Last updated: 5th September 2017

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Warrants and derivatives risks

 

These risk warnings cannot disclose all the risks and other significant aspects of warrants and/or derivative products such as futures or options or contracts for differences. Certain strategies, such as a ‘spread’ position or a ‘straddle’, may be as risky as a simple ‘long’ or ‘short’ position. Riskbridge or its representatives may, from time to time, recommend transactions in warrants and/or derivative instruments.
Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. Different instruments involve different levels of exposure to risk and in deciding whether to trade in such instruments you should be aware of the following points.

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The price of derivative instruments are highly volatile. Price movements of forward contracts, futures contracts and other derivative contracts are influenced by, amongst other things, interest rates, government policy, national and international politics and economic events and policies.

Warrants

A warrant is a time-limited right to subscribe for shares, debentures, loan stock or government securities and is exercisable against the original issuer of the underlying securities. A relatively small movement in the price of the underlying security results in a disproportionately large movement, unfavourable or favourable, in the price of the warrant. The prices of warrants can therefore be volatile.

The right to subscribe which a warrant confers is invariably limited in time with the consequence that if the investor fails to exercise this right within the predetermined time-scale, then the investment becomes worthless. Investors in warrants could sustain a total loss of money invested along with commissions and transaction charges.
Some other instruments are also called warrants but are actually options (for example, a right to acquire securities which is exercisable against someone other than the original issuer of the securities, often called a ‘covered warrant’).

Off-exchange transactions in warrants
Transactions in off-exchange warrants may involve greater risk than dealing in exchange traded instruments because there is no exchange market through which to liquidate your position, or to assess the value of the instrument or the exposure to risk. Bid and offer prices need not be quoted, and even when they are, they will be established by dealers in these instruments and consequently it may be difficult to establish what is a fair price.

 

Futures
Transactions in futures involve the obligation to make, or to take, delivery on the underlying asset of the contract at a future date, or in some cases to settle the position with cash. They carry a high degree of risk. The ‘gearing’ or ‘leverage’ often obtainable in futures trading means that a small deposit or down payment can lead to large losses as well as gains. It also means that a relatively small movement can lead to a proportionately much larger movement in the value of the investment, and this can work against the investor as well as for the investor. Futures transactions have a contingent liability, and investors should be aware of the implications of this, in particular the margining requirements.

Options
There are many different types of options with different characteristics subject to the following conditions.
 

Buying options:
Buying options involves less risk than selling options because, if the price of the underlying asset moves against the investor, the investor can simply allow the option to lapse. The maximum loss is limited to the premium, plus any commission or other transaction charges. However, if an investor buys a call option on a futures contract and later exercises the option, the investor will acquire the future. This will expose the investor to the risks described under ‘futures’ and ‘contingent liability investment transactions’.

Writing options:
The risk involved in writing an option is considerably greater than buying options. The investor writing the option may be liable for margin to maintain its position and a loss may be sustained well in excess of the premium received. By writing an option, the investor accepts a legal obligation to purchase or sell the underlying asset if the option is exercised against the investor, however far the market price has moved away from the exercise price. If the investor already owns the underlying asset which they have contracted to sell (when the options will be known as ‘covered call options’) the risk is reduced. If the investor does not own the underlying asset (‘uncovered call options’) the risk can be unlimited. Only experienced investors should contemplate writing uncovered options, and then only after securing full details of the applicable conditions and potential risk exposure.

Traditional options:
Traditional options may involve greater risk than other options. Two-way prices are not usually quoted and there is no exchange market on which to close out an open position or to effect an equal and opposite transaction to reverse an open position. It may be difficult to assess its value or for the seller of such an option to manage his exposure to risk.
Certain options markets operate on a margined basis, under which buyers do not pay the full premium on their option at the time they purchase it. In this situation, investors in such options may subsequently be called upon to pay margin on the option up to the level of the investors premium. Failure to do so as required may result in the position being closed or liquidated in the same way as a futures position.
 

Contracts for differences
Swaps, futures and options contracts can also be referred to as contracts for differences. These can be options and futures on an index, as well as currency and interest rate swaps. However, unlike other futures and options, these contracts can only be settled in cash. Investing in a contract for differences carries the same risks as investing in a future or an option and investors should be aware of these. Investors are referred to the risk warnings set out above. Transactions in contracts for differences may also have a contingent liability and investors should be aware of the implications of this as set out below.
 

