Financial Instrument

1 January 2017

Because the process of determining the exercise price is dependent upon the arithmetic average of the index of 7 particular days during 7 month with 30 days of interval, extremely volatile results due to the daily fluctuation of the market can be reasonably avoided. So, by arithmetic average, investors will be able to minimize the risks due to volatilities and seek rather stable returns as the investors of the product would be risk averters rather than risk seekers. b) Benefits to HSBC The main characteristic of Asian option is low volatility compared to other options.

According to Black Scholes option pricing model, if the volatility is low, the option can also be priced lower. As HSBC needs to minimize the insurance premiums for the protection of the fund, it will try to minimize option premiums and relatively lower prices of Asian options will help HSBC remain profitable. In practice, as the option premiums for the protection of investment is usually expensive, the seller of the product write options and put the cap on investment in order to reduce the total premium expenses.

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By using Average index for the premium, HSBC could become more profitable as the investment will become more popular and more profitable. Question 3 Question 4. Explain how the investor pays for 100% capital protection In the product, the present value of zero coupon bond that has the face value of $100,000, interest rate 6% of per annum annually compounded, and 4. 5 years of maturity is $76,934. 9 ( 10,000/(1+0. 06)4. 5). The difference of AUD23,065. 1 between PV of zero coupon bond and initial investment will be used for the purchase of the options to guarantee the initial investment.

In addition, HSBC will write the call option that will keep the maximum return up to the cap of 70% of ASX 200 index with the participation rate of 100%. In order to maintain the participation rate of 100%, approximately 21. 156 contracts of options should be traded for the initial investment of $100,000. This will be explained in detail in Question 5. As the price of the bought call option for the capital protection is $705. 2 and the price of the written call option is $40. 9, investors will have to pay $14,323. 34[21. 156 x ($705. 2 – 40. )] as the insurance premium for the 100% capital protection and maintain cap of 70% on index. In short, it can be said that the investor combines zero coupon bond and the ‘bull spread’ strategy that can be to protect 100% capital. In addition, according to the Product Disclosure Statement(“PDS”) issued by HSBC, the separate upfront fee of 2. 475% will be deducted as an Advisor fee and a fee of 0. 825% will be deducted as administration fee. So, the fee of $3,300 will be deducted for $100,000 invested into HSBC for the Advisory and administration service.

The payoff graph of the bull spread strategy is as below; Question 5. HSBC 100+ Series S&P/ASX 200 Linked Investment can be decomposed into bought call, sold call and 4 ? year zero coupon bond. In practice, when constructing Equity Linked Products like this, 100% participation ratio cannot be maintained by just trading one pair of bought and sold options. For example, only $3,246. 525 will be earned when 7 months’ average ASX200 index rises up to 70% from 4,637. 893 to 7,884. 418. But, as specified in the PDS, investors should earn 7,000, a return of 70% from initial investment of $10,000.

So, the ideal number of option contracts will be 2. 156(7000 / 3,246. 525) for every $10,000 investment. In other words, as the participation rate for the Equity Linked Investment will only be 46. 38%($3,246. 52 / $7,000), the option of 2. 1561 contracts should be accompanied for every $10,000 investment in order to satisfy the conditions in the PDS. Below are the payoffs of individual financial instruments. Question 6. An alternative strategy for the replicated portfolio can be made by using the combination of S&P/ASX 200 Exchange Traded Fund(ETF) combined with the bought put option and sold call option.

In order to exactly replicate the Equity Linked products with 100% participation ratio, each set of the contract should be multiplied by 2. 1561. SPDR S&P/ASX 200 Fund can be used as the equity indexfund that imitating the return of ASX 200. But the problems can occur when using the alternative strategy as listed. a) When the options are priced as a form of Asian option, the price is calculated on average index. But, the price of equity index future is dependent upon daily indexes. So, the exact replication may not be possible. ) Considering the transaction costs of buying, selling options and index fund, a complicated fine tuning process is required to make similar profit as original product. Instead of investing in ASX 200 index fund, we can use synthetic forward to imitate ASX 200 index movement. We can buy a call and sell a put on the ASX200 index with same strike price and time to expiry. 7. The benefit of investor Investors who want to replicate the portfolio may try to do the same investment. The investor can deposit 4. 5years zero coupon bond and combine bull spread(buy call option and sell call option).

