40 Things You Should Know to Pass HKSI Paper 9 – Derivatives

TOPIC 1 – OVERVIEW OF THE DERIVATIVES MARKETS

1. Exchange-Traded Derivatives

• In recent years, the global value of exchange-traded futures contracts has grown significantly. Three features of exchange-traded markets are:
• Novation
  • Once a completed trade is ready to be cleared and settled, the contract between the two parties is novated by the exchange
  • This means that the clearing house becomes the counterparty to the buyer and the counterparty to the seller
  • The clearing house buys from the seller and sells to the buyer, thereby guaranteeing settlement
  • Novation means that the buyer and the seller do not have to concern themselves with the creditworthiness of the other party – no counterparty or settlement risk
• Centralised marketplace
  • By offering standardised derivative products, an exchange provides a centralised marketplace for buyers and sellers to come together and trade
  • Liquidity and price discovery give confidence to both buyers and sellers that they are trading at the best possible prices
• Standardised contract specifications
  • All derivative products traded on exchanges have standardised contract specifications, including the quantity, price, expiry date and settlement date
  • Through standardisation, an exchange eliminates the contract terms risk for both buyers and sellers, so that there can be no dispute over the terms

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

2. Uses of Derivative Products

Hedging

• Derivatives can be used to hedge against adverse movements in price
• There are two types of hedging:

1. Hedging a current market position
2. Hedging a future transaction

 Asset Switching

• Switching funds from underperforming classes to outperforming ones is an important task for a portfolio manager in generating returns from the portfolio
• Derivatives can help fund managers re-weight their portfolios, as exposure to certain asset classes can be achieved without having to alter in any material way the physical asset mix of the portfolio
• Example: an asset manager wishing to move out of interest-rate securities and into equities could buy equity derivatives (gaining exposure to increases in equity values) and sell interest rate derivatives (locking in a selling price)

Making a Profit

• There are three trading strategies to make a profit from derivatives:

1. Directional trading occurs when there is an expectation of the future direction of prices and a trade is implemented to take advantage of it
2. Spread trading involves a long and a short position to take advantage of an expected movement in price
3. Arbitrage trading occurs when a mispricing is identified between the cash and derivative prices and exploited through the simultaneous purchase/sale of the underlying asset and the sale/purchase of the derivative

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

3. Participants in Derivatives Markets

Hedgers

• Financial institutions such as banks, fund managers, insurance companies and large trading companies have substantial portfolios (debt, equity, FX) exposed to price risk
• Consequently, they are major users of derivatives to hedge current and future market positions

Speculators

• Speculators add liquidity and depth to the market
• They trade derivatives to make a profit, not to hedge. They buy low and sell high
• Some hedge funds specialise in speculating on the future direction of prices by using derivative markets
• Use of derivatives avoids the need to outlay large amounts of capital and can allow investors to profit in both rising and falling markets

Arbitrageurs

• Arbitrage is the making of risk-free profit by exploiting price differences of securities
• Arbitrage activity accounts for a substantial proportion of market turnover and contributes to market efficiency
• Examples of investment products used in arbitrage are depositary receipts and underlying stocks, and an index futures contract and the index’s constituent stocks
• In practice, most arbitrage activity involves securities listed on SEHK and futures traded on HKFE. Such arbitrage tends to be conducted by the proprietary trading desks of EPs

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

TOPIC 2 – GENERIC DERIVATIVE PRODUCTS

4. Features of a Futures Product

Contract Value

• This refers to the notional value of the contract and is based on the price of the underlying asset multiplied by the contract multiplier
• The contract multiplier for the HSI contract is HK$50 per index point
• If the HSI futures were quoted at 26,450 points, the contract value for the HSI futures contract would be HK$1,322,500 (22,450 x HK$50)

Contract Price

• Generally, the futures price is quoted using the same convention as for the pricing of the underlying asset
• The quotation price for the HSI futures contract is whole index points, as is the underlying HSI

Minimum Fluctuation

• This is the minimum movement in the price of the futures contract that can occur
• The amount of a single movement is referred to as a “tick”
• The minimum price fluctuation for HSI futures contract is one index point

Contract Months

• Futures contracts are quoted in terms of the month when they expire – for example, a June 2020 contract will expire in June 2020
• “Contract months” refers to the contracts that are available for trading and the months in which they expire
• Short-dated contract months for HSI futures are the “spot” (current) month, the next calendar month and the next two calendar quarterly months (March, June, September and December)
• If it was November 2020, the short-dated contract months would be November and December 2020 and March and June 2021
• Long-dated contract months for HSI futures are the following five December months. If it were now December 2020, you could trade futures that expire in December 2021, 2022, 2023, 2024 and 2025

