HK Warrants & CBBCs market has been developed for many years. Other Asia’s derivative market takes HK as a reference because HK derivative market has a mature system.
Both Warrants and CBBCs are derivative products with leverage, but they have a different structure. Investors should learn more about products’ characteristics and consider investors’ risk tolerance before investing in derivative products.
Vontobel is going to provide investors a brief description of Warrants & CBBCs through this education information. This piece of information will include concepts, strategies, and risk for Warrants & CBBCs. Investors can use this information as an entry or reference tools.
If investors want to know more about Warrants/CBBCs, please contact warrant issuers. Investors can also get a reference from “Frequently Asked Questions - HK Listed Warrant & CBBC Market” of HKEx.
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The trading channel for Warrants & CBBCs are the same as those stocks listed on HKEx. The trades will be excutaed during Hong Kong stock market trading hour and the mininum investment amount will be determined by the lot size of the Warrants & CBBCs. Investors can obtain Warrants & CBBCs quote and related information from website and mobile apps.
For trading Warrants & CBBCs, investors only need to have securities accounts at banks/securities firms. It is not required to have account at warrant issuers and futures account or margin trading account at banks/securities firms.
Warrants & CBBCs are subject to regulations and guidelines which are supervised by regulatory authorities. According to regulations, issuers must provide offer quote and liquidity for their Warrants & CBBCs .
Warrants and CBBCs are leveraged products, and investors can use Warrants and CBBCs to amplify their return on investment or to reduce the amount of money invest. However, the investor should pay attention to the risk that Warrants and CBBCs can also expand potential losses.
Warrant is a popular derivative product that can be traded in HKEx. It is a leveraged product with an expiry date. Warrant’s theoretical price not only affected by its underlying prices, but also by many factors that will be discussed later.
In Hong Kong, warrant issuers can issue warrants with underlying of stocks/indices (such as local indices, overseas indices, local stocks, overseas stocks ETFs, etc.), commodities (such as gold, oil, etc.) and currency (such as the Euro against the Dollar, etc.).
Warrants can be applied in both bullish and bearish market environment. If investors are optimistic about the market or predict stock prices will rise, they can choose Call Warrants. If they expect stock prices will fall, they can buy Put Warrants. In case of stock price increases, with other factors remain constant, theoretical price of call warrants will rise, and that of put warrants will drop. Warrant’s main feature is amplifying the return/loss effect base on leverage.
When warrants expired, it is unable to trade anymore. Derivate Warrant will be settled in cash automatically when expired, no physical settlement of underlying stocks will be involved. Whether investors can obtain the settlement amount is depends on warrant’s "moneyness". The settlement amount for in-the-money (ITM) warrants would be greater than zero when expired, and the actual amount depends on the level of ITM.
Investors can buy/sell warrants before expiry date based on their views. They can “buy low, sell high” to make profit. Warrants are flexible products that investors are not necessarily to hold warrants until expiry day.
CBBC is also a leveraged derivative product with an expiry date. The main difference between it and warrant is that CBBC has a Call Price and a mandatory call feature. That means CBBC can be knocked out (or called Mandatory Call Event) when the underlying price reach Call Price before expire. If CBBC has not been knocked out, they can be traded until expired.
The full name of CBBC is “Callable Bull / Bear Contracts”. If investors are optimistic about the market or predict stock prices will rise, they can choose Bull. If they expect stock prices will fall, they can buy Bear. Currently, issuers launch CBBCs with underlying of local indices, blue chips, and ETFs.
CBBCs have call price. If the underlying price fall to/ below call price before expires, the Bull Contracts will be knocked out, and suspend trading. If the underlying rise to/ above call price before expires, the Bear Contracts will be knocked out, and trading will be suspended.
CBBCs can also be divided into N and R-type. Once knock out, N-type CBBCs have no residual value, and R-type may have residual value. The residual Value is depended on the difference in underlying price & strike price of the CBBC; it may fall to zero. In HK, most CBBCs are R-type.
Although the CBBC has the mandatory call feature, it's pricing methodology is simpler than the warrant. Theoretical price of CBBC is mainly affected by the underlying price, and other factors that affect theoretical price include the date to expire, interest rate, dividend and market supply/ demand. The theoretical value of CBBC consists of an intrinsic value and "financial expense". The higher the financial cost, the higher the theoretical price of CBBC.
