allocation can be
made on the basis of this forecast.

The outcome of such an optimization tailored to the investor’s

personal risk profile is important for setting a suitable strategic
benchmark for portfolios which are oriented to the long term.
The investment horizon for strategic asset allocation is very
long term, and short-term fluctuations in the risk and return of
the individual investment instruments are ignored.

As the next step, tactical asset allocation defines the

investment instruments or asset combinations the funds are
to be invested in and with what weighting Fine Art. Here, it is
a question of selecting the actual investments. This selection
is based on short to mid-term market forecasts which can
differ from the long-term assessments for the purposes of
strategic asset allocation. For instance, macroeconomic data
and current market developments are considered, which
make it necessary to adjust the short to mid-term outlook for
returns and volatility. With these tactical decisions it is also
attempted to outperform the strategic benchmark which, as
discussed, is closely linked to the strategic asset allocation.

The following table illustrates the two asset allocation

versions with the example of a portfolio based on a
“Moderate” strategy. The first column shows a possible
strategic asset allocation based on the investor’s risk profile.
The second column shows the portfolio’s current weighting
(the “tactical asset allocation”), with the current
overweighting or underweighting of the various asset classes
indicated in the last column.

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Excursus: Once the strategic asset allocation has been defined, the
Portfolio Theory funds can be distributed between various countries and
regions, different market segments and individual
securities. Thanks to the pioneering study by Markowitz
(1952) quantitative portfolio theory provides an answer to
this question and is widely accepted in practice. By virtue
of its simplicity and clarity it has established itself as a
standard model in the financial markets.

The optimum portfolio, i.e. the portfolio which delivers the

maximum income for a given level of risk, measured in
terms of the variance of the returns, or a minimum level of
risk for a given income, can be determined by applying
standard deviation optimization. The conclusion from
Markowitz’s study was that the risk of a portfolio
consisting of a number of risk assets is not simply the
average of the individual risks of the respective assets but
depends on how the individual assets correlate with each
other. This leads to an apparent paradox: the overall risk of
a conservative portfolio (e.g. bonds) can be reduced in
many cases by adding higher-risk assets (e.g. equities).
The key factor is how the individual asset classes are
weighted in the portfolio. The term “efficient portfolio” is
used when the individual elements of the portfolio are
combined in such a way as to produce the optimum
relationship of return and risk for the given investor.

The chart below illustrates how the expected return and

the risk of a portfolio can be modified by altering the
weighting of equities, bonds and other assets. If all
conceivable combinations of these values are plotted on a
return-risk matrix, one obtains a number of possible
portfolios but not all of them are efficient. In other words,
some portfolios offer higher potential returns for the same
level of risk while, conversely, others offer less risk for the
same expected return. In the chart, the efficient portfolios

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are all located on the upper part of the curve encircling
this matrix, the so-called “efficiency curve”. They offer the
optimum expected return for a given level of risk. The
efficient portfolio with the lowest level of risk is referred to
as the “minimum variance” or “safety-first” portfolio
(see chart).

Aim of portfolio structuring; a portfolio on/at

the efficiency curve

This particularly stable portfolio consists of a mix of

weakly correlated assets. The aim of portfolio structuring
is to put together a portfolio which comes as close as
possible to the efficiency curve. Where the respective
portfolio is located on the curve depends entirely on the
level of risk the investor is willing to accept. But the
principle is always the same: whatever the risk profile –
whether conservative or growth-oriented – a combination
of various assets can be found which optimally reflects
that profile.

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 The market portfolio:

What we have been saying so far applies to portfolios

which consist entirely of risk assets. But what happens if
these portfolios are combined with a risk-less investment?
This is a question that was investigated by Markowitz‘s
colleague James Tobin. He assumed that an investor was
able to invest or raise capital at a given interest rate. In our
matrix, this risk less investment would be located on the
vertical axis of the chart (risk = 0). The higher the
investment is on the axis, the higher is the assumed
interest rate. A combination of the risk-less investment
with any given securities portfolio can then be reproduced
by simply drawing a straight line between the two points
along which all possible combinations are reflected.
Obviously, the steeper the line is, the better the risk-return
relationship of the portfolios located along it. The steepest
of all possible lines touches the efficiency curve as a
tangent at just one point. The line is called the capital
market line, and the point at which it touches the
efficiency curve is the so-called market portfolio
(see chart).
Determining the market portfolio

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In this extended model the same principle applies:
efficient investor portfolios can be located anywhere
along the capital market line – where it lies depends on
the level of risk the investor is willing to take.

