Understanding latest financial products in Hong Kong

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Enriching knowledge series:

Understanding latest financial products in Hong Kong

7 July 2011

Joseph Lee

Senior Manager, External Relations

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Part 1

–

Warrants

–

Equity linked investments (ELI)

–

Investment-linked assurance schemes (ILAS)

Break

Part 2: Renminbi investment products

Part 3: Latest investor protection measures

Q&A

Rundown

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What are warrants (認股證)?

Warrants are issued by financial institutions (or listed

companies) that give the holder a right to buy or sell a specified amount of the underlying stock (正股) at a pre-determined price (strike/exercise price 行使價) on or before a stipulated future date (expiry date or maturity date 到期日)

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Types of warrants

Right to buy/sell

–

Call Warrant (認購證) – right to buy

–

Put Warrant (認沽證) – right to sell

Exercise style

–

American (美式) – can be exercised at any time up to the expiry date

–

European (歐式) – can only be exercised on the expiry date, mostly used for warrants traded in HK

Settlement

–

Cash (mostly) or Physical

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How to trade warrants

Through brokers (Stock Exchange of Hong Kong)

Warrants are traded like stocks

Minimum trading unit: one board lot

How ?

– Buy a warrant and exercise it on expiry date; or

– Buy a warrant and sell it before expiry

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Example of a call warrant

An investor buys a call warrant on China Telecom

Strike price = $3.56

Warrant price (premium) = $0.6

-0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1 1.2 1.4

2.56 3.06 3.56 4.16 4.76 5.36

Breakeven point

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Example of a put warrant

An investor buys a put warrant on ICBC

Strike price = $5.8

Warrant (premium) = $0.28

-0.4 -0.2 0 0.2 0.4 0.6 0.8 1

4.68 4.96 5.24 5.52 5.8 6.08

Breakeven point

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Warrants name

ML-HSBC @EC1107 (stock code:14428)

–

Stock Code: 14428

–

Issuer: ML – Merrill Lynch

–

Underlying: HSBC

–

Settlement: @ = Cash / * = Physical

–

Style: E = European / A = American / X = Exotic

–

Type: C = Call / P = Put

–

Maturity: 1107 = 2011 July

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Pricing of warrants (1)

Intrinsic value (內在值)

–

Call = Maximum (Underlying Price – Strike Price or 0)

–

Put = Maximum (Strike Price – Underlying Price or 0)

Underlying stock price (股價) vs warrant exercise price (行使價)

Call Warrant (認購證)

Put Warrant (認沽證)

Underlying stock price >

warrant exercise price

In-the-money (價內)

Out-of-the-money (價外)

Underlying stock price <

Out-of-the-money (價外)

In-the-money (價內) Underlying stock price =

At-the-money (平價)

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Pricing of Warrants (2)

On 1 Mar 2011, why the value of the ABC call warrant (strike price = $140) was not $0 (closing price = $0.081) when the ABC share price was closed at $129?

(assuming the warrant’s expiry date is 1 Sep 2011)

– Time Value (時間值) : 180 days (1 Mar 2011 vs 1 Sep 2011)

– Intrinsic Value (內在值) = strike price – stock price (for put) or stock price – strike price (for call)

– Warrant Value = intrinsic value + time value

– Time Decay: warrant is a short term investment

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Key factors affecting warrant prices

Call Warrant Put Warrant

Underlying Price Ï Ï Ð

Underlying Volatility Ï Ï Ï

Strike Price Ï Ð Ï

Time to Expiry Ï Ï Ï

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Warrants - Uses

Bullish view on the stock

– Buy a Call Warrant

Bearish view on the stock

– Buy a Put Warrant

Hedging (對沖)

– Buy a Call Warrant – lock in the price to purchase a stock in the future

– Buy a Put Warrant – hedge the price risk of a stock portfolio in a falling market

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Terminologies

1. Delta (對沖值)

– Change in warrant price ($) in response to one dollar change in stock price

– For example, suppose call warrant A and put warrant B have a delta value of 0.45 and -0.6 respectively.

That means for every $1 increase (decrease) in the underlying asset price, theoretically, the price of call warrant A is expected to rise (drop) by $0.45,

While the price of put warrant B is expected to drop (rise) by $0.6.

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Terminologies

2. Conversion ratio (兌換率)

– The number of warrants that need to be exercised to buy/sell one underlying share

– For example: the ratio of 1 (i.e. one warrant for one share) or 0.1 (i.e.10 warrants for one share).

3. Premium (溢價)

– Usually expressed as a percentage, indicates how much extra an investor is paying to buy the warrant instead of buying or selling the stock directly; or

– Percentage by which the stock price needs to move (up for a call, down for a put) before the stock warrant breaks even at expiry.

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Terminologies

4. Gearing (控股比率/槓桿值)

– How many times the stock costs more than the warrant you buy

– Underlying stock price / (Warrant Price x Conversion Ratio)

Gearing for call warrant A = $8 / ($1 / 1) = 8 times

That means you pay only $1 for 1 unit of call warrant A to participate in the price movement of an underlying asset which costs $8, or 8 times more.

Gearing for put warrant B = $8 / ($0.21 / 0.1) = 3.8 times

That means you pay $2.1 for 10 units of put warrant B to gain

exposure to the underlying asset, which costs $8, or 3.8 times.

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Terminologies

5. Effective Gearing (實際槓桿比率)

– Expected rate of change in warrant price with respect to a 1% change in the underlying asset price

– = Gearing x Delta

Effective gearing of call warrant A = 8 x 0.45 = 3.6

Effective gearing of put warrant B = 3.8 x -0.6 = -2.28

That means that for every 1% movement in stock price, theoretically, the price of call warrant A is expected to move by 3.6% in the same direction

While the price of put warrant B is expected to move by 2.28% in the opposite direction.

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Terminologies

6. Implied Volatility (引伸波幅)

– Change during the life of the warrant

– Calculated from the warrant price

– Used to measure whether a warrant is expensive relative to other warrants

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Liquidity Provider (流通量提供者)

Quoting methods

– Continuous quotes

– Quote request

Listing document sets out obligations for liquidity provider , e.g.

– Maximum spread of ask / bid price for warrant

– Minimum number of lot of warrant concerned (e.g. 10 lots)

– Maximum response time on quote request

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Liquidity Provider

Liquidity provider can suspend its obligation, e.g.

– Trading suspension

– The fair value of warrant below $0.01

– Insufficient warrants to be offered

– Fast market of underlying stock

– Hedging becomes impracticable

– A specific period prior to the warrant’s expiry day

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Things to note when investing in warrants

1. Short-dated out-of-the-money warrants (極度價外末日 輪)

2. Gearing ratio can’t predict warrant price movements 3. Avoid overbuying

4. Look beyond the gimmick and warrant recommendations

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Class Activities

Activity 1

Visit the following page and select video #3 (How warrant works) to show students a video introducing derivative warrant, then discuss with them the difference of a call and a put warrants and factors affecting the price of warrant

– http://www.invested.hk/invested/tc/html/section/elearning/tools/video/flash .html

Activity 2

Click the following page and select video #5 to show students about short-dated warrants, then discuss with them why some investors are attracted these warrants and what are the risks of investing in these warrants.

– http://www.invested.hk/invested/media/video/common/sfc_ic_05.wmv

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ELIs - Definition

Equity Linked Instrument (ELI) [股票掛鈎投資] : A structured product (結構性產品) whose returns are linked to equity

A hybrid product of a zero coupon instrument (零息投資工具) and a stock option

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ELIs - Definition

Different terminologies according to legal forms :

–

Equity Linked Notes (ELN) (股票掛鉤票據)

–

Equity Linked Deposits (ELD) (股票掛鉤存款)

–

Equity Linked Investments (ELI) (股票掛鉤投資產品)

Listed vs Over-the-counter Market (場外市場)

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ELIs - Features

Type : Bull (看漲) / Bear (看跌)

Underlying : Stock or basket of stocks

Strike price (行使價) : Discount to spot price of the underlying

Valuation date (估價日)

Maturity date (到期日)

Settlement : Cash or physical delivery of stocks

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Bull ELI

Buy zero coupon instrument + Sell a put option (receives premium)

Holder expects the underlying price will rise

Usually physically-settled at maturity

P/L

Strike

Stock price

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Bull ELI

Principal：$50,000 Yield：12% p.a.

Issue date：1 March Valuation date : 1 May

Principal + Yield on valuation date：$51,000

Underlying stock：Flower World (花草國際)

Spot price of the underlying stock : $55 Strike price：$51 (92.7% of spot)

No. of stocks：1,000 shares

Underlying price (S)

on valuation date

$51

(Strike) Receive 1,000 shares of Flower World if S < $51 Receive $51,000 if S >

$51 Scenario 1

Scenario 2

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Bull ELI

Example for Scenario 1

Underlying price on valuation date : $54 (>$51), then Receive cash : $51,000 (Principal + Interest)

Underlying price on valuation date: $45 (<$51), then Receive stocks : $51,000/$51

= 1,000 shares

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Bear ELI

Buy zero-coupon instrument + Sell a call option (receives premium)

Holder expects the underlying price will drop

Usually cash-settled at maturity

Stock Price P/L

Strike

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Bear ELI

Principal：$50,000 Yield：12% p.a.

