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					        By Dr. Louis Cheng and Mr. Kevin Cheng

 Introduction
Listed Equity Linked Instruments (ELI) are a new investment product available for trading on HKEx’s stock exchange.
They are marketed to investors who want to earn a higher return rate than the current rate of less than 2 per cent on an
ordinary time deposit and accept the risk of repayment in the form of underlying shares, or losing some or all of their
investment. While ELI can come in the form of Bull ELI, Bear ELI and Range ELI, investors prefer to trade Bull ELI.

The purpose of this educational article is to provide investors with a better understanding of Bull ELI and a newly
released ELI Calculator on HKEx’s website designed to facilitate their investment decisions. To this end:

•       The fundamentals of Bull ELI are explained;
•       The benefits of trading ELI in the HKEx market are discussed;
•       The obligations of Liquidity Providers (LP) for ELI are highlighted;
•       How the newly released ELI Calculator can better facilitate an investment decision on ELI is explained. Readers
        should note that there may be other models to calculate the ELI value and the calculated figures are for reference
        only. HKEx hopes that the ELI Calculator can raise research interest in developing other valuation models for the
        benefit of the whole market; and
•       Points to note when investing in ELI are mentioned.

 The Fundamentals of Bull ELI
Investors taking a bullish view on the underlying security may consider buying a Bull ELI. When an investor purchases
a Bull ELI, he is indirectly writing a put option on the underlying security. If the market moves as the investor expected,
he earns a fixed return from his investment which is derived mainly from the premium received on writing the put
option. If the market moves against the investor’s view, he receives shares that may be worth less than the initial
investment, or if the ELI is cash settled, he may lose some or all of his investment.

A Bull ELI offers two possible forms of payback on expiry:

•       If on the expiry day the closing price of the underlying security is AT or ABOVE the strike price, investors will
        receive a cash payment at the total par value (total investment plus predetermined yield) of the ELI; and

•       If on the expiry day the closing price of the underlying security is BELOW the strike price, investors will receive
        a predetermined quantity of the underlying security at the strike price (total par value/strike price). If the ELI is
        cash settled in lieu of share delivery, investors will receive a cash payment based on the closing price of the
        underlying security.
                                                Table 1: Example of Bull ELI
    An investor selects Stock A as the underlying security and buys one board lot of physically-settled Bull ELI (i.e. 400 ELI)
    at the current ask price of $82. Details of his investment are as follows:
      Total Investment                                                      $32,800
      Underlying Security                                                   Stock A (400 shares)
      Spot Price (Underlying Security)                                      $93
      Strike Price (Underlying Security)                                    $85
      No. of Outstanding Days                                               100 days
      Potential Yield                                                       13.35 per cent per annum
      Payback if Stock A closes at or above $85 on Expiry Day               $34,000 ( $32,800 x (1 +13.35% x 100/365) )
      Payback if Stock A closes below $85 on Expiry Day                     400 Stock A shares
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      Benefits of Trading ELI at HKEx
     Compared with similar products, investing in ELI listed on HKEx’s stock exchange offers investors numerous benefits
     including:

     •    High transparency of prices and information;
     •    Trading and settlement in the same manner as ordinary shares;

     •    No separate account or additional documentation needed if an account has been established with a Stock Exchange
          Participant;

     •    Buying and selling through brokers anytime during trading hours on or before the last trading day;
     •    LP appointed by issuers to provide liquidity by way of continuous quotations or responses to quote requests. LP
          may act as counterparties for investors to buy and sell ELI. Investors can also sell their ELI to other investors.
          (Similar products can only be sold to the issuer);

     •    Convenience of receiving shares in a board lot, the most convenient tradable parcel; and

     •    Choice of underlying stocks, strike prices and duration.

