Understanding Risks of Structured Products

Some Risks Associated with Structured Products

1. Issuer default risk
   
   In the event that a structured product issuer becomes insolvent and defaults on their listed securities, investors will be considered as unsecured creditors and will have no preferential claims to any assets held by the issuer. Investors should therefore pay close attention to the financial strength and credit worthiness of structured product issuers.
   
   Note: “Issuers Credit Rating” showing the credit ratings of individual issuers is now available under the Issuer and Liquidity Provider Information sub-section under Derivative Warrants section, under CBBCs section and under Inline Warrants section on the HKEX market website.
   
   
2. Uncollateralised product risk
   
   Uncollateralised structured products are not asset backed. In the event of issuer bankruptcy, investors can lose their entire investment. Investors should read the listing documents to determine if a product is uncollateralised.
   
   
3. Gearing risk
   
   Derivative warrants and callable bull/bear contracts (CBBCs) are leveraged and can change in value rapidly according to the gearing ratio relative to the underlying assets. Investors should be aware that their value may fall to zero resulting in a total loss of the initial investment. 
   
   The level of gearing embedded in an inline warrant depends on a variety of factors including but not limited to time-to-expiry and spot price of the underlying asset compared to the lower and upper strike prices. An inline warrant will be expected to have a high effective gearing when trading price close to the lower or upper strike price, and a relatively low effective gearing in other cases. These differences in effective gearing are amplified when inline warrants are close to expiry.
   
   
4. Expiry considerations
   
   Structured products have an expiry date after which the issue may become worthless. Investors should be aware of the expiry time horizon and choose a product with an appropriate lifespan for their trading strategy.
   
   
5. Extraordinary price movements
   
   The price of a structured product may not match its theoretical price due to outside influences such as market supply and demand factors. As a result, actual traded prices can be higher or lower than the theoretical price.
   
   
6. Foreign exchange risk
   
   Investors trading structured products with underlying assets not denominated in Hong Kong dollars are also exposed to exchange rate risk. Currency rate fluctuations can adversely affect the underlying asset value, also affecting the structured product price.
   
   
7. Liquidity risk
   
   The Exchange requires all structured product issuers to appoint a liquidity provider for each individual issue. The role of liquidity providers is to provide two way quotes to facilitate trading of their products. In the event that a liquidity provider defaults or ceases to fulfill its role, investors may not be able to buy or sell the product until a new liquidity provider has been assigned.
   
   

Some Additional Risks Involved in Trading Derivative Warrants

1. Time decay risk
   
   All things being equal, the value of a derivative warrant will decay over time as it approaches its expiry date. Derivative warrants should therefore not be viewed as long term investments.
   
   
2. Volatility risk
   
   Prices of derivative warrants can increase or decrease in line with the implied volatility of underlying asset price. Investors should be aware of the underlying asset volatility.
   
   

Some Additional Risks Involved in Trading CBBCs

1. Mandatory call risk
   
   Investors trading CBBCs should be aware of their intraday “knockout” or mandatory call feature. A CBBC will cease trading when the underlying asset value equals the mandatory call price/level as stated in the listing documents. Investors will only be entitled to the residual value of the terminated CBBC as calculated by the product issuer in accordance with the listing documents. Investors should also note that the residual value can be zero.
   
   
2. Funding costs
   
   The issue price of a CBBC includes funding costs. Funding costs are gradually reduced over time as the CBBC moves towards expiry. The longer the duration of the CBBC, the higher the total funding costs. In the event that a CBBC is called, investors will lose the funding costs for the entire lifespan of the CBBC. The formula for calculating the funding costs are stated in the listing documents.
   
   

Some Additional Risks Involved in Trading Inline Warrants

1. Pricing structure
   
   The pricing structure of the inline warrants requires investors to assess accurately the value of the inline warrants in relation to the expected probability of the valuation of underlying asset falling within the range between the upper strike price and the lower strike price (both inclusive).  It may be difficult for investors to properly value and/or to use as a hedging tool.
   
   
2. Maximum potential payoff is capped
   
   If the valuation of underlying asset falls within or at the price range between the lower strike price and the upper strike price (both inclusive), investors will only receive a maximum payoff of HK$1 per inline warrant at expiry. Therefore, the potential payoff is capped.
   
   
3. Cancellation of trade above HK$1
   
   Due to the pre-determined fixed maximum payment at expiry of HK$1, an inline warrant should not be traded above HK$1. Any trades executed at the price above HK$1 shall not be recognized and will be cancelled by the Exchange.