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LOGISTABLE LIMITED

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GIBRALTAR


An analysis of financial instruments
and the risks associated with them

FOREWORD

This document aims to provide the clients of Logistable Limited (Logistable) with an explanation of the financial instruments typically used by Logistable (please refer to the list below) as part of its investment strategy and an overview of the risks generally associated with those financial instruments.

  • Money market instruments
  • Equities
  • Bonds
  • Investment Funds
  • Commodities
  • Derivatives

It is impossible and indeed impractical to describe in detail all financial instruments, their characteristics and their related risks in one document. This document is by no means definitive or exhaustive and does not describe all financial instruments and the risks inherent to them. The intention is therefore to try and provide Logistable’s clients with basic information and make them aware of the existence of the most relevant/material/essential risks inherent to such financial instruments.

If the characteristics of a financial instrument deviate from the description in this document, the client will be informed, in writing, about these deviating characteristics and the specific investment risks. Furthermore, if financial instruments are traded on behalf of the client that are not described above, the client will be informed in writing, of the characteristics of these financial instruments and the specific risks involved.

When selecting financial instruments, investors must carefully consider which financial instruments fall within their investment profile. Risks are attached to all forms of investing to a greater or lesser extent. Investors should only ever trade in financial instruments if they are prepared to bear the potential losses associated with that financial instrument and are fully aware of the risks associated with that financial instrument.

BASIC INFORMATION ABOUT RISKS

Investing in general and investing in financial instruments in particular will expose an investor to risk.

As a general principle, the higher the volatility or fluctuation in the price of a financial instrument over a period of time, the higher the risk of capital loss for an investor.

A fundamental principle of investing in financial markets is that an investor needs to be rewarded for the risks they take. Therefore the higher the risk, the higher the return the investor will require and vice-versa. This means that assets in financial markets are priced relative to the risk they represent for an investor.

In financial markets, an investor will face two types of risks:

  1. Market risk: Whatever the investor does, market risk will always exist and the investor has no option but to accept it. This risk is the same for all investors and will depend on existing market conditions and economic sentiment. For example; a global war or the financial collapse of a country represents such a risk.
  2. Non-systematic risk: The investor can reduce the risks associated with investing in financial markets by tailoring his/her investment portfolio to ensure;
    • Industry diversification:
    • Financial instrument diversification:
    • Currency diversification

It is therefore sound strategic management for an investor to create a diversified portfolio as this can help reduce non-systematic risk and maximise returns.

GENERAL RISKS

The risks highlighted below could apply individually or cumulatively to any type of financial instrument. Therefore the greater number of risks identified with a financial instrument the greater the level of risk the investor is exposed to.

Economic risk

Economic risk refers to the economic cycle and macroeconomic situation of;

  • a country, and/or
  • a continent, and/or
  • the global economy.

Economic risk can have a significant impact on the price of a financial instrument.

The price of a financial instrument will vary depending on where in the economic cycle an economy finds itself. Hence equities will usually perform well in periods of economic growth and underperform during periods of economic slowdown whereas bonds will usually perform well in periods of economic slowdown (given that interest rates tend to fall during an economic slowdown) and underperform in times of economic growth, (given that interest rates tend to rise during periods of economic growth).

It is also important to note that the length and scope of economic cycles vary; therefore an investor must understand and take account of economic risk when creating a diversified portfolio.

Inflation risk

Inflation is essentially the rate at which prices increase in an economy. Inflation is closely monitored by central banks because high inflation is generally not good for an economy. High inflation usually affects most financial instruments and causes;

  • currency depreciation; this could cause financial losses to an investor as the value of their investment will decrease in value when converted their domestic currency, and
  • reduces the real return (its actual return less inflation) of financial instruments.

Therefore an investor must understand and take account of the risks associated with inflation (in particular when they invest in emerging economies and/or bonds) when creating a diversified portfolio.

Exchange rate risk

Exchange rate risk arises when an investor holds financial instruments in a foreign currency that is different from their own domestic currency.

The exchange rate between two currencies will depend on the domestic and foreign countries’;

  • inflation rates,
  • interest rates,
  • differences in their productivity,
  • growth forecasts, and
  • political stability.

Therefore an investor must understand and take account of exchange rate risk when in an effort to create a diversified portfolio they invest in a foreign currency.

