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Warrants and CBBCs Education

  • 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.

    July 2017

    Financial Products Public Distribution, Vontobel

  • 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.

    Residual Value of Bull Contract:
    Residual Value of Bear Contract:
    Observation Period:

    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
    Example:
    Stock: HSI
    Category: R-type Bull Contract
    Strike Price: 21,800
    Call Price: 22,000
    Conversion Ratio: 10,000 to 1

    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:

    • Non-collateralisation - Warrants and CBBCs are not secured by any asset of the issuer or the guarantor (if any) or supported by any other collateral
    • Credit risk - Holders of warrants and CBBCs are unsecured creditors of the issuer and the guarantor (if any) and they have no preferential claim to any assets that an issuer or a guarantor (if any) may hold.
    • Gearing risk - Although warrants and CBBCs often cost less than the underlying assets, a warrant or CBBC may change in value to a much greater extent than the underlying assets. Although the potential return on warrants or CBBCs may be higher than that on the underlying assets, in the worst case the value of warrants or CBBCs may fall to zero and holders may lose their entire investment amount.
    • Limited life - Unlike stocks, warrants and CBBCs have an expiry date and therefore a limited life. Unless the warrants or CBBCs are in-the-money, they become worthless when they expire.
    • Time decay - So long as other factors remain unchanged, the time value of warrants or funding costs of CBBCs will decrease over time and will become zero upon maturity.
    • Market forces - In addition to the basic factors that determine the theoretical price of a warrant or CBBC, prices of warrants or CBBCs are also affected by the demand for and supply of the warrants or CBBCs.
    • Turnover ‐ High turnover should not be regarded as an indication that the price of a warrant or CBBC will go up. The price of a warrant or CBBC is affected by a number of factors in addition to market forces, such as the price of the underlying assets and their volatility, the time remaining to expiry, interest rates, and the expected dividend on the underlying assets.
    • Possibly limited secondary market - The liquidity provider may be the only market participant for a particular warrant or CBBC. The more limited the secondary market, the more difficult it may be for you to realise the value in the warrant or CBBC before expiry.
    • Operational and technical problems are affecting liquidity services – The liquidity provider may not be able to provide liquidity when there are operational and technical problems hindering its ability to do so. Even if the liquidity provider is able to provide liquidity in such circumstances, its performance on liquidity provision may be adversely affected. For example:
      i. the spread between bid and ask prices quoted may be significantly wider than its normal standard;
      ii. the quantity for which liquidity will be provided by the liquidity provider may be significantly smaller than its normal standard; and
      iii. the liquidity provider’s response time for a quote may be significantly longer than its normal standard.
    • Corporate action of the underlying stocks – Corporate actions affect the value of the underlying stocks which in turn affect the value of the warrants or CBBCs. Adjustments may or may not be made to the terms of the warrants or CBBCs (such as entitlement ratio, exercise price, etc.) depending on the terms and conditions set out in the listing documents. Where adjustments are to be made, the adjustments will only become effective (the “Effective Date”) when all necessary parameters can be determined. The prices of the warrants or CBBCs may be volatile from the ex-entitlement date of the underlying stocks until the Effective Date. You should exercise particular caution in trading those warrants and CBBCs during that period. In addition, no adjustment will be made to those warrants and CBBCs that expire within that period.
  • 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.

    Details of the "ITM", "OTM" & "ATM" of warrants are shown in the table below:
    "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▲
    5. Dividend▲
    6. Market Supply & Demand▲
    • Underlying Price: This is the primary factor affecting the theoretical price of a warrant. Assume other factors remain unchanged; the theoretical price of a call warrant will rise, and that of a put warrant will drop when underlying price increase.
    • Implied Volatility: Implied volatility reflects market risk premium, market volatility and market supply/demand for that warrant. Underlying price volatility rise or market demand for such warrant increase will also lead to implied volatility increase. Higher implied volatility leads to higher theoretical price, even for call warrant or put warrant. Warrants issuers adjust implied volatility based on OTC options, hedging cost, etc.
    • Date to Expire: For warrants, the longer time to expire, the higher theoretical price, and vice versa. In general, a short term warrant will expire within 3-4 months. A middle term one will expire within 5-8 months, and long term one will expire after 9 months.
    • Interest Rate: Interest rate refers to market lending rates here, its impact on warrants’ price is mild. Due to different costs for different issuers, interest rates are not consistent among issuers.
    • Dividend: This is a factor that is often overlooked by investors. When issuers launch a warrant, they will predict dividend payable amount and date and considered the prediction mentioned above when calculating warrant’s theoretical price. For call warrants, the higher expected dividend will lead to lower theoretical price. If the actual dividend is more than anticipated, then the theoretical price of the warrant will be adjusted downward. On the contrary, put warrant's theoretical price will be adjusted upward if the actual dividend more than expected. Issuers determine adjustment timing for their products.
    • Market Supply & Demand: Warrants are trading on HKEx, the actual price will be affected by market supply & demand, as well as its liquidity.
  • 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”.

    Quote Request

    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.

    Active Quote

    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.