Last Trading (or expiry) Day

• The last trading day refers to the day in the month when the contract expires
• For the HSI futures contract, the last trading day is the second-last business day of the month

Final Settlement (or delivery) Day

• This is the date when the buyers and sellers of a futures contract have their open positions settled
• Either cash payments are made/received with the exchange clearing house, or there is a physical delivery/receipt of the underlying assets
• HSI futures: the final settlement day is the last business day of the month

Final Settlement Price

• This is price used to settle expiring contracts
• The final settlement price for the HSI futures contract is the average of quotations taken at: (i) five-minute intervals from five minutes after the start of, and up to five minutes before the end of, the continuous trading session of the SEHK; and (ii) close of trading on the last trading day

Large Open Positions

• This refers to the number of open contracts (in any one contract month) that are required to be reported to the Exchange by an Exchange Participant
• These reportable positions and position limits (the maximum number of contracts that can be held in any one contract month) are determined by the Exchange and may change from time to time
• The large open position for the HSI futures contract is 500 contracts in any one contract month

Settlement Method

• There are two methods of contract settlement: cash settlement or physical delivery
• HSI futures contracts are cash-settled

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

5. Forward Rate Agreements

• A forward contract to borrow/lend money at a specific rate on a set date in the future
• FRAs settle in cash but no loan is made at the settlement date.
• FRAs are described by the length of the contract and the term of the interest rate in the contract
• If rates rise above the contract rate, the long receives a payment at settlement and the short makes a payment; if the specified rate falls below the contract rate then the short receives from the long
• A borrower entering into an FRA with a bank is the long party (buying an FRA)
• An investor entering into an FRA with a bank is the short party (selling an FRA)

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

6. Features of a Swap

• Two parties agree to exchange (swap) income streams derived from a portfolio of assets or liabilities
• The most popular types are interest rate swaps and currency swaps, which are traded OTC and are highly customized
• With interest rate swaps, loan principals are not swapped and net interest is exchanged between parties
• With currency swaps, principals are swapped and gross interest payments are exchanged

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

7. Credit Default Swap

• The credit default swap (CDS) is the most popular type of credit derivatives
• The notional amount of CDS increased from USD6.4 trillion in 2004 to USD57.9 trillion 2007 and then fell to USD41.9 trillion by the end of 2008
• The buyer of a CDS receives credit protection by making a series of payments (like insurance premiums) to the seller in return for the right to receive a payment if a credit instrument (eg a bond) defaults (like an insurance claim)
• The buyer does not have to own the underlying credit instrument
• The CDS market was originally over-the-counter (OTC) and not regulated, however efforts are now being made to regulate it

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

8. Options

• A call option is the right to buy an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
• A put option is the right to sell an underlying asset at a specified price (strike price) on or before a specified date (expiry date)
• Taking up the right is known as exercising the option
• The seller (writer) of an option has an obligation to sell/buy when the option is exercised by the buyer (holder)
• Unlike futures and forwards, the buyer of an option has no obligation to sell or buy the underlying asset, but will exercise if it is profitable to do so
• The price paid to purchase an option is known as the option premium and is paid to the option seller
• Examples of exchange-traded options are: options on shares; options on indices; and options on futures
• Examples of OTC options are: interest rate options; currency options; and exotic options
• A swaption is an option to enter into a swap agreement
• American style options can be exercised up to and on the expiry date
• European style options can only be exercised on the expiry date
• Important contract specifications for the HSI option contract are:

Underlying index              HSI

Contract multiplier          HKD50 per index point

Contract value                  Option premium x contract multiplier

Exercise style                    European

Settlement on exercise    Cash settlement

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

9. Features of an Option

Exercise Style

• American style options can be exercised up to and on the expiry date
• European style options can only be exercised on the expiry date
• The value of an American style option should not be less than the value of the equivalent European style option
• On the SEHK, HSI options are European style and stock options are American style

Moneyness

• Depending upon the strike (exercise) price of an option and the current market price of the underlying asset, an option will be:
  • In-the-money
  • At-the-money; or
  • Out-of-the-money

Cash or Physical Delivery

• On a cash basis, the party exercising the option receives a cash payment from the option seller – HSI options are cash settled
• With physical delivery, the underlying asset is delivered in the event of an option being exercised
• Hong Kong stock options are settled on a physical delivery basis with the exercise date counted as the trade date

Option Premiums

• Value of an option = intrinsic value + time value

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

10. Factors that Affect the Time Value of an Option Premium

Time to Expiry

• With American-style options (as with all SEHK traded stock options), the longer the time to expiration, the higher the value of the option (both call and put)
• With European-style options that have long times to expiration, the effect of the time to maturity is less certain than with American-style options

Market Volatility

• As the volatility of a stock price increases:
  • The probability of a call option increasing in value is higher
  • The probability of a put option increasing in value is higher
• So, as the price volatility of an underlying security increases, so does the value of both call and put options

