Hong Kong Derivatives Markets

© 2002-2004

Robert H. Terpstra

Worapot Ongkrutaraksa

Introduction

Derivative financial instruments can be quite bewildering, particularly in terms of the terminology used to describe their characteristics.   In the simplest terms, derivative instruments are contracts that create opportunities for investors to transfer or exchange specified amount of cash flows and/or quantity of commodities at particular points of time in the future.  Most importantly, the behavior of these specified cash flows is derived from their reference to underlying commodities, including individual securities and financial indices, which are traded in cash markets.

The growth in the trading of derivative instruments has been dramatic in all major securities markets throughout the world, and Hong Kong is no exception.  In fact, the trading of options, warrants, and futures consistently accounts for a substantial portion of the total value of the transactions on the Hong Kong Exchange.  Complementing these traded derivatives is an over-the-counter (OTC) market where both options and swaps are popular products.  As a result, Hong Kong has become one of the largest and most active derivatives markets in the Pacific Rim.

This paper will provide an overview of the derivative instruments that are popular in Hong Kong together with a description of how these instruments influence the manner in which people manage their investments.  It begins with a discussion of the characteristics and functions of futures contracts together with a review of some useful trading strategies.  This will be followed by a similar review of financial options and warrants (i.e., options on common stock) and a discussion of the similarities and differences between futures and options.  The chapter will conclude with a description of interest rate swaps and the development of a swap market in Hong Kong.

Characteristics of Financial Futures Contracts

One of the most popular derivatives in Hong Kong is the Hang Seng Index (HSI) Futures Contract and its close cousin, the Mini HSI Futures Contract.  As such they represent an agreement to buy or sell the HSI on a specific date in the future at the future or settlement price.  Every transaction involves a buyer and seller, where the buyer is said to be in a long position and the seller a short position.

The very essence of a futures agreement means the positions are set up without an initial transfer of funds between the buyer and seller.  This makes the futures price quite unlike the price of most other financial instruments.  A stock price, for instance, is what an investor pays for a share of stock and the right to receive dividends and resell the stock; and a bond price is what an investor is willing to pay for the right to receive future interest and principal payments. A futures price is neither of these.  A futures contract is an agreement to trade at a future date at the futures or settlement price.  One does not “buy” the contract by paying the “future price.”  The futures contract merely stipulates that the parties promise to transact at that price in the future. 

A “good faith” security deposit, referred to as margin, must be paid when opening a futures position.   This deposit is very small relative to the value of the contract and thus allows for considerable leverage.  The margin is held by a clearinghouse and is to ensure that the buyer/seller can complete the contract at expiration.

The clearinghouse is an agent or subsidiary of the futures exchange and is unique to exchange-based transactions in contrast with over-the-counter transactions.  The most important role of the clearinghouse is to serve as counter-party to every transaction.  In other words, once the buyers and sellers settle on a transaction price, the clearinghouse will act as a buyer to every seller and a seller to every buyer.

Another role of the clearinghouse is to determine the settlement price at the end of each trading day.  This price is based upon the closing bid-ask prices or last transacted price.  If the settlement price is higher than the previous day’s settlement price, the difference is credited to the margin accounts of those holding long positions and charged to the margin accounts of those holding short positions.  If the settlement price is lower than the previous day, the difference is credited to those holding short positions and charged to those holding long positions.  This is called the daily settlement or “marking-to-market.”  It is intended to monitor the financial integrity of the parties to the contract on a daily basis.  While this is a significant factor in the maintenance of trust in the context of exchange-based trading, it has little or no impact on the futures prices.

Each account must maintain a minimum margin.  If the daily settlement results in a deficiency in the margin account, additional funds must be deposited or the broker must close out the contract by selling, (or, for short positions, buying), it back in the market.  Excess margin can be withdrawn or left to meet future margin calls.

The Futures Market Participants

Traditionally, futures markets have served the needs of four user groups: those who want information about future prices of assets or indexes; those who want to speculate; those who want to transfer risk by hedging; and those who engage in arbitrage.

The first group consists of market-watchers who look to the futures markets for unbiased information about what will happen to the spot price in the future.  For example, the HSI Futures Contract is viewed as a popular barometer of market sentiment in Hong Kong.   A strong premium on HSI Futures over the spot index is thought to bode well for the future performance of the cash market, while a discount on the futures may trigger selling.  Unfortunately the accuracy of futures prices as predictors of future spot prices is somewhat disappointing as there is a tendency for such forecasts to have large errors.  However, the forecasts seem to be as good as any other; and they are inexpensive as they are readily available from futures exchanges.

Speculators make up another important user group, particularly in Hong Kong.  In fact, annual surveys conducted by the Hong Kong Futures Exchange, and more recently by the Hong Kong Exchange, have found that “pure traders”, or speculators, account for about three-quarters of the futures transactions.  Speculators enter the futures market in search of profit by increasing their risk exposure.  For example, if you buy a stock index futures contract it is as if you are betting that the Hang Seng Index will rise.  If it does rise, you can make a profit, but if it falls, you will lose.  As a speculator, you are taking risks.  Alternatively, if instead of buying you decide to sell a stock index futures contract and you don’t own any of the stocks in the index, then again you are speculating by taking on risk in search of profit.  You do not have any pre-existing risk exposure because you do not own any of the index stocks.  Thus, the profit you might earn is viewed as compensation for risk taking.  Whether or not you belong to this group and are pursuing a speculative motive, however, depends upon your current investments.  If you buy contracts but are not short the underlying commodity, or if you sell contracts but do not own or plan to purchase the underlying commodity in the future, you are a speculator.

Speculators are sometimes classified by the length of time they plan to hold a position.  The shortest period would range from a few seconds to a few minutes and traders in this category are called scalpers.  Normally they do not expect to make much profit on each trade but they trade frequently.  Since they are almost certain to be members of the exchange, their transactions cost are very low.  Another category is day traders who profit from price movements that take place over the course of one trading day and will not maintain their position overnight.  The majority of speculators are either scalpers or day traders.  Those who hold their positions over night are called position traders.  While there are no statistics available to indicate the trading volume of these three categories of traders in Hong Kong, the behavior of the open interest does shed some light on the magnitude of position trades.  Open interest is simply the number of outstanding or “unliquidated” contracts for both long and short positions.  Since daily changes in the total open interest typically account for less than fifteen percent of the daily volume of transactions, it suggests that trades by scalpers and day traders greatly outnumber those of position traders. 

The third user group, the hedger, tries to reduce risk by entering the futures market with a pre-existing position.  This group accounts for between ten and twenty percent of the futures transactions in Hong Kong. Referring back to the previous example of someone who sold a stock index futures contract, if he owned the index stocks he would be hedging.  No matter which way the index moved, he would have offsetting gains and losses.  Hedgers may wish to buy or sell futures contracts, depending upon the nature of their pre-existing position.

Hedging is often viewed as a form of insurance with the premiums paid to the speculators who bear the risk the hedgers are trying to avoid.  In some instances, however, no speculators are needed as long as the long and short hedgers balance each other’s positions.  Thus, hedgers as a group need speculators to assume the risk whenever there is a mismatch between long and short hedgers.  This does not mean that speculators are not performing a useful service unless there is a mismatch.  Any activity by hedgers or speculators brings liquidity to the market and makes it easier and less costly for all participants to trade.

The fourth user group consists or the arbitragers, or those who seek to profit from divergence between the prices of the futures and their underlying assets.  Since mispricing conditions are necessary for prompting transactions by this group, the volume arbitrage transactions tend to be quite volatile.  In Hong Kong, arbitragers occasionally account for a substantial portion of futures transactions while, on average, the percentage of the annual futures transactions by this group has been between ten and fifteen percent.  To see how the process might work, consider the investment strategy involving arbitrage between the cash market and the Hang Seng Index Futures contract depicted in Table 1.  Arbitrage opportunities arise when the equilibrium or theoretical futures price differs from the actual futures price.  As you can see, the underlying asset, the HSI in this example, plays a crucial role in establishing the theoretical price of the futures contract.  In fact, for financial index futures, the theoretical price will be same as the value of the underlying index when the risk-free rate of interest equals the dividend yield on the index.   

