Prices of structured products

5.1 What is the “theoretical value” of a structured product? How is it determined?

Structured products have a “theoretical value” that may be very different from their traded (nominal) price.

The theoretical value is the price of the structured product calculated by reference to the issuer’s pricing model, taking into account all relevant market factors. See FAQ 5.2, FAQ 5.4 and FAQ 5.6 for the factors that can affect the price of structured products generally.

5.2 What factors affect the price of a standard warrant?

The price of a standard warrant (i.e. put/call warrant) generally depends on the price of the underlying asset. However, throughout the term of a standard warrant, its price will be influenced by a number of other factors, including:

Assuming other factors remain unchanged, the theoretical impact of changes in certain key factors on call and put warrants is illustrated in the table below:

* Please note that the table above only shows the theoretical relationship with the key pricing parameters. In reality, there are other factors affecting the price of a standard warrant.

5.3 Why is the price movement of a standard warrant not directly proportional to the movements in the price of its underlying assets?

5.4 What factors affect the price of an inline warrant?

The price of an inline warrant generally depends on the price or level of the underlying asset. The underlying price or level movement may have a positive or negative (inverse) effect on the price of inline warrants, depending on where the underlying price or level is compared to the upper and lower strike prices or levels. Throughout the term of an inline warrant, its price will be influenced by a number of factors, including:

Assuming other factors remain unchanged, the theoretical impact of changes in certain key factors on inline warrants is illustrated in the table below:

* Please note that the table above only shows the theoretical relationship with the key pricing parameters for reference only. In reality, there are other factors affecting the price of an inline warrant and the above relationship may not be applicable to extreme cases.

5.5 Why is the price movement of an inline warrant not directly proportional to the movements in the price or level of its underlying assets?

The underlying price or level movement may have a positive or negative (inverse) effect on the price of an inline warrant, depending on where the underlying price or level is compared to the upper and lower strike prices or levels. In general, assuming all other factors are constant and ignoring dividend and interest rate effect, when the underlying price or level is below the mid-point of the upper and lower strike prices or levels, an increase in the underlying price or level will cause an increase in the inline warrant price. When the underlying price or level is above the mid-point of the upper and lower strike prices or levels, an increase in the underlying price or level will cause a decrease in the inline warrant price, i.e. an inverse relationship. The sensitivity (or delta) of the underlying price or level movement to the inline warrant price movement will also change depending on where the underlying price or level is compared to the upper and lower strike prices or levels, as well as the time to expiry.

As the price of an inline warrant is not only affected by the price or level of the underlying asset, movements in the price of an inline warrant may not be proportionate or may even be opposite to the price or level movement of the underlying asset, in addition to what is described above. For example:

5.6 What factors affect the price of a CBBC?

During the term of a CBBC, its price will be influenced by a number of factors, including:

5.7 Does the price movement of a CBBC always correspond to the movements in the price or level of its underlying assets?

The price of a CBBC tends to follow closely the price of the underlying asset. As a result, if the underlying asset increases in value, a “bull” CBBC with an entitlement ratio of 1 to 1 (i.e. one CBBC to one unit of the underlying asset) generally increases in value by approximately the same amount, whereas a “bear” CBBC with an entitlement ratio of 1 to 1 generally decreases in value by approximately the same amount (see FAQ 5.8 regarding entitlement ratios generally).

However, when the underlying asset of a CBBC is trading at a price close to its call price, the value of CBBC may become more volatile (and less sensitive to movements in the price of the underlying asset due to the risk of occurrence of a mandatory call event) and the change in its value may be disproportionate to the change in the value of the underlying asset.

5.8 What is the entitlement ratio?

Standard warrants and CBBCs — the entitlement ratio for a product is the number of such products required to be converted into a unit of the underlying asset at the strike price on the expiry date.

Assuming all other factors affecting two different products are the same (underlying asset, strike price, expiry date, volatility etc.), their respective entitlement ratios would directly affect their respective values per unit.

Generally, a product with a higher entitlement ratio would have a relatively small value per unit. However, in theory, the entitlement ratio would not affect the performance of a particular product, as it has been calculated into the effective gearing.

Inline warrants — the entitlement ratio of inline warrants is always equal to 1 since the final cash settlement amount of inline warrants is fixed at either HK$1 or HK$0.25 depending on where the underlying settlement price or level is compared to the upper and lower strike prices or levels.

5.9 What is the premium?

Standard warrants and CBBCs — The premium reflects the degree by which the price of the underlying asset needs to move before reaching the break-even price of a product at expiry. For example, if the premium of a call warrant or a bull CBBC is 10%, the underlying price should rise by 10% at expiry, in order to reach the break-even price.