Portfolio theory is an important foundation for concrete

asset allocation. With the help of this model, it is possible
to develop mathematical models that derive the optimum
mix of investor portfolios.

However, portfolio theory is based on the assumption that

the historical values for the risk (measured in terms of
volatility, in other words the degree to which the values
fluctuate) and the return of a given asset can be applied
to the future. If this were possible on a one-to-one basis
and the returns of the respective asset classes were
normally distributed, it would indeed be possible, by
purely quantitative means, to construct portfolios which
always exactly reflect a given investor’s respective
expectations with regard to return and risk. But this is
not the case, especially since the returns of certain asset
categories are not normally distributed. Consequently,
the estimation of the future development of values and
the volatility of an asset plays an important role. This is
taken into account within the framework of strategic
asset allocation.

In the following sections we describe the individual asset

classes and their special features:

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 Equities

Definition
Classification

Measuring Risk
Types of Risk

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Definition Equities or stocks are certificates which document the
shareholder’s share of the capital stock of a corporation. The
shareholder has an ownership interest in the corporation and
shares in its profits in the form of dividends. The market price
of the stock, or share price, is determined by supply and
demand, and at the same time reflects the rise or fall in the net
worth of the corporation.

Classification Stocks can be assigned to different market sectors, e.g.

Financials, Basic Materials, Consumer Goods, Consumer
Services, Energy, Healthcare, Technology, etc. Another form of
classification is based on the respective corporation’s market
capitalization. A distinction is made between Small Cap,
Mid Cap and Large Cap companies according to the market
value of the corporation’s capital stock. Other terms used to
differentiate stocks are “Value” and “Growth”. Value stocks
have high book value to market capitalization ratios; growth
stocks have low book value to market capitalization ratios.

The performance of individual groups of stocks is tracked in

the form of indices. The most important and best known
international indices are the S&P 500, the Nikkei 225, the Euro
Stoxx 50 and the FTSE 100. There are also indices which track
the performance of stocks based on specific sectors or market
capitalization. One example is the Russell 2000. This index
consists of US Small Cap stocks.

Measuring There are various methods for measuring the risk of equity
Risk investments. Volatility and beta are the most commonly used.

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 Volatility (historical/implied)
The first measure of risk is the standard deviation
(volatility) of the returns. A distinction is made
between historical volatility and implied volatility.
Historical volatility indicates how high the stock’s range
of fluctuation was in the past. This measure represents
both the positive and negative deviations from the
expected value. Implied volatility is the volatility
contained in today’s market prices and reflects the
market’s expectations regarding the future range of
fluctuation in the share price.

Beta
Another measure of risk is the so-called beta coefficient.
Beta measures how strongly the stock reacts to changes
in the value of a benchmark, which in most cases is a
leading index, and is referred to as systemic risk. If a
stock has a beta of 1 relative to the Dow Jones Index,
this would mean that the stock has moved in unison
(1-to-1) with that index.

Types of risk The risk of an equity asset can be divided into two main
components: the fundamental risk and the market
psychology risk.

Fundamental risk covers the general market risk

(systemic risk) and company-specific risk (non-systemic
risk). The former is the risk of a price change that is
attributable to the general trend in the equity market and
is not directly related to the economic situation of the
individual company. The latter denotes the risk of a fall in
price due to factors which are directly or indirectly
related to the issuing company.

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The market psychology risk results from irrational
opinion-forming among investors and mass psychological
behaviour. The share price also reflects the hopes and fears,
assumptions and sentiment of buyers and sellers. In so far,
the stock market is a market of expectations on which it is
not possible to draw a clear-cut dividing line between
objectively justified and more emotionally driven behaviour.

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Fixed Income Securities

Definition

Types of Bonds
Risks

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Definition Fixed income securities, often also referred to as bonds, notes
or debentures, are debt certificates which are made out to the
respective (anonymous) bearer or registered in the name of a
specific holder. They carry a fixed or variable rate of interest
and have a specified life and specific repayment terms. The
buyer of a fixed income security (=creditor) has a monetary
claim against the issuer.

