This document provides an overview of exchange traded funds (ETFs), exchange traded commodities (ETCs), stapled securities, structured products, and energy hedge funds. It discusses the history and types of each, how they work, their advantages, and examples. The key information covered includes: - ETFs track market indexes and trade like stocks on exchanges with low costs. ETCs are similar but track commodities. - Stapled securities combine two entities that must be bought/sold together. Structured products link returns to market indexes with features like capital protection. - Energy hedge funds invest in energy companies and commodities. Their growth was spurred by opportunities from energy industry changes.

1. [AN OVERVIEW OF] September 6, 2009
SCHOOL OF PETROLEUM MANAGEMENT
2009
An Overview of
Exchange Traded Funds | Exchange Traded Commodities
STAPLE Securities | Structured Products (LSE)
Energy Hedge Funds
Joydeep Mukherjee (20081020) | Mrugesh Brahmbhatt (20081031)
Rejo Mathew (20081042) | Suresh Vaghasiya (20082001)
G A N D H I N A G A R

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Contents
Exchange Traded Fund..................................................................................................................4
History of ETFs.....................................................................................................................................4
Creation of ETFs...................................................................................................................................5
Implementation of ETFs.......................................................................................................................6
How ETFs work? ..............................................................................................................................6
How can one use ETFs?....................................................................................................................6
How an overseas investor can use ETFs?..........................................................................................6
Types of ETFs and market they covers .................................................................................................6
Comparison with mutual funds............................................................................................................7
Advantages of ETFs..............................................................................................................................7
Exchange Traded Commodities .................................................................................................8
Types of ETC ........................................................................................................................................8
ETCs - Historical Overview ...................................................................................................................8
Reasons of ETC ....................................................................................................................................9
Trading of ETC ...................................................................................................................................10
Range of Commodities in ETC ............................................................................................................10
Stapled security .............................................................................................................................12
Types of stapled structures................................................................................................................12
‘Twin’ structures - stapling provisions............................................................................................12
Parent/child’ structures - stapling provisions .................................................................................13
Example of staple structure ...........................................................................................................14
Conditions of admission.....................................................................................................................14
Foreign entities..............................................................................................................................14

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Other entities ................................................................................................................................15
Stapled securities issued by the same issuer......................................................................................16
Trading and settlement .....................................................................................................................16
Value Adding from Stapling ...............................................................................................................16
Stapled Security example...................................................................................................................17
Structured Products .....................................................................................................................18
Tracker ..............................................................................................................................................18
Accelerated Trackers .........................................................................................................................19
Reverse Tracker.................................................................................................................................20
Bonus Tracker....................................................................................................................................21
Discount Tracker................................................................................................................................23
Capital Protected Products ................................................................................................................24
Energy Hedge Funds.....................................................................................................................27
Hedge Fund.......................................................................................................................................27
Energy Hedge Funds..........................................................................................................................28
Figure: Percentage of Companies dealing with Energy Hedge Funds ..............................................29
History of Energy Hedge Funds..........................................................................................................30
Impetus for Energy Hedge Funds .......................................................................................................31
Bibliography....................................................................................................................................32

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Exchange Traded Fund
An ETF is an index investment crossed with an exchange-listed corporate security and an open-
ended mutual fund. They enable investors to trade ―the market‖ with a single investment as
easily as if they were buying an individual stock. ETFs represent ownership of a portfolio of
common stocks that closely track the performance of a specific index, either broad market, sector
or international. In an active secondary market, individual investors can buy or sell as little as a
single ETF share during trading hours. By contrast, traditional mutual funds generally can be
purchased or redeemed only at the end of the trading day.
While ETFs compete with index mutual funds for investor dollars, they have a very different
operational structure. Most ETFs are unit investment trusts: A UIT is an investment company
with a finite life that raises capital from investors and uses the proceeds to buy a fixed portfolio
of securities. ETFs trade throughout the day over an exchange, and investors can buy or sell
shares through a broker or in a brokerage account just as they would shares of any publicly
traded company. ETFs have low expense ratios ranging from .18% to .25%. An additional cost to
investors is the ―spread‖ between the bids and asks prices, which can amount to over 1% of the
purchase or sale price. Although ETFs have low expenses, investors do pay a brokerage
commission on a per-trade basis to buy or sell them.
History of ETFs
ETFs are known by a variety of sometimes quirky names—Spiders, Diamonds, OPALs, WEBS
(now iShares), Qubes, VIPERs, HOLDRs and StreetTracks are just a few. The biggest
institutional players in ETFs are State Street Global Advisors, the Bank of New York and
Barclays Global Investors. The American Stock Exchange launched the first ETF in 1993, with
Standard and Poor‘s Depository Receipt Trust, called SPDR 500 or Spiders. Currently there are
90 ETFs listed on the AMEX with nearly $75 billion under management, not including
HOLDRs.
Morgan Stanley created OPALs—Optimized Portfolios of Listed Securities—in 1994. Listed on
the Luxembourg Stock Exchange, they represent Morgan Stanley‘s Capital International (MSCI)

