Financial Instrument Case Study

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Question 1
Index observation date| Scenario 1 Closing level of S&P/ASX 200 Index| Scenario 2 Closing level of S&P/ASX 200 Index| Scenario 3 Closing level of S&P/ASX 200 Index| 9 December 2013| 3,847.050| 5,641.000| 7,662.310|

9 January 2014| 3,803.930| 5,705.370| 7,916.180|
10 February 2014| 3,821.420| 5,622.830| 8,133.700|
10 March 2014| 3,811.580| 5,623.730| 8,294.210|
9 April 2014| 3,733.190| 5,785.730| 8,868.370|
9 May 2014| 3,732.870| 5,862.420| 8,620.520|
10 June 2014| 3,771.800| 5,928.520| 8,831.430|
Arithmetic Average| 3,788.834| 5,738.514| 8,332.389|
Initial investment| 100,000.00| 100,000.00| 100,000.00| Initial index level| 4,637.893| 4,637.893| 4,637.893|
S&P/ASX index return| -18.31%| 23.73%| 79.66%|
Investor's return at maturity| 0.00%| 23.73%| 70.00%|
Payoff at maturity| 100,000.00 | 123,731.06 | 170,000.00 |

Question 2
HSBC 100+ Series S&P/ASX 200 Linked Investment can be decomposed to the zero coupon bond(face value : $10,000, interest rate 6% per annum annually compounded), bought call option of price AUD705.2 for the capital protection under S&P 200 index of 4,637.893 and written call option of price AUD40.9 for the return cap level over S&P 200 index of 7,884.418.

The return is based on 7 months’ arithmetic average index. In order to create the similar option payoff, instead of using American or European Options, a similar form of Asian options could be used to determine the maturity payoffs of the options. And this type of options can have benefits to both investors and HSBC.

a) The benefits to the investor
Investors can enjoy returns with lower volatility. Because the process of determining the exercise price is dependent upon the arithmetic average of the index of 7 particular days during 7 month with 30 days of interval, extremely volatile results due to the daily fluctuation of the market can be reasonably avoided. So, by arithmetic average, investors will be able to minimize the risks due to volatilities and seek rather stable returns as the investors of the product would be risk averters rather than risk seekers.

b) Benefits to HSBC
The main characteristic of Asian option is low volatility compared to other options. According to Black Scholes option pricing model, if the volatility is low, the option can also be priced lower. As HSBC needs to minimize the insurance premiums for the protection of the fund, it will try to minimize option premiums and relatively lower prices of Asian options will help HSBC remain profitable. In practice, as the option premiums for the protection of investment is usually expensive, the seller of the product write options and put the cap on investment in order to reduce the total premium expenses. By using Average index for the premium, HSBC could become more profitable as the investment will become more popular and more profitable.

Question 3

Question 4.
Explain how the investor pays for 100% capital protection
In the product, the present value of zero coupon bond that has the face value of $100,000, interest rate 6% of per annum annually compounded, and 4.5 years of maturity is $76,934.9 ( 10,000/(1+0.06)4.5). The difference of AUD23,065.1 between PV of zero coupon bond and initial investment will be used for the purchase of the options to guarantee the initial investment. In addition, HSBC will write the call option that will keep the maximum return up to the cap of 70% of ASX 200 index with the participation rate of 100%. In order to maintain the participation rate of 100%, approximately 21.156 contracts of options should be traded for the initial investment of $100,000. This will be explained in detail in Question 5. As the price of the bought call option for the capital protection is $705.2 and the price of the written call option is $40.9, investors will have to pay $14,323.34[21.156 x ($705.2 – 40.9)] as the insurance...
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