Types of There are a wide range of fixed income securities which

Bonds differ with regard to the payment of interest, repayment
options and other features such as protection against
exchange rate changes.

Classic straight bonds have a constant rate of interest (nominal

interest rate or coupon) over their entire life. In most countries
the interest coupons are paid half-yearly in arrears.
In the case of floating rate notes the nominal interest rate is
variable and is based on a reference rate, usually money
market rates such as EURIBOR or LIBOR. Depending on the
terms of the issue, the respective interest rate is fixed three, six
or twelve months in advance.

There are two basic variants of these floating rate notes:

floaters with a minimum interest rate (“floors”) and floaters
with a maximum interest rate (“caps”). With “floors” the
investor is guaranteed a minimum interest rate regardless of
the level of the reference rate. With “caps” there is a ceiling on
the rate of interest paid so the buyer never receives a coupon
payment above the maximum rate.

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 Another type of fixed income security is zero bonds,
which do not carry an interest coupon. In this case, there
are no periodic payments. The difference between the
purchase price and the repayment amount on maturity
represents the interest income over the life of the bond
to maturity.

When selecting fixed income securities one needs to

differentiate between bonds denominated in local
currency and foreign currency. Another important
distinction is between government bonds and corporate
bonds. Corporate bonds normally carry a higher yield or
premium versus government bonds, referred to as the
“spread”, which reflects the additional risk normally
associated with an investment in corporate bonds.

Risks Although fixed income securities are considered to be

relatively safe investments compared with other types of
security, they still present a number of major sources of
risk. Investors should be familiar with these risks before
they invest, in order to be able to make a reliable
assessment of the potential returns.

Credit Risk
Credit risk denotes the risk of the issuer’s bankruptcy or
insolvency, in other words the possibility that it might be
unable, either temporarily or permanently, to meet its
interest and/or repayment obligations as agreed.
Alternative terms for credit risk are borrower risk or
issuer risk. An issuer’s credit quality can change during
the life of a bond as a result of macroeconomic or
company-specific developments. Deterioration in credit
quality therefore has an adverse effect on the price of the
respective securities (risk discount). Generally, credit risk
tends to be higher, the longer the bond’s remaining life
to maturity is.

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Rating
Ratings are used as a means of assessing the probability that an
issuer will discharge the obligations to pay interest and repay
principal related to the securities it has issued punctually and in
full. The two best known rating agencies are Moody’s and
Standard & Poor’s. The rating has an influence above all on the
level of the yield: the better the rating the lower the yield.

Interest rate
Interest rate risk is one of the central risks of a fixed income
security. Interest rate levels on the money and capital market
constantly fluctuate and can cause the market price of the
securities to change daily. Interest rate risks arise as a result of the
uncertainty surrounding future changes in market rates. If the
market rate rises, the price of the bond normally falls until its yield
is roughly in line with the market rate. Conversely, if the market
rate falls, the price of the bond rises until its yield is roughly in line
with the market rate. Yield denotes the effective rate of return,
which represents the nominal interest rate (coupon), the price at
which the bond was issued or purchased, the repayment amount
and the (remaining) period to maturity of the fixed income security.

Currency Risk
Investors are exposed to a currency risk if they hold securities
denominated in a foreign currency and the underlying exchange
rate fluctuations. This is an important factor particularly in the case
of fixed income securities. Foreign bonds might have an attractive
coupon but this is generally associated with a higher currency risk.
A country’s exchange rate is influenced by fundamental factors
such as the country’s rate of inflation, differences in the level
of interest rates in relation to other countries, how the country’s
economic outlook is assessed, the geopolitical situation and
investment safety. If a currency’s exchange rate moves in the wrong
direction, this can quickly erode any yield advantage and diminish
the return achieved to such an extent that, with hindsight, it would
have been better to have invested in a fixed income security
denominated in one’s own local currency.

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 Derivatives

Definition

Financial Futures
Options

Possibilities
Risks

21
Definition Derivatives are not straightforward cash or spot market
transactions which are settled immediately but are a “derived“
form of transaction in equities, fixed income securities or
foreign exchange. A distinction is made between conditional
(options) and unconditional (futures) transactions.

