Chapter 16 notes 2012 08 04

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Chapter 16 notes 2012 08 04

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 16Knock-out ProductsAugust 2012
  2. 2. Chapter summary and outlineThis chapter outlines the features of knock-out products, types ofknock-out products, what types of investors would invest in knock-out products, risks involved in knock-out products and similaritiesand differences between knock-out products and other structuredproducts.Chapter outline:• Complex options• Barrier options• Types of “Knock-out” barrier options• Callable Bull/Bear Contracts (CBBCs)• Risks involved in CBBC Investments• Similarities and differences between knock-out products and structuredwarrantsfinlogIQ 2
  3. 3. Complex Options• Uncertain timing of option exercise, time of option expiration, variability of option payoff and other attributes that are customized to meet the objectives of the option investor.• Also known as “exotic” option and some variable features include: – Timing of option exercise – Uncertainty as to time of expiration – Payoff computation – Conditional events or trigger points – Underlying assets – Multi-currency featuresfinlogIQ 3
  4. 4. Barrier Options• Type of exotic option which payoff depends on the “barrier level” with respect to the underlying asset.• If during the life of the option the price of the underlying asset touches or crosses the barrier level (trigger point), a “barrier event” occurs – Option gets triggered and becomes live – Option gets extinguished and expires• Option’s barrier event can be triggered with respect to underlying asset’s: – Price level (for a stock or an asset class); – Index level (for a market related index); – Exchange rate level (for foreign exchange options); – Interest rate level (for fixed income options); or – A numerical indicator or value that is computed by a specified formula for a customized product basket.• If the option terminates when event occurs: – Payoff to the investor will depend on the terms of the option agreement – Can be zero, or fraction of the initial premium paid, or – Fixed mandatory pay off determined at outsetfinlogIQ 4
  5. 5. Types of “Knock Out” Barrier OptionsSingle Barrier Option• Most common barrier option in which there is One barrier• When barrier level is reached, the option gets “knocked out”• The barrier level is call price and the strike is: – For a call barrier option, the call price is HIGHER than or EQUAL to the strike price. – For a put barrier option, the call price is LOWER than or EQUAL to the strike price.finlogIQ 5
  6. 6. Types of “Knock Out” Barrier OptionsDouble Barrier Option (or “Double Knock Out” Option)• It has two barrier levels instead of one;• There is one barrier on either side of the strike price• 1 barrier which is HIGHER than the strike price;• 1 barrier which is LOWER than the strike price Investor Strike Price: $8.00 Knock-out Price 1: $7.00 Knock-out Price 2: $9.00 Current Spot Price: $8.00• If, at maturity, spot price >= $9.00 or <= $7.00 then Option is WORTHLESS• It is Knocked Out once Barrier of $9.00 or Barrier of $7.00 is reachedfinlogIQ 6
  7. 7. Types of “Knock Out” Barrier OptionsBarrier Option Categories 1 Up & In Underlying asset has to move up and exceed the barrier price for the option to become active (knock-in) 2 Up & Out Underlying asset has to move up and beyond the barrier price for the option to terminate (knock-out) 3 Down & In Underlying asset moves down and beyond the barrier level for the option to become active (knock-in) 4 Down & Out Underlying asset moves down and beyond the barrier level the option terminates (knock-out)• For Up & In calls and Down & In puts: – These barrier options work like simple European-style options that are out-of-the- money (“OTM”) until the barrier level is reached (i.e. trigger event) and the option then becomes active.• For Up and Out calls and Down & Out puts: – These barrier options work like simple European-style options that are in-the- money (“ITM”) until the barrier level is reached (trigger event) and the option then terminates.finlogIQ 7
  8. 8. Advantages of Barrier Options• Are cheaper and require a lower investment amount as compared to standard options: – Possibility exists that it will terminate before expiration – Double barriers are even cheaper than single barriers as probability of being knocked out is higher• Higher returns on capital investment for investor if barrier conditions are satisfied that is: – That is, of no knock-out event or if the knock-in event occurs as investment sum is lower due to cheaper cost• Greater selection of option available for those with diverse market views and with benefit of leverage on capital invested – Knock-in barrier options - Ideal for speculating large market moves. – Knock-out barrier options - Ideal for speculating small moves in a sidewaysfinlogIQ 8