Off-exchange transactions in derivatives
It may not always be apparent whether or not a particular derivative is arranged on exchange or in an off-exchange derivative transaction. While some off-exchange markets are highly liquid, transactions in off-exchange or ‘non transferable’ derivatives may involve greater risk than investing in on-exchange derivatives because there is no exchange market on which to close out an open position. It may be impossible to liquidate an existing position, to assess the value of the position arising from an off-exchange transaction or to assess the exposure to risk. Bid prices and offer prices need not be quoted, and, even where they are, they will be established by dealers in these instruments and consequently it may be difficult to establish what is a fair price.

Foreign markets
Foreign markets will involve different risks from the UK markets. In some cases the risks will be greater. The potential for profit or loss from transactions on foreign markets or in foreign denominated contracts will be affected by fluctuations in foreign exchange rates.

 

Contingent liability investment transactions
Contingent liability investment transactions, which are margined, require investors to make a series of payments against the purchase price, instead of paying the whole purchase price immediately.
 

A total loss of the margin deposited with a firm to establish or maintain a position may be incurred if trading in futures, contracts for differences or selling options. If the market moves against the investor, the investor may be called upon to pay substantial additional margin at short notice to maintain the position. If the investor fails to do so within the time required, the investor’s position may be liquidated at a loss and the investor will be responsible for the resulting deficit. Even if a transaction is not margined, it may still carry an obligation to make further payments in certain circumstances over and above any amount paid when you entered the contract.
 

Limited liability transactions
The extent of loss that may be sustained in limited liability transactions will be less than in other margined transactions which have no predetermined loss limit. Nevertheless, even though the extent of loss will be subject to the agreed limit, investors may sustain the loss in a relatively short time. Investors loss may be limited, but the risk of sustaining a total loss to the amount agreed is substantial.
 

Collateral
If an investor deposits collateral as security with a firm, the way in which it will be treated will vary according to the type of transaction and where it is traded. There could be significant differences in the treatment of your collateral, depending on whether you are trading on a recognised or designated investment exchange, with the rules of that exchange (and the associated clearing house) applying, or trading off-exchange. Deposited collateral may lose its identity as an investor’s property once dealings on the investor’s behalf are undertaken. Even if the investor’s dealings should ultimately prove profitable, they may not get back the same assets which they deposited, and may have to accept payment in cash.
 

Commissions
Before trading, investors should obtain details of all commissions and other charges including any taxes for which they will be liable. If any charges are not expressed in money terms (but, for example, as a percentage of contract value), investors should obtain a clear and written explanation, including appropriate examples, to establish what such charges are likely to mean in specific money terms. In the case of futures, when commission is charged as a percentage, it will normally be as a percentage of the total contract value, and not simply as a percentage of the investor’s initial payment.
 

Suspensions of trading
Under certain trading conditions it may be difficult or impossible to liquidate a position. This may occur, for example, at times of rapid price movement if the price rises or falls in one trading session to such an extent that under the rules of the relevant exchange, trading is suspended or restricted. Placing a stop-loss order will not necessarily limit an investor’s losses to the intended amounts, because market conditions may make it impossible to execute such an order at the stipulated price.
 

Clearing house protections
On many exchanges, the performance of a transaction by the firm (or third party with whom the firm is dealing on the investor’s behalf) is ‘guaranteed’ by the exchange or clearing house. However, this guarantee is unlikely in most circumstances to cover the investor and may not protect the investor if the firm or another party defaults on its obligations to the investor. There is no clearing house for traditional options, nor normally for off-exchange instruments which are not traded under the rules of a recognised or designated investment exchange.
 

Insolvency
A firm’s insolvency or default, or that of any other entities involved with an investor’s transaction, may lead to positions being liquidated or closed out without an investor’s consent. In certain circumstances, the investor may not get back the actual assets which were lodged as collateral and the investor may have to accept any available payments in cash. On request, a firm must provide an explanation of the extent to which it will accept liability for any insolvency of, or default by, other firms involved with the investor’s transactions.

 

Securities lending and borrowing risks

If an investor uses borrowings as part of an investment policy, although this presents opportunities for increasing total returns, it has the effect of potentially increasing losses as well. The level of interest rates at which the Investment Manager can borrow will affect the results of the investment. Any event which adversely affects the value of an investment would be magnified to the extent that borrowings have been utilised to make such investment. The cumulative effect of the use of borrowings in a market that moves adversely to its investment could result in substantial loss that would be greater than if borrowings were not used.
 