Interest Rate

• Instead of buying a security now, an investor can choose to buy a call option and then exercise, thereby buying the stock. In the interim, funds to buy the stock can be put on deposit, earning interest.  The higher the interest rate, the more popular this strategy and the higher the call option price
• So, call options increase in price when interest rates rise
• Instead of selling a security now, an investor can choose to buy a put option and then exercise, thereby selling the stock. In the interim, funds required now would need to be borrowed, incurring interest.  The higher the interest rate, the less popular this strategy and the lower the put option price
• So, put options fall in price when interest rates rise

Dividends

• When a dividend is paid, the stock price will fall
• Accordingly, a dividend payment will lower the value of a stock’s call option and increase the value of a stock’s put option

Current Price vs Exercise Price

• The closer an option is to being in-the-money, the higher the time value
• An option that is 100 points out-of-the-money will be worth less than an option that is 10 points out-of-the-money

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

11. Exchange-traded Options (ETOs)

• ETOs have standardised contract specifications detailing product features such as expiry dates, exercise prices, quantity of underlying asset and option type
• In Hong Kong, there are six main ETO products:
  • Stock options
  • HSI options
  • Mini-HSI options
  • Hang Seng China Enterprises Index (HSCEI) options
  • Mini-HSCEI options
  • USD/CNH options

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

12. Over-the-Counter Options

• Similar to ETOs, except:
  • Strike price, expiry date and quantity and quality of underlying asset are usually tailored to investor needs
  • Pay-off characteristics can be tailored to the investor’s needs
• Options with both tailored aspects are known as exotic options, including the following seven instruments:

Binary Options

• A bet on the movement and/or direction of prices
• A binary option could be based on the HKD strengthening to 10 against the UK Pound – If the HKD strengthens to 10, the option seller must pay out to the buyer an agreed amount (eg 10 or 20 times the premium)

Barrier Options

• Options that come into effect (or cease to be in effect) when prices move through a predetermined level, known as a “knock out” feature
• For example, a French importer wants protection from a fall in the value of the Euro, however is comfortable with the Euro anywhere between 1.2 to 1.3 to the USD. As the importer cannot tolerate the Euro weakening beyond 1.1, a barrier option can be used to provide coverage for the importer, if the Euro falls below 1.1
  • There are numerous varieties of barrier options
  • As they provide limited cover, they cost less than a vanilla option

• Similar to ETOs, except:
  • Strike price, expiry date and quantity and quality of underlying asset are usually tailored to investor needs
  • Pay-off characteristics can be tailored to the investor’s needs
• Options with both tailored aspects are known as exotic options, including the following seven instruments:

Compound Options

• An option on an option
• For example, a call on a put, where the buyer purchases the right to buy a put option

Lookback Options

• An option that gives the buyer the right to buy or sell an asset at the most advantageous price achieved during an elapsed period of time

Chooser Options

• An option that gives the buyer the right to choose, at a later date, whether the option will be a put or call option
• Complex chooser options also allow the buyer to choose the expiry date and strike price

Average-Rate (or Asian) Options

• An option that does not have a set strike price – instead, the buyer can exercise the option based on a price that is determined by taking the average of prices over a specified period of time

Rainbow Options

• An option that has more than one underlying asset
• Rainbow options can pay out according to the best, or worst, performing of the underlying assets
• Spread options are a subset of rainbow options where the payout depends upon the difference in the performance of two or more assets

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

13. Put-call Parity

• This is a fundamental concept in understanding options and their ability to create synthetic positions
• Put-call parity is based on the assumption that the put and the call options expire at the same time and have the same strike price
• Long put + short call =  synthetic short underlying
• Long call + short put =  synthetic long underlying

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

14. Futures and Options Combined Strategies

• We can combine futures and options on futures to create various futures and options positions
• Benefits of creating a synthetic long/short futures position using options on futures:
  • Traders can be more flexible in the execution of their trading strategies – synthetic long or short futures positions can be created by buying and selling options on futures
  • Traders can explore whether there is any mispricing between futures and the options on futures – an arbitrage profit can be made by buying and selling the futures and and options on futures simultaneously

• Benefits of creating a synthetic long/short position of call or put options using options on futures and futures contracts:
  • Traders can be more flexible in the execution of their trading strategies
  • Traders can explore if there is any mispricing

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

15. Black-Scholes-Merton Model (BSM)

• The BSM model was first published in the early 1970s and has been one of the most significant developments in the pricing of financial instruments
• The option price is affected by five variables in the BSM model:
  • Price of the underlying asset (stock price)
  • Time to expiry
  • Exercise price
  • Annualised volatility of underlying asset
  • Risk-free rate of interest

C  =  S₀N(d₁) – Xe^-rTN(d₂)