Liquidity risk

The liquidity of a financial instrument describes the ability of an investor to buy and/or sell a financial instrument without delay and without having an impact on its price. Therefore, should a financial instrument have little or no liquidity it may result in a situation where the investor was unable to buy and/or sell the financial

The lack of liquidity of a financial instrument may arise for several reasons chief among them being;

  • a lack of market supply and demand for the financial instrument, and
  • the characteristics of a financial instrument, or
  • market practices related to the financial instrument.

This could result in instructions, to buy or sell a financial instrument, not be carried out immediately and/or said instructions being only partially executed. Furthermore the instruction may be executed on terms that are not favourable to the investor. For example, in certain circumstances higher transaction costs may apply.

The primary measure of liquidity risk is the difference between the bid price (the price at which a dealer is willing to purchase a security) and the ask price (the price at which a dealer is willing to sell a security). The higher this difference, which is also called the “spread”, the higher the liquidity risk.

Therefore an investor must understand and take account of liquidity risk and the constraints it can place on their efforts to create a diversified portfolio.

Credit risk

Credit risk arises when one party lends money to another party (for example the purchase of a corporate bond).

Credit risk becomes a reality when a debtor is unable to honour their debt and repay the lender. This is known as being in default and may result in the lender losing part or all of their capital.

Credit risk will also exist if an investor chooses to borrow money to invest in financial instruments. The “leveraging” of the investor’s portfolio will therefore increase the risk attached to it.

Therefore an investor must understand and take account of credit risk when selecting financial instruments and structuring the financing of a diversified portfolio.

Interest rate risk

As a general rule, fluctuations in interest rates, both long-term and/or short-term, will have an impact on the price of a financial instrument. This is particularly relevant for bond instruments where both interest rate and default risk are the most important risks.

Emerging markets

Emerging markets, as a rule, generally show higher growth than developed economies. However this inevitably comes with enhanced and/or additional risks such as;

  • potentially unstable political systems,
  • weak economic fundamentals,
  • unsophisticated rules regarding the clearing and settlement of transactions, and
  • less developed regulatory supervision and investor protection.
  • Therefore an investor must understand and take account of the risks they are exposed to when investing in emerging markets as part structuring a diversified portfolio.

    FINANCIAL INSTRUMENTS

    Money Market Instruments

    Money Market instruments are highly liquid investments and include the following;

    1. Term deposits:

    The investor places cash with a financial institution for;

    • an agreed period of time that may vary from 24 hours to a year or possibly longer, and
    • at a pre-determined rate of interest which will be based on;
      • the time frame involved,
      • the currency, and
      • the prevailing market conditions.

    Specific risks typically associated with term deposits:

    1. Market risk; changes in short-term interest rates.
    2. Exchange rate risk; the instrument is not denominated in the domestic currency of the investor and therefore payments are not in the domestic currency of the investor.
    3. Credit risk; the debtor becomes insolvent.
    4. The investor may be charged a fee should they wish to withdraw their money before the end of the agreed period.

    2. Short term debt instruments:

    Usually only issued by entities with high creditworthiness for periods of up to 270 days in order to finance short-term cash requirements. They are issued at a discount and do not pay fixed coupons like conventional bonds.

    Specific risks typically associated with short term debt instruments:

    1. Market risk; changes in short-term interest rates.
    2. Exchange rate risk; the instrument is not denominated in the domestic currency of investor and therefore payments are not in the domestic currency of the investor.
    3. Liquidity risk: usually less liquid than other money market instruments.
    4. Credit risk; the debtor becomes insolvent.

    3. Treasury Bills:

    These are short-term debt instruments issued by the United States Federal Government. They are denominated in US dollars (USD) with maturities of less than one year. They are issued at a discount and do not pay fixed coupons like conventional bonds.

    Specific risks typically associated with Treasury Bills:

    1. Market risk; changes in short-term interest rates.
    2. Exchange rate risk; the investors domestic currency is not US dollars.

    Equities/Shares

    The term equity refers to the units of share capital of a particular entity/company. Therefore an investor who purchases shares in an entity/company actually owns a piece of it and (should there be any) will be entitled to receive a proportion of the company's profits by way of a dividend.