You can calculate the premium based on the formula below (based on the payout formula at expiry):

These formulae can therefore be used as a reference to calculate the percentage by which the price of the underlying asset needs to move before reaching the break-even price of a standard warrant or a CBBC at expiry.

Inline warrants — When the underlying price or level is at or between the upper and lower strike prices or levels, the underlying price or level needs to move 0% so that investors can receive the pre-determined fixed payoff of HK$1 at expiry. Hence, the premium for inline warrant when underlying price or level is at or between the lower and upper strike prices or levels is 0%.

When the underlying price or level is below the lower strike price or level, the underlying price or level needs to increase towards the lower strike price or level so that investors can receive the pre-determined fixed payoff of HK$1 at expiry. Hence, the premium for inline warrant when the underlying price or level is below the lower strike price or level is

When the underlying price or level is above the upper strike price or level, the underlying price needs to drop towards the upper strike price or level so that investors can receive the pre-determined fixed payoff of HK$1 at expiry. Hence, the premium for inline when underlying price or level is above the upper strike price or level is

5.10 I bought a call warrant linked to the underlying stock with an expiry date of late April. Why did the call warrant trade below its intrinsic value with a negative premium of 1% in mid-March?

This seems unreasonable as the call warrant price should at least be equal to its intrinsic value, i.e. the excess of the prevailing market price of the underlying stock over the exercise price of the call warrant.

While in most cases a call warrant does trade above its intrinsic value, this does not mean that the intrinsic value must be the minimum value of a call warrant. As explained below, it is possible for a call warrant to trade below its intrinsic value.

Holding a call warrant differs from holding the underlying stock, especially since the holders of the call warrant are not entitled to receive any dividends that might be declared by the underlying stock. In this particular case, the underlying stock was due to announce its annual results in late March. Based on practices in previous years, the underlying stock is likely to go ex-dividend in mid-April. With an expiry date for the call warrant in late April, the market price of the underlying stock would be the ex-dividend price in determining the payout of the call warrant on that expiry date. This would result in a lower payout to call warrant holders than it otherwise should. Although the final dividend that the underlying stock would declare was still unknown in mid-March, it was widely anticipated that the dividend would be no less than $1.5. It was not unreasonable for potential investors and the liquidity provider to deduct the dividend element when pricing the call warrant.

5.11 Why may a bull CBBC linked to the HSI expiring in 6 months sometimes have a negative premium?

In calculating the premium for a bull CBBC linked to the HSI based on the formula as set out in FAQ 5.9 above, we need to determine the underlying price for the HSI.

The spot level of the HSI may differ from its estimated future price, because the estimated future price of the HSI is calculated by reference to the sum of the cash value of the HSI (based on the HSI’s spot level) and interest rate, less the expected dividends. In most cases, as the expected dividends would be higher than the interest rate, such estimated future price of the HSI is therefore often lower than the cash value of the HSI’s spot level.

The premium calculated pursuant to the formula set out in FAQ 5.9 may therefore be different depending on whether you apply (i) the spot level of the HSI as the underlying price, or (ii) the estimated future price of the HSI as the underlying price.

However, as the product price of a CBBC linked to the HSI is generally based on the estimated future price of the HSI futures expiring in 6 months (rather than the spot level of the HSI), such estimated future price should be adopted as the underlying price for calculating the premium of the CBBC. It is therefore likely that the premium calculated based on such lower estimated future price may result in a positive premium, whereas the premium calculated based on the spot level of the HSI may result in a negative premium, using the formula as set out in FAQ 5.9 above.

5.12 What is delta of a structured product?

Delta is the ratio of the change in the structured product price (after adjusted by the entitlement ratio) to the change in the underlying asset’s price.

Standard warrants – delta normally ranges between 0 and 1 for standard call warrants and 0 and -1 for standard put warrants (the negative sign shows the opposite directional movement to the underlying). In general, at-the-money standard call and put warrants have a delta of approximately 0.5 and -0.5 respectively. In-the-money standard warrants will generally have a higher delta than out-of-the-money standard warrants with the same underlying asset and maturity. For example, a standard call warrant with a delta of 0.1 is generally a deep out-of-the-money standard warrant, whereas a standard call warrant with a delta of 0.9 is generally a deep in-the-money standard warrant. Vice versa, a standard put warrant with a delta of -0.1 is generally a deep out-of-the-money standard warrant, whereas a standard put warrant with a delta of -0.9 is generally a deep in-the-money standard warrant.

CBBCs – in general, the delta of a bull CBBC is close to but not exactly equal to 1 and the delta of a bear CBBC is close to but not exactly equal to -1.

Inline warrants – delta can be positive or negative depending on where is the underlying price or level compared to the strike prices or levels:

5.13 What is delta behaviour of inline warrant throughout the life?

The delta of inline warrants will change throughout the life of the product, depending on different scenarios such as time to expiry, underlying price or level compared to the upper and lower strike prices or levels (ignoring the effect of interest rate and dividend), as follows:

Investors should be aware that both the direction and absolute value of delta can change dramatically especially when the inline warrant is close to expiry and the underlying price or level is around the lower strike price or level or upper strike price or level.

