Callable Bull/Bear Contracts (CBBC) Basics

What are CBBC?

CBBC is an acronym of Callable Bull/Bear Contracts. By investing in a Bull Contract, investors are having a positive view on the underlying asset and intend to capture its potential price appreciation. Conversely, investors buying a Bear Contract are bearish on the prospect of the underlying asset and try to make a profit in a falling market. In short, investors, regardless of their views, only pay a fraction of the underlying price and have exposure to movements in the underlying or index.  

Similar to warrants, CBBC are derivatives that provide investors with a leverage investment in underlying assets and can be utilised for directional trading. Their transaction fees are also resemble to that of warrants. Unlike warrants, implied volatility and time decay are rather insignificant to the pricing of CBBC in the early stage of listing. With the mandatory call feature, the contract must be called right away when the underlying price hits or goes beyond the call price. This may represent a loss equivalent to the total amount invested. 

Though movement of the price of CBBC tends to move closely with the underlying asset, it is affected by a number of factors, including its own demand and supply, financing costs and remaining duration before expiry. In certain circumstances, the price performance of CBBC may not always equal that of the underlying. When the underlying price is close to the call price, the price of CBBC may be volatile with wider spread and lower liquidity. 

In addition, CBBC consist of Category N and Category R: 

	Bull Contract	Bear Contract	Remark
Category N	Call Price = Strike Price	Call Price = Strike Price	No residual value when called.
Category R	Call Price > Strike Price	Call Price < Strike Price	May have residual value when called. But there will not be any residual value in adverse cases.

Examples

The price of CBBC is determined by the difference between the spot price of the underlying and the strike price plus financing costs and then divided by the entitlement. Assume HSBC (0005) share price is $138, Bull Contract’s strike price $110, financing costs $8.8 and entitlement 10:1. Thus, the price of the Bull Contract is equal to $3.68 (being ($138 - $110 + $8.8)/10). Set out below are examples illustrating the value of a Bull Contract upon expiry or when a Mandatory Call Event occurs:

Scenario (1): If not called before expiry

The Bull Contract is not called during the investment period. If HSBC closing price is $128 when the contract expires, based on the formula mentioned above, the value of Category N and Category R Bull Contract at expiry is $1.8 (being ($128 - $110)/10). 

Scenario (2): Category N Bull Contract (strike price = call price = $110)

HSBC spot price falls below $110 and hits the call price before expiry. In this case, the Mandatory Call Event occurs and the trading of the contract terminates. The Category N Bull Contract has no residual value when called and cannot participate in any appreciation in HSBC shares thereafter.

 Scenario (3): Category R Bull Contract (call price = $120, strike price = $110)

HSBC spot price drops below $120 where a Mandatory Call Event occurs. Assume the settlement price is $118. Unlike Category N, Category R Bull Contract may have residual value as determined by the difference between settlement amount and strike price divided by entitlement i.e. ($118 - $110)/10 = $0.8. Of note is the settlement amount must not be lower the minimum trade price of the underlying after the Mandatory Call Event and up to the next trading session. If HSBC share price falls to $117 following the next trading session, Category R Bull Contract will be settled at $117 i.e. ($117 - $110) ÷ 10 = $0.7. 
In the adverse case where the minimum trade price of the underlying is at or drops below the strike price, the Bull Contract may not have any residual value when called.

As discussed above, with the unique call feature, CBBC holders may suffer a loss on the total amount invested earlier. When there is a distance between the underlying price and the call price, CBBC are less likely to be affected by the implied volatility and time decay and the price change is, in theory, rather predictable. The risks associated with the Mandatory Call Event depend on whether the underlying price moves as expected or closes to the call price. The closer the call price and the underlying price, the higher the risks of being called while the investment amount can be reduced. CBBC may not be a suitable investment for all investors. Investors should consider their risk tolerance level and consult professional advisers, where necessary, before investing in the product.