Callable Bull/ Bear Contracts (CBBC) - HSBC

[Pages:28]Callable Bull/ Bear Contracts

(CBBC)

Driving Investment Power

Ta b l e o f C o n t e n t s

Basic Power

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How do CBBC work? How are CBBC priced? Difference between Category R and N Mandatory Call Mechanism How to calculate Investment Profit/Loss? Investment Risks of CBBC

Advanced Power

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Factors affecting Gearing Ratio Conversion Ratio reflects Sensitivity Interpreting the name of CBBC Comparison between CBBC and Warrants Other Important Trading Information

Releasing Power

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Steps to select CBBC Medium to Long-Term Strategy Short-Term Strategy

Practical Tests

Introduction to HSBC CBBC Website

HSBC CBBC Hotline: 2822 1849

Prepared by Wealth Management Sales, HSBC Global Markets

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BASIC POWER

BA S I C P O W E R

ONE

How do CBBC work?

Callable Bull/Bear Contracts (CBBC) are derivatives traded on the Hong Kong stock exchange. Investors who have a positive view on the underlying asset can consider investing in a "bull contract". Conversely, those who are bearish on the prospect of the underlying asset may invest in a "bear contract". Movement of the price of CBBC is essentially dependent on the movement of the price of the underlying asset. CBBC's gearing feature allows investors to capture the movement of the underlying asset and hence magnify investment returns by paying only a fraction of the underlying asset price. However, investors' potential loss would also be magnified in the same fashion if their "market forecast" is proven to be wrong.

The first CBBC in Hong Kong was launched in June 2006. The underlying asset can be a local or foreign index and stock, or even a commodity or a currency. In addition to its gearing feature, the pricing mechanism of CBBC is simple and direct, and its price transparency is higher than that of other structured products. The price of CBBC consists of two components, "Intrinsic Value" (the difference between the price of the underlying asset and the exercise price of CBBC) and "Financial Costs" charged by the issuer.

In the meantime; however, CBBC features a mandatory call mechanism. If the price of the underlying asset touches or is below the "Call Price" of a bull contract, or the price of the underlying asset touches or is above the Call Price of a bear contract, a Mandatory Call Event will take place to the relevant bull contract or bear contract, and trading will be terminated immediately. Moreover, CBBC is an investment tool with a time period and has a maturity date. If an investor holds a CBBC until maturity, his/her profit or loss from this investment will depend on the settlement conditions.

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BA S I C P O W E R

TWO

How are CBBC priced?

As a type of derivatives, the price of CBBC is naturally linked to the price of the underlying asset. Intrinsic value and financial costs are the two major components of the price of CBBC. Hence, the price of the underlying asset and financial costs will be the key influential factors on the theoretical price of CBBC. However, as an investment tool traded freely on the stock exchange, the actual price of CBBC may be affected by market demand and supply and therefore, deviate from the theoretical value.

Intrinsic value is the difference between the spot price of the underlying asset and the exercise price of the CBBC. The wider the gap, the higher the intrinsic value will be. For example*: the exercise price of a bull contract on Stock A is HKD100.00, the conversion ratio is 1:1 and the spot price of Stock A is HKD120.00; then the intrinsic value of the bull contract on Stock A will be HKD20.00.

Financial costs are the charges an issuer imposes on investors to cover its financing costs. These financing costs are usually adjusted according to the borrowing rate of the market. For instance, the inter-bank offered rate will be used as a reference and a certain percentage will be added to it. Financial costs will be reflected by the price of CBBC, and will be reduced from the price of the CBBC on a daily basis as the CBBC is approaching maturity. Financial costs are calculated by the following formula:

Financial costs = exercise price x annual rate x tenor of CBBC

The following two simple formulae can be used to calculate the theoretical price of CBBC:

Theoretical price of a bull contract = (underlying asset price - exercise price) + financial costs conversion ratio

Theoretical price of a bear contract = (exercise price ? underlying asset price) + financial costs conversion ratio

Factors affecting price movement of CBBC:

Factor

Change in Factor

Price Movement of Bull Contract

Price Movement of Bear Contract

Underlying asset price

Financial costs

* The example is for illustrative purposes only and is not indicative of future returns.

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BA S I C P O W E R

THREE

Difference between Category R and N

Different from warrants, CBBC not only has an exercise price but also a call price. Depending on where the exercise price and the call price are placed, CBBC can be classified as "Category R" and "Category N". Category R refers to CBBC that has a "residual value" after the mandatory call event whereas Category N refers to CBBC that has "no residual value" after the mandatory call event.