  9. 9. Disadvantages of Barrier Options• High risk of loss of investment capital if barrier conditions are broken (i.e. knock-out event occurs or if there is no knock-in event).• They are Over the counter (“OTC”) products – Investors pays upfront for option premium and, – Do not trade on an exchange and the investor is exposed to counterparty risk on the issuerfinlogIQ 9
  10. 10. Common Examples of Knock-out ProductsfinlogIQ 10
  11. 11. Common Examples of Knock-out Products - 2finlogIQ 11
  12. 12. Common Examples of Knock-out Products - 3finlogIQ 12
  13. 13. Common Examples of Knock-out Products - 4finlogIQ 13
  14. 14. Common Examples of Knock-out Products - 5finlogIQ 14
  15. 15. Callable Bull/Bear Contracts (CBBCs)• Based on market outlook investors can purchase: – Bull contract: Investor takes a bullish (positive) position on the underlying asset – Bear contract: Investor takes a bearish (negative) position on the underlying asset• Traded on the cash market of the exchange• Issued by a third party• Independent of the underlying asset and the exchange on which it is listed• CBBC tracks performance of underlying assets which can be: – Domestic single stocks; – Domestic stock indices; – Overseas single stocks; – Overseas stock indices; – Currencies; – Commodities; or – Any other asset baskets as allowed by the stock exchange and deemed suitable by the issuer.finlogIQ 15
  16. 16. Price moment of a CBBC• Greater transparency for CBBCs in comparison to other structured products• Price changes of a CBBC tend to closely follow the prices changes of the underlying asset• Delta of the CBBC is close to 1 (∆≈1) – Hence if value of the underlying asset increases, the Bull CBBC (with conversion ratio of 1:1) will increase in value by approximately the same amount• Conversion ratio: number of underlying assets that each unit of CBBC is obligated to buy or sell• E.g. 10:1 means that 10 units of a CBBC control 1 unit of the underlying assetfinlogIQ 16
  17. 17. Lifespan and Mandatory Call Event (MCE)• CBBC have a fixed lifespan but contain a mandatory call feature• The call will occur if the price of the underlying asset reaches a given price level (the “call price”) at any time before expiry.• Such a trigger event is referred to as a “Mandatory Call Event” (“MCE”).• When this occurs, the CBBC will expire early and its trading terminates immediately• MCE is triggered before the expiry date if: – For a Bear Contract, the Spot Price touches or is exceeds the Call Price – For a Bull contact, the Spot Price touches or falls below the Call PricefinlogIQ 17
  18. 18. Gearing effect• CBBC are leverage products – Investors required only to commit a cash sum which is small proportion of the full value of the underlying asset – Hence, return on capital will be magnified – Percentage loss suffered by the investor will also be magnified• Effective Gearing – Value of its gearing ratio in a CBBC is equivalent to effective gearing (since delta ~ 1) – E.g. Effective gearing of 10: 1% change in the price of the underlying asset, the theoretical price of the CBBC may increase or decrease by 10% – Closer the strike price to the spot price of a CBBC’s underlying asset, the higher will be the gearing ratio of the CBBC – CBBC will experience higher price fluctuations when the asset’s spot price is close to the strike price (higher risk of being called)finlogIQ 18
  19. 19. Hedging Instrument (for bear contracts)• CBBC can be used to hedge market risk• An investor may hold assets with a long-term view that they will grow in value but wants to preserve his investment from market volatility in the near termfinlogIQ 19
  20. 20. Categories of CBBCs• Two types – N-CBBC => no residual value when CBBC is called – R-CBBC => residual value applicable when CBBC is calledfinlogIQ 20
  21. 21. Factors Affecting CBBC Pricing & ValuationTheoretical factors• Theoretical factors determine the intrinsic value of the CBBC (the simple definition of intrinsic value is the difference between the underlying asset price and the strike price)• Main variables: – Price movement of underlying asset – Strike price − Higher the strike price, the lower will be the intrinsic value of a Bull CBBC contract (reverse applies for a Bear CBBC contract) – Financial Cost • Issuer’s cost of borrowing, adjustments for dividends (assuming underlying asset is stock-related) and the issuer’s profit margin. • Financial cost will be higher the longer the maturity • Declines over time as the CBBC moves closer to expiration date • Included in the price of the CBBC at the time of issuancefinlogIQ 21