Issue date：1 March Valuation date: 1 May

Principal + yield on valuation date：$51,000

Underlying stock：Flower World (花草國際)

Spot price of the underlying : $48 Strike price：$51

No. of stocks：1,000 shares

Underlying price (S)

on valuation date

$51

(Strike) Receive $51,000 if S≤ $51 Receive cash of $51,000 –

$1,000 x (S-51) if S > $51

Scenario 1

Scenario 2

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Bull ELI

Underlying price on valuation date: $54 (>$51), then Receive cash : $51,000 – 1,000 X ($54-$51)

= $48,000

Underlying price on valuation date : $45 (<$51), then Receive cash : $51,000

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ELIs – Factors to Consider

Underlying

Volatility of the underlying

^Bull/Bear

^Strike

^Maturity

Annualised yield

Payoff calculation mechanism

Counter-party risks

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ELIs – points to note

Yield enhancement, short-dated and hold-to-maturity product

–

Interest bearing; 1- to 3-month tenor; can’t get out before maturity

Be prepared to receive the underlying stock if you buy a physically-settled bull ELI

Unlimited risk from the embedded short position of the stock option

–

If receive physical stock, in extreme case stock price may fall to zero

NOT principal protected

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Class activities

Click the following page and select video #4 to show students about equity linked investments (ELI), then discuss with them why some investors are attracted by ELIs and what are the investments risks.

–

http://www.invested.hk/invested/media/video/tc/know09_4.wmv

Share reading of page #2 of this PDF file with students for them to understand more about ELI and its investment risks.

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http://www.invested.hk/invested/common/pdf/intelligence/mar201 1.pdf

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What is an ILAS?

Life insurance policies with benefits linked to the performance of your selected investment options, e.g. funds

Policy holders are not investing in any underlying assets of the investment option and hence have no rights or claims in any of the assets of the insurance company

Pays a lump sum at the beginning or A premium on a regular basis

Capital + / - Accumulated returns Æ Investor on maturity

Lump sum Æ Beneficiary if policy holder dies within the term of the scheme

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Benefits / Considerations of Investing in an ILAS

^Benefits

–

Provide life protection as well as investment opportunities in funds

–

Regular contributions create a dollar-cost averaging (成本平均化) effect

Considerations

–

The insurance company owns the assets that you put into an ILAS, you do not own any underlying assets of an ILAS

–

Often have heavy fee loadings at the early stages of the term / Premature encashment may attract a heavy penalty

–

Early surrender value may be significantly smaller than the money invested

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Fees & Charges of an ILAS

Policy Level

–

Initial charge (初期費)

–

Surrender charge (退保費用)

–

Withdrawal charge (提款費)

–

Insurance charge (保險費用), administration charge (保單行政費)

Fund Investment Level

–

Similar to those of retail investment funds, e.g. initial charge, fund management fee, switching charge

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Regulation on ILAS

^Product

–

ILAS & marketing materials must obtain SFC’s authorization before selling to HK public

Issuer Insurance Co & Selling Intermediaries

–

Insurance Authority / self-regulatory bodies within the insurance industry

–

Depending on activities & services provided, some

insurance intermediaries are also licensed with the SFC

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Principal Brochure

Name of the ILAS

Investment objectives & strategies

Calculation of investment returns

Fees & charges

Details of the guarantee, if any

Name of the HK representatives

Available in Chinese & English

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Illustration Document

Based on 2 assumed rates of return

Demonstrates the projected surrender values over the term of the ILAS: the sum on redemption net all fees & charges at the end of the first 5 years, & for every 5th year until maturity

Requires the signing of the investor to confirm understanding

The rates used are HYPOTHETICAL!

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Cooling-off Period

Enables investors to rethink purchase decision

The Period (whichever is later):

–

14 days after the issue of the ILAS OR

–

21 days after the date on which the application form is signed OR

–

5 days after the date of a notice issued by the insurance company informing investors of the availability of the ILAS

& the expiry date of the cooling-off period

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Qs to Ask Before Investing in an ILAS

How is the death benefit structured?

Do the fund options suit your investment needs?

How long do you have to contribute?

What is the charge structure?

What options do you have if you need instant cash? Partial withdrawal? Contribution holidays? Policy loan?

Will reducing your contribution amount attract a penalty? How about stopping contribution or redeeming before the end of the term?

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Class Activities

Activity 1

Click the following hyperlink and select video #8 to let students know about the basic features of ILAS

– http://www.invested.hk/invested/tc/html/section/elearning/tools/video/foun dation.html

Activity 2

Click the following hyperlink and select video #5 to let students know about the differences between ILAS and funds

– http://www.invested.hk/invested/tc/html/section/elearning/tools/video/kno w09.html

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Renminbi (RMB) Investment Products

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What is RMB investment products?