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indexes and are marketed primarily to institutional investors. The SPDR is the most widely
traded and well-known ETF. Created in 1995, the mid-cap SPDR tracks the S&P Mid-Cap 400
Index. Diamonds, which track the Dow Jones Industrial Average, were added in 1998. NASDAQ
later introduced Qubes, named after its ticker symbol, QQQ, to track the NASDAQ 100 Index.
WEBS (World Equity Benchmark Shares now called iShares), mirror foreign equity market
indices. HOLDRs, a new product trading on the AMEX, issues depository receipts that represent
individual and undivided ownership interests in the common stock of companies involved in a
specific segment of a particular industry.
In May 2001 Vanguard began offering its exchange-traded class of shares called Vanguard Total
Stock Market VIPERs. The only fund to track the Wilshire 5000 Total Market Index, Vanguard
expects its VIPERs to have an annual expense ratio of 0.15% ($15 per year on a $10,000
investment)—the lowest of any ETF tracking the broad U.S. stock market.
Creation of ETFs
Exchange-traded funds are generally created in response to anticipated demand for a fund to
track a particular market index or industry such as the Nasdaq 100 or the Wilshire 5000. When
this happens, an institutional investor or large intermediary such as Barclays Global Investors or
State Street Global Advisors—known as an authorized participant (AP)—transfers a portfolio of
stock that closely approximates the specified index to a fund manager. The manager places the
stock in a trust and issues ETF shares to the AP. It is free to hold the new securities or sell them
to other investors.
The ETF shares trade freely between investors on established stock exchanges (the American
Stock Exchange is a major player in ETFs). Small investors generally sell their shares for cash to
another investor. When an institutional investor with large ETF holdings decides to exit an ETF,
the securities are retired in block-sized units. The institution gets shares of the stock or stocks
underlying the ETF plus some cash representing accumulated dividends. Depending on the kind
of ETF or the index being tracked there may be minimum requirements to create the fund. For
example a unit of 50,000 shares is required to create Diamonds while a 25,000-share unit is
required to create mid-cap SPDRs.

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Implementation of ETFs
How ETFs work?
While an ETF is registered with the SEC as an investment company—either as an open-end fund
or a UIT—it differs from a mutual fund both in how shares or units are issued and redeemed and
in how they are traded. (See the exhibit at the end of this article.) Unlike mutual funds and UITs,
ETF shares are created when an institutional investor (someone who manages money for
institutions and corporate investors such as retirement plans or endowment trusts) deposits a
block of securities with the ETF. In return for this deposit, the investor receives a fixed number
of ETF shares, some or all of which it may then sell on a stock exchange.
How can one use ETFs?
ETFs can be an excellent substitute for more expensive and cumbersome conventional index and
mutual funds. Since they have grown so dramatically in diversity, ETFs offer investors a unique
opportunity to diversify investments among a wide range of issues.
In the near future, we will see the release of currency ETFs, crude oil ETFs, and inverse ETFs,
which will allow individual investors to add more uncorrelated sectors to their portfolios and to
create their own hedge funds using ETFs. This is where it's all going in my opinion.
How an overseas investor can use ETFs?
Many overseas market indexes have their own domestic ETFs related to various internal market
indexes. For example, London has ETFs for the FTSE Index, Australia for the ASX Index, and
Hong Kong for the Hang Seng Index, to name a few. Individuals should consider dealing in
those through online discount brokers within their own countries. Overseas investors who wish
to engage in transactions in US ETFs may open an account with any online US discount broker.
A form W-8 needs to be signed by the individual investor, and an account is then opened and
ready to trade.
Types of ETFs and market they covers
There are currently over several hundred ETFs, with more being issued each week. ETFs today
cover a broad range of market sectors, including bonds, utilities, value, growth, small-cap,
technology, technology sub-sectors, energy, gold, overseas markets, and many more.

