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CBBC or Turbo Warrants – Knowing the product

CBBC or Turbo Warrants – Knowing the product

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Published by Jasvinder Josen
CBBC or turbo warrants sound like normal warrants but they are not. Despite its cheaper price, they are more risky, especially in volatile markets.
CBBC or turbo warrants sound like normal warrants but they are not. Despite its cheaper price, they are more risky, especially in volatile markets.

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Published by: Jasvinder Josen on Sep 01, 2010
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This article appeared in Capital page of The Edge Malaysia, Aug 8-14,2010
Callable Bull and Bear Certificates – Knowing the product
By Jasvin Josen
From the previous article, we now understand that Callable Bull and Bear Certificates (CBBCs) inMalaysia are actually a product of exotic barrier options. In this article, we examine the key featuresof this product and have the opportunity to work on some examples.
Essential features of a CBBCs
There are many useful sites including Bursa Malaysia that explain the dynamics of CBBC, but I findthe Hong Kong Exchange site, (http://www.hkex.com.hk/eng/global/faq/cbbc.htm) the finest as itenables a layman investor (almost) to understand the product.The key features of a CBBC are discussed below and at the same time, these features are comparedto its close neighbour, structured warrants.
Call price and Mandatory call event
 From the previous article, we now know that the call price refers to the barrier level of the CBBC. Toemphasise further, for a callable bull, the call price is always set to be equal to or higher than thestrike price. For a callable bear, the call price is always equal to or lowers than the strike price.The mandatory call event relates to the termination of the CBBC when the underlying asset reachesthe call price. We will investigate this feature further when we talk about settlement price later.
CBBCs tracks the underlying asset closely
The CBBC type of instruments currently track underlying assets such as stocks, indices, exchangetraded funds and currencies. It is believed that the price of a CBBC tends to follow the price of theunderlying assets closely. In other words, its delta is close to 1. (Delta = change in option price /change in underlying share price). In the case of structured warrants, only deep in-the-moneywarrants that are close to expiry have deltas of 1. CBBCs then do appear to have a better edge as itsconstant delta enables straightforward risk management for the investor, in addition to the lowerpremium.Due to this property, this product is promoted by issuers like investment banks as the idealderivative to closely track the price movement of underlying shares, having high price transparency.However, investors are always warned that when the underlying share price is close to its call price,the value of CBBC may become more volatile and the change in its value may be disproportionate tothe change in the value of the underlying assets.
One would question why the CBBC (which is actually more complex than a standard warrant/option)displays such simple pricing and delta properties and what causes the relationship to break down attimes. We will investigate this in the next article where I talk about pricing and risk of CBBCs.
There are two kinds of CBBCs
There are two categories of CBBC, Type I and Type II:
Type I is when the call price is equal to its strike price. When the underlying share pricehits the call price, the mandatory call event is triggered and the CBBC holder will notreceive any cash payment. This is not alarming as the residual value or payoff is tied tothe difference between the call price and the strike, (H-X or X-H) which will be zero.
Type II refers to a CBBC where its Call Price is different from its strike price. Here theCBBC holder may receive a residual value upon the occurrence of the mandatory callevent.
Determination of settlement price upon the mandatory call event
We know that the residual value is simply the call price minus the strike price. However, there aresome tweaks to this formula. For a callable bull, a call event will occur when the underlying stockprice crosses the call price on the way down as shown in
Chart 1
. This price is then referred to as“settlement price”.
Chart 1 – Mandatory call event (MCE) for the callable bull
The settlement price for the callable bull is then is determined as the “lowest traded price” of theunderlying share from the mandatory call event to the end of the next trading phase (tradingsession). Similarly for the callable bear, the settlement price is the “highest traded price” of theunderlying share after the MCE and up to the next trading session.The investor must bear in mind that in cases where the settlement price becomes equal to the strikeprice or goes beyond the strike price, there may be no residual value. However we will see in theworked examples below that the residual value is usually small. The investor is expected to make hisprofit mainly from speculation on the price movement of the CBBCs.
What happens if there is no MCE and CBBCs are held to expiry
CBBCs can be held until maturity (if not called upon the MCE) or sold on the exchange. In this case,the settlement is straightforward; it is just the closing price of the underlying share on the lasttrading day minus the strike price, for the callable bull and the reverse for the callable bear.
Funding cost
The upfront premium of CBBCs include funding cost and issuers are required to specify the formulafor calculating the funding costs of their CBBC at launch in the listing documents. The funding costincludes the issuer's financing/stock borrowing costs after adjustment for expected ordinarydividends of the shares and the issuer's profit margin. These items fluctuate from time to time,therefore the funding costs are not fixed throughout the tenure of the contracts. In general, thelonger the duration of the CBBC, the higher the funding costs. The funding costs decline over time asthe CBBC moves towards expiry. Investors can compare the funding costs of different issuers of CBBC with similar underlying shares and features, if there is more than one issuer in the market.
How do CBBCs work – Some examples
Some very good examples of callable bulls and bears are provided in the Hong Kong stock exchangewebsite, which are reproduced below. The following examples illustrate how a Bull contract works.Example 1 shows a Type 1 callable bull; Example 2 shows what happens if this contract is not calledbut held to expiry. Example 3 shows a Type II callable bull and Example 4 shows what happens if aMCE occurs for this contract.
Chart 2 - Example 1Type I callable bull (Without residual value)
Shares ofCompany XSpot price $110Call Price (fixed at issue) $90Strike price (fixed at issue) $90Funding costs (8%)
[8% * 90 = 7.2)
$7.2Contract entitlement
Expiry 12 monthsTheoretical price at issue:
$0.272[(spot price - strike price + fundingcosts) /entitlement]
( 110 - 90) + 7.2
/ 100
Value of one lot (10,000 shares)
Say MCE occurs, the callable bull is called and trading terminated. There will be no residual payment.

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