Financial Instruments and Risks
Purpose
Trading in financial instruments is risky by its nature. The purpose of this document is to provide the investor with an overview of the main types of financial instruments and the risks associated with investing in them, thereby enabling them to make appropriate investment decisions. This is not an exhaustive list, and other factors than those mentioned here may affect the value of the relevant financial instrument. When assessing whether a financial instrument is suitable for an investor, the following must be taken into account:
(1) An investor must have sufficient knowledge and experience to assess the relevant financial instrument.
(2) An investor must be aware of the risks associated with investing in the relevant financial instrument and the effect the investment may have on their assets and financial position.
(3) An investor must familiarise themselves with and understand the terms applicable to the relevant financial instrument and the markets in which it is traded.
(4) An investor must be able to assess the impact of external factors such as economic cycles, changes in interest rates and other comparable matters that may affect an investment in the relevant financial instrument.
An investor is advised to conduct their dealings in accordance with their knowledge, experience and financial standing, and also to seek further advice if they deem it necessary.
General information on the risks associated with securities trading
(1) Market risk. Market risk is the risk arising from changes in market prices, such as changes in the prices of shares and bonds; interest rates and exchange rates.
(2) Equity currency risk. Share prices can fluctuate unpredictably in the short, medium and long term, without the duration of the fluctuations being predictable.
(3) Currency risk. A change in exchange rates is called currency risk, and it affects the value of assets and liabilities. Exchange rates fluctuate irregularly, and therefore there is always some currency risk involved in transactions with foreign currency financial instruments. Changes in exchange rates can therefore cause an investor financial loss. For example, in the case of a foreign currency loan, the currency risk consists of the principal increasing or decreasing in line with the value of the currencies in the loan's currency basket. The principal increases when the Icelandic króna weakens but decreases when it strengthens. A strengthening króna, in turn, reduces the repayment burden, whereas a weakening króna increases it. Numerous factors influence exchange rates, including the rate of inflation in the respective country, the difference between domestic and foreign interest rates, assessments of economic developments, domestic and international political situations, and the security of the investment in question.
(4) Interest rate risk. Interest rate risk is a form of market risk and is the risk inherent in a change in interest rates. Changes in interest rates affect the value of fixed-rate assets and liabilities, thereby creating a risk of loss if interest rates move unfavourably. Higher interest rates generally lead to lower income and higher capital costs. Fixed-rate assets and liabilities therefore create risk, and to minimise it, it is necessary to have as little as possible of a mismatch between assets and liabilities, taking their remaining maturities into account. For example, the market risk that has the greatest impact on bond prices is changes in interest rates in the relevant market. The pricing of bonds is directly linked to the interest rate the bonds bear and the general yield requirement in the bond market. For example, a buyer of a fixed-rate bond takes a risk that the bond's price will fall if interest rates on the bond market generally rise. Furthermore, the risk associated with bonds increases the longer the term of the loan and the lower the interest rate.
(5) Inflation risk. Inflation has the effect on all financial assets of reducing their value by the rate of inflation. For example, inflation can affect assets in that it increases prices, which in turn can lead to an increase in index-linked debts as well as higher interest rates. Furthermore, high inflation can erode the returns on unindexed assets, thus leading to a negative real return. It is therefore important for an investor to take into account the real value of their assets and the real return they are expected to yield. To calculate returns, real interest rates should be taken into account, i.e. the difference between nominal interest rates and inflation.
Risk related to specified financial instruments
As noted above, this overview does not provide an exhaustive list of the risk factors that may be associated with securities transactions. The principal risks of the specified financial instruments are set out below, but it is not possible to detail all possible risks that may be associated with such instruments. Arev reiterates to investors that no one should engage in securities trading unless they have a full understanding of the nature of the financial instruments being traded and of the risks that can be associated with such transactions.
(1) Shares. A share is a certificate for a shareholding and the rights of a shareholder in a limited company. Shares may be issued as a written document or in electronic form with a securities depository. Shares must always be issued and may only be issued in registered form. A shareholder enjoys the rights provided for by law and the articles of association of the limited company.
Share risk factors:
a) Investment risk. By investing in shares, a shareholder provides capital to a company and thus becomes one of its owners. He can potentially take part in the company's development and possibly have a share in its profits or losses. Market expectations regarding the company's share price at any given time make it difficult to accurately predict the return on such an investment. The company may also become bankrupt, in which case a shareholder can lose the money they initially invested, as a shareholder's equity comes last in the order of priority of claims in a bankruptcy settlement.
b) Risk from the value of shares. The value of shares can fluctuate unpredictably, which increases the risk of loss. Thus, price rises and falls can occur in the short, medium and long term, without the duration of the fluctuations being predictable. A distinction is made between general market risk and the risk associated with the company and its operations. Both risk factors can affect the share price.
c) Dividend risk. Whether and how much investors receive in dividends from their shareholding is determined by the company's profits and its dividend policy. A loss from the company's operations can result in no dividends being paid.
2) Bonds. A bond is a financial instrument in which the issuer (the debtor) issues a written statement in which it unilaterally and unconditionally acknowledges its obligation to pay the holder of the bond (the bondholder) a specified sum of money. The terms of bonds are always agreed in advance, such as the interest rate and the repayment of the debt. Interest payments on bonds can be fixed or variable. In addition, bonds can be indexed, in which case the principal amount of the debt will change in line with a specific price index, such as the Consumer Price Index. The purchaser of a bond (the bondholder) has a claim against the issuer (the borrower) for the payment of money in accordance with the terms of the bond.