5.14 What is the difference between gearing and effective gearing?

“Gearing” means the relationship that the cost of the underlying asset bears to the cost of a standard warrant or a CBBC. For example, if the gearing for a particular standard warrant is 10 times, then the investment cost of that standard warrant is 1/10 of the underlying asset.

However, in the case of a standard warrant this only relates to the initial cost of the underlying asset and the initial cost of the standard warrant. It cannot be used later to reflect the dynamic relationship between the price of the underlying asset and the price of the standard warrant over time. “Effective gearing” of a standard warrant is calculated by multiplying the gearing and the delta of the standard warrant (adjusted with entitlement ratio).

For inline warrants, the gearing of inline warrant equals to the maximum payoff at expiry (i.e. HK$1) divided by the price of the inline warrant. Since the final settlement price of inline warrant is fixed at either HK$0.25 to HK$1, the price of inline warrant from issue to expiry date will be normalised to a range approximately between HK$0.25 and HK$1. Therefore, the gearing for inline warrant reflects the potential return at the particular price of the inline warrant and is used to calculate the effective gearing which provides a relationship between the underlying and the product. “Effective gearing” of an inline warrant is calculated by multiplying the gearing and the delta of the inline warrant.

Effective gearing is a better measure of the percentage change of a standard warrant or an inline warrant with a 1% change of underlying asset. For example, if the effective gearing is 10 times for a call warrant (and we assume other factors remain unchanged), when the price of the underlying asset rises by 1%, the theoretical price of the call warrant price should rise by 10%. Similarly, when the underlying asset falls by 1%, the theoretical price of the call warrant price should fall by 10%. For inline warrants, because the delta can be either positive or negative depending on where the underlying price or level versus the upper and lower strike prices or levels, when multiplied against the gearing, it could be presented as either a positive or negative effective gearing. For example, if the effective gearing is negative 10 times for a particular inline warrant (and we assume other factors remain unchanged), when the price of the underlying asset rises by 1%, the theoretical price of the inline warrant should fall by 10%.

However, effective gearing should only be used as a reference as it will change over time given other factors, such as the underlying price, delta, gearing, time decay and implied volatility, also change.

For CBBCs, “gearing” and “effective gearing” are the same in most circumstances, which is the potential multiplying effect on the price of the CBBC in response to a 1% change in the underlying asset price.

5.15 Why does the price movement of a structured product not correspond to the effective gearing?

A number of other factors affecting the price of the structured product may also change over time and, therefore, a mere rise in the underlying asset’s price may not necessarily lead to a corresponding increase to the extent of the effective gearing, or to any increase at all in the structured product’s price.

5.16 What is implied volatility?

Implied volatility represents the anticipated level of volatility of underlying assets over the remaining life of a structured product, as reflected in the price of the structured product.

5.17 How should implied volatility be interpreted?

Standard warrants — Implied volatility is one of the factors influencing the price of a standard warrant. For example, assuming other factors remain constant, when implied volatility of a standard warrant decreases, its price should theoretically also go down, and vice versa. The movement of implied volatility will always cause a same directional movement in the price of a standard warrant, and implied volatility is commonly used as a measurement to compare the expensiveness of a standard warrant with products of similar terms.

Inline warrants — Since the correlation between the movement of implied volatility to the value of inline warrants can be positive or negative, investors should not interpret the changes in implied volatility or compare the implied volatility of different inline warrants in the same way as standard warrants.

To price an inline warrant, issuers usually use several vanilla options with the same underlying securities, maturity and with strikes around the upper and lower strike prices or levels. Although every issuer may have their own pricing and structuring model, below is an example of how inline warrants may be constructed:

As illustrated in the above example, unlike standard warrants which involve a vanilla option with one implied volatility, inline warrants are constructed via several options (structured as call spreads), and every option will have different pricing and implied volatility.

5.18 How does volatility of the underlying asset affect the price of an inline warrant?

In general, the value of inline warrants is affected by the probability of the product expiring in-the-range, and the volatility of the underlying will have an impact on such probability. Below explains the theoretical effect of the underlying’s volatility to the price of inline warrants:

5.19 How does an issuer decide the implied volatility level of a structured product when pricing the product? Why does implied volatility of structured products over the same underlying asset differ between different issuers?

Implied volatility is a key parameter in the issuer’s pricing formulae that cannot be observed directly. However, issuers can estimate the implied volatility based on:

Implied volatility level of standard warrants varies between issuers because each issuer may hold a different market expectation on a particular underlying asset from other issuers and has different issuing cost.