Most CBBCs in HK are R-type, and only R-type CBBCs have residual value after Knock out. This section will explain the calculation method of residual value for R-type CBBCs.
When the underlying price reaches the call price of CBBC, that CBBC will be knocked out and trading suspended. The actual amount of residual value depends on the difference between settlement price & the strike price. For Bull Contract, the settlement price is the lowest underlying price during the “Observation Period” and the highest underlying price for Bear Contract. If the stock price reaches or passes through strike price during the observation period, the residual value will be zero. Also, even if CBBC’s residual value is larger than zero, its amount is less than investment principal in most case.
Observation period is the remaining time of trading session when the CBBC is knocked out, and the next full trading session.
|KO Time||Observation Period||Bull||Bear|
|Morning Trading Session||Remaining time of morning session, and next afternoon session 13:00-16:10||Minimum Underlying Price||Maximum Underlying Price|
|Afternoon Trading Session||Remaining time of afternoon session, and next morning session 09:20-12:00|
1) Assuming that the HSI Bull Contract is KO in the morning trading session, the settlement price is the lowest level of the HSI during the observation period. Assume HSI fell to a minimum of 21,950 points during the observation period, the residual value is:
2) Assume HSI fell to 21,750 points during the observation period, then the residual value become zero because the settlement price is lower then the strike price.
Warrants & CBBCs are structured products that are not suitable for all investors. Therefore, it is important to know the risks before investing. The investor should consider their financial endurance if "worst case" happened. In fact, “Listing documents of the Warrants & CBBCs” and "Frequently Asked Questions - Hong Kong Listing Warrants and CBBC Markets" (19 August 2016) issued by the HKEx listed the main risks as followed:
Investors should choose call/put warrants based on their expected trend on the stock market. They can choose different warrants terms based on their objective & risk tolerance.
Investors may concern expiry date & strike price when choosing warrants. Please note that expiry date & strike price do not mean target price and holding period, different warrants with different expiry date & strike price have different characteristics, they are suitable for various market condition & investment objective.
Assuming other factors remain unchanged, the longer expiry date means lower effective gearing. Besides, the OTM warrants’ have higher effective gearing compare with the IMT warrants.
Investors can also compare entitlement ratio, pricing and market making performance to choose warrants after knowing basic knowledge.
|Short Term Breakthrough||Unidentified Breakthrough||Mid/Long Term Trend|
|Significant Volatility||Short Term, OTM||Mid Term, OTM||Long Term, OTM|
|Limited Volatility||Short Term, ATM||Mid Term, ATM||Long Term, ATM|
|Range Trade||Short Term, ITM||Mid Term, ITM||Long Term, ITM|
In general, the gearing ratio will be higher for a CBBC if the call price is near to the underlying price, and this also means increased risk for that CBBC to be knocked out. Investors should choose CBBCs based on market trend, volatility, investment objectives and their risk tolerance.
Investors can compare different period, strike price & call price to choose CBBCs after knowing basic knowledge.
|Balance Strategy||Aggressive Strategy|
|Method||Choose larger Call Price & Underlying Price Distance CBBC||Choose smaller Call Price & Underlying Price Distance CBBC|
|Gearing Ratio||Lower||Very High|
|KO Risk||Relatively Lower||Higher|
There are two types of Callable Bull / Bear Contracts (CBBCs), type N and type R. Since Hong Kong’s first launch of CBBCs in 2006, most listed CBBCs have predominantly been type R. Type N CBBCs have the same call and exercise price while for type R the two prices are different. For example, a type R Bull Contract has a call price above its exercise price, if a mandatory call event (MCE) occurs, it generally has residual value which will then be distributed to holders; while as a type N Bull Contract has the same call and exercise price, if an MCE occurs, it will have no residual value left.
Investors may mistakenly think that the potential loss of investing in type R CBBCs is lower, however, one should understand that the buffer between call and exercise price has already been calculated into a CBBC’s intrinsic price, hence given the same factors, type R CBBCs cost more than type N CBBCs, which implies less leverage.
As type N CBBCs have no residual value, investors do not need to wait until the end of two sessions valuation period to know their final return. Since type N CBBCs have no buffer zone between call and exercise price, investors would be better off to invest the saved cost on buying more CBBCs and thereby increasing leverage.