  22. 22. Factors Affecting CBBC Pricing & Valuation - 2Theoretical factors (cont)• Intrinsic value of a CBBC is the difference between the underlying asset price and the strike price (adjusted for the conversion ratio) after taking into account the financial cost.CBBC Theoretical PricefinlogIQ 22
  23. 23. Factors Affecting CBBC Pricing & Valuation - 3Market factors• Market and trading conditions influence the price of a CBBC• Variables are: – Liquidity of underlying asset • Delta is close to 1 (+1 for Bull contracts, -1 for Bear contracts) • If the market for the underlying asset suffers from poor liquidity, the issuer’s hedging cost will rise and this in turn affects the price and trading liquidity of the CBBC. – Demand and supply factors • Demand and supply factors may impact the CBBC price – Issuer factors • Issuer makes a market and provides liquidity to the CBBC investors • In a stable market, the bid-ask spread is tight and transaction volume are able to meet investor demand • Trading of the CBBC can be adversely affected by disruptions which impact the issuers operationsfinlogIQ 23
  24. 24. Determination of Residual Value if MandatoryCall Event Occurs• Category N-CBBCs – no residual value• Category R-CBBCs residual value:• Mandatory Call Event Settlement Price = – Bull contract: Not lower than the minimum trading price of underlying asset between the period of MCE up to the next trading session. – Bear contract: Not lower than the maximum trading price of underlying asset between the period from the MCE up to the next trading session.finlogIQ 24
  25. 25. Valuation At Maturity (Expiry)• If CBBC not called before expiry, investors can hold it until maturity• Maturity valueCapital Adjustments for CBBCs• If CBBC based on Underlying stock – An adjustment of a corporate action: bonus issues, share splits, and reverse share splits – No action is needed for regular share dividends – Bonus shares, special and extraordinary dividends will require adjustmentsfinlogIQ 25
  26. 26. Example 1: Category R - Bull ContractsfinlogIQ 26
  27. 27. Example 1: Category R - Bull Contracts - 2finlogIQ 27
  28. 28. Example 1: Category R - Bull Contracts - 3finlogIQ 28
  29. 29. Example 2: Category R - Bear ContractsfinlogIQ 29
  30. 30. Example 2: Category R - Bear Contracts - 2finlogIQ 30
  31. 31. Example 2: Category R - Bear Contracts - 3finlogIQ 31
  32. 32. Example 2: Category R - Bear Contracts - 4finlogIQ 32
  33. 33. Risks Involved in CBBC InvestmentsPotential Loss of Capital• Requires upfront cash investment• Potentially lose the full amount of the invested capitalMandatory Call• If CBBC is called when the call price is breached – Payoff for the N-category investor is zero and the Residual Value for the R- category investor may be small• Investor does not get to profit from or recover any losses if the price of the underlying asset bounces backGearing Effect• Being a leveraged product exposed to greater downside risk if the market conditions are unfavourable• Negative returns are magnifiedfinlogIQ 33
  34. 34. Risks Involved in CBBC Investments - 2Limited Life• Limited lifespan (determined by issuer)• May become worthless upon expiry or when a MCE occursPrice Movement – Trading Close to Call Price• When there is demand-supply imbalance or turbulence in the wider market, delta being approximately equal to 1 (∆ ≈ 1) may not always hold• Price of the CBBC can be more volatile when the underlying asset is trading very near the call pricePrice Movement – Volatility• In volatile market, greater likelihood that the CBBC will be knocked outLiquidity & Market Disruption• If there is a market disruption (ie no trading) and price is unavailable on the underlying asset, the market for CBBC will also be affectedfinlogIQ 34
  35. 35. Risks Involved in CBBC Investments - 3Financial Cost• Included in the price of the CBBC• If issuer’s cost of borrowing increases in the interbank market, this cost component goes up and raises the price of the CBBC• Charged upfront and includes the entire period up to the expiry date• Early Termination: CBBC investor will lose the full cost of funding even though the CBBC was held for a shorter duration.Counterparty Risk• CBBCs issued by third party investment banks• In event issuer defaults: investor has to face the risk of any exposure to the issuerfinlogIQ 35
  36. 36. Comparison Between Knock Out Products andStructured WarrantsfinlogIQ 36
  37. 37. Comparison Between Knock Out Products andStructured Warrants - 2finlogIQ 37

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