Where:

C = Call-option price

d₁  =  [ln(S₀/X) + (r + σ²/2)T]/(σT^-2)

d₂  =  d₁ – σT^-2

T  = time to expiry

σ  =  annualised volatility of underlying asset

r  =  risk-free interest rate

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

16. Risk Measurement for Options

• To describe the sensitivity of the option price relative to certain variables, the names of Greek letters are used, known as “the Greeks”

Delta (∆)

• The delta of an option measures the sensitivity of the option price to changes in the price of the underlying stock

• The delta value of a long call/short put is always between 0 and 1
• The delta value of a long put/short call is always between -1 and 0

Gamma (Γ)

• Gamma measures the rate of change in the option delta:

• Gamma represents the sensitivity of delta to underlying stock price changes
• If gamma is low, delta changes slowly and little adjustment is required to keep the delta of a portfolio at the required level
• If gamma is large, delta is very sensitive to changes in the underlying stock price and frequent changes will be required to maintain a portfolio delta

Vega (ν)

• Vega measures the change in option price for a 1% change in volatility of the underlying stock price

Theta (θ)

• Theta measures the effect of the passage of time on the option price

• Theta is always negative, as option values always decrease as time passes

Rho (ρ)

• The Rho of an option measures the rate of change in the value of an option with respect to changes in the risk-free interest rate

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

17. Option Trading Strategies

Long Straddle – buy call and put at same strike

• Expectation: HSI will move out of its current range

Short Straddle – sell call and put at same strike

• Expectation: HSI will not move out of its current range

Long Strangle – buy call and put at different strike prices

• Expectation: HSI will move out of its current range and you want to reduce the option premium paid (or received)

Short Strangle – sell call and put at different strike prices

• Expectation: HSI will not move out of its current range but wider than that of the straddle – less option will be received as a result

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

18. Options with Underlying Assets

Covered Call

• A strategy used by fund managers to enhance portfolio income by selling call options with the underlying being stock held by the fund manager
• Used when the fund manager expects the price of the stock in question to trade within a narrow range with low price volatility
• The written call option is “covered” as the fund manager can deliver the stock if the option is exercised

Protective Put

• A strategy used by fund managers to protect portfolios from downward price movements
• If the price of the underlying asset drops significantly, the fund manager can sell the stock at the exercise price

Collar

• A strategy used by fund managers to protect portfolios from downward price movements. The cost of buying puts is financed by selling calls
• The put option has a lower exercise price than the current stock price and the call option has a higher exercise price than the current stock price

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

TOPIC 3 – EQUITY DERIVATIVES

19. Exchange-Traded Equity Derivatives

Hang Seng Index Futures

• The most popular futures contract traded in Hong Kong
• Global fund managers use HSI index futures and options to hedge or speculate on the direction of the Hong Kong market
• Cash settled
• Underlying instrument: HSI comprising 55 constituent stocks

Hang Seng Index Options

• Cash settled European options that can only be settled on the day of expiry
• Underlying instrument: HSI comprising 55 constituent stocks
• Flexible index options provide flexibility in strike prices and expiry days

Mini-Hang Seng Index Futures/Options

• Mini-HSI derivatives are smaller versions of HSI products designed for retail investors with a multiplier of HKD10 instead of HKD50 per index point
• Note that the Mini-HSI futures contract has a value one-fifth of that for HSI futures
• Cash settled
• Underlying instrument: HSI comprising 55 constituent stocks

Hang Seng China Enterprises Index (HSCEI) Futures/Options

• HSCEI derivatives are offered by HKEx to meet the growing needs of investors interested in China related securities
• The options are European options
• Cash settled and the contract multiplier is HKD50 per index point
• Mini-HSCEI futures have a contract multiplier of HKD10
• Underlying instrument: HSCEI reflecting the overall performance of Mainland securities listed in Hong Kong, including H-shares, Red-chips and P-chips
  • H-shares – shares issued by companies incorporated in Mainland China and listed on SEHK
  • Red–chips – Mainland securities that have least a 30% shareholding directly held either by Mainland entities or by companies controlled by such entities, and at least 50% of sales revenue derived from the Mainland
  • P-chips – companies that have more than 50% of their sales revenue derived from mainland China but are not H-shares or Red-chips
• HSCEI is compiled and calculated by Hang Seng Indexes Company Limited (HSIL)

Stock Futures

• Underlying instrument is a specified quantity of an individual stock or exchange-traded fund (ETF)
• Cash settled
• Underlying instrument: differs between stocks. For example, HSBC stock futures are based on the value of a parcel of 400 HSBC shares; China Mobile 500 shares; and CK Hutchison 500 shares

