Tuesday, September 14, 2010

Pricing and Risks of Callable Bulls and Bears

This article appeared in Capital page of The Edge Malaysia, Aug 15-21, 2010
In the last two parts of this series, I explained how Callable Bull and Bear Certificates (CBBCs) evolved from barrier options and its key features with some examples. This final article will discuss important pricing and risk factors that investors must know when trading CBBCs.
Pricing of the CBBC
From the previous article, we found that the theoretical price of CBBCs seems to just comprise its intrinsic value and funding costs. Investors ought to note that this theoretical price is only applicable when the product is called or settled at expiry. As the CBBC floats in the market, the trading price quoted by market makers is not necessarily its theoretical price, but more likely a price backed by a model.
As there is no information put forth by Bursa or CIMB (currently the single issuer of CBBCs in Malaysia), my thoughts are based on experiences in other countries, mainly Hong Kong and Europe.
Issuers world-wide mostly use some variant of the Black Scholes model to price CBBCs.  We were briefly introduced to the Black Scholes model in my previous article, “Pricing and Risks of Structured Warrants ”, Nov 16-22, 2009. This model has become the market standard to price options since 1970s. The basic model to price standard options can be modified in many ways to accommodate the pricing of exotic options, one of which is the CBBC.

The model can price CBBC in two ways: