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General Risks In The Investments

"(…) In order to appreciate the risk of an investment in financial instruments, the following have to be taken into account:

1 the variability of the price of the financial instrument

2 its liquidity

3 the currency in which it is denominated

4 other factors of general risk

1 Price variability

The price of a financial instrument depends on numerous factors and can vary more or less markedly, according to its nature.

1.1) Equity securities and debt securities

To begin with, it is necessary to distinguish between equity securities (the most common securities of this type are shares) and debt securities (among the most common of which are bonds and certificates of deposit), bearing in mind that:

a) buying equity securities means becoming a member of the issuer company and participating fully in its economic risk. Investors in shares are entitled to receive the dividend distributed each year out of the profits made during the reference period as decided by the shareholders' meeting. The shareholders' meeting may, however, decide not to distribute any dividend;

b) buying debt securities means becoming a lender to the company or entity that issued them and being entitled to receive the periodic interest payments stipulated in the issue rules and to repayment of the principal at maturity.

Other things being equal, an equity security is riskier than a debt security because the remuneration payable to its holder is tied more closely to the profitability of the issuer. The holder of debt securities, by contrast, risks not being remunerated only if the issuer is in a state of financial distress.

Furthermore, in the event of bankruptcy of the issuer, holders of debt securities may participate with the other creditors in the allotment of the proceeds from the sale of the company's assets -- although such allotment usually takes place after a long delay -- whereas holders of equity securities are virtually certain not to be repaid any of their investment.

1.2) Specific risk and generic risk

For both equity and debt securities, risk can be ideally divided into two components: specific risk and generic (or systematic) risk. Specific risk depends on the characteristics of the issuer (see point 1.3) and can be substantially reduced by investors spreading their investments over securities issued by different issuers (portfolio diversification), whereas systematic risk represents the portion of the variability in the price of a security that depends on the fluctuations of the market and cannot be eliminated through diversification.

Systematic risk on equity securities traded in an organized market stems from the variations in the market as a whole, which can be identified with the movements in the market index. Systematic risk on debt securities (see point 1.4) stems from fluctuations of market interest rates. The longer the residual life of securities, the greater the repercussions of such fluctuations will be on their prices (and thus on their yields). The residual life of a security at a given date is the length of time that must elapse from that date until its redemption.

1.3) Issuer risk

For investments in financial instruments it is essential to evaluate issuers' financial soundness and business prospects, taking account of the characteristics of the sectors in which they operate.

It is necessary to consider that the prices of equity securities always reflect an average of market participants' expectations regarding their issuers' earnings prospects.

In the case of debt securities, the risk that issuer companies or financial institutions may not be able to pay interest or repay principal is reflected in the rate of interest investors receive. The greater the perceived riskiness of the issuer, the higher the rate of interest the issuer will have to pay.

In order to evaluate the appropriateness of the interest rate paid by a security, one needs to bear in mind the interest rates paid by the issuers that are considered to be the least risky and in particular the yield offered by government securities of equal maturity.

1.4) Interest rate risk

With reference to debt securities, investors need to consider that the effective rate of interest adjusts continuously to market conditions as a result of movements in the prices of the securities. The yield of debt securities will approach that incorporated in the security at the time of purchase only if investors hold them to maturity.

If investors should have to dispose of their investments before the security matures, the effective yield may be different from that offered by the security at the time it was purchased.

In particular, for securities for which the interest to be paid is predetermined and not modifiable during the life of the loan (fixed-rate securities), the longer the residual maturity, the greater the variability of the security's price with respect to changes in market interest rates. For example, in the case of a zero-coupon security -- a fixed-rate security that provides for payment of interest in a lump sum at the end of the period -- with a residual maturity of 10 years and a yield of 10% per annum, an increase of 1 percentage point in market rates will cause the price of the security to fall by 8.6%.

Thus, in order to assess the appropriateness of an investment in debt securities, it is important for investors to consider whether, and at what stage, they may need to disinvest.

1.5) The effect of investment diversification. Collective investment undertakings

As mentioned, the specific risk of a given financial instrument can be eliminated through diversification, i.e. by investors spreading their investments over many financial instruments. However, diversification can prove costly and hard to implement for an investor with limited capital. Investors can achieve a high degree of diversification at a low cost by investing their capital in units or shares of collective investment undertakings (investment funds and open-end investment companies - SICAVs). These undertakings invest the funds paid in by savers in the various types of security provided for in their rules or investment plans.

Open-end investment funds, for example, allow savers to invest or disinvest by buying or selling fund units on the basis of the theoretical value of a unit, plus or minus the relevant commissions. The theoretical value of a unit is obtained by dividing the value of the entire portfolio managed by the fund, calculated at market prices, by the number of units in circulation.

It needs to be stressed that investments in such financial instruments may nonetheless prove risky owing to the nature of the financial instruments in which funds intend to invest (e.g. exclusively in securities issued by companies operating in a particular sector or located in certain countries) or to insufficient diversification of their investments.