Stock Options

• Settled by physical delivery
• Can be exercised at any time up to expiry (American style)
• Stock options include options on ETFs
• Underlying instrument: as with stock futures, the quantity of the underlying asset differs between stocks and the number in each case is the same as futures (ie HSBC is 400 shares)

Dividend Futures

• As equity indexes generally exclude dividends, the HSI and HSCEI dividend futures allow investors to hedge their dividend exposure, to bet on expected dividend outlook and to exploit arbitrage opportunities
• Underlying instrument: the dividend point index (calculated by HSIL) measuring the cumulative total cash dividend value for all constituents of the corresponding index

HSI Volatility Index (VHSI) Futures

• Measures the expected volatility of the corresponding market and is perceived as a barometer of investor sentiment (aka the “fear index”)
• Compiled and calculated by HSIL
• Allows investors to manage volatility risk in HSI or Hong Kong’s stock market in general
• Underlying instrument: VHSI that aims to measure the 30-calendar-day expected volatility of the HSI and is derived from HSI put and call options

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

20. Types of Warrants

• There are two broad types of warrants traded on the SEHK: equity warrants and derivative warrants

Equity (Subscription) Warrants

• Equity warrants carry the right to subscribe for the underlying stock of the issuer
• Although warrants are less certain, as to the funds raised in the future, than rights issues, there will in general be no immediate dilution effect to shareholdings before the warrants are exercised
• They involve the physical delivery of shares
• Expiry for equity warrants is between one and five years
• Exercise usually follows the American style, although European-style warrants are also available
• Dilution of shareholdings occurs when warrants are exercised as new shares will be issued
• Holders are not entitled to dividends

Derivative Warrants

• Derivative warrants are similar to equity warrants but are issued by a party that is independent of the issuer of the underlying securities of the company and its subsidiaries – usually investment banks and other institutions
• Exchange-traded and usually have an expiry of between six to nine months
• Majority in Hong Kong are settled in cash
• Can be call or put warrants
• Derivative warrants with a physical delivery are for shares that are already in issue, so there is never a diluting effect on shareholdings
• May be issued over assets other than securities (such as currencies or commodities)
• Index warrants, basket warrants and single stock warrants are commonly issued in Hong Kong

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

21. Reasons for Investing in Warrants

• Advantages of investing in warrants:
  • Suit investors with longer term views, as they have longer expiry periods than options
  • They are available over baskets of stocks, providing exposure to a certain sector of sub-sector
• Drawbacks of investing in warrants:
  • As warrant supply is controlled by issuers, market prices can sometimes be distorted by a demand and supply imbalance
  • Short-selling is not possible for exchange-traded warrants

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

22. Equity Swaps

• Similar to an interest-rate swap, an equity swap involves two parties who agree to swap cash flows for a specified period of time, linked to the performance of a stock, a basket of stocks or a stock index
• A common situation would be one party swapping the cash flows from a portfolio of short-dated debt securities for the returns of an equity index
• Equity swaps enable parties to swap returns on their portfolio of investments to better suit their needs and views of the market

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

23. Inline Warrants

• A type of structured product arranged by the HKEX, entitling investors to receive a specified amount at expiry
• Payment at expiry is conditional upon either of the following two conditions:
• An underlying asset’s price falls within a specified range (in-the-range, ITR)
• The asset price falls outside the specified range (out-of-the-range, OTR)
• HKEX limits underlying assets for Inline Warrants to the Hang Seng Index and a small number of actively traded stocks

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

24. Cost of Carry

• Central to calculating the theoretical value of a futures contract is the concept of “cost of carry”
• Cost of carry is the cost involved in holding the underlying asset
• For financial futures, the cost of carry represents the opportunity cost of having capital invested in the underlying asset that could be more productively invested elsewhere
• For commodity derivatives, the cost of carry relates to the costs involved in physically storing the commodity
• Fair value =  spot price + cost of carry
• The nearer a contract is to expiry, the less the cost of carry
• On the day of expiry, there will be zero cost of carry, therefore the futures and spot price must be equal
• How to think about cost of carry for HSI futures contracts:
  • If an investor wishes to gain exposure to equities, she has two choices: (i) invest capital in stocks and receive dividends; or (ii) buy HSI futures
  • When buying futures, the investor is required to pay out a small amount of capital, in the form of an initial margin
  • The balance of the capital that would have been needed, had the investor bought the physical stock, could be invested and earn interest at the current rate
  • If current interest rate > gross dividend yield, the seller of the futures product will want to be compensated, so the futures price will be higher than the spot price
  • Or, if current interest rate > gross dividend yield, the buyer of the futures product will enjoy a higher interest income over the dividend forgone, so will be willing to pay a higher futures price over the spot price
  • In both cases, if current interest rate < gross dividend yield, the futures price will be lower than the spot price