There are additional risks that are associated with borrowings, including the risk of delay and recovery. For example, should securities which are pledged to brokers to secure an investor’s margin accounts decline in value, that investor could be subject to a ‘margin call’ and need to deposit additional funds with the broker or suffer the mandatory liquidation of the pledge securities in order to compensate for the decline in value. If the borrower of securities fails financially or defaults in any of its obligations under any securities lending transaction, then the collateral provided in connection with such transaction will be called upon. If there is a sudden drop in the value of assets, then the Investment Manager may not be able to liquidate the assets quickly enough in order to pay off the margin debt.

 

Underwriting and sub-underwriting risks
Riskbridge or its representatives may, from time to time, recommend you to underwrite an issue or offer for sale of investment or other assets. The underwriter of an issue or offer for sale of investments or assets bears the risk of being able to sell the underlying investments or assets and there is a risk that the underwriter will not be able to sell the relevant investments or assets. The underwriter bears the cost of holding the investments or assets until they are sold.
 

The value of the investments or assets which are underwritten may rise or fall and the income or profit derived from underwriting such investments may fall as well as rise. The underwriter may not recoup the costs involved in underwriting the investments or assets and may not be able to sell the investments or assets which are underwritten.

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Risks involved in dealing in securities which may be subject to stabilisation

Riskbridge or its representatives may, from time to time, recommend transactions in securities to you where the price may have been influenced by measures taken to stabilise it.
 

Stabilisation enables the market price of a security to be maintained artificially during the period when a new issue of securities is sold to the public. Stabilisation alleviates sales pressure which is generated by short term investors and aims to maintain an orderly market in the relevant securities. Stabilisation may affect not only the price of the new issue, but also the price of other securities relating to it.

Stabilisation may be carried out by a firm in relation to a significant distribution of securities. A firm conducting stabilisation may purchase or offer to purchase securities that were previously sold to investors or allotted to institutions which have decided not to keep them exclusively for the purpose of supporting the market price of these securities for a pre-determined period of time. The effect of this may be to keep the price at a higher level than it would otherwise be during the period of stabilisation.
The fact that a new issue or a related security is being stabilised should not be taken as any indication of the level of interest from investors, nor of the price at which they are prepared to buy the securities.

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Additional risks relating to the investments
 

General
The value of investments and income derived from them may fall as well as rise and investors may not recoup the original amount invested. An investment should only be made by persons who are able to sustain a loss on their investment. There can be no assurance that the investment objective will be achieved.

Past performance does not necessarily indicate future performance. It can in no way provide a guarantee of returns that you will receive in future.
 

Investments are subject to normal market fluctuation and other risks inherent in investing in securities, whether equity securities or debt securities, or in derivatives of these securities. There can be no assurance that any appreciation in value of investments will occur, and the capital value of an investor’s original investment is not guaranteed. The value of investments and the income from them may go down as well as up, and you may not get back the original amount invested.
 

Equity securities
Investments in equity securities tend to be more volatile than investments in bonds, but also offer greater potential for growth. Equity securities include ordinary shares, preferred stocks, convertible securities, warrants and similar instruments. The value of the underlying investments in equity securities may fluctuate quite dramatically in response to activities and results of individual companies, as well as in connection with general market and economic conditions. Such investments will be subject to the general risks and considerations associated with investing in equities. For example, the market may fail to recognise the intrinsic value of particular stocks for a long time. In addition, if Riskbridge’s assessment of a company’s value or market conditions is wrong, the investment could suffer losses or produce poor performance relative to other investments, even in a rising market. Certain investments may never reach what we think is their full value or may go down in value.

Debt securities
Debt securities include investments such as bonds, debentures, government obligations and commercial paper. The value of debt securities may fluctuate based on changes in interest rates and the issuer’s financial condition and in response to market movements. When interest rates rise or the issuer’s financial condition worsens or is perceived by the market to be at greater risk, the value of debt securities tends to decline. Such investments will be subject to the general risks and considerations associated with investing in debt securities. High-yield debt securities, or junk bonds, are usually more credit sensitive than interest rate sensitive. In times of economic uncertainty, these securities may decline in price, even when interest rates are falling. There is also the risk that an issuer of a debt security will fail to make timely payments of principal or interest, a risk that is greater with junk bonds. Some issuers, particularly of junk bonds, may default as to principal and/or interest payments after a client purchases their securities. A default, or concerns in the market about an increase in risk of default, may result in losses. In addition, the market for high-yield debt securities generally is less liquid than the market for higher-rated securities, subjecting them to greater fluctuations.
Debt securities which are rated below investment grade or which are unrated may have a higher degree of risk than debt securities of investment grade. Investment in debt securities below investment grade may result in a greater risk of loss of principal and interest than an investment in debt securities which are deemed to be investment grade or higher.
 