In respect of inline warrants, different issuers can construct inline warrants by using different option strategies (e.g. options with different strike prices or levels), so the price of inline warrants (even with same terms) issued by different issuers may vary.

5.20 What is historical volatility of underlying asset and where can investor find such information?

Volatility is determined by annualised statistics measuring changes in price of its underlying asset: the greater the fluctuations, the higher the volatility.

“Historical volatility” is a measure of underlying price fluctuations over a certain period in the past. You may obtain information on historical volatility of the underlying asset by subscribing to the data provision service of a market data information provider.

5.21 Why does the implied volatility of listed and OTC options affect the price of a standard warrant and an inline warrant?

Implied volatility of a standard warrant and of the combination of options used to construct an inline warrant has a close relationship with the implied volatility generated by OTC and listed options.

After an issuer sells a standard warrant or an inline warrant, it generally needs to hedge against the risks arising from that issuance through different channels: two of those channels are OTC options and listed options. OTC options are options that are traded on a bilateral basis outside of the trading facilities provided by any exchange. Usually, the counterparties are institutional professional investors, such as investment banks. Listed options are those traded on a trading facility such as the Exchange.

If the implied volatility of an OTC option or a listed option is moving downward, the implied volatility of a related standard warrant or the options strategies used to construct an inline warrant may also move downward. On the contrary, if the implied volatility of an OTC option or a listed option is going upward, the implied volatility of the related standard warrant or the option strategies used to construct an inline warrant may also go upward. Therefore, variations in the implied volatility of an OTC option or a listed option may indicate a trend in the implied volatility of a related standard warrant. For an inline warrant it may be less obvious on the price of the inline warrant since the effect may be different to the different options strategies used in the construction of inline warrants.

5.22 Where can I see information on the implied volatility of an OTC option?

OTC options are bilateral contracts traded privately between two participants, off-exchange. As a result, there is no public information available for the implied volatility of an OTC option.

5.23 Where can I see information on the implied volatility of a listed option?

You may obtain information on the implied volatility of a listed option by subscribing to the data provision service of a market data information provider.

5.24 How does “funding cost” affect the price of a CBBC and how is it calculated?

The funding cost of a CBBC is relevant to determining its price. A CBBC is generally traded at a price that represents:

The funding cost is determined based on:

These items fluctuate from time to time. The funding cost of a CBBC may be affected by its supply and demand. Furthermore, depending on the liquidity and volatility of the underlying asset at the time, the cost and risk of hedging may also cause a fluctuation in the issuer’s funding costs. This means that the issuer’s funding costs are not fixed throughout the term of the CBBC. In addition, the longer the duration of the CBBC, the higher the funding costs. The funding costs decline over time as the CBBC moves towards expiry.

When choosing between CBBCs, amongst other considerations, you should compare the funding costs of different issuers of CBBCs with similar underlying assets and features.

5.25 What is time value and how does it affect the price of a standard warrant?

Time value is the value of a standard warrant arising from the time left to maturity and is equal to the difference between the current standard warrant price and its intrinsic value. The time value can be considered as the cost paid in return for the gearing effect. In general, the longer the time to expiry, the higher the probability that the underlying price will move in favour of the standard warrant holder and hence a higher standard warrant price. However, the time value of a standard warrant will become zero when the standard warrant has reached maturity. This is often referred to as the time decay of a standard warrant.

5.26 How does time value affect the price of an inline warrant?

As an inline warrant approaches expiry, the effect of time value on its price can be either positive or negative, depending on where the underlying price or level is compared to the upper and lower strike prices or levels. This is different from a standard warrant where time value is always decreasing as it approaches maturity.

Generally, the effect of time value (i.e. time to expiry) on the price of an inline warrant can be explained as follows (assuming other factors remain unchanged and ignoring the effect of dividend and interest rate):

5.27 How does the outstanding quantity affect the price of a structured product?

“Outstanding quantity” means the quantity held by investors and is generally shown as a percentage. It is calculated by dividing the number of structured products held by the market on a particular day (after closing) by the total number of structured products issued. For example, if the number of certain structured products held after closing on a particular day is 90 million and the number of those structured products that had been issued is 100 million, then the outstanding quantity is 90%.

A product with a high outstanding quantity may be more vulnerable to the influence of the forces of market supply and demand. For example, when there is a selling pressure on a product, the price of that product may be squeezed (that is, brought down) by prevailing market forces. The price of the product may also be volatile due to short supply. As a result, its price may not follow the price of the underlying asset very closely.

5.28 How does further issuance affect the price of a structured product?

Issuers are entitled to increase market supply of a structured product where the outstanding quantity exceeds 50%, to prevent price fluctuations caused by short supply. The way this takes place is that the issuer applies to the Exchange for a further issuance of the product.

