In assessing whether a financial instrument is suitable for an investor, the following must be borne in mind:
Financial instruments involve a variety of risks and before taking an investment decision it is important to become acquainted with the nature of the financial instrument in question and the risks connected to it. Emphasis is placed on having investors never undertake transactions with financial instruments without being fully aware of the risk involved, having regard their financial strength and experience of such investments.
The price of financial instruments is generally strongly correlated with economic fluctuations. Economic cycles vary in both their length and scope and their impact on different industrial sectors can vary. In deciding on an investment, sufficient attention must be paid to general economic cycles, for instance, in different countries and different economies. Failure to pay heed to these factors or incorrectly analysing economic developments when making investment decisions can result in losses.
Investments must be assessed with a view to the inflation rate and inflation outlook at any given time. In deciding on an investment, regard must be had for the estimated real return over the specified period, i.e. after deducting inflation from the nominal return. Investors must therefore assess the real value of their assets in terms of the real return they can be expected to deliver.
Leveraged investments are considerably more sensitive to movements in the price of the financial instruments purchased than are investments which do not involve borrowing. Investments in financial instruments which are financed with credit are risky for investors. On the one hand, margin calls may be made if price developments cause the value of collateral to fall below the authorised limit. If the investor cannot provide additional collateral, the mortgagee may be forced to sell the financial instruments in its custody at an unfavourable moment. Secondly, the loss resulting from unfavourable movements in the price of a financial instrument may exceed the amount of the initial investment. Fluctuations in the price of financial instruments may negatively affect an investor's ability to repay loans.
Investors must be aware that, due to the leveraging involved in purchasing financial instruments with borrowed funds, such investments are relatively more sensitive to price volatility. As a result, while the potential profit increases, the risk of loss grows accordingly. This means that the risk on such purchases grows the higher the leveraging is.
Even if the issuer of a financial instrument is completely solvent, the issuer could be unable to repay the principal and/or interest on a loan at maturity, and the loan could even end up in default, e.g. because the issuer cannot acquire foreign currency due to currency controls, changes in legislation, etc. Government actions can result in both economic and political instability.
In the case of financial instruments in foreign currency, there is a risk that investors may be repaid in a currency which is no longer convertible due to currency controls. No actions can protect investors against risk of this sort.
Investments in financial instruments which are denominated in foreign currencies generally involves currency risk, since exchange rates of individual currencies can fluctuate considerably. Unfavourable exchange rate movements can result in financial loss to the investor. Those tangible aspects which affect exchange rates include, for instance, the level of inflation in the country concerned, the domestic-foreign interest rate spread, assessment of business developments, the global political situation and the security of the investments concerned. The domestic political situation can also weaken the exchange rate of the currency in question.
Low market liquidity can make it difficult for investors to sell financial instruments at market value. A distinction must be made between illiquidity resulting from supply and demand on the market, on the one hand, and from the characteristics of the financial instrument and trading practices, on the other.
Illiquidity arising from market supply and demand is due to low or no supply or demand for financial instruments at a specific price. Under such circumstances it can be impossible to execute by or sell orders immediately, or even to partly execute them, and then on unfavourable terms. In addition the cost of transactions can be higher.
Illiquidity due to the characteristics of the financial instrument, or to market trading practices, for instance, may be the result of time-consuming transfer processes for trading listed equities, long delays in settlement due to market practices or other trade-impeding circumstances.
Illiquidity can also result from a temporary liquidity shortage, which cannot be met sufficiently rapidly with the sale of financial instruments.
The market price of financial instruments is sensitive to what might be called market sentiment, which is shaped by current trends and developments, the tendencies and behaviour of market players, news and opinions of opinion makers or rumours. Market prices can fluctuate strongly due to such sentiments, regardless of the actual performance of those factors which determine the value of financial instruments, e.g. the operations or situation of companies listed on the market.
Transactions with financial instruments that have not been registered or accepted for trading on a regulated market, e.g. at the Icelandic Stock Exchange (Nasdaq Iceland), are much riskier than listed financial instruments. In the case of unregistered financial instruments, there is often a lack of information and little transparency, i.a. there is often little or no reliable information about their issuers. Also, their liquidity and price formation is generally lower than that of listed financial instruments, which means that it may take longer to sell unlisted financial instruments and their pricing is more uncertain. In addition, the operations of unregistered companies are often less extensive than those of registered companies, but the operations of smaller companies are usually more sensitive to changes in the economic environment and/or changes related to the operation of the company in question or its industry, and/or political conditions that result in economic consequences.
A bond is a debt instrument whereby the issuer of the security promises to pay to the owner of the security a specific monetary debt at a specified time on the interest terms prescribed in the security. A bond is an instrument covered by claims law, i.e. the purchaser of the bond is the lender and has a claim against the issuer (the debtor). The terms of bonds may vary but are always determined in advance, such as the interest rate and repayment of the debt. Interest rates may be fixed or variable and bonds can be inflation-indexed or not inflation-indexed. Bonds may be issued to the bearer or registered to a specific owner.