2 LiquidityEx

The liquidity of a financial instrument consists in the possibility of converting it promptly into cash without losing value.

A security's liquidity depends in the first place on the characteristics of the market in which it is traded. As a rule, other things being equal, securities traded in organized markets are more liquid than securities not traded in such markets. This is because the demand for and supply of securities is largely channeled into such markets, so that the prices recorded in them are more reliable indicators of financial instruments' effective value.

Nevertheless, it must be borne in mind that disposing of securities traded in organized markets which are hard to access because they are located in distant countries or for other reasons may make it difficult for investors to liquidate their investments and force them to incur additional costs.

3 Foreign currency

Where financial instruments are denominated in currencies different from that of investors' reference currency (typically the lira for Italian investors), in order to measure the overall risk of investments, investors have to take account of the volatility of the exchange rate between the reference currency (the lira) and the foreign currency the investment is denominated in.

Investors need to consider that the exchange rates with the currencies of many countries -- especially those of the developing countries -- are highly volatile, and that the behaviour of exchange rates may influence the overall result of the investment.

4 Other factors of general risk

4.1) Money and assets deposited

Investors should find out about the safeguards provided for the sums of money and assets deposited for the execution of transactions, especially in the event of the intermediary's insolvency. The possibility of regaining possession of the money and assets they have deposited could be affected by specific provisions of law in force in the places where the depository is located or by the orientations of the bodies which, in insolvencies, are empowered to settle the defaulting party's claims and liabilities.

4.2) Commissions and other charges

Before starting to invest, investors should obtain detailed information regarding all the commissions, expenses and other charges that will be payable to the intermediary. Such information must in any case be stated in the investment service contract. Investors must always remember that such charges will be subtracted from any gains on transactions whereas they will be added to any losses.

4.3) Transactions carried out in markets located in other jurisdictions

Transactions carried out in markets located abroad, including transactions in financial instruments that are also traded in domestic markets, may expose investors to additional risks. The regulation of such markets may provide investors with fewer guarantees and less protection. Before carrying out any transaction in such markets, investors should find out about the rules governing the transactions. They should also bear in mind that the Italian supervisory authorities will not be able to ensure compliance with the rules in force in the jurisdiction where the transactions are carried out. Investors should therefore find out about the rules in force in such markets and the actions that can be taken with respect to such transactions.

4.4) Electronic trade support systems

Most electronic and call-auction trading systems are supported by computerized systems for order routing and trade checking, recording and clearing. Like all automated procedures, these systems are subject to stoppages and malfunctioning.

The possibility for investors to be indemnified for losses deriving directly or indirectly from the above-mentioned events could be impaired by liability limitations established by system providers or markets. Investors should ask their intermediary about any such limitations of liability bearing on the transactions they are preparing to carry out.

4.5) Electronic trading systems

There may be differences between electronic trading systems as well as between them and call-auction systems. Orders to be executed in markets that use electronic trading systems may not be executed in accordance with investors' instructions or may remain unexecuted where a trading system suffers a malfunctioning or stoppage due to its hardware or software.

4.6) Transactions executed outside organized markets

Intermediaries may execute transactions outside organized markets. The intermediary investors choose may also act as the direct counterparty to the customer (i.e. act for own account). In transactions for execution outside organized markets it may prove difficult or impossible to liquidate a financial instrument or measure its effective value and the effective exposure to risk, especially if the instrument is not traded in any organized market.

For these reasons such transactions involve higher risks.

Before engaging in such activities investors should collect all the relevant information about the transactions, the applicable rules and the consequent risks.

***

Derivative financial instruments are characterized by a very high degree of risk which it is difficult for investors to assess because of the instruments' complexity.

Investors should therefore conclude transactions in derivative instruments only if they understand the nature and extent of the exposure to risk they entail. Investors must bear in mind that the complexity of these instruments can more easily result in unsuitable transactions being carried out.

As a rule, trading in derivatives instruments is not suitable for many investors.

Once the risk associated with a transaction has been assessed, the investor and the intermediary must determine whether the investment is appropriate, with special reference to the investor's net assets, investment goals and experience in investing in derivative instruments.

Some risk characteristics of the most widespread derivative instruments are described below.

1 Futures

2 Options

3 Other risk factors common to transactions in futures and options

4 Transactions in derivative instruments executed outside organized markets. Swaps

1 Futures

1.1) Leverage

Transactions in futures involve a high degree of risk. The initial margin is low (a few percentage points) in relation to the value of the contracts, and this produces «leverage». This means that a relatively small movement in market prices has a proportionally larger impact on the funds investors deposit with their intermediary: the effect can, of course, be unfavourable as well as favourable. Consequently, investors can lose all the margin they deposit initially and the additional margin deposits they have to make in order to maintain their positions. If the movements in the market are unfavourable to investors, they can be called on to deposit additional funds at short notice in order to maintain their positions in futures; if they do not make the additional deposits requested within the time limits established, their positions are likely to be liquidated at a loss and they will be charged any other liability that arises.