Further issuance has the potential to bring greater stability to the product price and minimise the chance of price fluctuations caused by the disequilibrium between supply and demand.

5.29 How does the distribution of dividends of an underlying stock affect the price of a structured product?

When a listed company announces its financial results, it will also generally announce whether dividends will be paid. Whether or not this affects the price of a related structured product depends on whether or not dividends were expected and, if so, at what level and on what date. This is because the issuer considers past records of dividend distribution and the dividends expected by the market, when calculating the structured product price.

If the dividend distribution and ex-dividend date are as expected and other factors remain constant, theoretically, the dividends should not affect the price of the structured product.

5.30 What if the underlying stock eventually declared a dividend lower than expected? How about if the declared dividend is larger than expected?

If the dividend declared is lower than expected, the price of the call warrant would be expected to move up, assuming other factors remain unchanged. On the other hand, if the underlying stock declared a larger dividend than expected, the price of the call warrant would be expected to drop, assuming other factors remain unchanged. Accordingly, investors who bought the call warrant may lose. The impact on a put warrant will be opposite to that of the call warrant.

In respect of an inline warrant, as the issuer’s pricing model involves a combination of option strategies with different strike prices or levels, the combined impact arising from unexpected dividend declaration on the price of an inline warrant is less obvious.

5.31 Will the terms of a structured product be adjusted when there is a capital adjustment of the underlying asset?

Under normal circumstances, a standard warrant or CBBC linked to shares of a company will be adjusted if there is a capital adjustment of those underlying stocks (such as bonus issue, rights issue and restructuring event or spin-off / merger / consolidation). Specifically, an adjustment will be made to the call price, strike price and entitlement ratio according to terms specified in the relevant listing documents.

In the case of a merger/consolidation, an adjustment will be made to the call price, strike price and entitlement ratio of the standard warrant or CBBC of the company being merged or consolidated with. If the merger/consolidation results in an extinguishment of the current underlying, such underlying of the standard warrant or CBBC will change from the original underlying to a surviving/new underlying. Where there is a surviving company, no adjustment will be made to the standard warrant or CBBC of the surviving company.

Where the Effective Date of the adjustment occurs after the ex-entitlement date of the underlying stocks (such as in the case of spin-off), no adjustment will be made to those standard warrants or CBBCs that expire in the interim period.

In the case for inline warrants, the adjustment approach will be similar to that of standard warrant mentioned above, except (a) the adjustment will apply to both the upper and lower strike prices or levels; and (b) no adjustment will be made to the entitlement ratio.

5.32 Will structured products be suspended when the underlying stock is undergoing a merger?

It is possible that trading of shares of the entities undergoing a merger may be suspended for a period of time. The Listing Rules require suspension of structured products where the underlying stock is suspended. When this happens, the value of standard warrants and CBBCs may be adversely affected due to time decay during the suspension period. For inline warrants, the value of inline warrants may be adversely affected when the underlying price is outside the upper and lower strike prices (see FAQ 5.4).

5.33 What will be the arrangements on structured products if there is a spin-off of the underlying company and a distribution of specie to shareholders?

Under normal circumstances and for the purpose of calculating the value of the rights attached to the spin-off company, issuers will use volume-weighted average price (VWAP) of those auto-matched trades of that company on its first day of listing as the basis of adjustment. The adjustment will take effect from the day following the listing date. Investors should note that no adjustment will be made to those structured products that expire before the effective date of the adjustment.

Depending on circumstances of the case, structured products may be suspended from trading from the ex-entitlement date to the listing date of the spin-off company. In this case, the value of standard warrants and CBBCs may be adversely affected due to time decay during the suspension period. For inline warrants, the value of inline warrants may be adversely affected when the underlying price is outside the upper and lower strike prices (see FAQ 5.4).

Similarly, depending on circumstances of the case, the observation period for CBBCs may be suspended from the ex-entitlement date to the listing date of the spin-off company. Thus, no mandatory call event will occur during such period.

5.34 I hold a call warrant on a stock underlying. The price of the underlying only dropped by 2%. Why did the liquidity provider’s quote for my call warrant fall much more than 2%?

A call warrant is a short-term trading instrument with a gearing effect (see FAQ 5.14), it could magnify your loss relative to the underlying performance.

5.35 I bought a call warrant on a stock underlying in the morning trading session, when the underlying was traded at HK$50. The underlying price then dropped to HK$48 and the liquidity provider’s quote also dropped. In the afternoon, the price of the underlying went back to HK$50 but the liquidity provider’s quote was still lower than the price at which I bought the call warrant, why?

In addition to the underlying price, the liquidity provider’s quote also depends on a number of other factors (see FAQ 5.2). Assuming all other factors remain constant, although the underlying price went back to HK$50 from HK$48, it is likely that the increase in the underlying price was offset or even outweighed by the decrease in the implied volatility of the call warrant, hence lowered the call warrant price.