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

25. Trading Futures to Profit from Stock Outperformance

• It is August and Ivan Investor expects the pharmaceutical industry to outperform the overall Hong Kong stock market due to the spread of a new infectious disease and the measures that will be taken to contain it
• Ivan believes that the share price of Philly Pharma, a Hong Kong listed pharmaceutical company, will rise by more than the Hang Seng Index over the next 4 months
• Ivan decides to:
  • Buy 10 December Philly stock futures, priced at HK$125 with a contract size of 1,000 shares; and
  • Sell one December HSI futures contract currently trading at 25,000

Closing the Trade

• Once again, Ivan got it right. In late December, the HSI futures contract is trading at 25,100 and the December Philly stock futures contract is trading at HK$135
• To exit the trade, Ivan sells 10 December Philly stock futures and buys one December HSI futures contract
• Profit on Philly stock futures: (HK$135 – HK$125) x 1,000 shares x 10 contracts
  =  HK$100,000
• Loss on HSI futures: (25,000 – 25,100) x HK$50 =  -HK$5,000
• Overall profit: HK$100,000 – HK$5,000 =  HK$95,000

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

TOPIC 4 – INTEREST-RATE DERIVATIVES

26. Hong Kong Interbank Offered Rate Futures

• There are two types of Hong Kong Interbank Offered Rate (HIBOR) futures:
  • Three-month HIBOR futures contracts introduced in September 1997
  • One-month HIBOR futures contracts introduced in October 1998
• HIBOR futures contracts are cash-settled
• They are designed to enable management of interest-rate risk
• HIBOR is the rate on which all Hong Kong dollar-denominated instruments are traded between banks in Hong Kong

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

27. Interest-Rate Swaps (IRSs)

• Transactions in which two parties agree to make periodic payments to one another computed on the basis of specific interest rates on a notional principal amount
• Usually, there are two legs or payments: a payment based on a floating rate of interest (LIBOR or HIBOR); and a payment based on a fixed rate of interest
• The swap market began in 1980 and is now the largest type of traded interest-rate derivative in the OTC market
• The largest swap market is in US dollar, followed by the Euro, Japanese Yen, and the British pound sterling. IRSs are traded in many countries
• Hong Kong is one of the most active markets in the Asia Pacific region
• In Hong Kong, certain types of IRS transactions are subject to mandatory reporting to the Hong Kong Trade Repository, operated by the Hong Kong Monetary Authority, and mandatory clearing at SFC designated central counterparties

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

28. Caps, Floors and Collars

• Caps and floors are options that can be bought to hedge against a rise or fall interest rates
• The seller of a cap agrees to compensate the buyer if interest rates rise above a specified strike rate. The buyer pays the seller a premium
• Borrowers can hedge the cost of borrowing by buying caps. If interest rates do not rise, beyond the strike rate, the seller is ahead by the premium
• The seller of a floor agrees to compensate the buyer if interest rates fall below a specified strike rate. The buyer pays the seller a premium
• Lenders can hedge the interest-rate received by buying floors. If interest rates do not fall, beyond the strike rate, the seller is ahead by the premium
• For both caps and floors, the agreement is for a specified period over a notional amount
• A collar is a combination of a cap and a floor – by combining the two, both upside and downside risks can be hedged
• If both cap and floor were set at the same strike price, the net effect would be the same as entering into a swap
• A zero-cost collar can be established by:
• Selecting the appropriate floor (or cap)
• Selecting the opposite cap (or floor) with a net present value which, when added to the premium of the floor (or cap), will result in a zero net premium
• The purchase of either a cap or a floor can be offset by the sale of a cap or a floor

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

29. Swaptions

• A swaption is the option to enter into a swap
• Two types of swaptions: calls and puts
• A receiver swaption, like a call option on a swap, gives the buyer the right, but not the obligation, to receive a fixed rate
• A payer swaption, like a put option on a swap, gives the buyer the right, but not the obligation, to pay a fixed rate
• There are several types of expiry for swaptions, including American, European and Bermudan (the last is not described)

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

30. Hedging Using Interest Rate Futures

• With debt securities, there is an inverse relationship between yield and price:
  • When price rises, yield falls
  • When price falls, yield rises
• Similarly, with interest-rate futures contracts, there is an inverse relationship between the interest rate and the interest-rate futures contract price
• When interest rate rises, futures contract price falls
• When interest rate falls, futures contract price rises
• When an investor buys an interest-rate futures contract, his bond portfolio’s exposure to a change in interest rate increases
• Conversely, when an investor sells an interest-rate futures contract, her bond portfolio’s exposure to a change in interest rate decreases
• Therefore, interest-rate futures contracts can be used to change the duration (bond price sensitivity to a change in interest rates) of a bond portfolio

