Investors looking to position themselves for a potential revaluation of the yuan, or simply wanting an easier way to trade the largest Hong Kong-listed China stocks, may consider a new set of derivatives products to be introduced today. The new futures and options - based on the FTSE/Xinhua China 25 Index - have been created by Hong Kong Exchanges and Clearing following requests from investors who felt existing index derivatives failed to reflect some of the most significant Chinese companies listed in Hong Kong. 'People like H shares because the concept is very clear and focused, but if you look at the constituents in the H-share index, you are missing out on big companies like China Mobile, BOC (Hong Kong), CNOOC as well as some others,' said Calvin Tai, head of the HKEx derivatives group. 'Also, the H shares are very much oil and energy-related, which means the index is not very broad-based or well-balanced from a portfolio manager's point of view.' China Mobile, BOCHK and CNOOC are incorporated in Hong Kong and are therefore classified as red chips, excluding them from the H-share index. They are all members of the blue-chip Hang Seng Index, but that is of little use for investors who want to focus specifically on companies that derive the majority of their revenues from China. Futures and options are a cost-effective way for investors to either hedge their positions in the cash market or take direct bets on the market's direction. With futures, the investor commits himself to buy a specific product at a set price on a set date while options give him the right, but not the obligation, to do so. Other China-linked derivatives offered by the HKEx have failed to attract much investor interest. Last year, the exchange withdrew a futures product based on the MSCI China Free Index launched in 2001 because there was virtually no trading. In July 2001, it scrapped a red-chip futures product after investor interest in the underlying shares plummeted. But the exchange is confident that the new products will generate better demand. Futures and options based on the H-share index have seen a steady pick-up in daily trading volumes since they were launched about 18 and 12 months ago, respectively. China-related stocks account for about 49 per cent of the average daily turnover in the cash market. More specifically, investors avoided the MSCI product because it was heavily concentrated on just a few stocks, most notably China Mobile, Mr Tai said. The FXI China 25 index, which tracks the 25 most widely followed and liquid Hong Kong-listed H shares or red chips on a free-float adjusted market capitalisation basis, avoids this by capping each stock at 10 per cent at the quarterly index rebalancing. 'Derivatives traders and structured product issuers like this kind of index very much as most of the stocks are easy to trade in and out of,' Mr Tai said. 'When you hold a portfolio or trade a basket of stocks you always worry about the liquidity of the smaller constituents, so limiting the total number of stocks to 25 is a wonderful idea for derivatives trading.' Also, there is already about US$1.2 billion invested in exchange traded funds (ETFs) in New York, London, Amsterdam and Frankfurt based on the FXI China 25 index. If you include an options contract on the New York ETF that trades in Philadelphia, and over-the-counter structured products linked to the index, those assets increase to about US$3 billion, according to the index providers. 'This kind of activity in the OTC and overseas markets gives us a lot of confidence that we will be able to build liquidity, because these people are in need of a hedging instrument to protect their portfolios,' Mr Tai said. The new products should also attract arbitrage traders trying to profit from small price differences between index derivatives and the underlying products. 'We anticipate a lot of arbitrage activity between the index and the basket stocks, either through the cash market or through the overseas ETFs,' Mr Tai said. According to market sources, Hang Seng Investment Management is considering launching an ETF based on the FXI China 25 Index in the local market, making such arbitrage trading even more convenient. Because the FXI China 25 Index has a high correlation with the H-share index but a slightly different return, Mr Tai also anticipates spread trading between the two indices. According to data provided by the HKEx, the FXI China 25 returned 86.7 per cent between May 2, 2003 and April 29 this year compared with 111.8 per cent for the H-share index and 57.9 per cent for the Hang Seng Index.