To simplify the arithmetic, the futures contract we are pricing will not expire for one year – normally contracts are not available that far out.  Under the assumed conditions, the theoretical price of the futures contract is $11,000(1 + .05 - .03)^365/365 or $11,220, while its actual price is $11,500, or a difference of $280 or basis points.  Since the price of the futures contract exceeds its theoretical value, it is “overpriced” relative to the cash market and the proper investment strategy is to sell or short the futures and simultaneously establish a long position for an equal amount in the index portfolio.

 

This position is held until the futures contract expires and the position is unwound.  The fact that the settlement price of the futures contract must equal the cash price of the index portfolio at expiration, i.e. F_expiration = I_expiration, this arbitrage strategy will always yield a gain that equals the mispricing of the futures contract at the time the position is established.

It should be emphasized that the outcome described in this example does not depend on the assumption regarding the level of the index in the cash market at expiration of the futures contract.  The level of the index at expiration simply does not matter.  If it had gone up in our example, the additional gain from the sale of the portfolio would be offset by the loss on the futures position.  That is why existence of arbitrage opportunities produces the seeds for “risk-free” gains.  The prospect of these gains, in turn, motivates arbitrageurs to transact in a manner that will eliminate the mispricing in the market.

Seldom do the various futures contracts traded in Hong Kong sell at their theoretical prices.  This does not necessarily mean that unexploited arbitrage opportunities exist in Hong Kong as there may be departures from the previously cited assumption of the pricing model.  When various transactions costs are considered, theoretical prices may diverge from actual prices without producing arbitrage opportunities.  In addition, another departure from the assumptions used in the example involves the margin that traders must put up against outstanding contracts.  In Hong Kong at present, members of the Exchange can use Exchange Fund bills to meet the margin requirement but clients must put up cash.

Another explanation for the existence of unexploited arbitrage opportunities is the manner in which the expiration settlement price for equity futures is established in Hong Kong.  Rather than using the value of the underlying asset at the close of trading as employed in the example, the Hong Kong Exchange uses the average of the quotations for the underlying asset taken at five-minute intervals during the last day of trading.  This means that F will not equal I at expiration.

Types and Specifications of Financial Futures Products in Hong Kong

Despite the fact that a number of new types of financial futures products have been introduced in Hong Kong in recent years, the product of choice since its inception in 1986 is clearly the HSI Futures contract.  The various products available, as of January 2002, are summarized in Table 2.

* Hong Kong Interbank Offered Rate

Over the years, a number of other products have come and gone such as the HSI Sub-Indices Futures, the Hang Seng 100 Futures and the Red Chip Index Futures, and it seems that the GBP Rolling Forex contracts may be destined to incur the same fate.

As you can see, trading in the HSI Futures contract accounted for nearly 90 percent of the total transactions in futures contracts for 2000, while there was virtually no trading in stock futures or Rolling Forex contracts.  The recently introduced Mini HSI Futures contract has proved to be quite popular as well. In only three months of trading it accounted for 2.7 percent of the total futures contracts traded for the entire year.  Both of the HSI Futures contracts are particularly popular with local retail investors who accounted for 56 percent of the HSI Futures and 88 percent of the Mini HSI Futures transactions in 2000.  The 3-Month HIBOR Futures was the most actively traded interest rate futures, and is clearly preferred by institutional investors who were responsible for 79 percent of the transactions in 2000.

The contract specifications for the HSI Futures, the Mini HSI Futures, and the 3-Months HIBOR Futures contracts are presented in Table 3.  As revealed in the table, the Mini HSI is nothing more than a scaled-down version of the HSI Futures.  The only differences between the contracts are the contract size, minimum fluctuation and margin requirements, with the Mini HSI Futures having smaller values for all three of these features.

The settlement prices for both of the index futures are established by the clearinghouse at the close of each trading day.  For all but the last trading day, the settlement prices for each quoted month are calculated as follows:

1.        If the last trade was less than or equal to the closing bid price, the settlement is the bid price at close.  For example, if the bid is 11,490, the ask 11,500, and the last trade was at 11,485, the settlement price is set at 11,490.

2.        If the last trade was greater than or equal to the closing ask price, the settlement is the ask price at the close.  Using the bid-ask prices of the previous example, if the price of the last trade was 11,505, the settlement would be set at 11,500.

3.        If the last trade was between the closing bid-ask prices, the settlement is the price of the last trade.   For example, if the last trade was at 11,495 while the closing bid-ask were 11,490–11,500, the settlement price would be 11,495.

4.        If there has been no trading in the quoted month, the settlement price is set equal to the mid-point of the closing bid-ask spread.

5.        If there has been no trading nor any bids or offers in the quoted month, the settlement price will be set by the clearinghouse.

 

As mentioned previously, the final settlement price is set quite differently.  HSI quotes are taken every five minutes during the last day of trading and the final settlement is set equal to the average of these quotes, rounded down to the nearest whole number.  As a result, the futures prices and spot prices converge on the final day of trading, but only in terms of an average price as opposed to a particular closing price.

Table 4 shows the settlement prices for the HSI Futures as they were reported in the South China Morning Post for the trading day December 28, 2001.  The settlement price for the spot month HIS Futures contract was 11,387 and at HK$50 per index point, represented a contract value of HK$569,350.  Given the 17 point increase over the previous day’s settlement of 11,370, the one-day increase in the contract value was HK$850.  In the cash market, the HSI closed at 11,431.59 on December 28, 2001, a 72.09 increase over the previous day. Thus, the December HSI Futures sold at a discount to the cash market.

 

Source: South China Morning Post, December 29, 2001

For those who held long positions in the December contract from the previous day, their   one-day gain was HK$850 per contract.  Since contracts are marked to market at the close of each trading day, participants with long positions were credited with the gain. Meanwhile, those who were short lost HK$850 and had their accounts debited with the loss.  Also, since the initial margin requirement in December 2001 was HK$44,250 per contract, the one-day profit of HK$850 for those with long positions translated into a one-day rate of return of 1.92%. 

The futures contract on the 3-month Hong Kong Interbank Offered Rate (HIBOR), like the HSI Futures, have standardized specification in size, maturity months, and minimum fluctuation.  They are quoted in terms of an index that is measured by subtracting the interest rate from 100.00.  For example, if the HIBOR is 3.5 percent, the index becomes 96.5.  Thus the daily quotes for HIBOR Futures vary inversely with interest rate expectations and for each basis point increase, (decrease), in expected interest rates, the quote for the HIBOR Futures index will decline, (increase), by 0.01 percent. 

Table 5 shows the settlement prices for the 3-months HIBOR Futures for the trading day December 28, 2001 as reported in the South China Morning Post.  As indicated in the table, the settlement price for the spot month contract was 98.3, an increase of 0.03 from the previous day’s settlement price.  At HK$25 per basis point, the value of the contract was HK$245,750, and investors who held long positions from the previous day earned HK$75 per contract.  Also, given that the calculation of the settlement price involves subtracting the future HIBOR 3-month rate from 100, a settlement price of 98.3 equates to a HIBOR 3-month Futures rate of 1.7 percent.

 

Source: South China Morning Post, December 29, 2001

Since the prices of interest rate futures contracts vary with changes in interest rates, the increase in the settlement price might be viewed as an indication that traders were revising interest rate expectations downward.   In addition, given that the spot rate for the 3-month HIBOR at the close of trading on December 28^th was 2.03 percent, the 1.7 percent rate implicit in the settlement price suggested the anticipated trend in the 3-month HIBOR rate until the contract expired on January 16^th, was downward.  

An examination of the lifetime high and low settlement prices for the eight contracts listed in Table 5 reveals a mixed pattern of volatility.  The differences in the highs and lows for the January and February contracts are very low, less than 100 basis points, while the variation in the June 2002 contract was 472 basis points.  As will be discussed later, interest rate volatility is a major factor in shaping the attractiveness of interest rate derivatives.

Financial Futures Trading Strategies

A wide range of strategies is possible with financial futures.  Basically all of the strategies seek to exploit, modify, or eliminate the risk exposure associated with the fluctuations in the value of the underlying financial instrument. 