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

31. Trading strategies Using HIBOR Futures

• To speculate on interest rates rising:
  • Sell HIBOR futures now at current HIBOR futures price
  • Buy back same number of futures contracts at HIBOR futures price when the reversing trade takes place
  • If interest rates have risen, a profit will be made; if interest rates have fallen, a loss will be made
  • The settlement value will be:
    change in futures price x HK$125 x 100 x number of contracts
• To speculate on interest rates falling:
  • Buy HIBOR futures now at current HIBOR futures price
  • Sell same number of futures contracts at HIBOR futures price when the reversing trade takes place
  • If interest rates have fallen, a profit will be made; if interest rates have risen, a loss will be made
  • The settlement value will be:
    change in futures price x HK$125 x 100 x number of contracts

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

TOPIC 5 – CURRENCY AND COMMODITY DERIVATIVES

32. Currency Swaps

• In principle, the same as an interest-rate swap, except that it involves two currencies
• A currency swap is an agreement between two parties to exchange their financial obligations (interest payments) for a portfolio of liabilities that are denominated in difference currencies
• Currency swaps usually involve an exchange of principals at the beginning and end of the swap period, such that the common stages of a currency swap are:
  • Exchange of principal amounts
  • Exchange of interest-rate payments
  • Reversing exchange of principal amounts

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

33. Exchange-traded Currency Derivative Products in Hong Kong

• HKEX has introduced the world’s first deliverable RMB currency futures, which allows investors to hedge or take on RMB exposure
• The futures contracts are traded on a margin basis and settled at expiration with delivery of US$ by the seller and payment of RMB by the buyer – USD/CNH futures
• The underlying asset is US$100,000 of CNH
• The contract is quoted in standard interbank FX terms: RMB to USD (eg RMB6.5 per USD)
• In March 2017, HKEX launched its first RMB currency options to help market participants hedge currency risk more efficiently against the backdrop of increased volatility of the CNH

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 34. Pricing Currency Forwards

• Currency forwards are agreements to buy or sell a quantity of currency for delivery at some time in the future, at an exchange rate fixed at the time of the agreement

• F  =  S x [(1 + in)/(1 + id)]

Where:

• F – Forward rate
• S – Spot rate
• in – interest rate of numerator currency
• id – interest rate of denominator currency

Currency Forward Exchange Rate Example

Calculate the 1-year forward exchange rate with the following information:

• GBP/USD spot rate: 35
• UK interest rate: 3% pa
• US interest rate: 0.75% pa

Answer

F = 1.35 x (1 + 0.0075)/(1 + 0.03)

= 1.32

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 35. Commodity Derivative Products

Agricultural Instruments

• Agricultural instruments can be further broken down into:
  • Grains: corn and soybean
  • Softs: coffee, sugar, cocoa and orange juice
  • Meats: live cattle and pork bellies
• While primarily used as hedging instruments, speculators often trade particular futures, such as orange juice and coffee
• Some of the major agricultural derivatives exchanges are: the Chicago Board of Trade, Dalian Commodity Exchange, the Intercontinental Exchange (ICE) and the Tokyo Commodity Exchange

Metal-Based Instruments

• Metal-based instruments can be further broken down into:
  • Base: nickel, aluminium, copper and tin (used by heavy industries)
  • Precious: gold, silver and platinum
• They are traded OTC and on exchanges, such as the Commodity Exchange Inc, the London Metals Exchange (LME) and Shanghai Futures Exchange

Energy Instruments

• Energy instruments can be further broken down into:
  • Crude oil: West Texas Intermediate (WTI) and Brent Crude oil
  • Refined products: heating and gasoline oil, natural gas and electricity
• Market analysts watch crude oil instruments closely, since they are seen as important economic growth leading indicators
• They are traded OTC and on exchanges, such as the New York Mercantile Exchange and the ICE

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

36. Hedging Using a Gold Swap

• A miner and producer of gold, who is concerned about a fall in the price of gold, could hedge price risk in any of the following ways:
  • Enter into a gold forward contract for the sale of its production
  • Sell gold futures
  • Enter into a gold swap
  • Purchase gold put options
• In reality, the miner/producer would probably enter into a swap for the following reasons:
  • A swap agreement is longer term than the other instruments
  • A swap agreement requires less on-going management than options and shorter-dated forwards
  • Compared to futures, a swap agreement does not involve the tying-up of capital in initial and variation margins

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

TOPIC 6 – DERIVATIVES: TRADING, CLEARING AND SETTLEMENT

 37. Risks of Derivative Products

Market Risk

• The chance of losing money from movements in price as a result of changes in market conditions, be it interest rates, exchange rates and volatility
• Given the element of leverage with derivative products, market risk can be substantial

Liquidity Risk

• The chance of losing money from there being no buyers or sellers when you want to enter or exit a position
• Liquidity risk is greater in OTC markets than in exchange-traded markets