An investment in debt securities, in particular in bonds, which include a condition to repay the original sum at a specified date in the future and provide a fixed level of income tend to be less volatile than a pure investment in equity securities. The capital value of a bond fund and the level of its income will still fluctuate. Investments in higher yielding bonds issued by borrowers with lower credit ratings may result in a greater risk of default and have a negative impact on income and capital value. Income payments may constitute a return of capital in whole or in part. Income may be achieved by forgoing future capital growth.
 

Fixed interest securities
Fixed interest securities are particularly affected by trends in interest rates and inflation. If interest rates go up, the value of capital may fall, and vice versa. Inflation will also decrease the real value of capital.
 

The value of a fixed interest security will fall in the event of the default or reduced credit rating of the issuer. Generally, the higher the rate of interest, the higher the perceived credit risk of the issuer. High yield bonds with lower credit ratings (also known as sub-investment grade bonds) are potentially more risky (higher credit risk) than investment grade bonds.
 

Shorter term fixed interest securities entail a lesser price risk than longer term fixed interest securities; however, shorter term fixed interest rates typically offer lower returns than longer term fixed interest securities.
 

Investments in collective investment schemes
A collective investment scheme (CIS) is an investment vehicle which enables a number of investors to invest on a pooled basis through the CIS. The value of a CIS holding will depend on how the underlying investments perform. The level of risk of an investment in a CIS will depend among other things on the underlying investments in which it is invested, how well diversified it is, the aggressiveness of its investment strategy and its use of leverage.
 

Normally there is no established secondary market in CISs which means that investments in them cannot usually be sold to third parties. However, the constitutional documents of the CIS will normally provide for an investor to be able to redeem its investment in the CIS at its net asset value. The frequency with which the investor can redeem its investment will depend upon the precise terms of those constitutional documents.
 

Some CISs are regulated, which means they are subject to specific regulatory rules on the types and spread of investments they can invest in, the level of leverage they employ (for example through cash and stock borrowing and the use of derivatives) and the frequency and price at which investments in the CIS can be redeemed.
Other CISs such as hedge funds are unregulated. Investment in unregulated funds involves greater risks than investment in regulated CISs.
 

Hedge funds are generally unrestricted as to the assets and markets in which they can invest (for example illiquid and distressed securities and emerging markets) choice of trading style, or the level of concentration or diversification they maintain. They also often use significant leverage to increase their risk/return profile. Whilst returns may be higher than standard investments, investments in hedge funds involve a high degree of risk and are only suitable for investors who are willing to assume the risks involved. In particular, such investors are exposed to potential loss which could involve the complete loss of the investment. Their use of leverage may mean that market movements could have a disproportionate effect on the net asset value of the CIS. Hedge funds are often domiciled in offshore jurisdictions where the standards of regulation and in particular the standards of regulatory supervision do not match the standards required in the UK. Investments in hedge funds are typically subject to transfer and redemption restrictions. Transfers are usually subject to the approval by the CIS and redemption may be permitted only after an initial lock-in period and long notification periods. In most cases there is no liquid market for investments in hedge funds. It may therefore be difficult for an investor to obtain reliable information about the value of such investments or the extent of the risks to which it is exposed.
 

Funds of funds are CISs that invest in other CISs. They offer an opportunity for investors to invest in a portfolio of funds and thereby further diversify their risk. The returns on a fund of funds may be lower than a series of direct investments in the underlying funds because the manager of the fund of funds takes a fee in addition to the fee charged by the managers of the underlying funds. Fund of funds may be established in the same way as hedge funds in which case they will be subject to similar structural issues.
 