But, the replication may have following difficulties for the individual investor. a) Due to the characteristics of the equity index option that need daily settlement, individual investors should keep an eye on daily indexes and need to reserve enough liquidity to answer the margin call if required. Unlike investing in HSBC S&P/ASX 200 linked investment, investors cannot just invest and do nothing. Daily actions are needed to keep the investment going. b) In order to meet the 100% participation ratio, about 2. 156 contracts of options are needed for each $10,000 investment.

As the minimum contract size is restricted to 10 in the Australian Exchange, individual investors cannot meet the planned participation ratio. To meet the same payoffs, the investment amount should be set to the multiple of $46,378( $10,000 x 10 / 2. 156) to in order to keep to the market-defined option contract requirement. Instead, if investors invest in HSBC, they will be able to invest relatively free amount of money. c) In the Australian exchange, special type of options such as Asian options are not traded.

Instead, individual investors may be able to split the investment in options to 7 maturities to get the average returns, and heavy administration efforts follow for them to bear. By investing in HSBC, investors will be able to save their resources in individual wealth management. d) With the structured product from HSBC, investors can enjoy tax concession. But, if investors would try to structure the product, a complicated tax issue may appear that would need advices from tax specialists the cost of which would not be negligible for individual investors. Question 8. ) When an investor intends to hold the investment until its maturity, he(she) has to undertake some risks. * Investors could lose the gain from term deposit. Even though the fund guarantee 100% capital protection, that does not mean that investors lose nothing. The Underlying Index may depreciate as well as appreciate and the ending underlying average index level could fall below the initial index causing zero Return on the Investment(ROI). * Even if the underlying index exceeds over the return cap of 70% at maturity, still an investor would lose return above the return cap.

Compared to direct investment into index products in the bullish market, the product carries opportunity costs that are hard to carry for some risk seekers to endure. * Investors need to pay the fee of 3. 3%(Upfront fee of 2. 475% plus Administration fee of 0. 825%) which would not be needed for direct investment into market. * Counterparty risk exists to the product. As this product is not backed up by Australian Government Guarantee Scheme, in case of failure of HSBC, though it is not specified in the PDS, return from the product could be substantially lower than declared capital protection level. Early termination in respect of the investment can be declared by HSBC preceding the maturity date regardless of the investor’s will to keep the investment to maturity. And there are no safeguards against HSBC’s internal failure on fund management or operational catastrophe as management of the fund is wholly dependent on HSBC’s capacity to deal with the stated contract and ability to lead the daily operation. b) When an investor does not intend to hold the investment until its maturity, he(she) has to undertake some risks. Though there is no early withdrawal fee, no upfront fee is not allocated over holding period and is not returned. Investor could waste relatively heavier amount of fees in early withdrawal. * For the early withdrawal before maturity date whether in whole or in part, investor can receive less than initial investment because capital protection applies only on the Maturity Date, and not on Early Withdrawal date. * There are tax consequences on early withdrawal.

Unlike withdrawal at Maturity where the capital gain that an investor makes will be eligible for concessional treatment as a discount capital gain where the relevant conditions are satisfied, early withdrawal within 12months after acquisition date will not get concessional treatment. Question 9. There are many issues that HSBC needs to consider when designing the complicated product like this. In short, the issues can be classified to product design, profitability, operational risks and counterparty risks, and marketing issues as detailed below. ) Product design issue: * The product is different from ordinary ELS that guarantees investment protection and cap level by the spot index of the maturity date that market practice because it uses the 7 months’ arithmetic average of the closing level of the S&P/ASX 200 index. As the options that calculate its return based on 7 months’ average are not traded in the Australian Exchange, HSBC should either divide option protection to 7 different maturities and trade them in ASX or make an Over-The-Counter(OTC) option with the relevant counterparty. HSBC needs to decide whether to invest in zero coupon bond and bull spread or to invest in equity index product with bought put and sold call options in order to guarantee 100% capital protection and 70% cap over S&P/ASX 200 index and to cope with the probable early withdrawal requests from individual investors. * Investors may be able to assume that the product is based on SPDR S&P/ASX200 index fund because investors’ cost base is dependent upon market value of the fund when calculating capital gain or loss according to the taxation consequences opinion issued by Mallesons Stephen Jaques which is contained in the PDS.