For those who want to exploit the risk of the stock market, for example, stock index futures contracts are very effective instruments.  One of the most basic speculative strategies is to use stock index futures to profit from anticipated market movements.  If a trader is bullish about the market and anticipates a major rally, he could simply buy a futures contract and hope for a price rise on the contract when the rally occurs.  The high gearing and relatively low transactions cost make this an attractive strategy when compared to the alternative of taking a position in the index stocks in the cash market. 

Stock index futures also permit investors to change their exposure to the underlying cash market much more quickly than by transacting in each of the underlying stocks.  For example, a fund manager wishing to increase her exposure to Hong Kong stocks can do so quickly by buying HSI Futures contacts.  If she wishes to hold the underlying stocks for the long term, she may rollover the contracts or buy the underlying stocks and unwind her futures position.  Similarly, selling HSI Futures contracts can quickly reduce a portfolio’s exposure to the HSI stocks. 

While speculators do not play a major role in the HIBOR Futures market, nonetheless it is also an instrument that can be effective for exploiting opinions about the future course of interest rates.   For example, if an investor thinks that interest rates have declined too far and are likely to rise, he can sell a HIBOR Futures contract.  If interest rates do rise, the HIBOR Futures prices will fall and the investor will make a profit by buying the futures at a lower price to close out his position.

Financial futures markets also offer a means to hedge the risk of unexpected changes in the price of the underlying financial instrument.  As such, hedging involves the transfer of price risk from hedgers to speculators and represents one of the major economic functions of futures markets.

Hedging with futures involves locking in a value for an investor’s portfolio of stocks or loans.  A hedge is simply the purchase (sale) of a futures market position as a temporary substitute for the purchase (sale) of the investor’s portfolio in the cash market.  If the prices of the stocks or loans that make up the portfolio move together with futures prices, any loss realized by the hedger in one position will be offset by a profit on the other position.  When the profits and losses are equal, the hedge is called a perfect hedge.  

In practice, hedging is not that simple.  A perfect hedge can only be obtained when the cash market prices of the securities in the portfolio that is being hedged move identically with the prices of futures contracts used to hedge the portfolio.  The difference between the cash and futures price is called the basis.  The basis can be positive or negative and the chance of changes in the basis is called basis risk.  The quotations for the HSI Futures in Table 4 can be used to illustrate the basis for this product.  The December contract’s settlement price of 11,387 was 45 points below the HSI closing value of 11,432.  Also, as previously noted, the method used to determine the final settlement price for the HSI Futures does not guarantee convergence between the cash and futures prices and therefore creates basis risk.  Thus, perfect hedges are seldom possible and hedging reduces risk to the extent that the basis risk is smaller than the price risk of the portfolio being hedged.

There are two basic types of hedge transactions, the short or selling hedge and the long or buying hedge.  A short hedge is used to protect against the possibility of a price decline in the future cash value of a portfolio of index stocks or HIBOR loans.  To execute a short hedge, the hedger sells futures to fix the future cash price and transfer the price risk of owning the portfolio to the buyer of the futures.   For example, an investor who anticipates a general decline in the stock market but is reluctant to liquidate the portfolio of stocks he is holding.  Selling stock index futures will compensate for the loss on his portfolio the stock market declines as anticipated.  This is also referred to as a cash hedge since it involves the hedge of an existing position in the cash market.

In contrast, a long hedge is undertaken to protect against changes in the price to be paid for the purchase of a portfolio of stocks or loans in the cash market at some time in the future.  In a long hedge, the hedger buys futures contacts.  For example, a fund manager who receives investment funds on a regular basis anticipates a “bull” market in the next three weeks before the additional funds are received.  By buying index futures he can lock in the current prices for the index stocks.  When the additional funds are received, he can buy the index stocks in the cash market and use the profit from his long hedge to cover the appreciation in the stocks values.  In other words, he can effectively buy the index stocks in the cash market at prices that prevailed three weeks ago.  This is also referred to as an anticipatory hedge since the cash position that is being hedged has not been taken but is expected to be taken in the future.

Hedges may also be referred to as direct or cross hedges.  When a futures contract is available in the financial instrument owned, a direct hedge may be established.  When a futures contract is not available for the financial instrument to be hedged, a cross-hedge may be constructed with a futures contract on another closely correlated index or instrument.

Characteristics of Exchange-Traded Financial Options Contracts

An option is defined as the exercise of the power of choice.  Consistent with this definition, an option contract provides the buyer the right, but not the obligation to complete a transaction in a particular commodity, at a particular price, at some time in the future.  Option contracts are similar to futures contracts in terms of their ability to provide the holder of the contract a mechanism to lock in a future price for the underlying commodity.  Unlike futures, however, the holder of the option can exercise the power of choice by deciding whether or not he wants to exercise his right to buy or sell the underlying commodity.

Options, like many other derivative products, trade either through organized exchanges or privately on over-the-counter markets.  One of the advantages of exchange-traded derivatives is the significant reduction in credit or counterparty risk.  As mentioned in the section on futures, this occurs because of the presence of the clearinghouse acting as a buyer to every seller and seller to every buyer.  The clearinghouse also guarantees the availability of funds to ensure performance of the contracts.  In contrast, investors in OTC derivatives do not have recourse to such protection and must depend upon the creditworthiness of the counterparty.  Another advantage of exchange-traded derivatives is the existence of a liquid market for trading the derivatives prior to expiration.  In OTC markets, such opportunities do not generally exist and most parties to OTC derivatives must take their positions all the way through to settlement or expiration.  Offsetting the advantages of exchange-traded derivatives is the standardization of the product in contrast with the ability to custom design the products terms in the OTC.     

The Language of Options

The parties to an options contract are commonly referred to as the holder or buyer and the writer or seller.  The position of a holder is referred to as a long position and that of a writer as a short position.  While the holders have no obligations to exercise their rights, writers are required to honor the contracts if the holders choose to exercise-regardless of how disadvantageous this may be to the writers.  When writing options, the writers incur the risk of having to forego profits or suffer out-of-pocket losses.  In return they receive a payment from the holders that is referred to as a premium.  Thus, the price at which the option trades is commonly referred to as the option’s premium and it is the limit to the holder’s exposure to the option contract.

There are two types of options: a call and a put.  A contract that provides its holder with the right to buy the underlying asset is called a call option while a contract that provides the right to sell is called a put option.

Every option contract has four defining elements: underlying asset, exercise or strike price, quantity, and exercise period.  Every option is issued on an underlying asset.  For options on financial instruments there are a wide range of products that can play this role, including a common stock, a stock index, a futures contract, a bond, or a currency.  In Hong Kong, exchange traded options are available on a variety of individual stocks as well as the Hang Seng Index.  Table 6 provides a description of the exchange-traded options in Hong Kong.

The strike price, also known as the exercise price, is the price at which the underlying asset will be delivered if the option is exercised.  A call option whose strike price is below the market price of the underlying asset is referred to as an in-the-money option.  Such an option allows the call holder to buy the underlying asset for less than the current market price.  A call whose strike price is above the underlying market price is said to be out-of-the-money.  Conversely, a put whose strike price is above the underlying price is in the money.  This means the put holder can sell the asset for more than the current market price.  A put whose strike price is below the current market price is out-of-the-money.  Only in-the-money options are likely to be exercised by their holders since they can buy or sell directly in the market at a better price.  If an option’s strike price is very close to the market price of the underlying asset, the option is said to be at-the-money.

There are two types of exercise, the American style and the European style.  An American style option can be exercised any time from its issuance up to its expiration.  A European style can only be exercised at expiration.  Since the American style offers more flexibility to its holders in terms of exercise, it can command a slight premium over its equivalent European style option.  All of the exchange-traded options in Hong Kong are American style. 

An option contract also specifies the quantity of the underlying asset that the option holder has the right to buy or sell.  For exchange-traded stock options in Hong Kong, the number of shares represented by an option contract, or contract size, is equal to one board lot of the underlying stock.  For HIS options, the contracts are cash settled contracts of difference which means there is no physical delivery if the HIS option is exercised.  The notational quantity of the HIS option contract is HK$50 per index point.