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Unfortunately, there are now too many repetitive ETFs, so it has become more critical for
investors to choose their ETFs carefully. The four major issuers of ETFs are Barclay's, State
Street, PowerShares, and Vanguard.
Comparison with mutual funds
Exchange-Traded Funds Mutual Funds
Trading Buy or sell on exchange
during trading hours.
Buy or sell at net asset value at the end of
the trading day.
Purchase/sale
options
Trade only through brokers.
Sponsors do not sell shares
directly to the public.
Generally available directly from the fund
sponsor. Many mutual funds are available
through brokers.
Expenses Operating expenses are
generally low. Costs to buy
or sell are based on
brokerage commission rates
plus a spread between bid
and ask prices.
Mutual funds may be subject to one or more
of the following: a sales load paid to the
broker who sold the fund, annual
management expenses, 12b-1 fees to cover
marketing and advertising costs, exit fees
when shares are sold and a deferred sales
charge intended to discourage frequent
trading.
Dividend
distributions
Rarely made. Typically made quarterly depending on
what stocks the fund holds.
Redemptions Broker-dealers buy creation
blocks, exchanging them
for a basket of securities
and some cash. This
protects other shareholders
from a taxable event.
Sponsor sells shares from its portfolio to
make cash payments to redeeming
shareholders. These transactions typically
result in a taxable event to other
shareholders.
Tax consequences Same as for traditional
stocks based on long- or
short-term holding period.
Sales taxed like traditional stocks based on
investor cost basis and holding period.
Mutual fund shareholders also receive
dividend and capital gains distributions
based on fund holdings.
Commissions/sales
load
Standard brokerage
commissions to buy and
sell.
Some funds carry a sales load as an
adjustment to the purchase price.
Advantages of ETFs
Their expenses are low, they are easy to buy and sell, and they offer tremendous transparency,
liquidity, and opportunities for diversification. Also, because capital gains distributions happen
very rarely with ETFs, these funds have built-in tax efficiency and are excellent to use in your
taxable account.

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Exchange Traded Commodities
An Exchange Traded Commodity (ETC) is an investment vehicle that tracks the performance of
an underlying commodity or basket of commodities. It is a variation on the Exchange
Traded Fund (ETF) that was first introduced in the US in 1993 and launched in the UK in 2000.
ETCs work on exactly the same principle as ETFs – with the ETC tracking the performance of a
single underlying commodity or a group of associated commodities. ―Single commodity ETCs‖
obviously follows the spot-price of a single commodity, whilst ―index-tracking ETCs‖ follow the
movement of a group of associated commodities, such as cattle, energy or livestock.
Types of ETC
They are open-ended securities so shares in each ETC are created and redeemed on demand by
the issuer, as with ETFs and come in two broad forms:
ETCs - Historical Overview
One of the biggest stories of 2006 was the global boom in the commodities markets. Exploding
demand for raw materials to feed the spectacular growth in China and India drove the price of
many commodities to dizzying heights. At the same time, the price of oil was inflated by
concerns over the continuing conflict in Iraq and the threat of conflict between Iran and the US.
The commodities markets have traditionally been used to trade a wide variety of homogenous
agricultural and industrial resources in their raw, unprocessed state, i.e. wheat and nickel as
opposed to flour or steel. These markets trade everything from frozen orange juice through to
cotton, gold and crude Oil.
Historically the commodities markets have grown out of the need to establish prices for
perishable agricultural products in the months prior to their harvest – allowing the farmers to
Single commodity
Investors can buy single-commodity ETCs like gold and oil or more exotic variants such as zinc
and lean hogs.
Index tracking
Investors can invest in index tracking ETCs giving exposure to a range of underlying from
broad indices to specific sub-indices such as energy or livestock, and all in one trade.

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guarantee the sale of their produce and the buyers to fix the price of their ingredients. These
markets were quickly adapted to include ‗hard commodities‘ such as platinum, copper and oil, as
well as the ‗soft commodities‘ such as grain, cotton, Rubber, etc.
The commodities market was also often referred to as the ―futures market‖ - on account of
buyers using it to order resources for future delivery. Then, in the 1970s the futures markets were
expanded further to include financial contracts and the term ‗commodities‘ is now often used to
refer to both physical commodities and financial futures.
Reasons of ETC
ETCs offer the aspiring commodities trader a number of inherent advantages over both shares
and futures - without the associated vagaries of trading an individual stock or the dramatic risk
inherent in futures trading. But please remember the value of your investments and the income
from them can go down as well as up. You may not get back the full amount you have invested.
ETC trading offers:
Stamp duty & CGT - ETCs are not shares and so trades are exempt from stamp duty. Furthermore,
ETCs can be traded within ISA accounts, allowing you to shelter your profit from Capital Gains Tax
Low dealing costs - ETCs are traded on the regular stock exchange, making them both accessible and
affordable – they can be traded through your share dealing service for a commission.
Direct exposure to the commodities markets – the value of your investment will rise and fall in
direct proportion to the price of the underlying commodity
Liquidity - ETCs are ‘open ended’ securities, which are created and redeemed on-demand. This
means that the supply of ETCs is unlimited and that price changes will accurately mirror
developments in the price of the underlying commodity
Portfolio diversification – ETCs give broad representtion across entire commodity sectors and
different geographic regions.