5.36 I note a call warrant launched three days ago was issued at HK$0.25, but its price dropped to HK$0.20 on its first listing date. How could this happen?

The issue price of a call warrant is determined based on the market factors prevailing on the launch date of a warrant. On the first trading day of the call warrant (being 3 trading days after the launch date), it is possible that substantial changes have occurred in respect of the market factors affecting the price of that call warrant.

5.37 I hold a call warrant issued by firm A. There was another call warrant with identical terms (same underlying, expiry date and strike price) issued by firm B. Why was price quoted by firm A lower than that quoted by firm B?

In addition to the terms of the call warrant (i.e. underlying, expiry date and strike price), its price also depends on a number of other factors (see FAQ 5.2) which are based on different pricing assumptions adopted by individual issuers (e.g. different implied volatilities, interest rate, expected dividends, etc.). Moreover, even with identical terms, different call warrants may have a different level of market participation and outstanding amount, which may affect the warrant price to a different extent. Accordingly, the prices of call warrants with identical terms issued by different issuers may vary.

5.38 I hold a bull CBBC issued by firm X which will expire in six months. There was another CBBC with identical terms (same underlying, expiry date, strike price and call price) issued by firm Y. Why was price quoted by firm X lower than that quoted by firm Y?

In addition to the term of CBBC (i.e. underlying, expiry date, strike price and call price), the price of a CBBC also depends on a number of other factors (see FAQ 5.6) which are based on different pricing assumptions adopted by individual issuers (e.g. different funding level, hedging cost, expected dividends, etc.). Accordingly, the prices of CBBCs with identical terms issued by different issuers may be different.

5.39 I hold a HSI call warrant which was last traded at HK$0.01. The HSI increased by more than 3% but the liquidity provider refused to quote and the call warrant’s last traded price still remained at HK$0.01. Why didn’t the liquidity provider’s quote increase in line with the underlying?

It is likely that the HK$0.01 last traded (nominal) price could have been brought down a while ago and does not reflect its prevailing theoretical value before the rally of the HSI, hence it is not the best reference to gauge the actual performance of the call warrant.

It is particularly the case for a short term and deep out-of-the-money call warrant. Despite the HSI rallied more than 3%, the warrant is still out-of-the-money with short time to expiry, hence its prevailing theoretical value after the rally of the HSI is still below HK$0.01.

The liquidity provider is not required to provide quote when the theoretical value of the warrant is less than HK$0.01 (see FAQ 4.16).

5.40 A call warrant had 70% of its volume outstanding in the market. Why did the price of the call warrant drop while the price of the underlying remained unchanged?

Assuming all other factors remain constant, it is likely that the call warrant price is affected by market force. The higher the outstanding amount, the greater the potential that the call warrant price is affected by market supply and demand, and as a result of which the call warrant price may drop due to the high selling pressure while the price of the underlying remained unchanged.

5.41 I hold a call warrant which will expire in 10 days. Why did the liquidity provider’s quote fall by 10% despite an increase in the price of the underlying by 1%?

Assuming all other factors remain constant, it is likely that the price of an out-of-the-money and extremely short term call warrant is insensitive to the change in the price of the underlying (due to low delta). It is likely that the liquidity provider’s quote fell despite an increase in the underlying price as such extremely short term call warrant was deeply affected by time decay (much more so than the change in the underlying price).

5.42 I hold a very deep in-the-money call warrant linked to HSI and expiring in June (in 2 months) with entitlement ratio 10,000. The delta of the call warrant is almost 1. The HSI index increased 150 points while HSI June futures contracts increased 110 points. The call warrant price increased by HK$0.011 (equivalent to 110 index points) only. Why did it not increase by around HK$0.015 (equivalent to 150 index points)?

HSI call warrants are not solely priced based on HSI index. They are mainly priced based on HSI index, interest rate and expected dividend. Since HSI futures contract reflects the value of HSI index, interest rate and expected dividend, the pricing of the HSI call warrants is generally priced based on HSI futures contracts.

5.43 I hold an inline warrant which will expire in 10 days with an upper strike price of $200 and lower strike price of $150. Why did the liquidity provider’s quote fall by more than 50% when the underlying price moved from $152 to $147?

The sensitivity of the price of inline warrants to the movement of the underlying price is the highest when (a) the inline warrants is close to expiry (i.e. short dated); and (b) when the underlying price is close to either the upper or the lower strike price. This is when the delta of inline warrant is the highest. Therefore a small change in underlying price from $152 to $147, given the lower strike price is $150 and the inline will expire in 10 days, causes a large movement on the price of the inline warrant.