 

 

The exercise period limits the life of an options contract.  After the exercise period, the option can no longer be traded or exercised.  The common exercise period for exchanged traded options is between one and nine months.  In Hong Kong the length of the exercise periods consists of the nearest three months and the next two quarterly months.  It may come as a surprise that most stock options expire unexercised.  When an option is exercised, the exchange must select the short open position against which to exercise.  This is done on a random basis and those chosen must deliver (in the case of a call option writer) or buy the underlying stock (in the case of a put option writer).

Another important feature of stock options is the so-called “payout-protection rule.”  This is intended to protect investors in stock options from the possible adverse effects of capitalization changes associated with the stocks that underlie the options.  For example, capitalization changes that result in the creation of shareholders entitlements such as rights issues, stock splits, bonus shares, and unusually large dividends can have a significant effect on the price of the stock as soon as the entitlement passes.  When the entitlement passes – the ex-day – the value of the shareholders total portfolio will not change.  The same is not true for the option holder, unless an appropriate adjustment is made to the terms of the option contract.  Without a change to the exercise price and/or contract size, the adjustment to the share price in response to the capitalization change will arbitrarily and unfairly affect the value of the option position.  A payout protection rule therefore ensures that the fair value of the option contracts is maintained after the ex-day has passed.  For ordinary cash dividends that are not unusually large, however, no adjustment will be made and there will be some effect on the value of the option.

Pricing Stock Options

The price at which an option trades, or premium, is ultimately determined by market forces.  But there are certain factors that reliably shape the market’s view of the option’s value.  Let us start with the simplest case: the terminal value or worth of an option when it expires or the option’s intrinsic value.  For example, consider a call option with a $30 exercise price on a stock.  At expiration, the option will either be worthless or equal to the difference between the option’s exercise price or strike price and the market value of the underlying stock.  In other words, if the stock price is at or below $30 at the expiration date, the call option will be worthless; if the stock price is above $30, the intrinsic value of a call will be equal to the stock price minus $30.   

In the more difficult case – the interim value or worth of an option that has not yet reached its expiration date, it is necessary to view valuation in terms of “upper” and “lower” boundaries or limits.   The lower limit of the value of a call option is the intrinsic value. The upper limit is the market value of the underlying stock as illustrated by the 45-degree line emanating from the origin.  It simply reflects the obvious fact that a rational investor would never pay more for an option than what it would cost to buy the underlying stock.    Most of the time, however, the value of a call option before expiration will fall between the upper and lower limits as shown by the curved, upward-sloping dashed line in Exhibit 3. This curve begins at zero where the upper and lower limits meet, and rises gradually and becomes parallel to the lower limit.  Thus the value of a call option increases as the stock price increases and is worthless when the stock price is worthless.  Furthermore, when the stock price substantially exceeds the exercise price, the option’s value approaches the stock price less the present value of the exercise price.  The reasoning is that once the call option is “deep-in-the-money”, the probability that the stock price will fall below the exercise price before the option expires approaches zero and exercise becomes a virtual certainty.  It also means that the holder of the option effectively owns the stock and does not need to pay for it – by paying the exercise price – until later, when the option is exercised.  This characteristic is sometimes referred to as the “installment credit” feature of call options and is one of the determinants of an option’s so-called time value or the difference between the value of an option and its intrinsic value.   In addition to interest rates and time to expiration, the time value of an option, is influenced by the likelihood of substantial movements of the underlying stock price.  In fact, stock price variability is one of the most important determinants of the time value of options and thus option prices.  An option on a stock whose price is not expected to vary will not be worth very much unless the installment credit feature is very attractive, i.e. interest rates are very high and the time to expiration is very long.   On the other hand, an option on a stock whose price may half or double is very valuable.  Furthermore, a call option on a stock that has a high degree of expected price volatility and a long time to expiration would be more valuable than one that is about to expire.  Finally, the dividend payout policy of a firm affects the time value of call options.   A high dividend payout policy normally equates to a lower rate of capital gain or price appreciation for the firm’s stock.  It also decreases the potential payoff from a call option and thereby lowers its value.                                                  

Table 7 summarizes the influence of the six factors that have been discussed for both call and put options.  As can be seen, values of put options respond to changes in three of the six factors – underlying stock price, interest rates and dividend payout – in a manner that is opposite to the behavior of call options.  Since the buyer of a put acquires the right to sell a stock at the stated exercise price, one would expect the value of a put to increase in response to a declining stock price or increased dividend payout.   The inverse relationship between the value of a put and changes in interest rates is not quite so obvious.  The reasoning here is that the proceeds from a put occur in the future, if and when the put option is exercised.  Since the present value of those proceeds is inversely related to interest rates, the value of the put is also inversely related.  The time to expiration is the real surprise.  There are actually two contrary effects.  First, greater time-to-expiration tends to increase put values by widening the dispersion of possible future stock prices.  Second, greater time-to-expiration, like higher interest rates, tends to decrease put values by lowering the proceeds from exercising the put.  At lower stock prices relative to the exercise price the latter effect dominates since the increased dispersion has relatively little influence on put values.  However, for put options that are well out-of-the-money, the opposite occurs and the first effect dominates.

 

*Increase for well-out-of-the-money and decrease for near or at-the-money puts

Financial Options Trading Strategies

There is virtually no limit to the variety of payoff patterns that can be achieved by investing in calls and puts with various strike prices, either separately or in combination with each other or other securities.  What matters most is the investor’s motivation together with the expectations the investor would like to exploit.  The following are examples of the more popular strategies.

Strategy:               Buying puts with an existing long position in underlying asset (protective long put)

Motivation:          Desire to hedge or limit risk

Expectation:        Bearish, overall market or specific stock to experience some downside variability

For this strategy, an investor can limit the downside risk of an existing long position in an individual stock or a market portfolio by buying put options on the individual stock or market index.  If the individual stock or market index subsequently declines, investors who employ this strategy can limit their downside losses by exercising their right to sell at the strike price.  Thus, investors maintain an exposure to upward movements but limit their exposure to downward movements to the strike price.  The price of this form of “insurance” is the put premium.

Strategy:               Buying puts without an existing long position in underlying asset (naked long put)

Motivation:          Desire to speculate when the price of underlying asset falls

Expectation:        Bearish, overall market or specific stock is likely to experience downward movement

An investor who is bearish about the prospects of an individual stock or market index can exploit her expectation by buying puts.  The investor will incur a profit if the stock price or market index drops below the breakeven point, which equals the strike price minus the put premium.  If the investor’s expectations turn out to be incorrect and the individual stock or market index rises, the loss is limited to the put premium.

Strategy:               Buying calls (outright long call)

Motivation:          Desire to speculate with a leverage effect or create an anticipatory hedge

Expectation:        Bullish, overall market or specific stock is likely to experience upward movement

Investors who are bullish about the prospects of an individual stock or market index can exploit their expectation by buying calls.  The investor will incur a profit if the stock price or market index rises above the breakeven point, which equals the strike price plus the call premium.  Given the “installment credit” characteristic of a call option, this strategy provides investors with a leverage effect if their expectations prove to be correct. If the investor’s expectations prove to be incorrect and the individual stock or market index drops, the loss is limited to the call premium.  This strategy is also useful as an anticipatory hedge.  This occurs when investors who only have enough money to pay the call premium but are going to have sufficient funds to purchase stocks at a later date and are “lock-in” a price-the strike price-in anticipation of establishing a long position at a later date.

Strategy:               Writing or selling calls without an existing long position (naked short call)

Motivation:          Desire to speculate

Expectation:        Bearish, overall market or specific stock is likely to decline

Investors who sell calls without existing long positions profit from the receipt of the option premium as long as the market or individual stock does not rise above the strike price.  If the investors’ expectations prove to be incorrect, the potential loss is the difference between the level of the market index or price of the individual stock and the strike price less the call premium.  Alternatively, investors employing this strategy can buy back the call to close their position and reduce further losses if their expectations fail to materialize.

Strategy:               Writing or selling calls on an existing long position (covered short call)

Motivation:          Desire to enhance income

Expectation:        Stagnant to bearish, overall market or specific stock is likely to move sideways or decline

This strategy is somewhat similar to the previous one except the investor has an existing long position in the market index or specific stock that underlies the option being sold.  As a result, if the investors’ expectation is correct, they can enhance the income from their long position by selling calls and receiving the premiums.  If their expectations do not materialize, the losses incurred by this strategy are the same as in the previous strategy except that the losses will be “opportunity losses” given their pre-existing long position.

Strategy:               Buying a call and a put on the same market index or stock at the same strike price (straddle)

Motivation:          Desire to speculate

Expectation:        Volatile market, overall market or specific stock is likely to move up or down

This strategy is useful when an investor thinks the market or a specific stock is likely to encounter a big move, but is not sure whether the move will be up or down.  Thus the investor does not need to predict the direction of the price movement, only its magnitude. Referred to as a “straddle,” the profit from this strategy is measured by the index of stock is “in-the-money” by rising or falling, less the sum of the premiums paid for the put and call.  Given need to pay for both a put and call option, to be profitable, the strategy requires large price rises or falls in order to be profitable.

Characteristics of Interest Rate Swap Contracts and Forward Rate Agreements

Interest rate swap contracts are similar to financial futures contracts.  By definition, an interest rate swap contract is an OTC agreement by which two parties known as counterparties agree to exchange their periodic cash flows derived from interest receipts or payments over the life of the swap contract.  The amount of the interest payments exchanged is based upon principal amount of the underlying debt instrument called the notional amount.  However, the only amount exchanged between the parties is the netted interest payment, not the notional amount.  In a typical interest rate swap transaction, the first party, called a swap buyer, agrees to pay fixed interest payments to, and in turn to receive floating interest payments from, the second party at pre-specified future dates.  The second party, called a swap seller, agrees to make the floating-rate interest rate payments that vary with certain short-term reference rates such as Treasury-bill rate, prime rate, HIBOR, or LIBOR (i.e., London interbank offered rate) in exchange for the fixed-rate interest payments from the first party.

The gain and loss from buying and selling an interest rate swap will fluctuate with market interest rates as shown in Table 8 below. When interest rates rise after the counterparties have enter the contract, the swap buyer will gain while the swap seller will lose; as interest rates fall, the swap buyer will lose while the swap seller will gain.

 

 

The reason why such are the cases is because interest rate swap contract allows the swap buyer to lock-in the interest cost he is expected to pay no matter which direction the market interest rates move in the future.  Swap seller, on the other hand, will be affected as his interest receipts or payments are tied with the movements of the market interest rates.  If he expects to receive interest income, then the rise in interest rest rates would certainly benefit him.  However, the same interest rate increase would hurt this swap seller if he expects to make the interest payments.

Pricing Interest Rate Swap Contracts and Forward Rate Agreements

To understand the pricing mechanics for an interest rate swap, one could use the insights gained from the knowledge of futures contract discussed earlier.  The interest rate swap contract is related to its short-term counterpart called a forward rate agreement (FRA).  An FRA is an over-the-counter equivalent of the exchange-traded futures contract in which the parties agree that a certain interest rate will apply to a certain principal during a specified future period of time.  The FRA can also be seen as a special case of the interest rate swap in which there is only one settlement date.

There are conventions in a typical FRA worth defining, which include contract date, settlement date, contract rate, reference rate, settlement rate, and notional amount.  The parties to an FRA agree on the contract date (T₁) to buy and sell funds on the settlement date (T₂) in the future.  The contract rate (R_k) is the fixed interest rate specified in the FRA at which the buyer of the FRA agrees to pay for funds and the seller of the FRA agrees to receive for investing funds.  The reference rate (R₁) is the floating interest rate used in the FRA.  The settlement rate (R₂) is the value of the reference rate at the FRA’s settlement date, or future reference rate.  The amount from which the interest payments are to be calculated under the FRA is called the notional principal (N).  Like in an interest rate swap contract, this amount is not exchanged between the two parties.

On T₁, the FRA buyer agrees to pay R_k, or, in other words, to buy N at the settlement date at R_k.  The FRA seller agrees to receive R_k, or, equivalently, to sell N at the settlement date at R_k.  If on T₂, R₂ is greater than R_k, the FRA buyer will gain because he can borrow N at a below-market rate.  If R₂ is less than R_k, this will benefit the FRA seller who can lend N at an above-market rate.  If R₂ is the same as R_k, neither party will benefit.

On T₂, one party must compensate the other party that benefits from the difference between R₂ and R_k.  The FRA buyer will receive compensation if the former is greater than the latter.  Similarly, the FRA seller receives compensation if the former is lower than the latter.  The compensation amount is calculated as follows:

                Compensation      =              Interest payment difference / [1 + R₂ x (Days to contract period / 360)]

where:    Interest payment difference  =   |R₂ – R_k| x N x (Days to contract period / 360)

It is important, however, to note that the amount that must be exchanged at T₂ is not the interest payment difference, but rather, the present value (PV) of the interest payment difference.  The discounting method used to derive the PV is the continuous discounted cash flow (DCF) method (see Endnote 1).

The value of the FRA or of the interest rate swap can be found by taking the present value of these two sets of interest flow:

Swap Value           =              [N e^R_k^(T₂ ^{– T}₁⁾  e^–R₂^T₂ ] – [N e^–R₁^T₁]

where:    [N e^R_k^(T₂ ^{– T}₁⁾  e^–R₂^T₂ ]   =  PV of the interest flow to be received on T₂

                                – [N e^–R₁^T₁]         =  PV of the interest flow to be paid on T₁

                                                R_k           =   (R₂T₂ – R₁T₂) / (T₂ – T₁)

Interpretation of Interest Rate Swap Position

There are two ways to interpret an interest rate swap position: first as a portfolio of FRAs or interest rate futures contracts (IRFs) such as Eurodollar futures for short-term rates and Treasury bond futures for long-term rates; and second as a package of cash flows resulting from buying (or investment in) short-term, and selling (or being financed by) long-term, instruments in the spot market as opposed to the futures market.

Interest Rate Swap as a Portfolio of Futures Market Transactions

It is important to note first the difference between FRA and IRF.  For the FRA, the unit of analysis is an “interest rate.”  In contrast, the unit of analysis for the IRF is a “market value” of the underlying asset, such as a price of a fixed-income instrument.  Since the FRA and the IRF have different units of analysis, Table 9 below shows how the changes in the market interest rates can affect the payoffs to the buyers and sellers of both FRA and IRF.

 

 

Using the conventions defined above, the buyer of FRA gains if R₂ rises above R_k and loses if R₂ falls below R_k.  Taking a long position in a portfolio of FRAs yields identical results as those shown in Table 8 since the FRA buyer assumes a position of the swap buyer, while the FRA seller takes the same position as the swap seller.

Considering the long position in an IRF portfolio, the buyer of IRF loses if R₂ rises above R_k and gains if R₂ falls below R_k.  Comparing the gain and loss with those of the interest rate swap party in Table 8, the gain-and-loss profiles are the complete opposites.  This is because the movement of the interest rates has an “inverse” relationship with the movement in the market value of the fixed-income instrument.  As a result, the IRF buyer would assume the same position as the swap seller whereas the IRF seller would take the similar position to the swap buyer.

The pricing of an interest rate swap will depend on the price of a package of FRA with the same settlement dates and in which the underlying for the FRA is the same reference rate.  Using interest rate swaps proves to be more beneficial than trading FRA or IRF alone because interest rate swaps can accommodate longer maturity with one contract, which effectively saves transaction costs for both parties.  Moreover, the liquidity of the interest rate swap markets has grown rapidly since its inception in 1981.

Interest Rate Swap as a Portfolio of Spot Market Transactions

An interest rate swap contract can also be seen as a net cash-flow position resulting from a combination of an investment in a floating-rate instrument (i.e., a long position in money market securities) and a financing of such an investment using a fixed-rate instrument (i.e., a short position in fixed-income securities), which effectively generates the equivalent cash-flow payoffs.  Considering the financing side of this transaction, the combination calls for fixed-rate interest payments.  For this fixed-rate payer, the transactions involve buying a floating-rate instrument and issuing a fixed-rate obligation.  For the floating-rate payer, the transactions would be equivalent to buying a fixed-rate bond and financing that bond purchase at a floating-rate loan.

Equivalently, a fixed-rate payer can be viewed as being a swap buyer who desires to lock-in his future interest payment.  Assume that the floating-rate investment is based on the 6-month LIBOR and the fixed-rate semi-annual obligation is based on the 10-percent annual interest rate, Table 10 below illustrates how the package of investment in short-term securities financed by long-term borrowing can be arranged for the fixed-rate payer to yield the same net cash-flow position as that of the swap buyer.

