Derivatives can be useful for hedging risks, but they become dangerous when they are used to make leveraged bets in the markets. A former private bank salesman, who wished to remain anonymous, said: 'In retrospect, I think most of the investors underestimated the downside risks. In behavioural finance, this is a classic case study of overconfidence of investors.'
In recent years, most private banks' revenues came from selling equity derivatives products. In comparison, structured products linked to other asset classes, such as foreign exchange, interest rates, credits and commodities, were relatively less important.
While 'minibonds' caused a lot of problems in the retail sector, they were not popular among the private bank clients.
'Minibonds are credit derivatives products. The expected returns for minibonds were too low, as they were just 2 to 3 per cent over the deposit rates,' he said. 'Unlike retail clients, private bank clients have usually bought structured products before, and they won't confuse minibonds with bank deposits. Private bank clients would only go for structured products with much higher expected returns.'
The most popular structured products among private bank investors are equity accumulators and 'worst-of' equity baskets. Both products are constructed by using various stock option contracts, such that their expected returns outperform the underlying stocks. However, with these contracts, investors would make a loss if it is more volatile, or if the stock market goes down significantly. Unfortunately, both scenarios happened at the same time this year.
'In a basic single-stock accumulator, an investor is buying an 'in-the-money' call option with a 'knock-out' feature and, at the same time, he is also selling an 'out-of-the-money' put option at the same strike price. The call option gives the investor some upside up to the knock-out level, and the put option gives the investor unlimited downside.
'Let's look at the call option first. Let's say the current stock is trading at HK$100, the strike price is set at HK$90, and the knock-out is at HK$105. As long as the stock trades higher than HK$90 [the strike price] and lower than HK$105 [the knock-out], then the investor's payoff would always outperform the referenced stock itself by HK$10 [or the difference between the current market price and the strike price]. This is the reason why in the bull market, investors were piling in money for this product.'
