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Callable Bull and Bear Certificates - an evolution of exotic options

Callable Bull and Bear Certificates - an evolution of exotic options

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Published by Jasvinder Josen
Turbo warrants or Callable bull and bear contracts are just introduced in Malaysia. They actually evolved from barrier options, a variety of exotic options.
Turbo warrants or Callable bull and bear contracts are just introduced in Malaysia. They actually evolved from barrier options, a variety of exotic options.

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Published by: Jasvinder Josen on Aug 12, 2010
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This article appeared in Capital page of The Edge Malaysia, Aug 1-7,2010
Callable Bull and Bear Certificates – an evolution of exoticoptions
By Jasvin Josen
Malaysians are fortunate to be the first retail investors in South East Asia to trade the exotic CallableBull Certificates (CBLC) and Callable Bear Certificates (CBBC), launched by CIMB earlier this month.Some investors must be curious about this product as to how it is an option similar to structuredwarrants in Malaysia, but yet differ significantly in other aspects.In this three-part series, I will show how CBLCs and CBBCs are linked to exotic options, describe theiressential features as well as provide examples of the product dynamics, pricing and risk. The focushowever will be the motivation for the investor trading this product and what he should be awareof.Similar products to the CBLC and CBBC are being traded around the world, but with different labels.It first appeared in Germany in 2001 as “turbo warrants”. In Australia they are known as “knock-outwarrants”, in Hong Kong as “callable bull and bear contracts” and in some countries as “stop losswarrants”. In this article, for simplicity, I will refer to both the callable bull and bear certificates as“CBBCs”.
CBBC - an evolution of barrier options
CBBCs are actually a product of a barrier option, a kind of exotic option. I will briefly illustrate thisbelow:
A recollection – what is an option
A previous article on structured warrants (“Structured Warrants – knowing the product”,
Nov 16-22,2009
) explained how standard options work. To recollect, when the investor buys a call option on astock (share), he pays a fraction of the stock price by paying a premium, and has the right to buy theshare at a predetermined exercise price within a certain time period. If the underlying stock exceedsthe strike price, the option price (premium) usually rises and the investor often chooses to close thecontract and make a profit. If the stock does not reach that strike price during its tenor, the optionexpires worthless and the investor only loses his premium. Structured warrants share these samecharacteristics.
...and now a barrier option
In the standard option, payoff depends on whether the underlying stock price hits the exercise price(or strike price). Let us say the underlying stock price (S
) is $4.00 and the strike (X) is $3.50. This callis then, already in-the-money.
Now, in a barrier option, an additional level is placed. Say this level (H) is at $4.30. If the underlyingstock of $4.00 reaches level H of $4.30 within the stipulated tenor, two things may occur:I.
The option will cease immediately, or is knocked out, or called. The payoff to the investorwhen this happens is simply the barrier level minus the strike price (H-X or $4.30 - $3.50).Note that in a standard option, the payoff to the investor would be S
– X; S
being thefuture price of the underlying stock which could be above or below its current price, $4.00. Itis obvious here that with a barrier in place, the investor is limiting his upside as he seemssatisfied when S
reaches a particular level (in this case when S
reaches H of $4.30).Intuitively we would expect the premium of the barrier then to be cheaper than a standardoption. This is one of the key motivations for the investor to trade barrier options.II.
The option will start its life- or the option “knocks in”. Here the option only starts when thestock price reaches $4.30. When this happens, S
will now be $4.30 and X is still $3.50. It willthen behave like a standard option.The barrier, H can be set above the stock price as in the above example or below the stock price.When the barrier is set above S
, the investor is bullish about the stock. We then have either an “Up& Out” or an “Up & In” option. When the barrier is set below S
, the investor is bearish about thestock and we have a “Down & Out” or a “Down & In” option. These properties are illustrated in
Chart 1
Chart 1 – The Standard Option vs. Barrier Options
The main motivation for using barrier options is that it involves less upfront cost (premium) and itdoes not require vigilant monitoring by the investor to match his personal stop loss criteria. This of course comes at a price -the payoff the investor gets with a barrier is limited (to H) compared to thestandard option where his upside is unlimited. Note that in both barriers and standard options, thedownside is limited to the premium paid upfront.
CBBCs – a case of a Knock Out Barrier Options
CBBCs are actually specific knock out barrier options, designed for the retail investors. In manymarkets, only in-the-money types of CBBC options are traded. A standard knock out call option forexample, when purchased, may be in any of the following three states:

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