 

 

When some dynamics in the market interest rate are put into the picture, an increase in LIBOR would increase the net cash flow of this portfolio whereas a decrease in LIBOR would reduce the portfolio’s net cash flow.  This is similar to the gain-and-loss profiles of the FRA buyer and of the buyer of interest rate swap.  The opposite effects on the net cash flow are true if the investment is based on the fixed interest rate and the borrowing on the floating rate.  In this situation, the gain-and-loss profiles from holding such a portfolio are akin to those of the FRA seller and of the seller of interest rate swap.

The Market for Interest Rate Swaps in Hong Kong

The interest rate swap market in Hong Kong is inextricably connected to the U.S. interest rate swap market since the Hong Kong dollar has been pegged to the U.S. dollar together with the interest rate parity that stems out from such a close tie between the two currencies.  Since its inception in early 1980s, the interest rate swap market in Hong Kong has experienced a constant development, adding more breadth of variety and depth of sophistication for its market participants.  Until mid-1990s, long-term interest rate swap contracts were still thinly traded.  Shortly afterwards, they had become more ubiquitous, even before the first ten-year fixed income instruments issued by the Hong Kong Exchange Fund (HKEF) in late 1996.

In order to fully appreciate the interest rate swap market in Hong Kong, one should be able to identify who the important market participants are along with their motives to use swaps and to gain some perspective on the chronological development of the market itself.

Swap Market Participants and Their Motives

There are two types of market participants in the swap market: first the natural floating-rate payers who want to swap for fixed-rate payments and become swap buyers; and second the natural fixed-rate payers wanting to pay floating rates thereby becoming swap sellers.  Along with their natural cash flow positions, both types of market participants have different motives in buying or selling swaps.  The first kind of motive for swap counterparties is to hedge their interest rate risk.  As market interest rates rise, the natural floating-rate payers would want to buy swaps in order to reduce their rising interest payments.  When the market interest rates start to fall, the natural fixed-rate payers would seek to sell swaps so that their fixed-rate obligations are lightened.  Most hedging-motivated participants are firms and financial institutions that attempt to lower their financing costs as well as optimizing their asset and liability portfolios.

The second kind of swap motive is for arbitraging the interest rates between two markets. Such an arbitrage opportunity is possible when interest-rate spread exists in yield curves between two different currencies.  For example, an arbitrageur would initially borrow from the low-yield U.S. dollar market and then swap the interest payments with a counterparty who has invested in the high-yield Hong Kong dollar market for a certain amount of swap transaction fee.  The net result is that the arbitrageur effectively utilizes the swap arrangement as a vehicle to mobilize a cheaper U.S. dollar fund to tap a higher-yield Hong Kong dollar investment opportunity without having to convert the underlying U.S. dollar principal into Hong Kong dollar one.  However, the arbitrage opportunity will quickly disappear whenever the swap transaction fee exceeds the profit from arbitrage or the yield-curve spread between the two currencies diminishes.

As the market interest rates had declined since the beginning of 1980s, banks operating in Hong Kong were more interested in selling interest rate swap (i.e., receiving fixed rate and paying floating rate) to profit from lower floating-rate obligations.  From 1987 onwards, however, the market interest rates began to rise, causing shrinkage in banks’ interest margin.  At the same time, interest rate swap market in Hong Kong began to lose its attractiveness and momentum.  Without the swap-selling counterparty to which their interest-rate risk could be shifted, Hong Kong-based banks continued to suffer deteriorating profitability and started to look for other means to hedge their interest-rate exposure.

Historically, an important swap buyer in Hong Kong has been the Mass Transit Railway Corporation (MTRC).  Since 1976, MTRC had been a leading buyer of interest rate swaps until the end of 1980s due to its natural position as a floating-rate payer.  By mid-1990s, the firm embarked on another infrastructure project to build new subway lines that link its current systems with the new Chap Lap Kok International Airport on the nearby Lantau Island.  In order to finance this mega-project, MTRC has begun to buy long-term swaps to change its floating-rate interest payments into fixed-rate ones.  This coincided with the preference of many banks that prefer to sell their swaps in order to become the counterparty to MTRC.

It was quite fortunate for Hong Kong that after the introduction of HKEF debt securities in 1990, an interest-rate hedging instrument had emerged and been available in the organized market in which the HKEF itself also acted as swap counterparty.  Practically, the HKEF entered the swap market whenever they issued bonds and simultaneously swapped their fixed-rate obligations to floating-rate ones.

During the early to mid-1980s, however, the banks were willing to take the fixed long position under Hong Kong dollar interest rate swaps as interest rates began to fall while gradually profiting from paying the lower floating rates.  The big players since the start of the Hong Kong dollar swap market were the major American banks such as Bankers Trust, JP Morgan, and CitiGroup, as well as the British’s Hong Kong and Shanghai Banking Corporation (HSBC).  The book runners on local floating-rate debt instruments were underwriting the instruments, entering the swap contracts, which converted the issuer’s obligations to fixed rate, and then keeping the fixed long positions on their own books.

Swap Market Development in Hong Kong

As the interest rates rose in both the U.S. and Hong Kong credit markets in 1987, the banks receiving fixed and paying higher floating rates were adversely affected by the asset-liability positions they had taken.  And a year later, the Hong Kong swap market began to lose its attractiveness.  Yet, its resiliency had proven otherwise when the market made a rebound in early 1990s due to the following factors.  Firstly, there were increasingly more receivers of fixed-rate Hong Kong dollar in the market.  With growing levels of sophistication, the traditional Hong Kong investors, such as the Hong Kong Jockey Club and the Schools Fund, were more ready to receive fixed-rate interest flows.  Secondly, the development of private banking had brought to the market large private clients, with more appetite for different instruments, creating a larger pool of fixed-rate receivers.  Thirdly, arbitrage opportunities between the U.S. and Hong Kong dollar yield curves had revived the banks’ interest in the swap market.

Based upon the third factor alone, most investors were interested in the fact that there was a steady spread between the U.S. Hong Kong dollar yield curve, which tracked each other with the Hong Kong dollar traditionally showing a steeper and higher curve (usually about 30-40 basis-point difference between the two yield curves).  This gave the investors an arbitrage opportunity by receiving the higher fixed-rate Hong Kong dollar and paying fixed-rate U.S. dollar on a swap or on the underlying obligation and capturing the spread.  By the early 1990s, this arbitrage opportunity was being pursued by most banks as well as other market participants.  In effect, the spreads between the two yield curves forcibly became narrower until the arbitrage positions were no longer attractive.

Soon afterward, the Hong Kong swap market had been revitalized with the help of the HKEF’s fixed-rate Hong Kong dollar bond market.  Along with other players, foreign fixed-income issuers such as the World Bank began to issue bonds in fixed-rate Hong Kong dollar and then swap their obligations into floating- or fixed-rate U.S. dollar since 1989.  The fixed-rate bank issuers of negotiable certificates of deposit (NCD) also re-entered the market at this time, having had no issuing opportunities after the death of the swap market in 1988.  For these intermediaries, they were eagerly interested in swapping their fixed-rate NCD to floating-rate Hong Kong dollar obligations.

However, the Hong Kong dollar swap market was very unstable engendering and enticing many speculative transactions in early 1990s.  The market began to stabilize and mature over 1995-1996 as transactions had gained in volume and frequency.  The maturity stage of the market meant that there would be fewer speculative positioning and arbitrage opportunities for active participants that lead to a shrinking number of international market players from a large group in the early 1990s including many European, Japanese, and American firms.  By 1996, the Hong Kong swap market became an exclusive arena for those banks that would claim to have sophistication to be able to generate profits in the matured climate.  This group includes the major American institutions and some European banks such as Union Bank of Switzerland (UBS) and HSBC.  Most of the local banks entered the market as clients of these major financial institutions.  The active participants are those who quote prices on swaps and hedge their positions through active management of their own swap books rather than by taking a matching position.