The words “NC” and “NP” in type N CBBCs’ English name refer to “Bull Contracts” and “Bear Contracts” respectively. Though there are no way to differentiate type N and type R CBBCs by their Chinese names, investors could still differentiate them by whether their exercise price and call price are equal.
CBBCs involve a high degree of risk and investors must be comfortable with that risk before investing. Given the lack of a buffer zone between call and exercise price, type N CBBCs with call price close to spot price are extremely risky, hence investors should instead invest in CBBCs with a more distant call price. Investors should always strike a balance between risk and rewards and control the amount of investment in CBBCs according to their own risk tolerate level.
A Type N CBBC is like a double-edge sword, it pushes leverage to the limit, and may magnify both potential returns and potential losses. If an MCE occurs, type N CBBC holders would loss all of their investment capital. Hence, investors are advised to carefully evaluate their risk tolerance prior to investing, and make prudent investment decisions.
Theoretical price of warrants is influenced by many factors. Although there are popular warrants pricing model can be used to calculate theoretical price of warrants, it is too complicated for the general investors. The basic concept of theoretical price is that is it mainly composed of two parts: intrinsic value and time value.
For call warrants, intrinsic value is the amount that stock price exceeds strike price. On the contrary, if the stock price is lower than the strike price of warrants, the intrinsic value does not exist. This can lead to “ITM” (in-the-money), “OTM” (out-of-money) &”ATM” (at-the-money), in other words, only “ITM” warrants have intrinsic value.
|"ITM", "OTM" & "ATM" of warrants|
|Moneyness||Call Warrants||Put Warrants|
|ITM||Underlying Price > Strike Price||Underlying Price < Strike Price|
|ATM||Underlying Price = Strike Price||Underlying Price = Strike Price|
|OTM||Underlying Price < Strike Price||Underlying Price > Strike Price|
As mentioned above, warrants price is composed of intrinsic value and time value. That is why there are many active trading warrants that have no intrinsic value, but its nominal price is positive.
Time value is greater than zero if the warrant is not yet expired. In fact, theoretical price of warrants is the probability that the warrant is exercised at maturity and the potential amount of settlement. For further expiry date, the warrant has more chance to change from “OTM” to “ITM”, and so higher time value.
In general, if the strike prices of warrants are the same, time value will be higher for the warrant with a further expiry date. Time value will gradually deduct from the warrants prices until the warrant expires. Once expired, the time value becomes zero.
|6 Factors Determining Theoretical Price|
|Factors||Call Warrant||Put Warrant|
|1. Underlying Price▲||▲||▼|
|2. Implied Volatility▲||▲||▼|
|3. Date to Expire▲||▲||▲|
|4. Interest Rate▲||▲||▼|
|6. Market Supply & Demand▲||▲||▲|
In order to convince investors trading Warrants/CBBCs, the Warrants/CBBCs issuers are required to appoint a liquidity provider for each of their listed Warrants/CBBCs to ensure the liquidity of Warrants/ CBBCs.
Liquidity providers will provide bid and ask prices for Warrants/CBBCs. The quote is calculated based on hedging costs, underlying liquidity, bid-ask spreads, volatility, etc. The liquidity providers are identified by a 4-digit broker number of 95XX, 96XX or 97XX.
The Liquidity providers may provide liquidity either by “Quote Request” or “Active Quote”.
Subject to specific exemptions, such as the theoricial price of the warrant below HKD 0.01, the Quote Request should be available for all listed Warrants/CBBCs.
After issuer receives the "quote request" from investors, they are required to provide the bid & ask price for the related product. Bid & ask quote will be subject to the relevant guidance and supervision. Investors are not necessary to trade at a price offered by the liquidity provider, and the liquidity provider is not obliged to support the price of Warrants/CBBCs, as other market participants, issuers can trade at any price they want.
Under certain criteria, some of the Warrants/CBBCs are required to provide Active Quotes which the service levels are tighter than those that apply to Quote Request in term of tighter bid/ask spread and continuous quoting. In general, Active Quotes should be provided for at least 90% of the time of a trading day for Warrants/CBBCs and each pause should not exceed 10 minutes.
The further information about obligations of liquidity providers of Warrants/CBBCs is listed in "Frequently Asked Questions - Hong Kong Listing Warrants and CBBC Markets" (19 August 2016). Investors can read this document before investing Warrants/CBBCs.