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Trading of ETC
You can trade ETCs online or by phone through your stockbroker in much the same way as you
would trade ordinary shares – we will quote you bid and offer prices on the ETC and you buy or
sell in exactly the same way.
This whole process is fully automated and each transaction is dealt with as soon as practicably
possible. ETC prices may be initially quoted in US dollars and converted to sterling when dealt.
Range of Commodities in ETC
Commodity TIDM Typical End Use Major Producers
Aluminium ALUM Automobiles, airplanes China, Russia,Canada
Brent Oil OILB Fuels, inc. heating oils, diesel and
kerosene. Brent crude is also the pricing
benchmark for oil produced in Europe,
Africa and the Middle East.
UK
Coffee COFF Coffee. Coffee beans are divided into
the more widely consumed arabica and
the stronger robusta
Brazil, Colombia(arabic
a); Indonesia,West
Africa(robusta)
Copper COPA Electrical wiring, construction Chile, Bolivia, Zambia,I
ndonesia
Corn CORN Livestock feed, gasoline additives,
cooking oil, sweeteners
USA
Cotton COTN Clothing fibres, home furnishings,
medical products
China, USA, India
Crude Oil CRUD Fuels, inc. diesel, gasoline and kerosene;
plastics, tar, asphalt, petrochemicals
The OPEC
countries.Saudi
Arabia, Iran,Venezuela,
Kuwait,Nigeria, and
theUnited Arab
Emiratesdominate
OPEC‘s production.
Gasoline UGAS Fuel for internal combustion engines USA, Canada
Gold BULL Jewellery, dentistry, investment South
Africa, USA,Australia
Heating Oil HEAT Residential heating Asia & Oceania
Lean Hogs HOGS Ham, pork spareribs China, EU, USA

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Live Cattle CATL Beef, veal USA, Brazil
Natural Gas NGAS Heating, electricity Russia, USA
Nickel NICK Stainless steel, non-ferrous metals for
specialised industry & aerospace
Russia, Australia,Canad
a, Indonesia,Japan, EU
Silver SLVR Jewellery, electrical appliances,
investment
Mexico, Peru,Australia,
China
Soybean Oil SOYO Salad oil, cooking oil, margarine, paints,
plastics
USA, China, Brazil
Soybeans SOYB Protein feed, vegetable oil, tofu, soy
sauce
USA, Brazil,Argentina
Sugar SUGA Raw sugar, refined sugar Brazil, EU, India
West
TexasInterm
ediate Oil –
Light Sweet
Crude
(WTI)
OILW Petroleum gas, gasoline, kerosene, gas
oil, lubricating oils. WTI oil also is the
pricing benchmark for light sweet crude
oil produced and refined in North
and South America.
USA
Wheat WEAT Food, brewing, distilling EU, China, India
Zinc ZINC Bronze, brass, batteries Asia

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Stapled security
A stapled security is where investors own two or more securities which are generally related and
bound together through one vehicle (ASX).
Types of stapled structures
Most entities with stapled securities that have previously sought admission to the official list
have adopted either a ‗twin‘ structure or a ‗parent/child‘ structure, but other structures will be
considered. The twin structure is the most common. Ordinary securities in one entity are stapled
to ordinary securities in the other entity, and the two entities are not related. A parent structure is
one where securities in one entity are stapled to securities in a subsidiary of that entity.
‘Twin’ structures - stapling provisions
Australian security exchange (ASX) requires that the stapling provisions in the constituent
documents of the entities contain adequate mechanisms to ensure each of the following:
 Voting rights of the securities must be in accordance with the Listing Rules
 All securities of the stapled classes must be stapled at the commencement of quotation.
 In relation to securities of the stapled classes, securities of one entity cannot be
transferred unless there is a matching transfer of securities of the other entity.
 In relation to securities of the stapled classes, securities of one entity cannot be issued
unless there is a matching issue of securities of the other entity. Also there must be
adequate mechanisms to ensure that if unstapled securities were to be issued by one entity
at a time when stapling is in place, they are not entitled to any benefits (e.g. voting and
dividend or distribution rights) until either those securities are stapled to securities of the
other entity or all securities are unstapled. This requirement, that securities not have
voting rights, does not apply to trusts. This is because the Corporations Act sets out the
voting regime for members of a managed investment scheme.

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 In relation to securities of the stapled classes, partly paid securities of both entities must
be treated in the same way, e.g. in relation to call programs.
 Corporate actions (e.g. reorganizations of capital) cannot occur in a way which would
prejudice stapling.
 In relation to securities of the stapled classes, there must be provision for joint
certificates, joint holding statements for uncertified securities and joint registers.
 Stapling provisions can only be amended or stop applying in specified circumstances that
are satisfactory to ASX. This may include a trigger event such as if security holder
approval is obtained and the terms on which the approval is obtained is satisfactory to
ASX. It may also include the occurrence of a specified event - this must also be
satisfactory to ASX.
Parent/child’ structures - stapling provisions
 The requirements for the constitution to contain provisions which prevent corporate
action which prejudice stapling, require joint registers to be maintained, and prevent
unstapled securities being issued (or, if issued, not to have voting and dividend or
distribution rights) or transferred while stapling is in place are the same for ‗parent/child‘
structures as for ‗twin‘ structures.
 However, in the case of a ‗parent/child‘ structure it is acceptable for voting securities of
the ‗parent‘ to be stapled to non-voting securities of the ‗child‘, and the voting securities
of the ‗child‘ to be held by the ‗parent‘. It is also acceptable for the stapled structure to be
able to be dissolved so that the ‗child‘ entity becomes a wholly- owned subsidiary of the
‗parent‘ entity without security holder approval being obtained.

