3Year Exchange Fund Note EFN Futures

1

• 3-Year Exchange Fund Note (EFN) Futures
• Market Development and Education Dept.
• Derivatives Market - HKEx
• Nov 2001

2
Trading of 3-Year EFN Futures will commence on
19 Nov 2001
3
Contents

• Fundamentals of bond and bond futures
• Characteristics of EFN
• Key features of 3-year EFN futures
• Contract specifications
• Settlement procedure for physical delivery
• How 3-year EFN futures can work for you?
• Points to note when trading EFN futures
• How to get market information
• Appendices
• Q A

4
Fundamentals of Bond and Bond Futures (1)

• What is a bond ?
• Also known as debt security or fixed income
  security
• An interest-bearing or discounted security that
  obligates the bond issuer to pay interest
  periodically and to repay principal at maturity
  to bondholder
• Repayment schedule based on bond covenant

5
Fundamentals of Bond and Bond Futures (2)

• Types of bond - classified by
• Issuer
• Government bond
• Corporate bond
• Supranational bond
• Par interest rate
• Fixed rate bond
• Floating rate bond
• Zero coupon bond

6
Fundamentals of Bond and Bond Futures (3)

• Relationship between bond price and interest
  rate/bond yield
• Inverse relationship

7
Fundamentals of Bond and Bond Futures (4)

• Relationship between interest rate and maturity
• Positive relationship

8
Fundamentals of Bond and Bond Futures (5)

• Relationship between interest rate and bond
  futures price
• Inverse relationship

9
Fundamentals of Bond and Bond Futures (6)

• Theoretical bond futures price
• Bond price conversion/price factor
• Cheapest-to-deliver bond
• It is the one that the seller of bond futures can
  buy at the lowest cost to deliver at the final
  settlement day.

Refer to Appendix for formula
10
Characteristics of EFN (1)

• Debt securities in HKD issued by Hong Kong
  Monetary Authority (HKMA)
• Direct, unsecured, unconditional and general
  obligations of the HKSAR Government for the
  account of Exchange Fund
• Outstanding amount was HK39.7 billion in Aug 01
• Serve as HKMAs monetary policy instrument

Source HKMA
11
Characteristics of EFN (2)

• A benchmark yield curve for the HKD debt market
• Issue with a maturity of 2-year and upwards
• Listed on the Stock Exchange of Hong Kong
• Issue in denominations of HK50,000 each and
  higher integral multiples

Source HKMA
12
Characteristics of EFN (3)

• Pay fixed interest rate on semi-annual basis
• Redeem at par at maturity
• Recognised Dealers and Market Makers to provide
  liquidity
• Exempt from profits tax and stamp duty

Source HKMA
13
Yield of 3-Year EFN (93/10/26 - 01/6/29)
14

• What is 3-Year EFN Futures?
• A futures contract on 3-year EFN with a coupon of
  6

15
Key Features of 3-Year EFN Futures (1)

• The first bond futures contract in H.K.
• A tool for hedging interest rate risk of holding
  EFN
• The most actively traded EFN(3-year EFN) chosen
  as the underlying
• Inverse relationship between EFN yield and
  futures price (i.e. the higher the yield, the
  lower the futures price)

16
Key Features of 3-Year EFN Futures (2)

• Market making system to enhance liquidity
• Quarterly contract months
• Same trading hours as HIBOR futures
• Two-tier system for position limits and large
  open position

17
Key Features of 3-Year EFN Futures (3)

• Physical delivery of EFN
• At expiry, sellers can elect any EFN with
  maturity between 2.5-3.5 years to deliver to
  buyers
• Take place at the final settlement day which is 2
  business days after the Last Trading Day (i.e
  T 2)

18
Key Features of 3-Year EFN Futures (4)

• Calculation of the Final Settlement Value
• Contract Size x Final Settlement Price x
  Conversion Factor Accrued Interest
• Conversion Factor - A price factor set by the
  exchanges for standardizing different deliverable
  bonds in the event of physical delivery
• Accrued Interest - Interest accrued from last
  coupon date to valuation date or the Final
  Settlement Day

Refer to Appendix for formula
19
Contract Specifications for EFN Futures (1)
Underlying Contract
3-year notional EFN with a coupon of 6
Contract Size
HK1,000,000
Contracted Value
Contracted Price x Min. Fluctuation x 100
20
Contract Specifications for EFN Futures (2)
Contract Months
Quarter months on the Mar, Jun, Sept, Dec
cycle (At launch, available contract months are
Mar, Jun, Sept Dec 2002)
Min. Fluctuation
0.01 of the Contract Size (i.e. HK100)
21
Contract Specifications for EFN Futures (3)
Trading Hours (H.K. Time)
830a.m. - 1200 noon (First Session) 130p.m. -
500p.m. (Second Session)
Trading Hours on the Last Trading Day (H.K. Time)
830a.m. - 1100a.m.
Trading Method
The Exchanges Automated Trading System (HKATS)
22
Contract Specifications for EFN Futures (4)
Price Quotation
A percentage of the Contract Size, at 2 decimal
places
Settlement Method
Physical delivery
Deliverable EFN
EFN with remaining maturity between 2.5years and
3.5 years as at Final Settlement Day
23
Contract Specifications for EFN Futures (5)
Last Trading Day
2 business days before the Final Settlement Day
Final Settlement Day
The 3rd Wednesday of the Contract Month
Final Settlement Value
Contract Size x Final Settlement Price x
Conversion Factor Accrued Interest
24
Contract Specifications for EFN Futures (6)
Position Limits
5,000 in any one Contract Month 1,000 during the
last 6 Trading Days in Spot Month
Large Open Positions
1,000 in any one Contract Month 200 during the
last 6 Trading Days in Spot Month
25
Contract Specifications for EFN Futures (7)
Final Settlement Price
The volume-weighted average price of all trades
recorded during the 5-minute interval in which
the last trade is recorded on the last trading
day If no trade in the contract month is
executed on the last trading day, the final
settlement price will be the previous business
days closing quotation.
Commission Rate
Negotiable
26
Contract Specifications for EFN Futures (8)
Trading Fees Levies (per contract per side)
Exchange Fee HK6.00 SFC Levy HK1.00 Compens
ation Fund Levy HK0.50 Total HK7.50
27
Settlement Procedure for Physical Delivery(1)