The principal characteristics of bonds are that their yields are determined by interest payments and, as the case may be, the increase in the price of the security. Bonds are issued for different lengths of time, i.e. repayment can be made over a number of months or years. Repayment of bonds is made on the agreed due dates and the interest depends on the terms of the loan. It is common for bond interest rates to be linked to market rates (e.g. REIBOR, LIBOR or EURIBOR).
The issuer of bonds may become temporarily or permanently unable to pay interest or to repay the loan. The issuer's solvency may change with general economic developments and/or due to changes in connection with its operations or its sector, and/or political circumstances which result in economic consequences. If the issuer's cash flow worsens this can have a direct impact on the price of the financial instruments which it issues. Similarly, the issuer's credit rating may change due to the positive or negative development of its activities.
Uncertainty concerning the future development of the interest rate level means that the purchaser of a bond with a fixed interest rate bears the risk that the price for the bond may drop if interest rates increase. The longer the term of the loan is and the lower the interest rate level, the more sensitive the bond is to increases in market interest rates.
The issuer of a bond may include provisions authorising it to prepay the amount to the owner of the bond if market interest rates drop. As a result, the real return could be less favourable to the investor than the expected return.
A bond may have provisions authorising the issuer to call the bond prior to maturity, e.g. if market interest rates drop. It is difficult to estimate the duration of bonds which are called. As a result, the estimated return on the bonds may change unexpectedly.
There may be additional risks connected with some types of bonds, such as floating rate notes and reverse floating rate notes, zero coupon bonds, foreign bonds, convertible bonds, indexed bonds, subordinated bonds etc. In the case of bonds of these types, investors should acquaint themselves with their risks by reading their prospectuses and terms and conditions, and should not purchase such bonds until they are confident that they understand all of the risks they involve.
In the case of subordinated notes, investors should ask about their rights compared with the issuer's other obligations. If an issuer becomes insolvent, bonds of this sort are not paid until all other creditors with higher priority have been paid.
Convertible bonds involve the risk that the investor will not receive full repayment, but rather only an amount equivalent to the underlying financial instruments on the due date.
Shares are certificates of shareholders' rights in a limited liability company. These rights are financial ownership rights determined by law and the Articles of Association of the company concerned. Shares are commercial paper and subject to all the traditional rules which apply to such paper, including on transfer.
Shares are generally riskier than bonds. The risk is due in particular to the higher volatility in the price of shares than that of bonds. Investment in shares can, however, be more profitable than investment in bonds in the longer term. Return on shares takes two forms. Firstly, there is a return in the form of a change in the value or price of the shares concerned and, secondly, owners of limited companies can expect to receive a dividend on their shareholdings. Distributing investments in shares by purchasing shares in many different companies can reduce the risk linked to individual limited companies considerably.
No claims rights exist for shareholders against the share issuer, i.e. the company, unlike bonds. The shareholder contributes share capital and thereby gains a share of the company's potential profit. The investment is therefore dependent upon the company's operations and the investor is at risk of losing the entire investment if the company's operations fail.
The value of shares fluctuates greatly, increasing the risk that investors could suffer financial loss on their investments. Fluctuations in the value of shares in the shorter or longer term can be unforeseeable. A distinction must be made between general market risk and the risk which is connected directly to the individual company. Both these factors, together or separately, can affect share price developments.
Dividends paid to shareholders depend upon the company's performance. A decision on payment of dividend is generally taken at a shareholders' meeting. If the company has performed poorly, returning little or no profit, dividends may be reduced or even cancelled.
Funds for collective investment in financial instruments and other assets (UCITS) and investment funds are intended exclusively to accept funds from members of the public for collective investment in financial instruments and other assets on the basis of spreading risk, in accordance with a previously stated investment strategy. Management companies can also set up funds which do not accept funds from the public and issue units or shares. There are many types of funds with varying investment strategies, in addition to which the legal framework which applies to their activities may also vary. Funds are either open-end or closed-end. In open-end funds, the total share capital is not determined in advance, which means that the number of shares and participants is not determined. The fund may issue additional units depending upon demand and may also redeem units. The fund is obliged to redeem units at the specified redemption price and in accordance with contract provisions. In the case of closed-end funds, the total share capital remains unchanged unless measures are taken to alter this. Unlike open-end funds, there is no redemption obligation for units in closed-end funds.
Investment in funds can involved the following risks and investors are advised to acquaint themselves with the investment strategy of the fund in question before making a decision on investment.
The activities and performance of individual funds depends upon the ability of its management and employees. A fund manager generally takes decisions on investments in accordance with the fund's investment strategy. If the contracts of the fund manager or key employees are terminated, it may not be possible to engage capable replacements without causing a loss to the fund. In addition, wrong decisions may result in losses.
The activities of individual funds may be subject to Icelandic or foreign laws, which could mean that certain investor protection rules or restrictions on activities, which apply in one jurisdiction, do not apply in certain instances. Applicable legislation may also be amended, with a resulting impact on the activities of the fund concerned or the value of the investment.