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Example of staple structure
Figure: Staple Structure
Conditions of admission
It is a condition of admission to the official list for entities issuing stapled securities that there is
pre- quotation disclosure in relation to complexities arising from the use of a stapled structure.
Foreign entities
If one of the entities is a foreign entity, the standard disclosures required in the case of all foreign
entities are required. It states that a foreign entity with an ASX Listing is required to make
disclosures about each of the following matter:
 The entity‘s place of incorporation or registration.
 That the entity is not subject to dealing with the acquisition of securities (i.e.
substantial holdings and takeovers).
 Any limitations on the acquisition of securities imposed by the jurisdiction in which
the entity is incorporated or registered.
 Any limitations on the acquisition of securities imposed by the jurisdiction in which
the entity is incorporated or registered.

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If the securities of a foreign entity are stapled to securities (principally Australian companies and
listed registered managed investment schemes), disclosure must also be made of the effect of the
application of these Chapters of the Corporations Act to that entity on the acquisition of stapled
securities. For example, if the regime applicable to the foreign entity does not provide for
compulsory acquisition powers matching those following a successful takeover, the disclosure
should deal with what will happen if the successful offer or exercises its compulsory acquisition
powers in relation to the other entity and is granted a modification of the Corporations Act by the
Australian Securities and Investments Commission (ASIC).
Other entities
It is a condition of continuing listing that entities with stapled securities maintain the stapled
structure and make disclosures about the stapled structure. The requirements are:
 The entities must make the disclosures to every person who subscribes for stapled
securities under a disclosure document or information memorandum, and set them out in
every annual report. An undertaking to this effect must be provided before admission.
 The entities must make the disclosures to every person who subscribes for stapled
securities under a disclosure document or information memorandum, and set them out in
every annual report. An undertaking to this effect must be provided before admission.
 The entities must provide the market with a joint abridged profit statement and a joint
abridged balance sheet for each half year and full year. The entities must nominate a
person as the ASX point of contact in relation to listing rule matters. It is expected that
the same person would be nominated for both entities.
 The entities must maintain the stapled structure. ASX reserves the right to remove entities
from the official list that do not do so.

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Stapled securities issued by the same issuer
 ASX will provide joint quotation for more than one class of securities of the same issuer,
and may treat the jointly quoted securities as the issuing entity‘s main class of securities.
 Listing rules from which waivers may be needed include condition (in relation to the
requirement for securities to have a value of $2,000) and listing rule condition (issue
price of 20 cents for main class). These are granted on the basis that the stapled securities
together satisfy the requirements, i.e. the stapled securities are treated as one security for
the purposes of the Listing Rules.
Trading and settlement
An on-market trade in stapled securities will be settled in CHESS in relation to each class of
securities. If the securities are not CHESS approved, paper-based transfer will be required in
relation to each class. In order to ensure that the stapled securities cannot be traded separately
off-market, ASX requires the constitution of the issuing entity (or entities), and the terms of issue
of the securities, to provide for the entity (or entities) to refuse to register a paper-based transfer
of securities in one class of the stapled securities unless there is a matching paper-based transfer
of securities of the other class or classes of the stapled securities. A waiver from listing rule 8.10
to the extent necessary to permit the issuing entity (or entities) to have such provisions will be
granted.
Value Adding from Stapling
 Benefits to issuer:
Control: larger outlay required (eg for equity + note) to gain voting rights, or less
risk of control change in trust structure v company
Leverage: investors funds treated as equity + debt for tax purposes, although
inherently equity. External debt can be added. Changed tax financial distress
trade-off from debt.
Investor perceptions: framing distributions as income (rather than income plus
return of capital)
 Financial engineering can ―un-staple‖ cash flows

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Stapled Security example
 Trust is a ―non-operating trust‖
Pass-through for tax purposes
 Taxable income of company component reduced by rental payments to trust
 Lower company tax bill than if a company structure or an operating trust
 Trust income distributions are pre-company tax rather than equivalent ―grossed-up‖
amount of smaller cash component and franked dividend
 Tax benefits only for non-resident investors

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Structured Products
Tracker
A tracker replicates the performance of an underlying asset directly and with no leverage.
In technical terms, this is a zero strike Call, but in reality, it is very much like holding the
underlying asset directly. Trackers give investors a cost efficient means to trade an asset (such as
a currency or commodity) or to diversify their exposure across an index. As with all securitized
derivatives, trackers are stamp duty free.
These instruments are typically long-dated or indeed undated with an indefinite lifespan, and can
be referred to as bull, tracker or benchmark certificates.
As can be seen from Fig 1, the tracker replicates the index without leverage. In this case, should
the FTSE 100 fall 500 points, the tracker will lose 50p in value and should the FTSE 100 rise
500 points, the tracker will gain 50p in value. Although no dividend is paid out, any income
streams are built into the capital value of the tracker over its lifetime. However, the precise terms
should be checked with the issuer.