Bond risk factors
a) Default risk. The issuer of the bond may become unable to meet its obligations under the bond. Factors that may affect the issuer's solvency include, amongst others, developments in economic and political conditions in the sector and countries in which the issuer operates, changes in the issuer's credit rating, and operational risks from the issuer's activities.
b) Interest rate risk. Uncertainty about future developments in the level of interest rates means that a purchaser of a fixed-rate bond takes the risk that the value of the bonds will fall if interest rates rise. The longer the term to maturity and the lower the interest rate, the more sensitive the bonds are to a rise in market interest rates.
c) Risk of redemption. The bond may contain a provision that allows the issuer to repay the bondholder its amount if market interest rates fall. Therefore, the actual return may be lower than the estimated return.
d) Risk associated with different types of bonds. Additional risk may be associated with some types of bonds, for example, floating rate notes and reverse floating rate notes, zero-coupon bonds, foreign bonds, convertible bonds, index-linked bonds, subordinated bonds, etc. With regard to bonds of this type, investors should familiarise themselves with their risks by reviewing their offering documents and should not purchase such securities until they are certain they understand all the risks involved.
3) Derivatives. A derivative, which is a type of financial instrument, is a contract where the settlement is based on the change in a particular underlying asset or factor over a given period, such as interest rates, currency exchange rates, share prices, share indices, or other underlying assets or factors. It should be noted that an investor should only invest in derivatives if they are prepared to suffer a substantial loss, and even a loss of their entire principal.
Derivatives are divided into three main categories:
a) Forward contracts. A forward contract is a commercial agreement where the parties commit to fulfilling the agreement on a specified date in the future. A futures contract stipulates an obligation for the contracting parties to buy or sell a specific asset for a fixed price at a predetermined time. Futures contracts can be risky, particularly as an investor often only needs to put down a fraction of the total value of the investment. This leverage means that a small movement in the price of the underlying asset can have a relatively large impact on the value of the contract, increasing or decreasing the investor's principal. Trading in futures contracts is only suitable for investors who have familiarised themselves with such contracts and have the knowledge and experience to assess the risks associated with them.
Risks of futures contracts:
(1) Change in the value of the contract or underlying asset. Regardless of an increase in the price of the contract or underlying asset, the seller under a futures contract is required to deliver the underlying asset at the originally agreed price, which may be much lower than the market value. For the seller, the risk is the difference between the contract price and the market value on the settlement date. Since the market value can, in theory, rise indefinitely, the seller's potential loss is unlimited and can far exceed the coverage limits. If the value of the contract or the underlying asset falls, the buyer under a futures contract is nevertheless obliged to take delivery of the asset at the price agreed in the contract, which could be much higher than the prevailing market value. Thus, the buyer's maximum loss is the initially agreed price. However, the loss can exceed the margin requirements. The trade is regularly valued (marked to market). The investor must have constant access to sufficient collateral. If the collateral becomes insufficient during the term of the futures contract, additional collateral will be required from the investor with little notice. If the investor fails to provide it, the position is liquidated before the contract's expiry.
(2) Risk of sale. To prevent excessive price fluctuations, a stock exchange may set limits for specific contracts. An investor should be aware that it can be extremely difficult, if not outright impossible for a time, to sell the contract under such circumstances and should therefore enquire about such limits. It will not always be possible (depending on the market and the terms of the trade) to sell contracts at any time to avoid or reduce the risk of an ongoing trade. If it is possible to trade to stop a loss, this may only be possible during office hours. Such trades do not allow the loss to be limited to a specified amount, but they are executed as soon as the limit is reached.
b) Exchange agreements. They are contracts in which parties agree to make payments to each other, e.g. based on fixed or floating rates calculated on a notional amount (interest rate swaps), or to exchange specified assets, e.g. different currencies (currency swaps). Swaps are contracts outside an organised securities market which may be standardised or negotiated specifically between a buyer and a seller. Trading in swaps is only suitable for investors who have familiarised themselves with the terms and risks of such contracts and have the knowledge and experience to assess their risks.
c) Options contracts. These are contracts that give the holder (the buyer) the right, but not the obligation, to buy or sell an asset at a pre-determined price on a specific date or within a specific period. In return for this right, the seller receives a premium which represents the market value of the option at the time the contract is entered into. The seller of the option is obliged to honour the contract, whereas the buyer is free to exercise their right under the contract or not. Options are derivative contracts whose value fluctuates in proportion to the value of the underlying asset. Upon payment of the option premium to the counterparty, i.e. the option seller, the option buyer acquires the right to buy or sell the underlying asset of the option contract on the contract's expiry date, or during a specified period, for a predetermined strike price.
Buying an options contract involves less risk than selling such contracts because if the price of the underlying asset moves unfavourably for the investor, they can decide not to exercise the option. The investor's maximum loss is therefore the price of the contract plus any commissions.
Selling an options contract involves considerably more risk than buying one. The seller may be required to make margin deposits to maintain their position and could suffer losses far in excess of the premium received for the contract. When selling an options contract, an investor is committing to buy or sell the underlying asset if the option buyer exercises the contract. Trading options is only suitable for investors who have familiarised themselves with the terms and risks of such contracts and have the knowledge and experience to assess their risks.