Tuesday, August 31, 2010

Callable Bull and Bear Certificates – Knowing the product

This article appeared in Capital page of The Edge Malaysia, Aug 8-14, 2010

From the previous article, we now understand that Callable Bull and Bear Certificates (CBBCs) in Malaysia are actually a product of exotic barrier options. In this article, we examine the key features of this product and have the opportunity to work on some examples.

Essential features of a CBBCs
There are many useful sites including Bursa Malaysia that explain the dynamics of CBBC, but I find the Hong Kong Exchange site, (http://www.hkex.com.hk/eng/global/faq/cbbc.htm) the finest as it enables a layman investor (almost) to understand the product.

The key features of a CBBC are discussed below and at the same time, these features are compared to its close neighbour, structured warrants.

 Call price and Mandatory call event
From the previous article, we now know that the call price refers to the barrier level of the CBBC. To emphasise further, for a callable bull, the call price is always set to be equal to or higher than the strike price. For a callable bear, the call price is always equal to or lowers than the strike price.

The mandatory call event relates to the termination of the CBBC when the underlying asset reaches the call price. We will investigate this feature further when we talk about settlement price later.

 CBBCs tracks the underlying asset closely
The CBBC type of instruments currently track underlying assets such as stocks, indices, exchange traded funds and currencies. It is believed that the price of a CBBC tends to follow the price of the underlying assets closely. In other words, its delta is close to 1. (Delta = change in option price / change in underlying share price). In the case of structured warrants, only deep in-the-money warrants that are close to expiry have deltas of 1. CBBCs then do appear to have a better edge as its constant delta enables straightforward risk management for the investor, in addition to the lower premium.

Due to this property, this product is promoted by issuers like investment banks as the ideal derivative to closely track the price movement of underlying shares, having high price transparency. However, investors are always warned that when the underlying share price is close to its call price, the value of CBBC may become more volatile and the change in its value may be disproportionate to the change in the value of the underlying assets.

One would question why the CBBC (which is actually more complex than a standard warrant/option) displays such simple pricing and delta properties and what causes the relationship to break down at times.
We will investigate this in the next article where I talk about pricing and risk of CBBCs.

 There are two kinds of CBBCs

There are two categories of CBBC, Type I and Type II:

o Type I is when the call price is equal to its strike price. When the underlying share price hits the call price, the mandatory call event is triggered and the CBBC holder will not receive any cash payment. This is not alarming as the residual value or payoff is tied to the difference between the call price and the strike, (H-X or X-H) which will be zero.

o Type II refers to a CBBC where its Call Price is different from its strike price. Here the CBBC holder may receive a residual value upon the occurrence of the mandatory call event.

 Determination of settlement price upon the mandatory call event
We know that the residual value is simply the call price minus the strike price. However, there are some tweaks to this formula. For a callable bull, a call event will occur when the underlying stock price crosses the call price on the way down as shown in Chart 1. This price is then referred to as “settlement price”.

Chart 1 – Mandatory call event (MCE) for the callable bull

The settlement price for the callable bull is then is determined as the “lowest traded price” of the underlying share from the mandatory call event to the end of the next trading phase (trading session). Similarly for the callable bear, the settlement price is the “highest traded price” of the underlying share after the MCE and up to the next trading session.

The investor must bear in mind that in cases where the settlement price becomes equal to the strike price or goes beyond the strike price, there may be no residual value. However we will see in the worked examples below that the residual value is usually small. The investor is expected to make his profit mainly from speculation on the price movement of the CBBCs.

 What happens if there is no MCE and CBBCs are held to expiry
CBBCs can be held until maturity (if not called upon the MCE) or sold on the exchange. In this case, the settlement is straightforward; it is just the closing price of the underlying share on the last trading day minus the strike price, for the callable bull and the reverse for the callable bear.

 Funding cost
The upfront premium of CBBCs include funding cost and issuers are required to specify the formula for calculating the funding costs of their CBBC at launch in the listing documents. The funding cost includes the issuer's financing/stock borrowing costs after adjustment for expected ordinary dividends of the shares and the issuer's profit margin. These items fluctuate from time to time, therefore the funding costs are not fixed throughout the tenure of the contracts. In general, the longer the duration of the CBBC, the higher the funding costs. The funding costs decline over time as the CBBC moves towards expiry. Investors can compare the funding costs of different issuers of CBBC with similar underlying shares and features, if there is more than one issuer in the market.

How do CBBCs work – Some examples

Some very good examples of callable bulls and bears are provided in the Hong Kong stock exchange website, which are reproduced below. The following examples illustrate how a Bull contract works. Example 1 shows a Type 1 callable bull; Example 2 shows what happens if this contract is not called but held to expiry. Example 3 shows a Type II callable bull and Example 4 shows what happens if a MCE occurs for this contract.

Chart 2 - Example 1
Type I callable bull (Without residual value)

Say MCE occurs, the callable bull is called and trading terminated. There will be no residual payment. Net loss will be the original investment of $2,720. The investor will be tempted to sell the callable bull when the price is moving downwards, as, if he waits until the price hits the call price, it will expire worthless. These dynamics definitely introduces volatility into the price. Perhaps this is why the price of the CBBC does not move in tandem with the underlying share when the underlying share approaches the call price. We will investigate this further in the next article.

Example 2 in Chart 3 shows what happens if the same callable bull is not called and held to expiry.
Chart 3 – Example 2
Type 1 callable bull : Not called before expiry, at expiry:

Now, for the Type II callable bull in Example 3, Example 1 is used again, only this time the call price is not the same as the strike price.

Chart 4 - Example 3
Type II callable bull (With residual value)

If spot price falls to $95 (ie the Call Price), MCE is triggered and the residual value is computed as in Example 4 in Chart 5.

Chart 5 – Example 4
Type II callable bull – MCE event and residual value

Conclusion

Having understood the key features of CBBC and how they work in practice, we have just one more phase to endeavour before being completely comfortable with the product. In the next article, I explain that there is more to the pricing of a CBBC, than the simple theoretical pricing in the above examples. We will also explore the important risks for investors to consider when trading the CBBC.

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