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Accelerated Trackers
Accelerated Trackers are growth orientated structured products. These instruments give
additional upside performance whilst maintaining a 1:1 relationship on the downside in return for
surrendering income streams related to the underlying asset.
In the example above, the two dotted lines represent the pay-out profiles of the plain tracker and
at-the-money Call option which form the components. The solid line represents the profit and
loss profile of the accelerated tracker.
At maturity:
On expiry, the holder of the accelerated tracker has the right to:
1. If the final underlying asset price is greater than or equal to the initial underlying asset price:
Initial price + (initial price x [participation level x change in underlying])
2. Otherwise:
Initial price + (initial price x change in underlying)
This means that should the index have risen 10% in value at maturity, then the investor will
receive a 21% profit.

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In this case, £121 in cash
(100 + (100 x [210% x 10%])).
The investor does not have to worry about the currency risk associated with the underlying asset
being priced in Yen as this product is Quanto and currency risk is hedged out on the investors‘
behalf by the issuing bank.
Despite the accelerated upside, the investor faces no additional downside risk (excluding
foregoing any income). Should the index have fallen 10% at maturity, the investor will realize a
loss of -10%.
Reverse Tracker
Reverse trackers are very similar to standard trackers but have an inverse relationship with the
underlying asset – should the price of the underlying asset fall, the price of the reverse tracker
will rise.
This figure shows the inverse relationship the reverse tracker has with the price of Lloyds TSB
plc - if the share price falls 10p, then the reverse tracker price would rise 10p and vice versa.
The price is simply calculated as follows:

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Price = strike - underlying
= 800 - 475
= 325p
In effect, this is a Put option, but so deeply in-the-money as to have a linear price relationship
with the underlying. However, should the underlying asset price increase dramatically towards
the strike, the linear relationship will break down and the instrument will increasingly take on the
characteristics of a standard Put option.
As with all trackers, no dividends are paid, but any income streams are built into the capital
value of the tracker over its lifetime - check the pricing supplement for details specific to each
product.
Bonus Tracker
These instruments have slightly more complex structures which are comparable to fixed term life
products or insurance bonds. However, they are continuously priced throughout their lifetime
and investors do not face early redemption penalties.
In addition, bonus trackers can be issued as much shorter-dated instruments where required.
A bonus tracker is a combination product incorporating:
A zero strike Call (or standard tracker)
A barrier option (down-and-out Put)
The standard tracker simply replicates the performance of an underlying with no leverage, and
expires at the value of the instrument or index it is tracking.
A down-and-out Put is a type of option called a barrier option which ceases to exist when the
underlying asset reaches a predetermined level (in our next example, 3000) and is therefore
cheaper than a standard option.
Figure shows an example of a FTSE 100 bonus tracker with a bonus level of 6000 (which
translates to 600p due to the conversion ratio of 1000:1) and a barrier level of 3000. This product

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is the combination of a zero strike Call (or tracker) and a Put option with a strike of 6000 and a
knock-out level of 3000.
This means that should the FTSE 100 fall below 3000 at any point during the five year life of
this product, the Put component will ‗knock-out‘ leaving the product as a simple tracker.
However, if the FTSE 100 doesn‘t fall below the barrier level of 3000, the Put option will
remain, guaranteeing a minimum payout level of 6000 (i.e. 600p) at expiry regardless of where
the FTSE 100 index is at expiry.
At maturity:
On expiry the FTSE 100 index closes at 4000 having never fallen below 3000 during the five
year lifespan of the product. The zero strike Call (or tracker) has a value of 400p while the Put
has a value of 200p (strike price - final index level) giving a total return of 600p.
If, on the other hand, the FTSE 100 had fallen below 3000 at any point during its lifetime, the
Put option would have ‗knocked out‘ and the total return would simply be that of the zero strike
Call (or plain tracker) of 400p.