Financial Financial futures are standardized, exchange-traded futures

Futures contracts. Futures constitute an agreement which places an
unconditional obligation on both parties – both seller and
buyer. Such contracts can be based on a variety of financial
products (underlying): for instance there are financial futures
contracts based on interest rates (interest rate futures), on
stock indices (stock index futures) and on foreign currencies
(foreign exchange futures). Futures have a symmetrical risk
profile. This means that the buyer and the seller have the same
profit or loss potential.

With the purchase/sale of the futures contract the buyer

undertakes to take/deliver a specified quantity of a specified
asset (underlying) at a future date (delivery, performance,
maturity date) at a predetermined price. The purchase of the
futures contract gives rise to a long/short futures position. The
buyer/seller expects the price of the underlying to rise/fall
during the life of the futures contract.

As a rule, the difference in gain or loss arising as a result of a

change in the price of the traded futures contract during its life
is realized by liquidating or closing out the position (making an
offsetting contract). The difference between the buying price
and the selling price of the futures contract determines what

22
 gains or losses are made on the transaction, whereby
other costs (such as transaction costs) have also to be
taken into account.

In the area of commodity futures physical delivery of the

commodity is usual, which can make this type of futures
contract unattractive for the private investor. Moreover,
these futures have high contract values and are therefore
not suitable for investors with small to medium amounts
to invest.

Options An option is an agreement under which the buyer (option

holder) has the right, but not the obligation, to buy or sell
a specified quantity of a given underlying asset within a
specified time period (American-style option) or on a
specified date (European-style option) at a predetermined
price (strike price). In exchange for this right the buyer
pays a price (option premium) to the seller of the option.

There are two types of option. An option to buy is

referred to as a call and an option to sell is referred to as
a put. The reference asset (underlying) is the asset to
which the option right relates. This can be individual
stocks or bonds, specific foreign currencies or indices
and futures contracts. There are two forms in which
option contracts can be settled: the underlying can be
physically delivered (physical settlement) or the contract
terms can provide for payment in cash (cash settlement).

Possibilities Depending on their strategy, investors can use futures

and options to pursue different objectives. Both can be
used for hedging purposes i.e. to protect against risk.
Market risks arising from existing or planned positions in
the underlying asset (cash or spot market position) can
be largely neutralized by taking up offsetting positions in

23
 the respective futures or options. If a loss arises on the cash
or spot market position, it is theoretically possible to achieve
a gain of roughly the same magnitude with a previously sold
futures contract or a put option. If prices move in the
opposite direction, a gain is made on the cash or spot market
position, while a loss is made on the futures/options position.

Besides hedging strategies, it is also possible to use futures

and options as a speculative instrument. Based on subjective
expectations and assessments of how the price of the
underlying asset will move, positions are deliberately entered
into with a view to making a profit. In this case, the leverage
effect, which arises because less capital needs to be
invested, plays an important role. This effect causes the price
of the derivative to react more than proportionally to changes
in the price of the underlying asset.

Risks For futures and options the biggest risk lies in

a. the risk presented by the leverage effect and
b. that the risk of loss is not limited
The higher the derivative’s leverage, the riskier the
position is.

Another danger is the greater risk of total loss. Owing to the

small amount of capital invested compared with other
investments and the high leverage, small market movements
can lead to considerable losses. A total loss is also possible
(and in the case of short positions a loss even beyond the
capital invested). Futures and options should therefore only
be used by investors with long capital market experience.

Derivatives are also exposed to the same general risks as the

underlying assets discussed in the earlier sections since their
performance is linked to the performance of the underlying.

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Alternative Investments

Alternative Products /
Investments
Hedge Funds
Private Equity Funds
Venture Capital Funds
Commodities
Real Estate
Currencies

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Alternative Alternative products and investments are assets which do not
Products/ count among the traditional investments (equities and fixed
Investments income securities). Generally, a distinction is made between
unregulated - in other words not subject to special regulatory
supervision - partnerships or corporations which serve the
purpose of collective investment (hedge funds, real estate,
private equity and venture capital funds), and non-homogeneous
asset classes. Non-homogeneous asset classes include
commodities and currency investments which do not relate to
classic asset classes such as equities and fixed income securities.
The aim of Alternative Investments is to offer opportunities for
capital appreciation independently of the equity and fixed-income
markets. They are therefore suitable for portfolio diversification.
This modifies the overall return and risk profile.