Cash and near-cash investment
An investment in various cash or near cash instruments may be made, for example, for short-term liquidity or to take a defensive position. Such instruments may be used to attempt to avoid losses in response to adverse market, economic, political or other conditions, to invest uncommitted cash balances, or to maintain liquidity. These include: (i) Commercial paper which consists of unsecured promissory notes issued by corporations to finance short-term credit needs. Commercial paper is issued in bearer form with maturities generally not exceeding nine months. Commercial paper obligations may include variable amount master demand notes; (ii) Bank certificates of deposit which are certificates issued against funds deposited in a bank or a savings and loan and which are issued for a definite period of time and earn a specified rate of return; or (iii) Bankers’ acceptances which are short-term credit instruments evidencing the obligation of a bank to pay a draft that has been drawn on it by a customer. These instruments reflect the obligations both of the bank and of the drawer to pay the face amount of the instrument upon maturity. They are primarily used to finance the import, export, transfer or storage of goods. They are ‘accepted’ when a bank guarantees their payment at maturity. Investment in these instruments could reduce the benefit from any upswing in the market and reduce potential performance.
 

Liquidity considerations
Not all securities or instruments in which Riskbridge may recommend transactions to you will be listed or rated and consequently liquidity in such investments could be low. Investment in securities and/or instruments which are not generally publicly traded may only be able to be resold in privately negotiated transactions with a limited number of purchasers. The difficulties and delays associated with such transactions could result in your inability to realise a favourable price upon disposal of such securities and at times disposal may not be possible. In the absence of an active secondary market, your ability to sell or purchase securities at a fair price may be impaired or delayed. Accumulation and disposal of holdings in some investments may be time consuming and may need to be conducted at unfavourable prices.
 

Credit and settlement risk
There may be exposure to the credit risk of parties with whom the investor trades and there may also be a risk of settlement default. Your or we may instruct a custodian to settle transactions on a delivery versus payment basis where you or we believe that this form of settlement is appropriate. Investors should be aware, however, that this may result in a loss if a transaction fails to settle and the custodian will not be liable to the investor for such a loss.
 

Inflation risk
Inflation erodes the real value of investments and changes in the anticipated rate of inflation could lead to capital losses in the investments made by the Investment Manager.
 

Political and/or regulatory risks
The value of investments may be affected by uncertainties, such as political developments (domestic and international), changes in government policies, taxation and currency repatriation and restrictions on foreign investment in some of the countries in which the investor may invest. Further, the legal infrastructure and accounting, auditing and reporting standards in certain countries in which an investment may be made may not provide the same degree of investor protection or information to investors as would generally apply in major securities markets. Foreign ownership restrictions in some markets may mean that corporate actions entitlements may not always be secured or may be restricted.
 

Market risk
Securities in certain markets such as emerging markets may pose greater risks than in other markets. For example, securities traded in certain markets may not be subject to the same degree of regulation as in other markets. Investing in companies located in certain markets may involve some degree of information risk, such that key information about an issuer, security or market is inaccurate or unavailable. Brokerage commissions, custodial services and other costs relating to investment in certain securities markets are more expensive than in other markets. Clearance and settlement procedures may be different in certain countries. Transaction costs may be higher and, in some markets, such procedures may be unable to keep pace with the volume of securities transactions, thus making it difficult to conduct such transactions. Issuers in some countries may not be subject to uniform accounting, auditing and financial reporting standards. There may be less publicly available information about those issuers. There may be less government regulation of certain markets, companies and securities dealers than in other markets. Some securities markets may have substantially less volume, and securities of many issuers are less liquid and more volatile than more developed markets and subject to greater price fluctuations. With respect to certain countries, there is a possibility of nationalisation, expropriation or confiscatory taxation, imposition of withholding or other taxes on dividend or interest payments (or, in some cases, capital gains), limitations on the removal of funds or other assets of the investor, the application of currency controls, and political or social instability or diplomatic developments that could affect investments in those countries.
 

Currency risk
Riskbridge may recommend transactions to you in instruments which are denominated in a wide range of currencies, some of which may not be freely convertible. The value of investments will fluctuate in accordance with changes in the foreign exchange rate between the currency in which the investor makes his investment and the currencies in which the investments made are denominated. The investor may be exposed to a foreign exchange risk.

 

Legal, tax and accounting risk
Incidental to providing advice on potential transactions, Riskbridge may draw your attention to certain tax, legal or accounting aspects.  However, Riskbridge is not your legal, tax or accounting advisor and does not provide give tax, accounting or legal advice, and no communication from Riskbridge should be construed as such advice.  Riskbridge strongly recommends that appropriately qualified independent advice is procured in relation to these risks.
 

Definitions
For the purposes of these Risk Warnings:

“our”, “we” and “us” means Riskbridge Associates Ltd (“Riskbridge”) and, where applicable, its officers, employees and authorised agents; and
“investor”, “you” and “your” means any business which is a client of Riskbridge or with which you are associated and on behalf of which you use our Site, products or services.