Investment products denominated, traded and settled in RMB; or

Products invested in RMB denominated assets

Examples：RMB Bonds, RMB Funds and RMB

Securities

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Dim Sum Bonds

June 2007 － First issuance of offshore RMB denominated bond in Hong Kong by China Development Bank

As at January 2011

No. of RMB bonds issued： 59

Issued amount：RMB840 billion

Duration：2 – 10 years

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RMB Bonds

Bonds denominated in RMB

Bond subscribers lend money to bond issuers

Bond issuers agree to pay bond holders the interests and

principal on designated dates

^Jargons

–

Onshore vs Offshore

–

Exchange vs OTC

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Types of RMB Bonds

Fixed Rate Bonds

–

Bond interest rate fixed during the investment period

Floating Rate Bonds

–

Bond interest rate adjusted based on reference rate plus or minus certain percentage during the investment period

–

Example: bond interest rate = 3-month Shanghai Interbank Offered Rate [reference rate] + 0.1%

Synthetic RMB Bonds

–

Example: A synthetic RMB bond is denominated in RMB but traded and settled in USD

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Bond trading

Primary Market Secondary Market

–

Very few bonds offered through public offering

–

In case of public offering, offering period normally is longer than that for stock IPO

–

Investors may not get the exact no. of bonds they applied for

–

Retail secondary market not very active

–

Due to supply and demand, trading price may be higher or lower than initial offering price

–

Return is calculated in Yield to Maturity, YTM

–

Bond mostly traded through OTC market

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RMB Funds

Funds denominated and traded in RMB

Similar to other funds, investors can subscribe or redeem RMB funds in their NAV through fund distributors (e.g.

banks) or fund houses

Example：RMB Bond Funds

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Listed RMB Securities

Securities denominated, traded and settled in RMB

Traded on the Stock Exchange of HK

Examples: stocks or Real Estate Investment Trusts (REIT 房地產信託基金)

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Trading of Listed RMB Securities

Initial Public Offering (IPO)

–

White Form

–

Yellow Form

–

e-IPO

Secondary Market (i.e. Stock Exchange of HK)

–

Trading charges: SFC levy, Exchange levy, stamp duty and settlement fee

–

Trading charges will be levied in HKD，RMBÆHKD

exchange rate for levying those charges will be set by the HKMA and listed on HKEx webpage (www.hkex.com.hk) around 11am on each trading day

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Class activities

Go to the following InvestEd web page and select video #2 and #4 to show students about the IPO process and secondary market trading for listed RMB securities

–

http://www.invested.hk/invested/tc/html/section/elearning/tools/

video/nowRMB.html

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Latest investors protection measures

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Key Facts Statement (KFS 產品資料概要) –

Types of information

–

Finding information of authorized funds

Other protective measures for investors –

Restrict offering of gifts

–

Pre-sale disclosure of monetary and non-monetary benefits

–

Disclosure of sales related information

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KFS of Funds

What can you find in a fund’s KFS

Quick facts (including the name of the fund manager and custodian, dealing frequency, and base currency of the fund)

What is this product?

What are the investment objectives and strategy?

What are the key risks?

Performance information (optional)

What are the fees and charges?

Additional information (e.g. the frequency in which the net

asset value of the fund is calculated, and the frequency in

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KFS of Funds

Implementation

Effective 25 June 2010, the SFC requires product

issuers to roll out within 12-month period KFS for all their products that continue to be marketed in Hong Kong.

Therefore, when you buy a product, ask your

intermediary whether a KFS has already been

prepared for the product.

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Finding Information of Authorized Funds

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Restrict offering of gifts

Restrict the offering of gifts, other that a discount of fees and charges, to promote a specific investment product so that investors would not be distracted from the features and risks of the particular product.

Became effective September 2010

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Pre-sales disclosure of monetary and non- monetary benefits

Intermediaries will be required to disclose benefits they receive from product issuers for distributing investment products.

For quantifiable benefits, specific disclosures in terms of percentage ceiling will be required.

However, an intermediary may disclose a specific percentage or the dollar equivalent.

For benefits which are not quantifiable prior to or at the point of sale, generic disclosure of the benefits will be required.

Became effective on 4 June 2011

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Disclosure of sales related information

Intermediaries are required to disclose sales related information (i.e. capacity in which a distributor is

acting, affiliation with product issuer, benefits received from product issuer and terms and

conditions in generic terms of discount of fees and charges) to investors.

Such information should be disclosed prior to or at the point of sale and in written form.

Became effective on 4 June 2011

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Class activities

Go to the following InvestEd web page to show students the videos and then discuss with them how these latest measures can help protecting investors

–

http://www.invested.hk/invested/tc/html/section/elearning/tools/

video/kyps.html

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Questions?

SFC Website: www.sfc.hk

InvestEd Website: www.InvestEd.hk

Understanding latest financial products in Hong Kong

Enriching knowledge series: