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Chapter 16 notes 2012 08 04
1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 16
Knock-out Products
August 2012
2. Chapter summary and outline
This chapter outlines the features of knock-out products, types of
knock-out products, what types of investors would invest in knock-
out products, risks involved in knock-out products and similarities
and differences between knock-out products and other structured
products.
Chapter outline:
• Complex options
• Barrier options
• Types of “Knock-out” barrier options
• Callable Bull/Bear Contracts (CBBCs)
• Risks involved in CBBC Investments
• Similarities and differences between knock-out products and structured
warrants
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3. Complex Options
• Uncertain timing of option exercise, time of option expiration, variability of
option payoff and other attributes that are customized to meet the objectives
of the option investor.
• Also known as “exotic” option and some variable features include:
– Timing of option exercise
– Uncertainty as to time of expiration
– Payoff computation
– Conditional events or trigger points
– Underlying assets
– Multi-currency features
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4. Barrier Options
• Type of exotic option which payoff depends on the “barrier level” with
respect to the underlying asset.
• If during the life of the option the price of the underlying asset touches or
crosses the barrier level (trigger point), a “barrier event” occurs
– Option gets triggered and becomes live
– Option gets extinguished and expires
• Option’s barrier event can be triggered with respect to underlying asset’s:
– Price level (for a stock or an asset class);
– Index level (for a market related index);
– Exchange rate level (for foreign exchange options);
– Interest rate level (for fixed income options); or
– A numerical indicator or value that is computed by a specified formula for a
customized product basket.
• If the option terminates when event occurs:
– Payoff to the investor will depend on the terms of the option agreement
– Can be zero, or fraction of the initial premium paid, or
– Fixed mandatory pay off determined at outset
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5. Types of “Knock Out” Barrier Options
Single Barrier Option
• Most common barrier option in which there is One barrier
• When barrier level is reached, the option gets “knocked out”
• The barrier level is call price and the strike is:
– For a call barrier option, the call price is HIGHER than or EQUAL to the strike
price.
– For a put barrier option, the call price is LOWER than or EQUAL to the strike
price.
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6. Types of “Knock Out” Barrier Options
Double Barrier Option (or “Double Knock Out” Option)
• It has two barrier levels instead of one;
• There is one barrier on either side of the strike price
• 1 barrier which is HIGHER than the strike price;
• 1 barrier which is LOWER than the strike price
Investor
Strike Price: $8.00
Knock-out Price 1: $7.00
Knock-out Price 2: $9.00
Current Spot Price: $8.00
• If, at maturity, spot price >= $9.00 or <= $7.00 then Option is WORTHLESS
• It is Knocked Out once Barrier of $9.00 or Barrier of $7.00 is reached
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7. Types of “Knock Out” Barrier Options
Barrier Option Categories
1 Up & In Underlying asset has to move up and exceed the barrier
price for the option to become active (knock-in)
2 Up & Out Underlying asset has to move up and beyond the barrier
price for the option to terminate (knock-out)
3 Down & In Underlying asset moves down and beyond the barrier
level for the option to become active (knock-in)
4 Down & Out Underlying asset moves down and beyond the barrier
level the option terminates (knock-out)
• For Up & In calls and Down & In puts:
– These barrier options work like simple European-style options that are out-of-the-
money (“OTM”) until the barrier level is reached (i.e. trigger event) and the option
then becomes active.
• For Up and Out calls and Down & Out puts:
– These barrier options work like simple European-style options that are in-the-
money (“ITM”) until the barrier level is reached (trigger event) and the option
then terminates.
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8. Advantages of Barrier Options
• Are cheaper and require a lower investment amount as compared to
standard options:
– Possibility exists that it will terminate before expiration
– Double barriers are even cheaper than single barriers as probability of being
knocked out is higher
• Higher returns on capital investment for investor if barrier conditions are
satisfied that is:
– That is, of no knock-out event or if the knock-in event occurs as investment sum
is lower due to cheaper cost
• Greater selection of option available for those with diverse market views
and with benefit of leverage on capital invested
– Knock-in barrier options - Ideal for speculating large market moves.
– Knock-out barrier options - Ideal for speculating small moves in a sideways
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9. Disadvantages of Barrier Options
• High risk of loss of investment capital if barrier conditions are broken (i.e.
knock-out event occurs or if there is no knock-in event).
• They are Over the counter (“OTC”) products
– Investors pays upfront for option premium and,
– Do not trade on an exchange and the investor is exposed to counterparty risk on
the issuer
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15. Callable Bull/Bear Contracts (CBBCs)
• Based on market outlook investors can purchase:
– Bull contract: Investor takes a bullish (positive) position on the underlying asset
– Bear contract: Investor takes a bearish (negative) position on the underlying
asset
• Traded on the cash market of the exchange
• Issued by a third party
• Independent of the underlying asset and the exchange on which it is listed
• CBBC tracks performance of underlying assets which can be:
– Domestic single stocks;
– Domestic stock indices;
– Overseas single stocks;
– Overseas stock indices;
– Currencies;
– Commodities; or
– Any other asset baskets as allowed by the stock exchange and deemed suitable
by the issuer.
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16. Price moment of a CBBC
• Greater transparency for CBBCs in comparison to other structured products
• Price changes of a CBBC tend to closely follow the prices changes of the
underlying asset
• Delta of the CBBC is close to 1 (∆≈1)
– Hence if value of the underlying asset increases, the Bull CBBC (with conversion
ratio of 1:1) will increase in value by approximately the same amount
• Conversion ratio: number of underlying assets that each unit of CBBC is
obligated to buy or sell
• E.g. 10:1 means that 10 units of a CBBC control 1 unit of the underlying
asset
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17. Lifespan and Mandatory Call Event (MCE)
• CBBC have a fixed lifespan but contain a mandatory call feature
• The call will occur if the price of the underlying asset reaches a given price
level (the “call price”) at any time before expiry.