Hedge funds Hedge fund managers pursue an investment style of their own.
The basic idea is to generate a positive absolute return
irrespective of market trends. They can use the whole
spectrum of financial instruments including futures contracts,
options and securities of diverse asset classes. Most managers
concentrate on specific investment strategies and processes.
To simplify matters, the investment strategies can be divided
into five broad categories: Relative Value, Event Driven, Global
Macro, Equity Hedge and Short Selling.

Private equity Investments in private equity funds represent entrepreneurial

funds equity stakes in portfolios of young, usually unlisted companies.
The equity stakes serve to finance the growth of young
companies or special situations such as restructuring measures.
By subscribing a specific sum, investors acquire an ownership
interest in the private equity company and share in the assets of

26
 the fund. The income, which mainly represents gains
realized upon the sale of the equity stakes, is usually
distributed to the individual investor after it is received by
the fund and after deducting the investment manager’s
success fee and is not reinvested.

Venture capital Venture capital funds are very similar to private equity
funds funds. The main difference is that for the most part they
invest in companies which are at a very early stage of
development. They are mainly active in growth sectors
such as the internet, information technology and biotech-
nology.

Portfolio constructions (so-called funds of funds and

special index certificates) provide an opportunity for
investing indirectly in hedge funds, private equity funds
and venture capital funds. In the case of funds of funds,
investors acquire units in a fund which in turn invests in
funds. This gives the investor access to a diversified
investment, whose individual assets may require high
minimum investment sums. However in such cases there
is very limited public information available in such cases.

Commodities The term commodities relates to commercial products

traded on the markets. Commodities are divided into
three broad categories: minerals (e.g. oil, gas, aluminium
and copper), agricultural products (e.g. wheat and maize)
and precious metals (e.g. gold, palladium and platinum).
Another class are so-called soft commodities such as
coffee, cocoa, sugar or orange juice concentrate. “New”
commodities include electricity, weather and catastrophe
derivatives.

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Oil is the most important asset class among the mineral
commodities. The oil price reacts quickly and sharply to
supply shocks and geopolitical events, and is therefore
regarded as a crisis barometer. This class also includes
cyclically-sensitive metals such as aluminium and copper
whose price development is strongly correlated with
economic cycles.

Demand for agricultural products is less cyclical and price

fluctuations are mainly due to changes in supply conditions
which are difficult to predict such as weather factors.
However, prices can also be influenced by long-term
factors such as increase in demand as a result of population
growth or changes in eating habits (e.g. switch from
vegetarian foods to non-vegetarian foods as people become
more affluent).

Gold, which is still regarded as a crisis currency and “safe

haven”, plays the most important role among the
precious metals.

Soft commodities are acquiring greater importance in the

international markets in recent times as they are being
used more and more as substitutes for the traditional
commodity classes.

Most commodities are traded on specialized exchanges, or

directly between market players around the globe in the
form of OTC (over-the-counter) transactions, as largely
standardized contracts. Commodities are mainly added to
portfolios to improve the risk structure as they are only
weakly or negatively correlated with traditional asset classes
such as equities or fixed income securities.

28
Real Estate Real estate is an asset class which offers a wide variety
of investment opportunities. Basically, a distinction can
be made between directly and indirectly owned real
estate. The main forms of indirectly owned real estate
are real estate company stocks, including Real-estate
Investment Trusts (REITs), and open and closed-end real
estate funds – whereby the individual categories differ
widely from country to country. Directly owned real
estate assets are investments in apartments or office
properties. However, this mostly requires a large amount
of capital to be invested, and is therefore not attractive
for most investors, and is a less liquid form of investment
compared with traded instruments and fund units.

Real estate assets can also be differentiated according to

regional focus or different types of use. Finally, it is
customary to categorise real estate investments
according to different investment styles based on their
risk-return profile. On a broad definition real estate
investments also include property finance, mortgage
loans, securitized forms such as mortgage backed
securities and mezzanine capital, which is a hybrid form
of debt and equity capital.

Currencies The prices traded in the foreign exchange market are

rates of exchange between two currencies. The
motivation for investors to engage in the foreign
exchange market is usually to make a profit as a result of
short to mid-term fluctuations in exchange rates. It
should be noted that in this case the gains are generally
achieved from short-term changes in value and not in the
form of interest income.