So, it is important to operate the product in order to occur reasonable return within the pre-determined investment guideline. b) Profitability issue * In order to meet the participation rate to 100%, about 2. 156 option contracts have to be attached to the zero coupon bond of $10,000 and the costs for the purchase of the options come from the difference between present value of zero coupon bond and investor’s investment as summarized below table. Initial investment by investor| 10,000. 00| Zero coupon bond interest rate| 6% | Investment Period| 4. 0 | Present Value of the protected fund. | 7,693. 49 | Difference between PV and initial investment| 2,306. 51 | Price of Embedded option @ protection level| 705. 20 | Price of Embedded option @ cap level| -40. 90 | The number of option contract to satisfy 100% participation ratio| 2. 156 | Net option premium cost| 1,432. 33 | Adviser fee(2. 475%)| 247. 50 | Admin fee(0. 825%)| 82. 50 | Net margin from bank| 544. 17 | So, if funds are operated as planned, HSBC would be able to get margin of 5. 4% from investors after deducting all necessary initial expenses. But the margin may not be enough for HSBC as it will still need the costs to keep the fund going(management, operational expenses, transaction costs, and more) and it should answer for the investors’ abrupt early withdrawal. Management need to keep details on the expenses. c) Operational Risk management issue * It is extremely important to build internal operation structure that would record all transaction and keep mark to market prices accurately. With the heavy amount of fund going in and out of HSBC for trading, a strict internal control system to keep the cashflow in designated circle between HSBC and counterparties should be built in advance. * Enough liquidities to meet the margin calls of holding option positions should be prepared and managed with solid outlook on economic prospects along with S&P/ASX 200 index. d) Counterparty issue * As the investment in zero coupon bond with 4. 5 years of maturity is crucial in building the product structure, it is extremely important to purchase risk-free or lowest risk bonds with solid credit rating. As the bond itself is not 100% risk free asset and carries the risk of going default, during the investment period, HSBC should keep an eye on the performance of the bond and be ready to switch to alternative bonds with the same remaining maturities. * If the option trades are done over the counter, HSBC should focus some of its resources to the counterparty so that the pre-arranged contracts will be executed in timely and accurate manner. e) Marketing issue * HSBC should make sure that the marketing plan of the product is planned and executed appropriately.

The success of the product is dependent upon the amount of the viable contract so that HSBC could maintain bonds and option contract as designed and keep efficient internal operational structure. * HSBC should have a set a minimum level of total investment under management and set the plan to call off all investment and return the amount back to investors in case total application amount is below feasible level. * Also HSBC should anticipate the likely maximum level of total investment to process the applications and operate the process within its capacity. Even after the fund structure is designed, the fund cannot be launched if the recent market is extraordinarily bullish and turbulent as the individual investors will believe that the market is already over the top and will not seek further return after 4. 5 years. If the market is too bearish and under recession, individual investors would lose any motivations to keep their assets for 4. 5 years. * So, HSBC should focus on touching investors’ desire to keep relatively safe return with the protection on invested funds when the market is relatively calm and the indexes have been stable. ——————————————- [ 1 ]. An Asian option (or average value option) is a special type of option contract. The payoff is determined by the average underlying price over some pre-set period of time. ; Asian options are thus one of the basic forms of exotic options. Asian options are so called because they were introduced in Tokyo, Japan, in 1987, at a branch of an American bank. [ 2 ]. A bull call spread is constructed by buying a call option with a low exercise price (K), and selling another call option with a higher exercise price.

Often the call with the lower exercise price will be at-the-money while the call with the higher exercise price is out-of-the-money. Both calls must have the same underlying security and expiration month. [ 3 ]. Payoff from bought call option = 7,884. 418 – 4,637. 893. [ 4 ]. The S&P/ASX 200 Index (XJO) is recognised as the investable benchmark for the Australian equity market, it addresses the needs of investment managers to benchmark against a portfolio characterised by sufficient size and liquidity.

The S&P/ASX 200 is comprised of the S&P/ASX 100 plus an additional 100 stocks. It forms the basis for the S&P/ASX 200 Index Future and Options and the SPDR S&P/ASX 200 Exchange Traded Fund (ETF). [ 5 ]. SPDR S&P/ASX 200 seeks to closely match, before fees and expenses, the returns of the S&P/ASX 200 Index. Its approach is designed to provide portfolios with low portfolio turnover, accurate tracking, and lower costs. [ 6 ]. Division 115 of the Income Tax Assessment 1997 Act

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