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.
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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.
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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. 2. 3. 4. 5. 6. 7. 8. Select Bull ELI for calculation Input the ELI name/code of 1823 (optional) and lot size of 400 Input the spot stock price of 89 Input the strike price of 83.363 Input the ELI outstanding days of 135 Input the estimated volatility of the underlying share price of 25 per cent Input the discount note rate (market interest rate of the ELI bond component) of 1.5 per cent 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 Then, click the “ELI Price” button 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. 2. 3. 4. 5. 6. 7. 8. 9. 10. Select Bull ELI for calculation Input the ELI name/code of 1823 (optional) and lot size of 400 Input the spot stock price of 89 Input the strike price of 83.363 Input the ELI outstanding days of 135 Input the discount note rate (market interest of the ELI bond component) of 1.5 per cent 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 Input the price of the Bull ELI of 81 Then, click the “Implied Volatility” button 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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