29
Another possibility is so-called “carry trades” where the
investor seeks to exploit the interest rate spread between two
currencies, in other words borrowing money in a low-interest
currency and reinvesting it in a high-interest currency.

Currencies can be traded in a number of ways. The most

common are trading on a cash or spot market basis (with
settlement following as a rule two business days later) in the
form of currency futures contracts (settlement at a future
date) or a currency option.
With a daily trading volume of more than 1 trillion US dollars,
the international foreign exchange market is the world’s
biggest market.

30
Investment Funds

Characteristics of
Investment Funds

Performance
Possibilities

31
Characteristics Investment funds gather money from different investors and,
of Investment depending on the fund’s terms of reference, invest them in
Funds specific securities (e.g. in equities or fixed income securities,
in the home market or internationally) or in real estate.
Investment funds are professionally managed, so the portfolio
is under constant review and the various markets are analyzed.
The portfolio is adjusted according to the respective market
situation (tactical asset allocation). Investment funds are able
to practice the diversification described in portfolio theory very
well since they have the necessary capital and are therefore
able to invest in a range of asset classes. The resultant risk
spreading reduces the overall risk of this kind of investment.

Funds also make it possible to invest in markets which require

considerable market expertise, where asset values are highly
volatile, or to which small investors do not have access owing
to market restrictions.

Although funds have a better risk profile, the potential return is

still exposed to the same risks as a direct investment in
individual asset classes. The advantage lies in the fact that the
risk is diversified.

Performance The value of the investment certificate changes as the market

price of the securities in which the fund is invested changes.
The value of an investment fund unit (= the buying price, or the
price at which the unit is bought back by the investment fund)
is calculated on the basis of the fund’s total net asset value

32
 divided by the number of units in circulation. The
so-called “buying price” is fixed once a day. When the
units are purchased, a premium is usually charged. The
issue price paid thus represents the buying price plus the
premium. Funds which offer units for sale without a
premium are referred to as no-load funds.

Exchange traded funds (ETFs) are another type of fund.

ETFs can be traded continuously on a stock exchange
and are mostly index funds or actively managed
no-load funds.

Possibilities The following describes the different variants in terms of

investment focus:

The first distinguishing feature is the composition of the

fund’s assets in terms of investment instruments.

Standard equity funds invest in stocks, and mostly in

stocks which are regarded as “blue chips” owing to their
generally accepted quality. The fund’s assets are widely
spread and are not confined to specific sectors.

Specialized equity funds concentrate on specific

segments of the equity market, for instance sector funds
which invest in stocks in specific industries or business
sectors, small cap funds which hold small and mid-sized
companies (second-tier stocks) in their portfolios, or
stock index funds which track specific stock indices.

Standard bond funds invest mostly in fixed income

securities with different coupon rates and maturities,
and almost entirely in issuers of good or very good
credit quality.

33
Specialized bond funds concentrate, like specialized equity
funds, on specific segments of the fixed income market, for
instance low-coupon bond funds (bonds with low interest
rates), high-yield funds (high-yielding bonds of mixed credit
quality), junk bond funds (high-yielding bonds of low credit
quality) and short bond funds (securities with short periods
to maturity).

Hybrid funds are mixed funds which use both equity and
fixed income market instruments.
There are also funds which concentrate their investments on
specific markets, instruments or combinations thereof
(speciality funds). Examples are warrants funds and futures
funds. These speciality funds might also pursue specific
investment styles such as “value” or “growth” strategies.

The following types of fund can be distinguished on the basis

of their geographical investment horizon: country funds
which only invest in financial assets of issuers based in one
specific country; regional funds which only consist of assets
of the given region (e.g. Europe, North America or
Asia-Pacific); international funds which invest in the capital
markets worldwide and emerging markets funds which invest
in one or more emerging market countries.

34
Structured Products

Characteristics
Safety / Risk

Price performance
Certificates

35
Characteristics Structured products are products whose risk/reward profile is
tailored to specific market situations. There is no clear-cut
definition. They derive mostly from equities, fixed income
securities, derivatives, real estate and specific strategies.

Safety / Risk By investing in structured products it is possible to combine

the characteristics of different asset classes in terms of return
and risk so that a specific return and risk profile can be
generated according to how the market outlook is assessed.
Structured products have an asymmetrical risk/reward
relationship, in other words the buyer and the seller do not
have the same profit or loss potential owing to their different
rights and obligations. Structured products can also be used
as a hedging instrument. For instance, they can offer
protection against falling prices but this is at the price of a
lower potential return.