5.44 I hold an inline warrant which will expire in 10 days with an upper strike price of $200 and lower strike price of $150. Why did the liquidity provider’s quote fall by 5% when the underlying price remained at $140 compared to the previous trading day?

There are many factors affecting the price of inline warrants, including the time to expiry. The effect of time to expiry will be negative when the underlying price is outside the upper and lower strike prices. As the inline warrant is very short dated, expiring in 10 days, the effect of one day time decay will be much higher compared to a long dated inline warrant.

5.45 I hold an inline warrant which will expire in 10 days with an upper strike price of $300 and lower strike price of $250. The liquidity provider’s quote fell by 10% when the underlying price remained at $240. The issuer explained that the volatility of the inline warrant decreased. What does this mean?

When the underlying price is outside of the upper and lower strike prices, a fall in implied volatility will have a negative effect on the price of the inline warrant. As the volatility decreases with an out-of-the-range inline warrant, the probability of the inline warrant to expire in-the-range also decreases (i.e. the probability of the holder receiving a cash settlement of HK$1 is lower). Therefore, the price of the inline warrant will reduce to reflect this. This effect is larger as the inline warrant becomes closer to expiry.

5.46 I hold an inline warrant which will expire in 3 months with an upper strike price of $120 and a lower strike price of $100. The price of the underlying stock increased from $115 to $117. Why did the price of the inline warrant drop?

The price of inline warrants may move in the same or inverse direction as the underlying price during the life of the product, which depends on where the underlying price is compared to the upper and lower strike prices, assuming all other factors are constant and ignoring dividend and interest rate effect. As the underlying price is above the mid-point of the upper and lower strike prices (i.e. $110), the price movement of the inline warrant will be inverse to the movement of the underlying price (i.e. a negative delta).

5.47 Why are the price movements of inline warrants with same terms issued by different issuers different?

This is due to different assumptions and hedging strategies adopted by different issuers, and hence the price movement of inline warrants with the same terms may vary.

5.48 The inline warrant calculator from an issuer’s website showed that the price of the inline warrant that I hold would move up by HK$0.1 while the underlying stock price moved up by HK$1. Why did the quotes of the liquidity providers only rise by HK$0.08?

The objective of the inline warrant calculator shown on the issuer’s website is to illustrate the relationships between different factors to the price of inline warrants. The pricing result of the calculator may be different from the issuer’s real time pricing model which involves different option strategies with different strike prices or levels and implied volatility. Therefore, the results from the calculator are for reference only.

5.49 Since the minimum cash settlement amount for an inline warrant at expiry is HK$0.25, can the value of an inline warrant be lower than HK$0.25 during its life?

When the probability of the inline warrant expiring in-the-range (i.e. holder receiving the HK$1 cash settlement amount) is almost close to zero, the value of the inline warrant should be very close to HK$0.25. However, when there is still a period of time to expiry, this HK$0.25 value will be discounted by the interest rate during this period before expiry. Hence in theory the value of an inline warrant can be below HK$0.25.

5.50 Since the minimum cash settlement amount for an inline warrant at expiry is HK$0.25, does that mean I will never lose all the money?

Since the minimum payout at expiry for an inline warrant is HK$0.25, investors will not lose all of their investment unless the issuer/guarantor becomes insolvent or defaults on its obligations, in which case investors may lose the whole investment amount.

It should be noted that in order to receive a minimum cash settlement amount of HK$0.25, investors have purchased the inline warrants with an upfront payment which they would not otherwise need to pay.

5.51 I hold a bull CBBC linked to the HSI expiring in 6 months. The spot level of the HSI increased by 0.1% since I bought the CBBC during the day. Why did the price of the CBBC remain unchanged despite an increase in the spot level of the HSI?

The price of such CBBC is based on the estimated future price of the HSI futures expiring in 6 months against which the CBBC is hedged (rather than the spot level of the HSI or the future price of the front month HSI futures). The estimated future price of the HSI is calculated by reference to the sum of the cash value of the HSI (based on the HSI’s level) and interest rate, less the expected dividend. Assuming all other factors remain constant, it is likely that such increase in the spot level of the HSI was offset by the adjustment of expected dividend by the issuer, and hence the price of the CBBC remained unchanged.

5.52 I hold a bull CBBC linked to HSI expiring in 6 months and the entitlement ratio is 10,000. The bull CBBC was about 400 points to be knocked out. HSI index and futures both increased by 100 points but the bull CBBC only increased by HK$0.009. If the delta of the bull CBBC was equal to 1, its price should increase by HK$0.01 (i.e. 100 index points / 10,000 = HK$0.01). Why did the bull CBBC increase by less than HK$0.01?

This is because the delta of the bull CBBC is not exactly equal to 1. Besides, there are a number of different factors which may affect the price of a CBBC other than underlying spot such as expected dividend and funding cost (see FAQ 5.6).