      Obligations of ELI LP
     Each ELI has an LP, which is identified by a code of 95XX and is appointed by the issuer to fulfil certain obligations
     under the Listing Rules. The LP obligations are stated in the listing document. In general, the obligations include:
     •    Provide liquidity by means of continuous quotes or responses to quote requests on each trading day except for the
          first five minutes of each trading session (morning and afternoon);

     •    Quotes provided are for a minimum of 10 board lots and must be within the maximum bid/ask spread specified
          in the listing document; and

     •    Under the quote request system, respond to requests within the time stated in the listing document. Under this
          system, LP will only provide quotes upon request. Investors can call LP for quotes at the telephone number
          published in the listing document or in the LP information on the HKEx website. Investors can also submit quote
          requests via their brokers to LP. In the event the quote provided is considered not ideal, an investor can ask his
          broker to key his limit order into AMS/3, the Stock Exchange’s Third Generation Automatic Order Matching and
          Execution system, for processing.

     Circumstances in which LP will not provide liquidity are also stated in the listing document. The common circumstances
     include:
     •    When trading in the underlying stock is suspended;

     •    When an issuer has no ELI for sale, only bid prices will be provided;

     •    If the ELI value falls below $0.01, bid prices will not be provided;
     •    During the five business days prior to the expiry of an ELI (some issuers will provide liquidity during this period
          and investors should check the listing document);

     •    When the issuer or LP faces an operational or technical problem;

     •    The existence of a fast market; and
     •    When the LP is not able to short sell the underlying shares.
    An ELI Calculator to Better Facilitate
    Investment Decisions on ELI

Uses of ELI Calculator

HKEx has posted an ELI Calculator (see Table 2) onto its website to help investors to better understand the pricing of
ELI. This calculator is based on a mathematical model and allows ELI investors to:

•         Calculate a theoretical value for an ELI;
•         Find out how the above value will change when other factors that affect the value of the ELI change; and

•         Check whether an ELI is cheaper or more expensive than similar products.

Note: There may be other models to calculate the value of ELI. Please use the calculated figures for reference only.


The value of an ELI is affected by a number of factors including:
•         The spot price of the underlying shares (the market price of the underlying shares);

•         Strike price (a predetermined value);

•         Volatility (volatility of the underlying shares, which is based on investors’ estimates);
•         Risk-free interest rate (usually the applicable HIBOR rate);

•         Outstanding days (or the time to expiry, which is outstanding days of the ELI); and

•         Discount note rate (the market interest rate of the bond component of an ELI).

When using the calculator, an ELI investor first selects the type of ELI for calculation and then keys in the figures for
the variables and the lot size. The outputs are the option value, the ELI value per share, the ELI value per lot and the
annualised yield, as shown in Table 2.

                                                    Table 2: ELI Calculator and Outputs

    An example of using the calculator to obtain a Bull ELI value

    1.      Select Bull ELI for calculation
    2.      Input the ELI name/code of 1823 (optional) and lot size of 400
    3.      Input the spot stock price of 89
    4.      Input the strike price of 83.363
    5.      Input the ELI outstanding days of 135
    6.      Input the estimated volatility of the underlying share price of 25
            per cent
    7.      Input the discount note rate (market interest rate of the ELI bond
            component) of 1.5 per cent
    8.      Input the risk-free interest rate (usually take the HIBOR rate for
            about the same period as the ELI outstanding days) of 1.0 per
            cent
    9.      Then, click the “ELI Price” button
    10.     Outputs for ELI name/code, option value, ELI value per share
            and per lot, and annualised yield are shown.




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     In addition, an ELI investor can make changes to the various factors that can affect the calculated value of the ELI. This
     enables him to better understand the likely profit or loss for his ELI investment. Investors should note that there is no
     guarantee that the actual profit or loss will be the same as that determined by the calculator.

     Comparing relative prices of ELI and similar products

     When investing in ELI or similar products, smart investors usually look for the cheaper one. However, investors should
     note a comparison based on yield may not be meaningful as the terms of the two products are unlikely to be identical,
     preventing an apple-to-apple comparison. Another reason is different strike prices offer different potential yields. For
     example, a Bull ELI with a strike price equal to the underlying spot stock price provides a higher potential yield than
     ELI with a lower strike price. This is because the chance of receiving shares is much higher than with another ELI with
     a strike price substantially below the underlying spot stock price. The third reason is the settlement day for an ELI
     investment is T+2, while the settlement day for similar products may be different. As a result, the stated yield for the
     similar products with a settlement day T+3 or greater, and hence a shorter investment period, will look higher even
     though the real return is the same as that of ELI, assuming all other factors are the same.

