The term certificate, as it is used in finance, denotes a group of derivatives, some of which are more complex than others. Certificates are participation products. When you invest in a certificate, you are not investing in the actual underlying asset, but you still participate in gains or loses in the price of that asset.
There are many different subtypes of certificates. Among others, they include:
- Tracker certificate: Trackers follow the price of an underlying asset. You can use a tracker certificate to invest in the performance of multiple stocks, for example. Index certificates and bear certificates are also tracker certificates. Tracker certificates are the most common type of certificate.
- Bonus certificate: Bonus certificates have an upper threshold (the bonus) and a lower threshold (the protection). They also have a fixed contract term. If the price of the underlying asset does not exceed either of the two thresholds over the course of the investment term, the investor receives the bonus (the amount defined by the bonus threshold). Example: You buy a bonus certificate based on a stock. The price of the stock at the time that you get the certificate is 100 francs. The bonus level is 120 francs, and the protection threshold is 80 francs. Over the two-year term, the price of the stock fluctuates between 90 and 110 francs. When the certificate matures at the end of the term, you receive the bonus price of 120 francs.
- Outperformance certificate: This type of certificate rewards you disproportionately well if the price of the underlying asset surpasses a certain threshold. The so-called participation factor determines the return you get. Example: You buy an outperformance certificate based on a stock. The certificate’s strike price is 100 francs and its participation factor is 150 percent. If the price of the underlying stock surpasses the strike price of 100 francs, you are rewarded with a 150 percent return, instead of just 100 percent. If the price of the stock climbs to 110 francs, for example, the value of the certificate would be 115 francs.
- Discount certificate: Discount certificates are time-limited certificates which you buy at a discount compared to the actual price of the underlying asset. In exchange, the returns you can receive at the end of the contract term are also limited. This upper threshold is called the cap. So you pay less for the certificate than you would pay for the underlying asset – but your potential return is also lower. The bigger the discount, the lower the cap on returns is.
- Express certificate: With express certificates, the price of the underlying asset is recorded at annual intervals over a limited term (three years, for example). If the asset’s value exceeds a certain threshold, the certificate matures early, and you receive an amount equal to the price of the underlying asset, plus an additional return. The return is based on the number of years over which you have held the certificate. If the price never exceeds the threshold before the standard contract term expires, you normally only receive the amount you initially invested.
In many cases, certificates do not give you as the investor the right to receive dividend distributions from the underlying stocks or other assets. This is typically the business model behind certificates. Example: You buy a bonus certificate issued by your bank which is based on a stock that pays annual dividends. During the certificate’s term, the bank holds the underlying stock and receives the dividends. At the end of the term, the bank pays the predefined bonus, even though the actual price of the stock is lower (but not below the protection threshold).
Depending on the type of certificate, the exact terms and conditions, and the contract’s expiry date, it is possible that you may receive the underlying asset instead of money at the end of the investment term. That is often the case with discount certificates based on stocks, for example, when their price sits below the predetermined cap.
Because certificates are complex financial derivatives, you should only use them if you know how they work and understand their exact terms and properties. Correctly gauging your risk capacity and the risks associated with certificates is particularly important.
Certificates are bearer debt notes and subject you to counterparty risk. If the certificate’s issuer (a bank for example) becomes insolvent, the assets which underly the certificate (stocks, for example) are considered part of the issuer’s liquid assets. That is in contrast to owning actual securities or shares in investment funds, as these are segregated assets which remain your property if your stock broker or custodian bank fails.
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