1.2) Orders and strategies designed to reduce risk

Certain types of order designed to keep losses within predetermined limits may prove ineffective because particular market conditions can make it impossible to execute them. Investment strategies that use combinations of positions, such as «standard combination orders», may be just as risky as individual «long» or «short» positions.

2 Options

Transactions in options involve a high level of risk. Investors intending to trade options should do so only if they understand the operation of the types of contract they intend to trade (puts and calls).

2.1) Buying an option

Buying an option is a highly volatile investment and the probability of its expiring without any value is very high. In this case investors lose the entire price paid for the option plus commissions.

After buying an option investors can hold it until it expires or carry out a transaction of the opposite sign, or else, for «American-style» options, exercise the option before it expires.

Exercising an option can involve either the cash settlement of a difference or the purchase or delivery of the underlying asset. Exercising an option on futures contracts results in taking a position in futures and assuming the related obligations to adjust margins.

Investors intending to buy options on an asset whose market price is very far from the price at which it would be profitable to exercise the option («deep out of the money») should bear in mind that the possibility of their becoming profitable is remote.

2.2) Selling an option

Selling an option generally involves taking on a much higher risk than buying an option: in fact, the premiums option sellers receive are fixed but the losses they can incur are potentially unlimited.

If the market price of the underlying asset moves in an unfavourable direction, option sellers are required to increase their margins in order to maintain their positions. If the option is an American-style option, the seller can be called on at any time to settle the transaction in cash or to purchase or deliver the underlying asset. If the option is on futures contracts, the seller will take a position in futures and assume the related obligations to adjust margins.

Sellers of options can reduce their exposure to risk by holding positions in the underlying asset (securities, indices or other) corresponding to the positions associated with the options they have sold.

3 Other risk factors common to transactions in futures and options

In addition to the factors of general risk described in Part A, investors should also consider the following points.

3.1) Terms and conditions of contract

Investors should ask their intermediary about the terms and conditions of the derivative contracts they intend to buy or sell. They should pay particular attention to the conditions on which they can be forced to deliver or receive the assets underlying futures contracts and the expiry dates and procedures for exercising options.

In certain circumstances the conditions of contract may be modified by the market supervisory authority or the clearing house in order to incorporate the effects of changes regarding the underlying assets.

3.2) Suspension or limitation of trading and of the relationship between prices

Particular conditions of market illiquidity or the application of certain rules in force in some markets (such as circuit breakers) can increase the risk of losses by making it impossible to carry out transactions or liquidate or offset positions. In the case of positions deriving from the sale of options, this may increase the risk of incurring a loss.

Moreover, the relationship that normally exists between the price of the underlying asset and the derivative instrument may not hold when, for example, the futures contract underlying an option contract is subject to price limits but the option is not. The absence of a price for the underlying could make it difficult to judge the significance of the pricing of the derivative contract.

3.3) Foreign exchange risk

Profits and losses on contracts denominated in currencies different from that of investors' reference currency (typically the lira) may be affected by exchange rate movements.

4 Transactions in derivative instruments executed outside organized markets. Swaps

Intermediaries may execute transactions in derivative instruments outside organized markets. The intermediary to which investors give orders may also act as the direct counterparty to the customer (i.e. for own account). In transactions executed outside organized markets it may prove difficult or impossible to liquidate a position or measure its effective value and the effective exposure to risk.

For these reasons such transactions involve higher risk.

Furthermore, the rules applicable to such transactions may be different and offer investors less protection.

Before engaging in such activities investors should collect all the relevant information about the transactions, the applicable rules and the consequent risks.

4.1) Swaps

Swaps involve a high degree of risk. There is no secondary market for these contracts, nor is there a standard form. At the most there are standardized model contracts, the details of which are usually adapted case by case. For these reasons it may prove impossible to terminate the contract before the agreed maturity without incurring high costs.

The value of a swap is always nil at the time the contract is signed, but the swap can rapidly assume a negative (or positive) value depending on the behaviour of the parameter to which the contract is linked.

Before signing contracts investors should be certain they understand how and how quickly variations in the reference parameter are reflected in the calculation of the differences they are to pay or receive.

In some situations investors can be called on by their intermediary to deposit margins even before the date fixed for settling the differences.

The counterparty's financial soundness is especially important in these contracts, since investors actually receive payment of any difference in their favour only if the counterparty is solvent.

For contracts signed with third parties, the investor should find out about the soundness of the third party and ascertain that their intermediary will be answerable in the event of counterparty insolvency.

If the contract is signed with a foreign counterparty, the risks associated with the execution of the contract are likely to be greater, depending on the legislation that applies. (…)"

Source: extract from annex 3, in English, to Italian Reg. 11522/1998 (outdated).