    As a regular income stream, dividends received from equities are generally riskier than debt security or corporate bonds given that, whereas the income stream from these financial instruments is fixed, the amount and frequency of dividends will vary depending on the profitability of the entity/company.

    Moreover equities are generally riskier because if an entity/company goes out of business, bond and debt holders will be compensated before shareholders raising the possibility that there may be no money left to pay the shareholders.

    The share capital structure of an entity/company may vary according to its circumstances. However in general the types of shares issued are usually the following;

    • Common shares (usually voting shares), and
    • Preferred shares (usually non-voting shares).

    Moreover shares can be either voting or non-voting. The purpose of issuing voting and non-voting shares is usually to preserve the influence of the founding shareholders by entitling them to vote on issues such as: what individuals will sit on the board of directors, corporate governance issues or strategic planning which relate directly to the day to day running of the entity/company.

    Non-voting shareholders meanwhile are entitled to a dividend that must be at least equal to that granted to shares with voting rights.

    Specific risks typically associated with equities/shares:

    Market risk: As described on page 2, whatever an investor does, market risk will always exist and the investor has no option but to accept it. This risk is the same for all investors and will depend on existing market conditions and economic sentiment.

    Volatility risk: The list below provides some examples of the factors that will determine the volatility of the price of and equity/share;

    • The size of the entity/company.
    • The guidance issued by the board of directors as to growth prospects of the entity/company and its competitive position within the industry and markets in which it operates.
    • The entity’s/company’s ability to gain market share (through innovative products or unique capabilities.
    • The entity’s/company’s ability to generate cash-flows (which relate to its profitability, expected growth, and capital management);

    Liquidity risk: For an equity/share, liquidity depends on the number that are in issue and available on the market for purchase/sale as well as the daily volume of transactions to purchase/sell them. Therefore the greater the purchase/sale volumes, the lower the liquidity risk. As a general rule it therefore follows that liquidity risk is higher for small entities/companies whose equities/shares are not frequently traded, than for large companies which tend to have high transaction volumes.

    Exchange rate risk: Occurs when an investor purchases or holds shares that are denominated in a currency other than that which the investor would normally use. The exchange rate risk increases if the foreign currency depreciates versus the domestic currency.

    Dividend risk: Arises given that the level and frequency of dividends paid primarily depends on the profitability of the entity/company.

    Bonds

    A bond is a debt investment. An investor loans money to the issuer of the bond (invariably companies or governments raising money to finance projects and/or activities) for a defined period of time.

    In return the bond holder is generally entitled to interest (or “coupon”) payments as well as the repayment of the original investment at the end of the defined period of time (or “upon maturity”).

    The coupon represents the amount that the bond must pay on predetermined dates (usually quarterly, every six months or annually). The size of the coupon generally depends on;

    • the quality of the issuer of the bond,
    • the length of time the money is being loaned/borrowed for,
    • the currency of the bonds, and
    • the liquidity of the bond .

    The issue price of a bond is normally quoted with a par or face value of 100. A bond whose market price is above 100 is said to be trading at a premium, whereas it is said to be trading at a discount if its price is below 100. Bond price variations will vary depending on;

    • interest rates,
    • the quality and/or creditworthiness of the issuer.

    There are a multitude of different types of bond available to purchase. The below examples provide an overview for the most common instruments.

  • Zero-coupon bonds: Issued at a discount, or below their par value, these bonds do not make coupon payments during their lifetime. The investor upon redemption or sale simply makes a capital gain equal to the difference between the price paid for the bond and the price of its redemption or sale.
  • Fixed coupon bonds: As the name would suggest these bonds pay a fixed rate of interest (on a periodic basis) as well as the repayment of the original investment at the end of the defined period of time.
  • Floating rate bonds: These bonds have variable coupon payments that are linked to a variable interest rate and are reset on specific dates.
  • Indexed bonds: With these bonds the yield is linked to the variations of an index such as inflation, or the stock market.
  • Convertible bonds: These bonds give the investor the right or the option to convert the bonds into common shares of the company that issued the bond. Two crucial features of convertible bonds are;
    • The conversion ratio, the number of common shares that an investor will receive when they exchange their convertible bond, and
    • The conversion price, the pre-agreed price at which the bond can be converted into common shares.
  • Specific risks typically associated with bonds:

    Interest rate risk: This is usually the most significant risk associated with a bond. Put simply, when interest rates increase bond prices fall and vice-versa. As a result and generally speaking, the longer the time frame to a bond’s redemption the higher the interest rate risk.