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Should the closing level of the FTSE 100 be above 6000 at expiry (e.g.7050), the total return
would be that of the zero strike Call (or tracker) of 705p. This is the case even if the barrier level
has previously been hit.
Discount Tracker
Discount trackers allow investors to buy into the performance of an asset at a discount to the
actual underlying price. However, the potential gain is limited to a pre-defined level (the cap
level).
A discount tracker is a combination product incorporating:
a zero strike Call (or tracker)
writing a Call option
The tracker simply replicates the performance of an index, with no leverage, and will simply
expire at the value of the index or underlying it is tracking.
This is akin to covered call writing where the options writing income translates to a discount on
the underlying asset. Selling the Call option means that the investor benefits from the premium,
hence the discount. Upside is capped however, as any rise in value of the underlying asset above
the strike price is cancelled out by the liability created in selling the Call option (Call option
strike price = cap level).
In the example above, the two dotted lines represent the profit and loss expiry profiles of the
tracker and the short Call option. The solid line represents the profit and loss profile of the
discount tracker.

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At maturity:
Should the value of M&S increase by 25% to 500p, the discount tracker would reach the cap
limit of 430p (a 19.4% rise in value).
Should the value of M&S increase by 7% to 428p, the value of the discount tracker will be 428p
(an 18.9% rise in value).
Should the value of M&S fall by 20% to 320p, the value of the discount tracker would also fall
to 320p (but because of the discount purchase price, this would represent only an 11.1% fall in
value).
In short, additional downside protection is purchased at the expense of limiting upside exposure
above a certain level. As with all trackers, no income is paid out but, according to the terms of
each product, is built into the capital value.
Discount trackers also have the unusual characteristic of appreciating in value as time passes, all
other factors remaining constant. Should the underlying asset remain static over the lifetime of
the discount tracker (i.e. a 0% return), the discount tracker will expire, in the example above,
with a 10% gain for the investor.
Capital Protected Products
Capital protected products allow investors to gain exposure to financial assets whilst protecting
the capital invested, in return for surrendering any income related to the underlying asset.
The degree to which there is participation in the performance of the financial asset and protection
over capital invested vary from product to product. This will largely depend on the maturity
profile, forward interest rates plus the yield and volatility of the underling asset (ignoring any FX
considerations).

25. 25 | P a g e
As can be seen from the above chart, the investor faces no downside risk over the three year
lifetime of the product but takes part in 100% of any upside performance. This achieved by
purchasing a zero coupon bond and using the discount from nominal value to invest in a Call
option. The zero coupon bond matures at par, thereby guaranteeing the investor‘s capital, whilst
the Call option maintains the upside exposure required.
At maturity:
On expiry, the holder of the capital protected instrument has the right to:
1. If the final underlying asset price is greater than or equal to the initial underlying asset
price:
Initial price + (change in underlying/conversion ratio x participation)
2. Otherwise:
The higher of:
a) Initial price/conversion ratio x protection level
b) Final price/conversion ratio

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In this case, regardless of whether the index falls to zero by the time the product expires, the
investor is guaranteed to receive the initial price of the product when launched. So a fall of -
100% equates to a 0% return.
Should the index rise over four years, then the investor fully partakes in any capital appreciation.
A 15% rise in the FTSE100 will result in a 15% rise in the value of the product. However, it
should be remembered that the income attributable to the underlying asset has been given up in
order to achieve this payout profile.

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Energy Hedge Funds
Hedge Fund
A hedge fund is an investment fund open to a limited range of investors that is permitted by
regulators to undertake a wider range of investment and trading activities than other investment
funds, and that, in general, pays a performance fee to its investment manager. Every hedge fund
has its own investment strategy that determines the type of investments and the methods of
investment it undertakes. Hedge funds, as a class, invest in a broad range of investments
including shares, debt and commodities.
As the name implies, hedge funds often seek to hedge some of the risks inherent in their
investments using a variety of methods, most notably short selling and derivatives. However, the
term "hedge fund" has also come to be applied to certain funds that do not hedge their
investments, and in particular to funds using short selling and other "hedging" methods to
increase rather than reduce risk, with the expectation of increasing the return on their investment.
Hedge funds are typically open only to a limited range of professional or wealthy investors. This
provides them with an exemption in many jurisdictions from regulations governing short selling,
derivatives, leverage, fee structures and the liquidity of interests in the fund. This, along with the
performance fee and the fund's open ended structure, differentiates a hedge fund from an
ordinary investment fund.

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The net asset value of a hedge fund can run into many billions of dollars, and the gross assets of
the fund will usually be higher still due to leverage. Hedge funds dominate certain specialty
markets such as trading within derivatives with high-yield ratings and distressed debt.
Unregulated and largely secretive hedge funds trade crude oil, petroleum products, natural gas,
physical and financial power, coal, emissions and renewable energy. They are also active in
distressed generation and other energy industry physical assets and both equity and debt for
energy companies. Some are even extending their platform into carbon trading.
Energy Hedge Funds
The combined research of Global Change Associates and UtiliPoint International has revealed
that there are over 250 energy hedge funds and perhaps as many as 400 with new funds emerging
on a daily basis. We classify ‗energy‘ hedge funds as those active in the following financial
sectors of the energy world:
Energy hedge funds are also now investing in oil and gas reserves in the ground particularly in
North America. Continued oil market price volatility in 2004 has been the catalyst for the hedge
funds. Frankly, the daily news reports in all media of energy market price volatility are driving
the attention of funds to trade energy commodities. This has been the opening to the
transformation of financial energy markets as the funds provide liquidity and exacerbate price
Energy equities
Energy debt
Distressed assets (such as power stations)
Oil & gas commodity futures trading
Over-the-Counter (OTC) energy derivatives

