Hong Kong structured products battered by index plunge

Demand for call warrants spikes as supply of CBBC contracts dwindles

A collapse of the Hang Seng Index (HSI) has left issuers scrambling to restock their inventories of popular Callable Bull/Bear Contracts (CBBCs) referencing the index, to meet rising demand from retail investors in Hong Kong eyeing a market rebound.

The index shed over 2,100 points between August 17 and August 26 on signs that the Chinese economy may be slowing. Speculators using CBBCs to bet on an upward movement of the index have seen the contracts' knock-out barriers triggered but are short of options to reinvest, as the speed of the rout has outpaced dealers' ability to list new products.

CBBCs are leveraged structured products tied to the performance of underlying assets and are issued as bull or bear contracts depending on an investor's market view. Unlike warrants, which are a type of option typically settled in cash, the contracts are immediately called if the price of the underlying reaches a specified level.

"When the HSI got knocked down last week, everyone rushed in on the Thursday [August 20] expecting a rally," says Johnny Yu, managing director, head of public distribution for Asia at UBS.

However, as the index continued to fall, the majority of bull CBBCs knocked out. As of August 26 only 39 bull contracts were outstanding on the HSI, compared with a typical number of roughly 300 to 400, Yu notes.

"The number of bull contracts is limited now for those investors who are still bullish, and the bear contracts are less attractive because the ones left are those with knock-outs far above the spot level with low effective gearing," he says.

The rules of the Hong Kong Stock Exchange require five working days to pass between the launch of a new CBBC contract and its listing, which means it will take time for dealers to replenish their inventories. As of August 28, 105 bull contracts referencing the Hang Seng were trading and many of them listed only today.

In a falling market, investors will typically buy up bull contracts to benefit from an anticipated upturn, and purchase bear contracts in a rally in expectation of a correction. Popular CBBCs generally have call levels close to the price of the underlying asset, allowing investors to take advantage of high gearing and make quick gains by buying and selling the contracts following small moves in the underlying.

"Issuers have launched a lot of products this week that will be listed next week," says Keith Chan, head of cross-asset listed distribution in the Asia-Pacific region at Societe Generale. "However, as spot continues to go down, you end up having a lot of bull contracts very close to knock-out, very highly geared. What is missing at the moment are products with a call price much further away from spot."

Investors have turned their attention to call warrants instead. "There has been a switch from CBBCs to index call warrants that can be held to maturity referencing the HSI. Over the last few days, the implied volatility on these warrants has gone up a lot," says Yu of UBS, adding that on August 21 call warrants on the HSI stood at 24% implied volatility for the January 2016 expiry and went up to 31% on August 24, pushing premiums higher.

The number of bull CBBCs sold on August 24 was only 56.5% of the number sold on July 8, at the bottom of a similar market decline, according to data by Credit Suisse based on Hong Kong Stock Exchange filings. The comparatively sluggish sales this time around reflect the fact that many contracts have knocked out, as well as, according to one dealer, investor uncertainty over whether another fall in the index is looming.

"Investors believe the market will stay volatile and that we are not at the bottom yet. They are bearish and we see a consistent interest in bear contracts even on big down days, which is quite abnormal," says Ivan Ho, head of Hong Kong warrants and CBBCs sales at Credit Suisse.

He adds that this counterintuitive investor behaviour, not seen since the depths of the eurozone crisis in 2011, may be driven by worries that a broader-based market correction is underway, after parallel falls in European and US bourses.