Explanation of the risks of structured product/derivative warrant/callable bull/bear contracts/exchange Traded Funds

Transcription

1 Explanation of the risks of structured product/derivative warrant/callable bull/bear contracts/exchange Traded Funds Pursuant to 5.1A of the Code of Conduct Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, an intermediary should explain the risks of different types derivative products traded on an exchange if clients without knowledge of such derivatives products. The following general information has been summarised from the website of the Stock Exchange of Hong Kong Limited ( HKEX, which highlights the risks of loss of trading or dealing in structured financial products (including Derivative Warrant and Callable Bull/Bear Contracts ( CBBC )). For details, you are recommended to refer to HKEX s website ( in particular, please remember to carefully read their risks warning and disclaimer relating to financial products ):- Some Risks Associated with Structured Products 1. Issuer default risk Investors will be considered as unsecured creditors and will have no preferential claims to any assets held by a structured product issuer in the event that the structured product issuer become insolvent and defaults on the listed product issued by it. 2. Uncollateralised product risk Since uncollateralized structured products are not asset backed, therefore, if the structured product issuer defaults, investors may lose who of their investment. Investors should check with the listing document of the structured product to determine if the structured product is uncollateralized 3. Gearing risk Structured product is leveraged and its values can change rapidly according to the gearing ratio relative to its underlying assets. In the worst scenario, value of structured product can drop to zero resulting in a total loss of initial investment. 4. Expiry considerations Structured product is worthless when expired. Investors should bear in mind of the expiry time horizon of the structured product when they formulate their trading strategy. KIM ENG SECURITIES (HK) LTD Level 30, Three Pacific Place, 1 Queen s Road East, Hong Kong 1

2 5. Extraordinary price movements Price of structured product may be different (i.e. higher or lower) from its theoretical price due to outside factors such as market supply and demand. 6. Foreign exchange risk Structured product not denominated in Hong Kong dollar is subjected to exchange rate risk. The price of structured product can be adversely affected by the currency rate fluctuation on the value of its underlying assets. 7. Liquidity risk Structured product issuer need to appoint a liquidity provider according to the requirements of Hong Kong Stock Exchange. The liquidity provider is responsible to provide two way quotes to facilitate the trading of the structured product. Investors may not able to trade the structured product if its liquidity provider is default or ceased to fulfill its role until a new liquidity provider has been assigned. Some Additional Risks Involved in Trading Derivative Warrants 1. Time decay risk Derivative warrant has time value which will be reduced over time as it approaches the expiry date of the derivative warrant. As such, derivative warrant should not be treated as a long term investment. 2. Volatility risk Price of derivative warrant is changing with the implied volatility of the price of its underlying assets. Investors should understand the volatility of the underlying assets of derivative warrant. Some Additional Risks Involved in Trading CBBCs 1. Mandatory call risk CBBC will cease trading when the value of its underlying assets equals to the mandatory call or knockout price/level as stipulated in the listing document. A residual value will then be calculated according to the listing document. Investors should note that they are only entitled KIM ENG SECURITIES (HK) LTD Level 30, Three Pacific Place, 1 Queen s Road East, Hong Kong 2