Both Category R CBBC and Category N CBBC have an exercise price and a call price. The distinction is that the call price and the exercise price of Category N CBBC are set at the same level whilst there is a gap between the exercise price and the call price of Category R CBBC. For a Category R bull contract, the call price will be above the exercise price; and the call price of a Category R bear contract will be below the exercise price. When a mandatory call event occurs to a Category N CBBC, its intrinsic value will be equal to HKD0, and therefore, no residual value can be distributed to its holders. On the contrary, when a Category R CBBC is called, its intrinsic value is generally above HKD0, and therefore it may have residual value to be distributed to its holders. In the worst case scenario, there may not be any residual value.

Bull Contract

Bear Contract

Category

Category R

Category N

Category R

Category N

Bull Contract Bull Contract Bear Contract Bear Contract

Function

Bullish view Bullish view Bearish view Bearish view

Where the call price and call price >

call price =

call price <

call price =

exercise price are placed exercise price exercise price exercise price exercise price

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BA S I C P O W E R

FOUR

Mandatory Call Mechanism

The mandatory call mechanism of CBBC is often considered an automatic execution of stoploss arrangement on behalf of investors. A CBBC being called implies that investors have already forecasted the price movement of the underlying asset inaccurately. The mandatory call event may allow investors to regain part of the principal so as to plan for further investment.

The operation of the mandatory call mechanism is that, when the price of the underlying asset touches or is below the call price of a bull contract, or when the price of the underlying asset touches or is above the call price of a bear contract, such bull or bear contract will be matured early and trading will be terminated immediately. For instance, assume the call price of a Hang Seng Index bull contract is 25,000 points and if the Hang Seng Index falls to the level of 25,000 points from a level higher, even though the index would bounce back soon after touching the call level, such Hang Seng Index bull contract will be called regardless.

The arrangement of a CBBC after the mandatory call event depends on whether it belongs to Category R or N. For Category N CBBC with no residual value after the mandatory call event, its value will be equal to HKD0 and its holders will not receive any cash distribution. On the contrary, for Category R CBBC which has residual value, under normal circumstances its holders will be able to receive residual value.

The listing document of a CBBC will clearly specify the calculation of residual value. First of all, a settlement price during a specific observation period will be used as a reference to calculate residual value. The observation period starts soon after the moment the mandatory call event occurred to the CBBC and is up to the next complete trading session. The lowest trading price during the observation period will be used for bull contracts while the highest trading price during the observation period will be used for bear contracts. However, one should note that under most circumstances residual value would be lower than the value of the CBBC before the mandatory call event. Under individual and distinctive circumstances such as market being unusually volatile, the settlement price could be below (for bull contracts) or above (for bear contracts) the exercise price, and CBBC holders would be left no residual value to receive.

The formulae to calculate residual value of CBBC are as follows:

Residual value of bull contract = settlement price ** - exercise price

conversion ratio

Residual value of bear contract = exercise price - settlement price **

conversion ratio

** Note: The settlement price of the bull contract must not be lower than the minimum trading price of the underlying asset during the period between the mandatory call event and up to and including the next trading session.

The settlement price of the bear contract must not be higher than the maximum trading price of the underlying asset during the period between the mandatory call event and up to and including the next trading session.

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FIVE

How to calculate Investment Profit/Loss?

The following examples* explain the profit and loss of CBBC under different scenarios: Assumptions:

Category R Bull Contract on Stock A

Exercise price:

HKD100.00

Call price:

HKD110.00

Conversion ratio:

10:1

Financial costs:

Annual rate 10.00%

Time remaining to maturity:

1 year

Spot price of Stock A:

HKD120.00

Price of bull contract (cost):

[(HKD120.00 - HKD100.00) + (HKD100.00 x 10.00% x 1)] / 10 = HKD3.000

Scenario 1: Contract is sold in market prior to maturity

Category R Bull Contract on Stock A

Exercise price:

HKD100.00

Call price:

HKD110.00

Conversion ratio:

10:1

Financial costs:

Annual rate 10.00%

Time remaining to maturity:

6 months

Spot price of Stock A: Price of bull contract:

HKD150.00

[(HKD150.00 - HKD100.00) + (HKD100.00 x 10.00% x 6/12)] / 10 = HKD5.500

Rise in Stock A: Rise in Stock A (%):

HKD150.00 - HKD120.00 = HKD30.00

[(HKD150.00 - HKD120.00) / HKD120.00] x 100% = 25.00%

Gain on each bull contract:

HKD5.500 - Cost HKD3.000 = HKD2.500

Gain on each bull contract (%): [(HKD5.500 - HKD3.000) / HKD3.000] x 100% = 83.33%

* The example is for illustrative purposes only and is not indicative of future returns.

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