• Such a trigger event is referred to as a “Mandatory Call Event” (“MCE”).
• When this occurs, the CBBC will expire early and its trading terminates
immediately
• MCE is triggered before the expiry date if:
– For a Bear Contract, the Spot Price touches or is exceeds the Call Price
– For a Bull contact, the Spot Price touches or falls below the Call Price
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18. Gearing effect
• CBBC are leverage products
– Investors required only to commit a cash sum which is small proportion of the full
value of the underlying asset
– Hence, return on capital will be magnified
– Percentage loss suffered by the investor will also be magnified
• Effective Gearing
– Value of its gearing ratio in a CBBC is equivalent to effective gearing (since delta
~ 1)
– E.g. Effective gearing of 10: 1% change in the price of the underlying asset, the
theoretical price of the CBBC may increase or decrease by 10%
– Closer the strike price to the spot price of a CBBC’s underlying asset, the higher
will be the gearing ratio of the CBBC
– CBBC will experience higher price fluctuations when the asset’s spot price is
close to the strike price (higher risk of being called)
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19. Hedging Instrument (for bear contracts)
• CBBC can be used to hedge market risk
• An investor may hold assets with a long-term view that they will grow in
value but wants to preserve his investment from market volatility in the near
term
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20. Categories of CBBCs
• Two types
– N-CBBC => no residual value when CBBC is called
– R-CBBC => residual value applicable when CBBC is called
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21. Factors Affecting CBBC Pricing & Valuation
Theoretical factors
• Theoretical factors determine the intrinsic value of the CBBC (the simple
definition of intrinsic value is the difference between the underlying asset
price and the strike price)
• Main variables:
– Price movement of underlying asset
– Strike price
− Higher the strike price, the lower will be the intrinsic value of a Bull CBBC
contract (reverse applies for a Bear CBBC contract)
– Financial Cost
• Issuer’s cost of borrowing, adjustments for dividends (assuming underlying
asset is stock-related) and the issuer’s profit margin.
• Financial cost will be higher the longer the maturity
• Declines over time as the CBBC moves closer to expiration date
• Included in the price of the CBBC at the time of issuance
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22. Factors Affecting CBBC Pricing & Valuation - 2
Theoretical factors (cont)
• Intrinsic value of a CBBC is the difference between the underlying asset
price and the strike price (adjusted for the conversion ratio) after taking into
account the financial cost.
CBBC Theoretical Price
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23. Factors Affecting CBBC Pricing & Valuation - 3
Market factors
• Market and trading conditions influence the price of a CBBC
• Variables are:
– Liquidity of underlying asset
• Delta is close to 1 (+1 for Bull contracts, -1 for Bear contracts)
• If the market for the underlying asset suffers from poor liquidity, the issuer’s
hedging cost will rise and this in turn affects the price and trading liquidity of
the CBBC.
– Demand and supply factors
• Demand and supply factors may impact the CBBC price
– Issuer factors
• Issuer makes a market and provides liquidity to the CBBC investors
• In a stable market, the bid-ask spread is tight and transaction volume are
able to meet investor demand
• Trading of the CBBC can be adversely affected by disruptions which impact
the issuers operations
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24. Determination of Residual Value if Mandatory
Call Event Occurs
• Category N-CBBCs – no residual value
• Category R-CBBCs residual value:
• Mandatory Call Event Settlement Price =
– Bull contract: Not lower than the minimum trading price of underlying asset
between the period of MCE up to the next trading session.
– Bear contract: Not lower than the maximum trading price of underlying asset
between the period from the MCE up to the next trading session.
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25. Valuation At Maturity (Expiry)
• If CBBC not called before expiry, investors can hold it until maturity
• Maturity value
Capital Adjustments for CBBCs
• If CBBC based on Underlying stock
– An adjustment of a corporate action: bonus issues, share splits, and reverse
share splits
– No action is needed for regular share dividends
– Bonus shares, special and extraordinary dividends will require adjustments
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33. Risks Involved in CBBC Investments
Potential Loss of Capital
• Requires upfront cash investment
• Potentially lose the full amount of the invested capital
Mandatory Call
• If CBBC is called when the call price is breached
– Payoff for the N-category investor is zero and the Residual Value for the R-
category investor may be small
• Investor does not get to profit from or recover any losses if the price of the
underlying asset bounces back
Gearing Effect
• Being a leveraged product exposed to greater downside risk if the market
conditions are unfavourable
• Negative returns are magnified
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34. Risks Involved in CBBC Investments - 2
Limited Life
• Limited lifespan (determined by issuer)
• May become worthless upon expiry or when a MCE occurs
Price Movement – Trading Close to Call Price
• When there is demand-supply imbalance or turbulence in the wider market,
delta being approximately equal to 1 (∆ ≈ 1) may not always hold
• Price of the CBBC can be more volatile when the underlying asset is
trading very near the call price
Price Movement – Volatility
• In volatile market, greater likelihood that the CBBC will be knocked out
Liquidity & Market Disruption
• If there is a market disruption (ie no trading) and price is unavailable on the
underlying asset, the market for CBBC will also be affected
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35. Risks Involved in CBBC Investments - 3
Financial Cost
• Included in the price of the CBBC
• If issuer’s cost of borrowing increases in the interbank market, this cost
component goes up and raises the price of the CBBC
• Charged upfront and includes the entire period up to the expiry date
• Early Termination: CBBC investor will lose the full cost of funding even
though the CBBC was held for a shorter duration.
Counterparty Risk
• CBBCs issued by third party investment banks
• In event issuer defaults: investor has to face the risk of any exposure to the
issuer
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