Credit Risk

• The chance of losing money from a counterparty failing to meet its financial obligations
• Credit risk is not an issue with exchange-traded markets as clearing houses guarantee settlement through novation – it is more of an issue with OTC markets
• OTC risk is being addressed by regulators worldwide after the 2008 episode

Basis Risk

• The chance of losing money from differences between the prices in the physical and futures markets. Basis risk can be broken down into three sub-categories:
  • Delivery basis: Cost of delivery, including storage, insurance and funding costs
  • Grade basis: Difference between grade of asset being hedged and underlying asset of derivative product
  • Hedge basis: Hedging an exposure using closely related, but not perfectly correlated, reference underlyings. For example, bonds with different tenors

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 38. Types of Orders

• All trading on the Hong Kong Futures Exchange (HKFE) is conducted electronically using the Hong Kong Automated Trading System (HKATS)

Order Types on HKATS

• Two primary types of orders in HKATS:
  • Limit order: a price limit is assigned by the user
  • Auction order: an order with no specified price – unfilled orders are automatically cancelled at the end of the pre-opening session

Orders Managed by a Broker

• A broker is involved in several other types of order:
  • Market order: the broker is instructed to execute the trade at the best price currently available
  • Limit order: the broker is instructed to buy or sell at a specified price. Usually, the price for a “buy” limit order is below the current market price, while a “sell” order is above it
  • Stop-loss/gain order: a stop-loss order is used for risk management purposes to ensure that market movements do not erode an open position and cause a loss greater than an amount the investor is comfortable with. A stop-gain order is the reverse, used to lock in a profit before market movements erode the profit
  • Spread order: a broker is instructed to buy one contract and sell a related contract

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 39. Dealing with Clients

• This section looks at some of the requirements that must be met when dealing with clients in relation to trading futures and options on HKFE
• The Code of Conduct stipulates that an intermediary has a duty to know the full identity of each client (KYC) as well as each client’s financial situation, investment experience and investment objectives
• Clients should understand the nature and risks of derivative products and have sufficient net worth to be able to bear risk
• Intermediaries should assess clients’ understanding of the nature and risks of derivative products
• Risk disclosure: Brokers must ensure that clients are given and sign a risk disclosure statement and a client information statement
• Client agreement: This should cover an individual account that can only be used by the broker to transact futures and/or options contracts on behalf of the client that are traded on HKFE
• Dealing with client transactions: Brokers are not permitted to trade their own accounts until all executable orders for clients have been transacted and they are not permitted to take the opposite side of a client’s order unless (i) the client has given written permission; and (ii) open interest and/or turnover is lower than the level prescribed by HKFE
• Responsibility for collecting margins: A broker must ensure that, before a trade is executed, the client has deposited sufficient collateral to cover the minimum HKFE margins and the client’s expected trading liabilities. HKFE margins must be cash-settled by the client
• Monitoring the performance of client accounts: A broker must monitor a client’s ability to meet margin calls or demands. Should a client fail to meet two successive margin calls, which exceed the prescribed threshold, the broker must inform HKFE and provide the client’s account details.  A broker may also liquidate a client’s collateral if the client fails to meet any margin calls
• Client money: Brokers should keep a segregated bank account for each client
• Client ledgers: Brokers must maintain a ledger account for each client. Information in each ledger account should cover all HKFE trades, all non-HKFE trades and all trades that are not futures/options transactions
• Commissions: Brokers can negotiate commission levels with clients
• Large open positions: Brokers must report any large open positions held by either themselves or their clients to the HKFE

[For Paper 9 practice questions, go to Examinator.online – Paper 9]

 40. Margining Methods

• Margin levels required by HKFE vary with changes in the values of underlying assets and any changes in the volatility of futures prices
• There are four margin categories:
  • Initial margins
  • Maintenance margins
  • Intra-day margins
  • Clearing House margins
• The first three apply to clients, while the Clearing House margins apply to HKCC Participants
• Client margins are calculated by HKCC Participants – it’s the HKFE that specifies the minimum margin that an HKCC Participant must collect from its clients

Initial Margins

• An initial margin is paid when opening a position – it provides cover against any loss that occurs when the position is first opened

Maintenance Margins

• A maintenance margin is a safety level maintained once the initial margin is paid
• When the margin level falls below the maintenance level, a margin call for a deposit is issued to restore the account balance back to the initial margin level

Intra-day Margins

• In certain volatile market conditions, an HKCC Participant is entitled to make an intra-day margin call, rather than waiting to the end of the day

Clearing House Margins

• Every HKCC Participant has a continuing obligation to maintain Clearing House margin at the level and during the period from time to time stipulated by the Clearing House

[For Paper 9 practice questions, go to Examinator.online – Paper 9]