Derivative Training
What is a Financial Derivative? A financial derivative is a contract between two or more parties with its price dependent upon / derived from one or more underlying assets. Fluctuations in the underlying asset will affect the derivatives value. The most common underlying assets include stocks, currencies, interest rates, commodities and market indices. 2
Major Types of Derivative Products Derivative Products Traded Traded on on the the Stock Stock Exchange -- Examples Warrants Callable Bull / Bear Contract (CBBC) Synthetic ETF (e.g. 2823.HK ishares FTSE A50 China Index ETF / 例 : ishares A50 ETF) Index Futures and Options Exchange Traded Note (ETN) (e.g. TRNM : NYSE Arca - U.S. Mid Cap Trendpilot Index ETN listed in the US) Derivative Products Offered by by Banks Banks -- Examples Structured Investment Deposit Dual Currency Deposit or Deposit Plus Equity Linked Investments Structured Notes Unit Trusts with the use of derivatives specified in the investment objective Before you decide to invest in any derivative products, you should Carefully read the offering documents Make sure you fully understand the features & risks of the product Consult your personal financial advisor if in doubt 3
Common Use of Derivative Products Generate potential return even under stable or bearish market Payoff can be structured to match different market view Provide leverage which magnify gains and losses Investors can earn a potential return higher than direct investment within a short period of time. Fund Managers may use derivatives with the aim to Enhance potential return Obtain exposure to restricted markets (eg China A-share market) Control the risk exposure to changes in FX / equity or other asset price 4
Example : Call Option - An Investor Buying a Call Option Buyer of option e.g. Retail Investor Pays HKD1 to buy a Call Option on Stock B Receives a Right (but no obligation) to buy a share of Stock B at HKD100 on the maturity date of the Call Option Seller of option e.g. Financial Institution On the maturity date If stock price = HKD120 Investor will exercise the right and buy at HKD100. Gain HKD19 (HK20 HK1) If the stock price = HKD100 Investor will NOT exercise the right to buy. Loss HKD1 It stock price = HKD80 Investor will NOT exercise the right to buy. Loss HKD1 5
Examples of Products that Involve Call Option Call warrant Callable Bull/Bear Contract (CBBC) Synthetic ETF 略 易 金 Principal protected structured investment deposit and structured notes Guaranteed funds 金 Unit Trusts that invest in derivatives 金 6
Example : Put Option - An Investor Subscribing a Deposit Packaged Product Embedded with Selling a Put Option Seller of option e.g. Retail investor Earns normal interest on the deposit component PLUS a fixed premium Buyer of option e.g. Financial Institution Sells a Put Option on Asset X. Obligation to convert deposit & interest to Asset X at a pre-set price if asset X weakens upon maturity On the maturity date If price of Asset X remains stable or appreciates Investor earns higher interest If price of Asset X drops Investor may incur loss if asset X is immediately sold at the market price which is lower than the preset price 7
Examples of Products that Involve Selling a Put Option Equity Linked Investments / Equity Linked Notes / Equity Linked Deposit Structured Investment Deposit Dual Currency Deposit or Deposit Plus Structured Funds 金 Unit Trusts that Invest in Derivatives 金 8
Example : Forward Contract - An Investor Entering into a Forward Contract Long Forward Contract e.g. Retail Investor Obligation to purchase Asset X at HKD1Mn one year later Obligation to sell Asset X at HKD1Mn one year later Short Forward Contract e.g. Financial Institution On the maturity date If price of Asset X = HKD1.2M Investor will buy at HKD1M Gain HKD0.2M If price of Asset X = HKD1M Investor will buy at HKD1M No Gain/Loss It price of Asset X = HKD0.8M Investor will buy at HKD1M. Loss HKD0.2M 9
Examples of Products that Involve Forward Contract FX Forward Contract RMB Non-Deliverable Forward 不 Unit Trusts that invest in derivatives 金 10
Example : SWAP Contract - An Investor Entering into a SWAP Contract Party to a SWAP e.g. Institutional Investor Pays a fixed rate of 2% p.a. Receives HIBOR+1.5% p.a. Party to a SWAP e.g. Financial Institution Floating Rate Loan HKD1Mn Pays loan interest of HIBOR+1.5% p.a. 11
Examples of Products that Involve SWAP Contract Synthetic ETF 略 易 金 Guaranteed Funds 金 Unit Trusts that invest in derivatives 金 12
Popular Features & Risks of Unlisted Derivative Products Autocall Airbag (also known as Knock-in Event ) Leverage Feature The product can be early terminated at 100% of principal during the investment period Cushion level can be set with a wide buffer, e.g. 50%-70% of initial price of the underlying. Issuer will monitor whether the price of the underlying has dropped to or below the cushion level during the investment period Return/loss will vary more than direct investment E.g. if the gearing ratio is 3, then a HKD1 change in the underlying value will result in HKD3 gain/loss in the derivative. Implication to Investors May not be able to enjoy the same return when re-investing in other investments Can receive cash dividend and 100% of principal at maturity if price of underlying never hits the cushion. May suffer loss if the price of the underlying has hit the cushion level and performs against expectation upon maturity Can incur big loss exceeding 100% of principal if underlying moves unfavourably. The higher the leverage, the higher the risk Physical/ Cash Settlement Maturity settlement option in case of unfavourable performance of the underlying: (1) Physical delivery of the underlying (e.g. FX, equity) converted at pre-set price which is higher than current market price (2) Settle the loss in cash at current market price 13 If you have sufficient liquidity and have a positive view on the underlying, you can choose physical settlement and wait for the price of the underlying to rebound. If you are bearish on the underlying, you can elect for cash settlement. Loss will be immediately realised as current market price is lower than pre-set price
Important Notes on Derivative Products (1) NON Principal Protected NOT normal Time Deposit/ Note/Debenture Market Risk of underlying asset(s) Issuer Risk Credit Risk of counterparty You could lose all of your investment if the product is not principal protected. Most derivative products are packaged as deposit/note/debenture. But they are not equivalent to normal time deposit/note/debenture, and have very different risk & reward relationship. Value is linked to the performance of underlying asset(s). Product is subject to the market risk of the underlying asset(s). Be familiar with the underlying. Research information on the underlying, or request the distributor to provide such reference information. Only invest if the product matches your view of the underlying. If the issuer defaults or becomes insolvent, you may get nothing back and potential maximum loss could be the full investment amount. Know the issuer of the product. Only purchase the product if you trust the creditworthiness of the issuer. If the counterparty of the derivative defaults or becomes insolvent, you may lose a large part or all of your investment. 14
Important Notes on Derivative Products (2) Understand the Payoff Formula Infrequent Dealing Loss at early redemption No government guarantee Understand the product risk Payoff of the product may involve more than one condition. Depending on the payoff formula, value of the product may change more rapidly or less rapidly than that of the underlying asset. Make sure you understand the payoff and the return dynamics. Most unlisted derivative products offer infrequent dealing. You will not be able to sell the product at any time. Make sure you have sufficient liquid emergency funds and consider your liquidity needs. If you sell the product before the scheduled maturity, you may receive an amount substantially less than the initial investment amount. The products are not covered by the Investor Compensation Fund / Deposit Protection Scheme. Make sure you understand the risks specific to individual derivative product before purchasing. Consult your personal financial advisor if in doubt. 15