Some funds finance certain aspects of their activities through borrowing. Such leveraging can increase the risk in a fund's activities and result in expense which could lead to a decrease in the price of the investor's units in a fund.
Fund investors generally have little or no right to participate in and/or influence the activities of the fund in question.
Funds' investment strategies can vary greatly. Some funds specialise in their investments, investing exclusively in certain types of financial instruments and/or in certain countries. The risk the fund bears is therefore primarily linked to the financial instruments and countries concerned. Some funds have a predefined investment strategy which is considered highly risky. Other funds invest in sectors where competition is high and as a result there are fewer investment opportunities.
If a fund invests in assets which are not liquid, it can be difficult to assess the value of its units/shares.
Underlying assets can vary greatly and include both buying and short selling financial instruments. The fund can be subject to market risk and the risk inherent in its investment strategy, such as for investments outside a regulated securities market, short selling of financial instruments and leveraged buying and/or selling, could result in a loss to the fund concerned. The investor's risk which is involved in directly investing in the underlying assets is also significant for assessing the risk involved in investing in the fund concerned.
Funds are subject to risk of a price slump, reflecting a drop in the price of the financial instruments or currencies which comprise the fund's asset portfolio. The more diversified the fund's assets are, the less risk there is of loss. Conversely, the risk is greater in specialised investments and where diversification of assets is less. It is therefore important to consider both the general and specific risk factors which pertain to the financial instruments and currencies which comprise the fund's assets. Investors can, for instance, obtain information on funds by reading their prospectuses.
Derivatives are financial instruments whose value changes depending on the performance of the underlying assets. The underlying asset may be a financial instrument, market index, interest rate level, currency, commodity price, or even another derivative.
Options are contracts that give one party, the buyer, the right but not the obligation, to buy (call option) or sell (put option) a specific asset (the object of the contract) at a predetermined price (strike price) at a designated point in time (expiration date) or within certain time limits (period of validity of the option). In return for granting this right, the other party, the writer of the option, collects a payment indicating the market value of the option at the commencement of the contract period. All changes to the value of the object result in a proportionally greater change to the value of the option. The option writer is irrevocably bound to fulfil the contract while the buyer of the option may decide at its discretion whether or not to exercise its right.
A future is a standardised and transferable contract which obliges the contracting parties to buy or sell a specific asset for a certain price at a pre-determined time. The value of a future is often calculated daily and the contracting party's position recorded in accordance with the calculation. A forward is a non-transferable contract which obliges the contracting parties to buy or sell a specific asset for a certain price at a pre-determined time. Settlement of such contracts can either by made with the delivery of the underlying asset or a financial settlement. In both the case of a purchase of a standardised forward contract or sale of an underlying asset, the original premium is determined when the contract is concluded. The premium is generally designated as a per¬centage of the contract's value. In general an investor can settle the contract or close it prior to maturity, either by selling the contract or by concluding an opposing contract. Settlement closes the position taken and the gain or loss which has accumulated until the settlement is realised. Parties must fulfil those contracts which have not been closed prior to settlement. Contracts which have a tangible valuable as their underlying asset can be fulfilled by delivering the asset. If an asset is delivered, then the provisions of the contract must be satisfied in full, while if settlement of a contract is expected to be made in cash, only the difference between the contract price and the market price at the time of payment must be paid. Investors therefore have to have more capital available for contracts which specify the delivery of an underlying asset than for contracts which provide for cash settlement.
Swaps are contracts in which contracting parties pay each other amounts determined by changes in their respective reference instruments during the contract period. Specifically, the contracting parties exchange payments which are based on changes in underlying references, such as interest rates or currencies. When concluding the contract the parties decide on the frequency of these payments.
Alternative investments are investments in funds for collective investment which follow an investment strategy which differs from the traditional investments in shares and bonds. Hedge funds are the most common form of alternative investment. Their investment strategy often involves short-selling, leveraging and derivatives. Investments in private equity funds also fall into this category (venture capital, buy-out financing). Investors interested in alternative investments, especially in offshore funds, must be aware of these risk factors. Before undertaking an investment the investment product itself needs to be thoroughly examined.
Investment in this area may involve a very high degree of risk. As a result of the effect of leveraging, for example, minor market fluctuations can lead to high profit or high losses. In some instances the entire investment may be lost.
Investors in alternative assets often have very little information to work from. The investment strategy followed by funds, which may be extremely complex, is often very opaque for investors. Changes in strategy, which may result in a substantial increase in risk, are often not evident to investors, who may even seriously underestimate the risk.
Alternative investments may be more difficult to dispose of than other investments. Sometimes their liquidity is extremely low. Redemption of shares in hedge funds, for example, may only be possible on a monthly, quarterly or yearly basis. Investments in private equity funds may be locked in for as long as 10 years or more.
A considerable number of funds of this sort are registered on offshore financial markets (offshore funds). It is common for such offshore jurisdictions to exercise a minimum of supervision of the funds. As a consequence, various difficulties or delays may arise in executing instructions to buy or sell and the banks concerned cannot be held responsible. There is no systematic insurance that investors' rights will not be violated.