     A more meaningful indicator to compare the relative prices of the two products is the implied volatility, if the terms
     are not significantly different. Profits from investing in ELI and similar products come mainly from the premium
     received in selling the embedded option. Higher implied volatility means that investors are receiving more option
     premium. It also means investors are paying a cheaper purchase price. On the other hand, lower implied volatility
     brings less option premium and a more expensive purchase price.

     With the input of the ELI price and other factors affecting the ELI price, the calculator will show the implied volatility
     for reference. Note that transaction fees of 0.262 per cent (brokerage commission of 0.25 per cent, transaction levy of
     0.007 per cent and trading fee of 0.005 per cent) are charged for trading ELI, while transaction fees for trading similar
     products are incorporated mostly in their prices. Hence, when comparing the implied volatility, the ELI price should
     include both the original ELI price and the transaction fee amount of 0.262 per cent per share. Table 3 shows the
     calculated implied volatility based on the inputs.

                                          Table 3: Calculated Implied Volatility Based on Inputs

       An example of using the calculator to obtain implied volatility based on
       the given Bull ELI value

       1.    Select Bull ELI for calculation
       2.    Input the ELI name/code of 1823 (optional) and lot size of 400
       3.    Input the spot stock price of 89
       4.    Input the strike price of 83.363
       5.    Input the ELI outstanding days of 135
       6.    Input the discount note rate (market interest of the ELI bond
             component) of 1.5 per cent
       7.    Input the risk-free interest rate (usually take the HIBOR rate for about
             the same period as the ELI outstanding days) of 1.0 per cent
       8.    Input the price of the Bull ELI of 81
       9.    Then, click the “Implied Volatility” button
       10.   Calculated implied volatility is shown
To facilitate easy comparisons, the ELI Calculator also allows investors to input the strike price as a percentage of the
spot stock price, and the price of similar products as a percentage of the strike price, which is the format for quoting
terms for those products.

By making the ELI Calculator available to the public, HKEx hopes that it will generate more discussion and more
research interest in developing other valuation models on the product for the benefit of the whole market.

The ELI Calculator was jointly developed for HKEx by Dr Joseph S K Chan and Dr Louis Cheng of the Hong
Kong Polytechnic University and is available at HKEx’s website (www.hkex.com.hk/invest/investedu/investedu.htm).

The ELI Calculator is designed to give users an understanding of ELI pricing only. It should not be used as a
reference for the actual market values or for trading purposes. HKEx and its subsidiaries make no warranty,
express or implied, regarding the ELI Calculator and shall not be liable to any person, whether in contract, tort or
otherwise, for any loss or damage that may directly or indirectly arise out of or in connection with the use of the
ELI Calculator.

 Points to Note When Investing in ELI
When investing in ELI, investors should note the following points:
•     Exposure to price movements in the underlying shares and the equity market;

•     While there is potential for higher yield than fixed deposits and traditional bonds, the return is limited and there
      are higher risks;

•     Any dividend payment on the underlying shares may affect the price of the ELI and its payback at expiry due to
      ex-dividend pricing;
•     Issuers may make adjustments to ELI due to corporate actions on the underlying shares and

•     Potential yield does not take into account transaction fees (brokerage commission of 0.25 per cent, transaction
      levy of 0.007 per cent and trading fee of 0.005 per cent).

 Conclusion
Like all other investment products, ELI involve risk. Investors will be required to pay more than the market price for
shares if on the expiry day the closing price of the underlying shares drops below the Bull ELI strike price. Hence,
investors should familiarise themselves with the characteristics of ELI before making any investment decisions. ELI are
suitable for investors who are looking for an investment that may provide a return higher than ordinary time deposits,
and are prepared to accept stock market fluctuations and to purchase the underlying shares at a pre-determined price.




The writers:   Dr Louis T W Cheng, Associate Professor of Finance, Department of Business Studies, Hong Kong Polytechnic University
               Mr Kevin Cheng, Vice President, Market Development and Education, Exchange Business Unit, Hong Kong Exchanges and
               Clearing Limited




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