5.53 I hold a bull contract. The price of the underlying was trading close to the call price. Why did the bull contract drop to HK$0.015 while the stock dropped only by HK$0.01 given the entitlement ratio is 1?

When the underlying price is trading close to the call price, the price of the CBBC may become more volatile and the change in the price of the CBBC may be disproportionate to the change in the underlying price. Investors should also be aware of the number of outstanding CBBC in the market. The higher the outstanding number, the greater the selling pressure when the underlying price gets closer to the call price. This leads to a more volatile price behaviour.

5.54 Why does the liquidity provider quote wider spread for a structured product with an illiquid stock underlying than a liquid or blue chip underlying?

A liquidity provider provides quotes for a particular structured product by taking into consideration the prevailing market conditions such as hedging costs and the liquidity, spread and volatility of the relevant hedging vehicles. Normally, blue chip stocks have better liquidity which allows the liquidity provider to provide a tighter quote than an illiquid underlying.

5.55 I hold a call warrant on HSI. I understand the call warrant price should drop as the HSI drops. However, why did the liquidity provider lower the bid price only but not the ask price. This deprives my chance of buying more call warrant at a lower price.

Liquidity providers can provide bid and ask quotes at the pricing level they deem fair by reference to the theoretical price of the call warrant provided that they comply with the maximum spread requirements. The bid and ask spread may change from time to time according to the prevailing market conditions affecting the underlying asset such as hedging costs and liquidity, spread and volatility of the relevant hedging vehicles. Therefore it is possible that their quotes will not match your expected price levels due to the widening of the bid and ask spread.

For example, we assume that the theoretical price of the call warrant was initially HK$0.2 with a spread of HK$0.003 on each side, such that the bid and ask quotes were initially HK$0.197 and HK$0.203 respectively. The HSI then drops which leads to a corresponding drop in the theoretical price of the call warrant to HK$0.197. Notwithstanding the drop in the theoretical price of the call warrant, the spread may be widened to reflect the prevailing market conditions. For example, if the spread is then widened to HK$0.006 on each side, the new bid and ask quotes will become HK$0.191 and HK$0.203 respectively for the warrant with a theoretical price of HK$0.197. In such case, the ask quote does not change but the bid quote is lowered due to the widened spread.

5.56 I hold a call warrant linked to an HSI constituent security and the entitlement ratio is 1. The closing price of the call warrant and the underlying was as below.

Why did the closing price of the call warrant drop while the closing price of the underlying increased?

This could happen because:

5.57 I hold a bull CBBC linked to an HSI constituent stock. The CBBC was still trading until close of the market at 4:00 p.m. I noted that the CBBC was knocked out subsequently at around 4:10 p.m. How could the CBBC be knocked out after market close at 4:00 p.m.?

CBBCs can be knocked out during the observation period which includes pre-opening session, continuous trading session and closing auction session. Even though the trading in the CBBC ceased at the end of the continuous trading session at 4:00 p.m., it could still be knocked out when the underlying stock hits the call price at the end of the closing auction session.

5.58 I hold a call warrant with an exercise price of HK$12.28 and the entitlement is 1 share. The underlying company announced a bonus issue of one bonus share for every ten existing shares. How does the bonus issue affect the price and the terms of the call warrant?

The entitlement and exercise price of the call warrant will be adjusted according to the following formula:

Where:

In this case:

The purpose of the adjustment is to ensure that as far as possible, the theoretical price of the call warrant remains unchanged immediately before and immediately after the adjustment. Assuming all factors being equal, the theoretical price of the call warrant will remain unchanged.

5.59 I hold a call warrant on a stock underlying with its expiry date on 14 June. On 5 April, the underlying declared a final dividend and the ex-dividend date of the underlying falls on 29 May. The ex-dividend date of the final dividend for last year was 17 June. How does this affect the price of the call warrant?

Assuming all other factors remain unchanged, the call warrant price will drop upon declaration of dividend on 5 April. It is because the actual ex-date (29 May) falls before the expiry date (14 June) and the dividend actually paid during the term of the call warrant is higher than expected (according to historical record it was expected that such dividend would only be paid after the expiry of the call warrant).

5.60 I hold an inline warrant with an upper strike price of HK$20 and a lower strike price of HK$15. The underlying company announced a bonus issue of one bonus share for every ten existing shares. How does the bonus issue affect the price and the terms of the inline warrant?

The upper and lower strike prices of the inline warrant will be adjusted according to the following formula:

Where:

In this case:

The purpose of the adjustment is to ensure that as far as possible, the theoretical price of the inline warrant remains unchanged immediately before and immediately after the adjustment. Assuming all factors being equal, the theoretical price of the inline warrant will remain unchanged. Please note that no adjustment on entitlement ratio is needed.