In summary, the current Hong Kong swap market can be seen as relatively active market, having a wide range of local and global market participants with prices quoted by the organized HKEF and from large financial institutions.  Conventional Hong Kong dollar swap transactions were arranged on a matching basis between those financial institutions.  As a result of increased volume and frequency in their swap transactions, financial institutions set up their off-balance-sheet (OBS) accounts to net their transactions without matching all individual payers and receivers.  However, the local corporate clients have been very conservative in the use of derivative interest-rate products in spite of the depth of the Hong Kong dollar swap market that allows a wide range of interest rate swap products to be arranged where demand arose.

Interest Rate Swap Arrangement Strategies

Between any two counterparties, the typical arrangements for interest-rate swap involve the periodic exchange of fixed stream of interest flows for variable stream of interest flows for one party and vice versa for the other party to the swap contract.  The interest flows that are exchange can either be the cash inflow or the cash outflow.  With respect to the swap arrangement strategies, there are two broad objectives to achieve.  The first objective is for the swap counterparties to lock-in their net interest margins (NIMs) as a result of asset and liability durations matching.  The duration swap arrangement pertaining to the first objective is discussed in detail in the sub-section to follow below.  The second objective is concerned only with the liability side of the balance sheet in that both swap counterparties attempt to minimize their costs of financing based upon the comparative advantage argument.  Under this second objective, two strategies can be implemented namely, quality swap and basis swap.

Strategy 1: Locking-in the Net Interest Margin through Duration Swap Transactions

One of the more frequently arranged interest rate swaps among banks and other financial institutions is duration swap as the need for it arises from duration matching between the institution’s asset and liability portfolios.  For the purposes of asset-liability management (ALM), banks whose average asset portfolio’s duration is greater than average liability portfolio’s duration – positive duration gap – would want to swap out their fixed-rate interest income for floating-rate cash inflow so that the expected rise in market interest rates, which directly affects the banks’ funding costs, would have less negative impact on their NIMs.  However, if the market interest rates were to fall instead of rising, then the positive-duration gap institutions would not be so interested in selling their fixed-rate interest income simply because they still enjoy the falling costs of funding.

On the other hand, financial institutions like insurance companies whose average asset portfolio’s duration is less than average liability portfolio’s duration – negative duration gap – would prefer the swap arrangements that provide them with fixed-rate interest income when market interest rates are expected to fall as they tend to decrease the companies’ NIMs.  When the market interest rates actually rise instead of falling, the negative-duration gap institutions should not swap as rising interest rates would naturally increase their NIMs.

Therefore, in order for duration swaps to be successfully arranged, both counterparties should have not only the opposite duration gaps but also different expectations in terms of future interest rate movement.  The following scenario and tables help illustrate how duration swap is set up and arranged by a third-party duration matchmaker.

Duration Swap Scenario:

1.        Two institutions have duration mismatch in their asset and liability portfolios and wish to lock-in their NIMs from undesirable movements of market interest rates.

2.        First-party institution has a positive-duration gap with a cash inflow from long-duration asset portfolio (i.e., fixed rate) and a cash outflow for short-duration liability portfolio (i.e., floating rate).  It is afraid of an unexpected increase in short-term interest rates because such an increase will hurt its target NIM.

3.        Second-party institution has a negative-duration gap with a cash inflow from short-duration asset portfolio (i.e., floating rate) and a cash outflow for long-duration liability portfolio (i.e., fixed rate).  It fears an unexpected decrease in short-term interest rates because such a decrease will reduce its target NIM.

4.        Third-party institution intervenes to arrange interest-rate swaps for both institutions.

 

 

 

Table 11 provides the input variables for both swap counterparties in terms of interest rates underlying their asset and liability portfolios as well as their desirable NIMs.  The following Table 12 includes additional inputs to short-term floating rates in which the first party must pay 140 basis points on top of its HIBOR payment of 4.6 percent whereas the second party shall receive 150 basis points in addition to its LIBOR receipt of 3 percent.  Both parties’ current NIMs and duration gaps are then calculated accordingly.  The pre-swap NIM of the first party was 2 percent whereas that of the second party was –0.5 percent.

 

 

With the target NIMs of 3 percent and 2.5 percent for the first and the second party, which are provided as the inputs in Table 11, the third-party swap arranger has proposed in Table 13 that the first party makes a fixed-rate interest payment of 8 percent it originally received to the swap arranger in exchange of the receipt of HIBOR plus 4.4 percent while the second party pay LIBOR plus 1.5 percent to, and receive 7.5 percent fixed interest cash flow from, the swap arranger.

 

 

In Table 14, both swap counterparties would be able to realize their target NIMs after they adopt the swap deal proposed by the third-party swap arranger.  It clearly follows that the first party’s fixed-rate interest receipt from its asset portfolio and payment to the swap arranger cancel each other out while the floating-rate interest payment to its liability portfolio is less than the floating-rate interest income from the swap arranger, leaving it with a post-swap NIM of 3 percent no matter which direction the market interest rates will change.  The same logic applies to the second party who receive the locked-in, post-swap NIM of 2.5 percent (see Endnote 2).

Strategy 2: Lowering the Cost of Funding through Quality Swap Transactions

The second swap arrangement strategy involves the exchange of interest payments between the two counterparties based upon comparative advantage argument with the objective to minimize the overall costs of financing their liabilities.  Assuming that both parties can borrow their funds from both money market and capital market.  But the credit ratings, which signify the quality of borrower’s creditworthiness, of the two parties differ.  Assuming further that the first party has a higher credit rating whereby it can borrow in both money and capital markets cheaper than the second party.  In this instance, the first party is said to have an absolute advantage in borrowing.

However, when interest-rate spreads between the two parties are calculated based on their ability to borrow in both credit markets, the quality differences, or quality spreads, emerge.  This means that an arbitrage opportunity exists between the two markets for loanable funds.  It also implies that the second party possesses a comparative advantage in borrowing form one market and a comparative disadvantage in the other.  The wider the difference in quality spreads, the more arbitrage opportunity to be exploited and shared between the potential swap counterparties.  To illustrate, the scenario and the following four tables below describe how the strategy for arranging quality swap can be implemented with pre-negotiated swap gain-sharing ratio.

Quality Swap Scenario:

1.        The credit markets for short-term floating rates (i.e., money market) and long-term fixed rates (i.e., capital market) are segmented in which interest-rate arbitrage can exist.

2.        Two institutions are able to access both interest-rate markets and wish to minimize the overall costs of funding their liabilities.

3.        First party has a higher credit-rating quality thereby having an absolute advantage, which enables it to borrow from both the money market and the capital market more cheaply than the second party.

2.        Second party has a lower credit-rating quality thereby having a comparative advantage in one of the two markets, which enables it to borrow from either market more cheaply than the first party where its quality spread is lower.

3.        Swap can be arranged between the two counterparties to share the gain from interest-rate arbitrage based on negotiated gain-sharing ratio.

4.        Third party can intervene to arrange the swap for both counterparties with pre-specified compensation, which can be obtained from the gain from swap.

 

 

 

Table 15 specifies the required inputs for the two counterparties to swap with or without the third-party swap arranger.  The quality spread derived from the money-market borrowing is 1.50 percent whereas the one derived from the capital-market borrowing is 0.75 percent.  The swap gain shown in Table 16, which is the difference between the floating-rate spread and the fixed-rate spread, was 0.75 percent with the comparative advantages lying in the floating-rate borrowing for the first party and in the fixed-rate borrowing for the second party.

 

 

 

With a third-party swap arranger requiring a 10-percent share from the realizable swap gain, the swap counterparties are left with 90 percent to share among themselves.  Assuming that the first party agrees to receive 20 percent of the swap gain and the remaining 70 percent belongs to the second party, the swap gain of 0.75 percent would be distributed accordingly.  The resultant negotiated swap gain turned out to be 0.15 percent (i.e., 0.75% total gain times 20% gain share) for the first party and 0.53 percent (i.e., 0.75% total gain times 70% gain share) for the second party.

As the comparative advantage for the first party lies in the floating-rate borrowing, it should have borrowed from the money market while letting the second party borrow from the capital market.  While the first party paid floating-rate interest of HIBOR plus 0.75 percent to the market, it also expected to receive another 0.15-percent share of swap gain from the second party.  The second party, on the other hand, would pay fixed-rate interest of 7.75 percent to the market and claim its share of swap gain of 0.53 percent from the first party.  The swap parties’ transactions are laid out in Table 17.