Price The value of the structured product changes as the market

Performance prices of the underlying investment instruments change. The
value of a structured product is normally determined and
published several times on each trading day.

Certificates Certificates are a good example of structured products.

Depending on the issuer, there are a whole range of products
on offer in the certificates market with different terms and
modalities. The most common types are index, discount and
bonus certificates.

36
 Index Certificates
Index certificates document a right to the payment of a
sum of money or other settlement, the amount of which
depends on the value of the underlying index on the
maturity date.
The certificates normally run for several years. As a rule,
there are no periodic payments of interest or other
distributions (e.g. dividends) during the life of the
certificate. By buying an index certificate, the investor
can participate in the performance of the underlying
index without having to buy the securities contained in
the index individually. Certificates are traded on and/or
off the exchange. As a rule, the issuer continuously
quotes bid and asked prices for the certificates every
trading day throughout the certificate’s life.

Discount Certificates
Discount certificates are securities with a fixed life where
the manner of repayment on maturity depends on the
price of the reference underlying (e.g. stocks or indices).
On a specified date there is an upper limit on the amount
disbursed. In return for this the discount certificate is
cheaper than the underlying so there is a buffer against
risk on the downside.

Bonus Certificates
Bonus certificates are instruments which enable the
investor to profit from rising prices without any limit
while benefiting additionally from a buffer against the
risk of falling prices. This takes the form of the payment
of a bonus amount (on top of the value of the certificate)
at the end of the certificate’s life if the value of the
underlying has always traded above a specified level, the
so-called barrier, throughout the life of the certificate. If

37
the barrier is touched during the life of the certificate, the
function of the risk buffer is cancelled. If the price of the
underlying rises and the barrier is not touched, the investor
either receives the nominal value of the certificate plus the
bonus amount or the value of the underlying, whichever is
higher, when the certificate matures.

38
 Glossary
Asset
Any possession that has value.
Asset allocation
The decision regarding how an investor’s funds should be distributed
among the major assets (e.g., equities, bonds, money markets,
commodities).
Asset class
An investment category that groups all securities sharing certain
defined attributes into that grouping (e.g., US large cap., US bonds,
REITs, etc.). In general, securities grouped into the same asset class
will tend to respond similarly to changes in economic climate,
profitability and market uncertainty, though this will not always be
the case. The asset classes are generally defined so that every
security will fall into one and only one asset class.
Benchmarks
The performance of a predetermined set of securities, used for
comparison purposes. Such sets may be based on published indexes
or may be customized to suit an investment strategy.
Beta
The measure of a fund’s or stock’s risk in relation to the market, or
an alternative benchmark. A beta of 1.5 means that a stock’s excess
return is expected to move 1.5 times the market excess return. For
example, if market excess return is 10 percent, then we expect, on
average, the stock return to be 15 percent. Beta is referred to as an
index of the systematic risk due to general market conditions that
cannot be diversified away.
Bonds
A bond is debt issued for a period of more than one year. The
government, local governments, water districts, companies, and
many other types of institutions sell bonds. When an investor buys
bonds, he or she is lending money. The seller of the bond agrees to
repay the principal amount of the loan at a specified time.
Interest-bearing bonds pay interest periodically.
Call option
A call option is the right, but not the obligation, to buy an asset at a
pre-specified price on or before a pre-specified date in the future.

39
Caps and floors
Interest rate options. Caps are an upper limit on interest rates (if
you buy a cap, you make money if interest rates move above
cap strike level). Floors are a lower limit on interest rates (if you
buy a floor, you make money if interest rates move below floor
strike level).
Correlation
A linear statistical measure of the degree to which two random
variables are related. A correlation will range from -1.0 to +1.0. For
market risk, international equity markets rising and falling together
show positive correlation. In credit risk, clumps of firms defaulting
together by industry or geographically show positive correlation of
default events.
Coupon
The periodic interest payment made to the bondholders during the
life of bond.
Currency risk
Risk of loss due to movements in currency rates.
Default
Failure of a debtor to make timely payments of principal and
interest or to meet other provisions of a bond indenture.
Derivatives
Securities, such as options, futures, and swaps, whose value is
derived in part from the value and characteristics of another
underlying security.
Diversification
Holding a large collection of independent assets to reduce
overall risk.
Efficient frontier
The efficient frontier is a set of allocations that delivers the highest
estimated return for a range of estimated risk levels. More risk does
not always imply greater estimated returns. Please note that if an
allocation is not on the efficient frontier it may be possible to
reduce risk while preserving, or even increasing, target return by
moving towards the efficient frontier.
Foreign exchange risk
Risk of loss due to movements in foreign exchange rates.

