Hong Kong investors are natural born gamblers. First reaction to any stock tip is likely to be: where can I buy the warrants? Equity derivative activity has grown massively out of such chutzpah. Yet, despite this famed appetite for risk, faddish enthusiasm for new products is rare. Reflecting the Hong Kong business culture, investors know what they do best and tend to stick with it. Perhaps for this reason only two types of equity derivatives have ever properly caught on. Hang Seng Index futures and covered call warrants on local stocks are popular, fantastically liquid and easily understood. By contrast attempts to introduce other products have met with varying degrees of failure. Now, the stock and futures exchanges are launching stock options and futures on two red-chip companies in the light of huge turnover and price volatility. A market that spreads risk around is a safer market being the reasoning. That this argument goes largely unchallenged - outcry greeted the launch of stock futures two years ago - is testament to Hong Kong's financial sophistication. It also reflects the less than intimidating record of stock futures and options since their launch. The latest products come as red-chip activity dominates investor attention. Trading in China-backed companies has approached that of blue chips in recent months. Market appetite has been revved up by a host of individual stock and basket warrant issues. By launching derivatives on China Resources Enterprise and Shanghai Industrial Holdings the two exchanges hopes to tap the huge liquidity in red chips. Investors who want leveraged exposure can buy either product - those wanting to short the stock will be likely sellers of futures. The test of success will be seen in the open interest numbers. To date, stock futures have attracted precious little attention and option activity is concentrated in a handful of shares, dominated by HSBC Holdings. Many property stocks, supporting vibrant covered warrant activity, generate pitiful option turnover. Exchange officials had hoped to convert warrant investors into using their listed contracts. Warrants are, after all, options by another name. Instead, investors have stuck with what they know. A long-time criticism of stock futures is they add little value. Sellers have the cheaper alternative of borrowing stock and directly short-selling through normal channels. Since the two red-chip stocks chosen are deeply liquid - and easy to borrow - it is hard to see a vibrant market developing. The exchange will hope that potential option buyers take a close look at their prices compared to counterpart warrants. Relative value is expressed in terms of implied volatility. Hong Kong warrant investors have long ignored the huge volatility premium that banks price into warrants. With a publicly listed alternative providing a ready benchmark it is to be hoped that pricing of red-chip derivatives becomes more transparent. The biggest users are likely to be market professionals. Whenever banks issue warrants they hedge themselves against moves in the underlying stock. Violent price movements over recent weeks have pushed banks into frantic covering activity. In the case of basket warrants and those on more illiquid stocks this has proved difficult. Most traders resort to trading over-the-counter options with fellow banks. The exposure runs from investors to banks in a seemingly endless chain of risk being passed around the market. Although most transactions tend to be bulky and unsuitable for a newly listed options contract, bringing activity into the public arena must improve market transparency. Stock exchange chief executive Alec Tsui Yiu-wa is right to say well-managed derivative trading reduces volatility in underlying shares. Volatility ultimately reflects the shifting emotions of investors. By giving another tool for venting that passion the risk of exaggerated movements should be reduced.