    Credit risk: This relates to the risk that the issuer/borrower is unable to honour their debt and repay the lender; the agreed interest payments, and/or repay the initial investment. This is known as being in default and may result in the lender losing part or all of their capital. The credit risk associated with a bond will depend primarily on the financial stability of the issuer. Therefore generally the more financially stable the issuer is considered to be the lower the coupon offered by the bond and vice-versa. The deterioration of an issuer's creditworthiness will have a negative impact on the price of the bond as investors seek to sell the bond and crystallise their investment in an effort to reduce their credit risk.

    Liquidity risk: This reflects the investor’s ability to buy/sell the bond in question without impacting its market price. As for any financial instrument the liquidity risk will depend on the number of bonds in issue and available on the market for purchase/sale as well as the daily volume of transactions to purchase/sell them. Therefore the greater the purchase/sale volumes, the lower the liquidity risk.

    Exchange rate risk: Arises for foreign bonds whose coupon payments and redemption/sale amount will be paid in a foreign currency. The exchange rate risk increases if the foreign currency depreciates versus the domestic currency.

    Inflation risk: An increase in inflation reduces the value of the coupon payments received by the investor over time.

    Investment Funds

    An investment fund groups monies received from investors with a view to investing it in accordance with the objectives stated in the Fund’s prospectus.

    Investment funds are managed by money managers or fund managers.

    Investment funds can be both;

    1. Non-complex or Undertakings for Collective Investment in Transferable Securities (UCITS), and
    2. Alternative Investment Funds (AIF’s).

    Prior to investing in a fund, it is imperative that the investor carefully review the Fund’s prospectus.

    1. UCITS

    European Union rules with regard to UCITS allow these funds to be operated freely across the EU. EU rules on UCITS provide for;

    • investor protection,
    • a clear definition of the types of financial instruments allowed, and
    • the level of liquidity, diversification and transparency of said financial instruments held within the UCITS.

    Exchange Traded Funds (ETF’s) are typically traded as equities in financial markets and usually replicate a stock market index, or basket of assets. Investing in ETF’s exposes an investor to risks similar to those faced in equities/shares.

    Specific risks typically associated with UCITS:

    Market risk: The risks and returns associated with, amongst other factors, the following:

    • The financial instruments held by the Fund,
    • Their sector concentration,
    • Their country allocation.

    Valuation risk: The financial instruments held by the Fund may be difficult to price in the market resulting in the Net Asset Valuation (NAV) being inaccurate.

    Liquidity risk: Although largely protected from liquidity risk by UCITS regulations, liquidity issues may arise with the financial instruments held by the Fund during severe market corrections to the downside or if the fund manager breaches UCITS requirements. In extreme circumstances UCITS funds are entitled to suspend redemptions until markets stabilise.

    Counterparty risk: Certain operations within a Fund, such as the administration or the custodial duties, are often subcontracted to third parties. The risks associated with these counterparties and the terms and conditions under which they operate should also be taken into account.

    Operational risk: Operational and control procedures instituted by the Fund Manager may be weak or inadequate and could result in errors and losses for the investor.

    Management risks: As a legal entity, a Funds success will depend on the quality of its management team.

    2. Alternative Investment Funds (AIF’s).

    As a general rule (and with the sole exception of the Castle and Key Fund Public Limited Company which is regulated in Gibraltar as an AIF but is in fact an “Long only global Fund”) Logistable does not invest in or purchase units in AIFs for its investors’ portfolios.

    Given that AIFs are typically complex, often lack transparency and liquidity and use hedging techniques in order to try and generate returns that outperform the market, the risks associated with them are considered to be too great and they therefore do not form part of Logistable’s investment strategy.

    Alternative Investment Funds typically include:

    • Hedge Funds
    • Private equity Funds
    • Real Estate Funds
    Commodities

    A commodity is a physical product that can be traded on a secondary market or exchange. Given that the price of a commodity will invariably increase in parallel with inflation, commodities are often used to hedge the effects of inflation on an investor’s portfolio. The return for an investor is therefore the capital gain associated with the change in the price of the commodity.