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volatility. Their presence has escalated intra-price volatility and increased trading volumes and
open interest in oil futures contracts. They also became more active in North American gas
futures trading in 2004. We are also seeing increased hedge fund formation in Europe, especially
around oil trading and this is a trend that we expect to continue and sharpen during 2005.
It has been established that there are over two hundred known hedge funds active in the energy
sector with many more in formation (2004). To put this in some context, there are more than
8,100 hedge funds globally managing over US$1 trillion in assets today. There are many factors
responsible for this change in hedge fund strategy. For one thing, traditional equity returns have
been flat so that many funds are not making the kinds of returns expected for this type of
investment. Furthermore, many pension funds and other institutional money are now looking for
safe harbour for higher yields through alternative investment strategies. There is a flood of new
money coming into the hedge funds. The energy complex, meanwhile, has seen higher prices,
rising volatility and greater trading volumes. That makes it attractive to the funds.
Figure: Percentage of Companies dealing with Energy Hedge Funds

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History of Energy Hedge Funds
The demise of Enron and the energy merchants left a liquidity vacuum in gas and power trading
that was vacant for about two years. That changed rapidly as the newest energy financial players
entered the market.
Along with big oil and investment banks, the new energy trading triangle marginalized electric
and gas utilities who have exited the ‗energy-trading‘ markets in droves. Financial energy trading
ramped up through hedge funds fueled by pension and institutional monies looking for higher
returns than they got in equity or bond markets.
Traditionally, hedge funds have played in the energy equity markets and made a mint shorting
merchant power and electric utilities in 2002. In 2003, they looked for opportunities in the equity
markets, but found little to invest in on the equity side.
2004 was different. That year they entered commodity trading of energy in a big way. Starting in
the well established and liquid oil markets, they are migrating into natural gas and electric power
trading. There are several plays that they are interested in:
What hedge funds don‘t have is the knowledge base to be successful. Some will be but most will
blow up. Traders love volatility. However, the energy trading complex is the most volatile on
earth, and electric power wins first prize due to its lack of storage capability, multi-fuel
capability and endemic weather risks. It can bring spectacular profits for a month or quarter and
spectacular losses. Speculative energy trading is back. The guys with the black boxes and the
deep pockets are going to shake up the markets. Expect more price volatility in the future. The
funds are attracted by this volatility but actually have little understanding of the physical
underlying risks of the energy markets. The added liquidity that they bring to markets is a
double-edged sword in that they also bring much more unpredictability and volatility to the short
end of the markets. The new energy markets promise to become more volatile and increasingly
dominated by financial players.
One is the pure commodity trading play.
• The second is the energy equity/energy commodity arbitrage.
Third is the distressed asset play on merchant generation which they are
now beginning to acquire.

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Impetus for Energy Hedge Funds
Due to these market driven factors, the funds are scaling up their oil trading operations;
particularly in Europe and Asia as well in North America. In the US, the latest play by the
investment banks and hedge funds is to buy physical oil and gas reserves in the ground. This
action has not only pushed out the forward curve and created greater open interest in the back
months on the NYMEX WTI contract, but also suggests that higher prices through 2010 are to be
the order of the day. Research has demonstrated that the hedge funds are now investing in the
energy complex in growing numbers and with a longer term viewpoint. They are, and always
have been, involved in distressed asset securities – both debt and equity – but now increasingly
seem to be taking a longer-term view with respect to these investments. This has been evidenced
by the funds flexing their shareholder muscle at British Energy and in other situations. Buying
oil and gas reserves in the ground is just part of a picture in which hedge funds are acquiring
assets across the energy value chain in the upstream, midstream and downstream energy sectors.
The global oil markets have now reached a new plateau in oil prices. The majors have been slow
to react to this phenomenon, but are now studying the long-term price affects. Another factor that
has brought hesitancy to stepping up oil and gas drilling by the majors is that other commodity
prices have also increased this year which has an effect in ballooning the exploration and
production budgets this year and next.
A multiplicity of factors can be seen in oil price formation. Today, exchanges like NYMEX and
the International Petroleum Exchange (IPE) set the price of oil to a much greater degree than
OPEC which has become the ultimate price taker. Oil prices are influenced by supply/demand
fundamentals, weather, geopolitical factors, a terrorist premium, hedge fund and other
speculative activity, to name a few. The fact is that higher intraday price movements will now be
the order of the day and oil traders particularly will have to get used to this change.

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