40
 Futures
A term used to designate contracts covering the sale of financial
instruments or physical commodities for future delivery on an exchange.
Hedge fund
A fund targeted to sophisticated investors that may use a wide range
of strategies to earn returns, such as taking long and short positions
based on statistical models.
Hedging
Eliminating an exposure by entering into an offsetting position. For
example, a gold mine can hedge exposure to falling prices by selling
gold futures. When hedging, we look for highly correlated
substitute securities.
Inflation
The rate at which the price that consumers pay for goods and
services rises over time.
Interest rate risk
Risk arising from fluctuating interest rates. For example, a bond’s
price drops as interest rates rise.
Interest rate
Cost of using money, expressed as a percentage rate per annum.
Long position
Opposite of short position, a bet that prices will rise. For example,
you have a long position when you buy a stock and will benefit from
prices rising.
Market risk
Risk that arises from the fluctuating prices of investments as they are
traded in the global markets. Market risk is highest for securities with
above-average price volatility and lowest for stable securities such as
Treasury bills.
Modern portfolio theory
Investment decision approach that permits an investor to classify,
estimate, and control both the kind and the amount of expected risk
and return.
Option
An option is the right, but not the obligation, to buy or sell a
reference asset at a pre-specified strike price on or before a
pre-specified future date. A European-style option can be exercised
only at maturity, whereas an American-style option may be exercised
any day before or on maturity.
Risk
Uncertainty about or exposure to loss or damage. The risk of a
security or an asset allocation describes its volatility, or the

41
uncertainty of the year-to-year performance relative to the
expected return. It does not describe other forms of risk.
Short position
Opposite of long position—a bet that prices will fall. For example, a
short position in a stock will benefit from the stock price falling.
Standard deviation
A statistical measure that indicates the width of a distribution
around the mean. A standard deviation is the square root of the
second moment of a distribution. More generally, it is a measure of
the extent to which numbers are spread around their average. If
returns followed a normal distribution, 66% of the possible return
values would fall within one standard deviation of the control (or
expected) value.
Stock
Ownership interest possessed by shareholders in a corporation
(i.e., stocks as opposed to bonds).
Strike price
The stated price for which an underlying asset may be purchased
(in case of a call) or sold (in the case of a put) by the option holder
upon exercise of the option contract.
Systemic risk
The risk of a portfolio after all unique risk has been diversified
away. Systemic risks may arise from common driving factors (e.g.,
market and economic factors, natural disasters, war) and can
influence the whole market’s well-being. (Also known as
systematic risk.)
Underlying
An asset that may be bought or sold is referred to as the underlying.
Unique risk
Exposure to a particular company sometimes referred to as
firm-specific risk.
Volatility
Portfolio volatility is a measure of deviation from that portfolio’s
mean return over the period in question.

42
 Master the fine art of financial markets and asset classes
Financial consultancy is an art. This compilation aims at equipping

you with fundamental financial terminologies and nomenclature,

to help you master this art. It explains the basics of financial

markets and asset classes in clear and simple terms with the

aim of helping you in pre-meeting preparations, during

negotiations and even in day-to-day situations.

Deutsche Bank states: The opinions, expectations and other information contained herein are entirely those of Deutsche Bank AG.
Whilst all reasonable care has been taken to ensure that the facts stated herein are accurate and that forecasts, opinions and
expectations contained herein are fair and reasonable, Deutsche Bank AG has not verified the contents hereof, and, accordingly,
neither Deutsche Bank AG nor any members of the Deutsche Bank Group nor any of their respective Directors, officers or employees
shall be in anyway responsible for the contents hereof. All decisions to sell or purchase units / securities shall be on the basis of the
own personal judgement of the Customer consulting his / her / their own external investment consultant. Deutsche Bank does not in
any manner guarantee any returns on any of the investment products.