    Commodities traded on a secondary market or exchange can be broadly split into the following categories;

    • Agricultural – such as cocoa, coffee, sugar and wheat.
    • Livestock – such as pork bellies and beef.
    • Metals – including gold, silver, platinum, lithium and copper.
    • Energy – including crude oil, natural gas and electricity.

    It is possible for an investor to purchase any one of the above commodities directly, however the most common way is to buy an equity/share that is directly linked to a particular commodity. Therefore an investor wishing to gain exposure to the price of gold may buy shares in a gold mining company or a Fund created specifically to hold physical gold and/or equities/shares in gold mining companies.

    Specific risks typically associated with Commodities:

    Market risk: Commodities are exposed to market risks because their supply and demand are influenced by the actions of producers, consumers, traders, and commodity investors.

    Exchange rate risk: the commodity is not denominated in the domestic currency of the investor. The exchange rate risk increases if the foreign currency depreciates versus the domestic currency.

    Geopolitical risk: Commodities such as oil and gold are closely linked to politics given their high value and importance to the global economy. Therefore political tensions and or instability in countries closely linked to the production of a commodity may significantly alter its supply and therefore its price in the market.

    Derivatives

    Derivatives consist of a contract between two investors (a buyer and a seller) that give them (depending on the terms of the contract) either the right or the obligation to execute the terms of the contract within the timeframe specified by that contract. The price of a derivative will depend on the price or value of the asset that underlies the contract. The underlying asset could be almost anything but is usually one of the following;

    • Equities/shares,
    • Bonds,
    • Interest rates,
    • Currencies, and
    • Commodities.

    Various derivative instruments exist, the most common of which are; forward contracts, future contracts, swap contracts, and option contracts.

    As a rule Logistable does not invest in or purchase derivatives for its investors’ portfolios as the risks associated with them are considered to be too great. Moreover given that derivatives are typically complex and more volatile than their underlying asset and are used for speculation or hedging purposes they do not form part of Logistable’s investment strategy.

    However and despite the aforementioned, below is a brief description of the most common derivative; option contracts.

    Option Contracts:

    An option contract is a contract between two investors (a buyer and a seller) where the seller is obliged to sell or the buyer obliged to buy the asset underlying the contract at a price and within a timeframe specified within the contract. Option contracts are generally highly standardised and are traded on organised exchanges.

    There are two types of options:

    1. Call option: A contract where the buyer pays a fee (premium) to the seller, and acquires the right or the option (there is no obligation) to buy the underlying asset from the seller at a predetermined price. Upon exercising the option, the seller must honour the contract either by delivering the underlying asset or through a cash settlement. Investors buying call options expect the price of the underlying asset to increase.
       
    2. Put option: A contract where the buyer pays a fee (premium) to the seller, and acquires the right or the option (there is no obligation) to sell the underlying asset to the seller at a predetermined price. The seller must honour the contract either by buying the underlying asset or through a cash settlement. Investors buying put options expect the price of the underlying asset to decrease.

    Option contracts may be used for any type of underlying asset, both for speculative and hedging purposes. They are highly volatile.

    Specific risks typically associated with Option contracts:

    Price risk: This represents the main risk for options whether they are call or put options. Option contracts are extremely sensitive to changes in the market price of the underlying asset and in extreme cases unlimited losses can occur.

    Leverage risk: Via the use of leverage techniques, small market movements may lead to significant gains but can also lead to large losses. In extreme cases the entire amount invested could be lost.

    Market risk: The investor is subject to the market risk associated with the underlying assets.

    Interest rate risk: Should interest rates increase the value of the call option increases, while the value of the put option decreases.

    Volatility risk: If the volatility of the underlying asset increases, the value of both the call and the put options increases.

    Liquidity risk: Although options traded on an organised exchange are usually highly liquid, the underlying asset may not be.

    Exchange rate risk: The option contract is not denominated in the domestic currency of the investor. The exchange rate risk increases if the foreign currency depreciates versus the domestic currency.

    Counterparty/Issuer risk: The investor is exposed to the risk that the issuer of the option contract/counterparty will default.

    Valuation risk: The valuation of the underlying instrument may be difficult to price and or assess in the absence of a true market. As a result the valuation may be inaccurate and or wrong.

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