The post-swap borrowing costs, as a result, are shown in Table 18 that the first party would finally pay a fixed interest rate of 6.85 percent while the second party would pay a HIBOR plus 1.73 percent.  With swap gain factored in, the first party could pay 0.15 percent lower than it could have paid to the market without a swap and the second party could enjoy a substantial reduction in its floating-rate borrowing cost of 0.53 percent.  At the same time, the swap arranger would pocket 0.075 percent (0.75% swap gain times 10% gain share) whenever such a swap deal was successful.  However, the swap gain shared between counterparties could have been higher should they eliminate the intervention by the third-party swap arranger.

Strategy 3: Minimizing the Cost of Borrowing through Basis Swap Transactions

Basis swap involves an exchange of interest payments that are tied either to the same index with different maturities or to different indexes with the same maturity.  The combination of both features, where spreads between two indices and two maturities exist, is also possible.  For the first two cases, a basis swap can be treated like a quality swap in the sense that there are the arbitrage opportunities to exploit from the segmentations between two different index groups and between two maturities.  With respect to the combination case, which is illustrated below, both basis spread and maturity spread are used to calculate for swap gain to be shared between the two counterparties.

Basis Swap Scenario:

1.        The markets for the first floating rate (e.g., 3-month) tied to one index (e.g., HIBOR) and the second floating rate (e.g., 6-month) tied to another index (e.g., LIBOR) are segmented in which interest-rate arbitrage can exist.

2.        Two parties have access to both interest-rate markets and wish to minimize their costs of borrowing.

3.        Basis spread arises from the difference between the interest rates that each party can borrow from each index.

4.        Yield spread arises from rate difference of the same index that both parties can borrow at different maturities.

5.        Basis swap can be arranged to share the gain from interest-rate arbitrage based on derived gain-sharing ratio.

 

 

 

The costs of borrowing of both swap counterparties are pre-specified in Table 19, with basis and maturity spreads being calculated at both margins resulting in a joint spread – swap gain – of 0.50 percent.  Using a comparative advantage argument based on the basis spread, the first party should pay the 6-month HIBOR, and the second party the 3-month LIBOR, to their respective markets.  In Table 20, the difference between basis gain and maturity gain is 2 percent for the first party while that of the second party is 1 percent.  When the differences between the basis saving and the maturity saving of both counterparties are combined, which is equal to 3 percent, the saving-sharing ratio can then be derived.   The first party will be entitled to a 2/3 share with the remaining 1/3 share belongs to the second party.  Thus, the swap gain of 0.50 percent can be divided between the two parties accordingly, leading to a 0.333 percent cost-saving for the first party and a cost saving of 0.167 percent to the second party.

 

 

 

In Table 21, a swap arrangement follows suit after the cost saving to be shared between the two parties has been established.  To the markets, the first party pays 6-month HIBOR plus 2.75 percent while the second party pays 3-month LIBOR plus 1.25 percent.  To each other, both counterparties swap their interest payments that, in conjunction with the payments to the markets, result in the post-swap borrowing costs of 3-month HIBOR plus 0.67 percent to the first party and 6-month LIBOR plus 3.33 percent to the second party as shown in Table 22.

Conclusion

In today’s constantly volatile global financial markets, individual and institutional investors alike have been more concerned with controlling and managing the risk exposures of their internationally diversified portfolios than improving the portfolios’ return performance.  The search for efficient methods and cost-effective instruments that help these investors manage various financial risks have become a prominent domain in finance study and practice during the last three decades of the twentieth century and to date.  The methods of hedging and insurance had long been utilized by commodity traders and merchants to reduce or eliminate their risks, yet the costs incurred to manage those risks, especially for traded securities, were prohibitively high as the markets for risk sharing had not been well established.  Thanks to the continuing developments of both organized and over-the-counter derivatives markets for futures, options, and swap contracts around the world, all investors are now able to participate in these exciting around-the-clock trading to hedge and/or speculate their portfolio positions at relatively lower transactions costs than in the past despite certain market frictions and differing market microstructure in some geographical areas.

For Hong Kong, the markets for derivative instruments have been placed highly relative to the rest of Asia-Pacific countries in terms of product variety, maturity dates, and trading volume.  Major participants are globally based and competitively active, leading to relentless introduction of new and more sophisticated instruments tailor-designed by financial institutions, corporate borrowers, and organized markets to meet the rising demands of various investor groups.  On the one hand, those who wish to hedge the variability in the market value of their local stock portfolios usually enter into and consequently trade stock index futures contracts in the HSI and Mini HIS Futures Markets.  Short hedgers sell index futures to protect the value of their underlying portfolios in the event of price decline while the long hedgers buy index futures to lock-in the price to be paid for the formation of their portfolios.  On the other hand, those who wish to hedge unfavorable risks of price and return volatility in their underlying portfolios while profiting from the favorable movements in prices and returns could opt to hold appropriate types of financial options.  Buyers and sellers of options in Hong Kong can trade their calls and puts for both individual stocks and stock index using a variety of trading strategies based upon their investment motives and market expectations.  For institutional players in Hong Kong, many OTC markets exist to accommodate the exchanges of their customized contracts such as currency forwards, FRAs, interest rate swaps, and exotic options that have become more essential for their risk management despite the higher transactions costs and counterparty risks than those found in the organized markets.

Needless to say, the fast-pacing development of global derivatives markets in general has undoubtedly benefited financial market participants on various fronts.  Nonetheless, those benefits must be weighed against the potential operational risks involved in the uses of these derivative instruments and contracts.   Other risk dimensions beside counterparty and operational risks include model risks that stem from the design and engineering of those derivative products themselves.  All of these new-breed, higher-level risk exposures are the ongoing research issues confronting both academic and professional worlds of finance in which we are currently living and experiencing.

Key Words

Futures Contracts	Options Contracts	Swap Contracts
Exchange-traded futures contracts	Stock options and Warrants	Interest rate swap contracts
Over-the-counter (OTC) markets	Stock index options	Forward rate agreements (FRA)
Cash or spot markets	European-style options	Interest rate futures contracts (IRF)
Hong Kong Futures Exchange	American-style options	Hong Kong Exchange Fund (HKEF)
Hang Seng Index (HSI)	Long position	London Interbank Offered Rate (LIBOR)
HSI futures contracts	Short position	Hong Kong Interbank Offered Rate (HIBOR)
Red Chip index futures contracts	Option premium	Net interest margins (NIM)
Rolling forex contracts	Payout-protection rule	Asset-liability management (ALM)
Arbitrage opportunities	Intrinsic value of an option	Counterparties to swap
Long hedges	Time value of an option	Comparative advantage
Short hedges	At-the-money options	Notional amount
Cross hedges	In-the-money options	Swap gain
Open interest	Out-of-the-money options	Duration gap and Duration swap
Marking-to-market	Covered call	Quality spread and Quality swap
Initial margin	Protective put	Basis spread and Basis swap
Maintenance margin	Straddle	Yield spread or maturity spread

Endnotes

1.        Continuous discounting and compounding rely on the discount factor of e^–rdt and the compounding factor of e^rdt, where e is a constant equivalent to an approximation of 2.7183, r is a prevailing market interest rate, and dt is the length of time between the discounting or compounding period.

2.        Notice in Table 12.14 that the receipts and payments of cash flow for both counterparties can be easily traced by the different in font faces: the normal font represents original portfolio cash flows, the bold face stands for the receipts from the swap arranger, and the italic font denotes the payments to the swap arranger.

References

Chesterton, Josephine M. and Tushar K. Ghose (1998).   Merchant Banking in Hong Kong.   Butterworths Asia, Singapore.

Fabozzi, Frank J., Franco Modigliani, and Michael G. Ferri (1998).   Foundations of Financial Markets and Institutions, Second Ed.   Prentice-Hall, New Jersey.

Hull, John C. (1998).   Introduction to Futures and Options Markets, Third Ed.   Prentice-Hall, New Jersey.

Rose, Peter S. (2002).   Commercial Bank Management, Fifth Ed.   McGraw-Hill Irwin, New York.