• Last Trading Day
• Clearing Participants (CPs) with short position
  of the expired contracts should fax/deliver form
  with deliverable notes and quantity specified to
  HKCC not later than 300p.m.
• HKCC will notify the CPs of the random assignment
  results
• Those delivery positions will still be subject
  to risk management measures

28
Settlement Procedure for Physical Delivery(2)

• Last Trading Day 2 (Final Settlement Day)
• The Short CPs should have confirmation of
  settlement instructions from the Long CPs
• Transfers will be effected upon confirmation
• Inform HKCC with supporting documents by 500p.m
  if either party does not receive fund or EFN

29
Settlement Procedure for Physical Delivery(3)

• Last Trading Day 3
• HKCC effects instructions to recall and repay the
  variation adjustment from those settled delivery
  positions for the period from Last Trading Day
  and Last Trading Day 1

30
How 3-year EFN futures can work for you?(1)

• Portfolio value protection
• protect the portfolio value against falling price
• Locking in a purchase price
• secure a purchase price against rising price

31
How 3-year EFN futures can work for you?(2)

• Return enhancement profit from
• expected directional moves in interest rate
• spread trading (e.g. EFN futures vs HIBOR
  futures)
• arbitrage

32
How 3-year EFN futures can work for you?(3)

• Example directional trading - rise in interest
  rate
• Interest rates have been cut several times this
  year
• An investor expects there is no room for further
  interest rate cut and the rate will start rising
  soon
• Wants to find an effective and low-cost way to
  increase his exposure to changing interest rate

33
How 3-year EFN futures can work for you?(4)

• Example - continued
• Sells 3-year EFN futures contracts in
  anticipation of falling futures price
• If interest rate increases, futures price will
  drop. The investor will make a gain by buying the
  futures at lower price to close out the position

34
How 3-year EFN futures can work for you?(5)

• Example directional trading - drop in interest
  rate
• An investor anticipates the Fed will further
  lower the interest rate this year
• Buys EFN futures contracts to benefit from
  falling rates
• If interest rate drops, the investor will profit
  from selling the futures at higher price to close
  out the position

35
How 3-year EFN futures can work for you?(6)
Example spread trading (EFN futures vs HIBOR
futures)
36
How 3-year EFN futures can work for you?(7)

• Fine-tuning existing risk management strategy
• Change the duration of portfolio or debt/equity
  ratio without interrupting the underlying asset
• Cross-hedge
• used for hedging the interest rate risk of
  semi-government or corporate bond

37
Points to note when trading EFN futures

• Liquidity of EFN futures market
• Market makers enhance the liquidity
• Third (3rd) Wednesday of the contract month as
  the Final Settlement Day
• Physical delivery of EFN
• Sellers should deliver the EFN to buyers
• Margin requirement
• Leverage risk

38
How to get market information ?

• List of real time quote vendors
• downloadable from HKEx website (www.hkex.com.hk)
• e.g. Bloomberg, Reuters
• Non real time information
• Local newspapers
• HKEx website

39
Appendix (1) - Historical development of H.K.
bond market

• 1970s - major debt instruments were medium-term
  HKD certificates of deposit(CD) and commercial
  papers(CPs)
• 1980s - local companies began issuing fixed-rate
  and floating-rate notes, e.g. MTRC and local
  banks
• 1990s -HKMA has taken steps to develop the local
  debt market
• introduced Exchange Fund Bills Program in 1990
• introduced Exchange Fund Notes in 1993

40
Appendix (2) - Comparison of Bond and Equity
41
Appendix (3) - Conversion Factor

• Calculation of conversion/price factor
• C annual coupon per nominal value of HK100 of
  EFN
• n no. of half years from next payment date to
  maturity date
• D no. of days between last and next coupon date
• d no. of days between Final Settlement Day and
  next coupon date

42
Appendix (4) - EFN Calculator
Link www.hkex.com.hk gt Market gt Cash Market gt
Bond Market gt EFN Calculator
43
Appendix (5) - Bond Valuation

• The following formula can be used to calculate
  the theoretical bond price at the settlement day
• PV Present value of the bond at the settlement
  day
• C Payment of period or coupon
• n no. of full interest payment period to the
  maturity day
• i annual discount rate

44

• Q A