3 to this residual value and it may be zero in the worst scenario. 2. Funding costs Investors should aware that issue price of CBBC includes funding costs, the calculation of which is mentioned in the listing document of the CBBC. The funding costs are gradually reduced overtime when the CBBC approaches its expiry date. The total funding costs are proportionate to the duration of CBBC. Investors will lose the funding costs for the entire lifespan of the CBBC in the event that the CBBC is being called or knockout. Some Risks Associated with Exchange Traded Funds (ETFs) 1. Market risk ETFs are typically designed to track the performance of certain indices, market sectors, or groups of assets such as stocks, bonds, or commodities. ETF managers may use different strategies to achieve this goal, but in general they do not have the discretion to take defensive positions in declining markets. Investors must be prepared to bear the risk of loss and volatility associated with the underlying index/assets. 2. Tracking errors Tracking errors refer to the disparity in performance between an ETF and its underlying index/assets. Tracking errors can arise due to factors such as the impact of transaction fees and expenses incurred to the ETF, changes in composition of the underlying index/assets, and the ETF manager s replication strategy. (The common replication strategies include full replication/representative sampling and synthetic replication which are discussed in more detail below.) 3. Trading at discount or premium An ETF may be traded at a discount or premium to its Net Asset Value (NAV). This price discrepancy is caused by supply and demand factors, and may be particularly likely to emerge during periods of high market volatility and uncertainty. This phenomenon may also be observed for ETFs tracking specific markets or sectors that are subject to direct investment restrictions. 4. Foreign exchange risk Investors trading ETFs with underlying assets not denominated in Hong Kong dollars are also exposed to exchange rate risk. Currency rate fluctuations can adversely affect the underlying asset value, also affecting the ETF price. KIM ENG SECURITIES (HK) LTD Level 30, Three Pacific Place, 1 Queen s Road East, Hong Kong 3

4 5. Liquidity risk Securities Market Makers (SMMs) are Exchange Participants that provide liquidity to facilitate trading in ETFs. Although most ETFs are supported by one or more SMMs, there is no assurance that active trading will be maintained. In the event that the SMMs default or cease to fulfill their role, investors may not be able to buy or sell the product. 6. Counterparty risk involved in ETFs with different replication strategies (a) Full replication and representative sampling strategies An ETF using a full replication strategy generally aims to invest in all constituent stocks/assets in the same weightings as its benchmark. ETFs adopting a representative sampling strategy will invest in some, but not all of the relevant constituent stocks/assets. For ETFs that invest directly in the underlying assets rather than through synthetic instruments issued by third parties, counterparty risk tends to be less of concern. (b) Synthetic replication strategies ETFs utilising a synthetic replication strategy use swaps or other derivative instruments to gain exposure to a benchmark. Currently, synthetic replication ETFs can be further categorized into two forms: i. Swap-based ETFs Total return swaps allow ETF managers to replicate the benchmark performance of ETFs without purchasing the underlying assets. Swap-based ETFs are exposed to counterparty risk of the swap dealers and may suffer losses if such dealers default or fail to honor their contractual commitments. ii. Derivative embedded ETFs ETF managers may also use other derivative instruments to synthetically replicate the economic benefit of the relevant benchmark. The derivative instruments may be issued by one or multiple issuers. Derivative embedded ETFs are subject to counterparty risk of the derivative instruments issuers and may suffer losses if such issuers default or fail to honour their contractual commitments. Even where collateral is obtained by an ETF, it is subject to the collateral provider fulfilling its obligations. There is a further risk that when the right against the collateral is exercised, the market value of the collateral could be substantially less than the amount secured resulting in significant loss to the ETF. KIM ENG SECURITIES (HK) LTD Level 30, Three Pacific Place, 1 Queen s Road East, Hong Kong 4

5 It is important that investors understand and critically assess the implications arising due to different ETF structures and characteristics. Please read the above carefully and please seek proper advice from a qualified financial adviser or other qualified professional if you do not understand the risks of trading or financial and other implications of transacting in the above types of financial/derivative products. Please note that we may not able to dealing financial/derivative products for you from 4 June 2011 if you do not sign and return the below confirmation to us. I/We have read the above and I/We confirm and agree that I/We fully understand and accept the risks involved of trading in the above types of financial/derivative products. I/We further confirm and agree that I/We fully understand and accept that while trading in the above types of financial/derivative products may give rise to significant profits and gains, I/We may also suffer or incur significant/enhanced losses as a result of trading in such products. Name [for individual investor]: Name of Authorized Signatory [for corporate investor]: Name [for corporate investor] Title [for corporate investor]: Date: KIM ENG SECURITIES (HK) LTD Level 30, Three Pacific Place, 1 Queen s Road East, Hong Kong 5