Guide for the More Experienced

The Guide for Beginners: How is the CBBC price determined? has explained that, in addition to the intrinsic value, the CBBC price also includes certain funding costs.

The sale of CBBCs by issuers is similar in nature to the provision of a margin facility (in the case of bulls) and lending stocks for a short sale (in the case of bears), hence the issuer charges certain funding costs for hedging against their own costs. Methods to calculate funding cost vary with different borrowing rates used by the issuers.

In practice, since the issuer cannot collect the funding cost from investors holding the CBBCs on a daily basis during the holding period, the issuer will first take into account all the funding cost up until the expiry date when calculating the CBBC price, and then gradually deduct it over time. If an investor sells a CBBC before expiry, he can recover the un-deducted funding cost from the issuer.

Some investors may compare the deduction of funding cost for a CBBC with the time decay of a warrant. However, the two are not the same concept. In addition, the funding cost of a CBBC only accounts for a very small part of the price, while time decay accounts for a large part of the value of a warrant, and even the total value of an out-of-the-money warrant. The impact of the deduction of time decay on the price of a warrant is much more apparent than the impact of the deduction of funding cost on a CBBC.

The funding cost of a CBBC depends mainly on the underlying asset and the tenor.

For assets such as the HSI CBBCs which are traded very actively and have a relatively low cost of trading and borrowing, the premium of the relevant CBBCs will also be lower.

However, for some second and third tier stocks which are less active and have a higher cost of borrowing, or some stocks with a high volatility, the issuer will build in more buffers after measuring the possibility of gaps, so the funding cost is also higher; examples are stocks in the gambling and mobile device sectors.

Moreover, the funding cost of a CBBC with a longer tenor is also higher since it involves a longer period of borrowing or stock borrowing, which increases the issuer’s cost.

The nature of a bull is similar to the provision of margin financing; that is, the issuer is lending money to the investor to buy the stocks. The investor can benefit from the movement of the asset at a low cost. The cost saved by the investor is equivalent to the financing provided by the issuer.

The nature of a bear is similar to short-selling; that is, the issuer is lending assets to the investor for short-selling in advance. After the asset price falls, the investor then buys the assets to close the trade, thereby earning the price difference. So this is equivalent to the issuer lending the assets. Since there is a cost for financing and asset lending, the issuer needs to collect the funding cost.

The cost of stock borrowing is generally higher than the cost of funding, so even for a bull and a bear with similar underlying assets and similar tenors, the funding cost of the bear will be higher than that of the bull.