Risk doesn't always balance reward

Full story published in the South China Morning Post

The third part of a series on financial products and practices takes a look at equity-linked deposits

I think I have mentioned this before: risk should balance reward.

That is a pretty simple rule and probably one that applies to more than just finance.

If you are going to go base jumping or scuba diving with sharks, the principle is a bit difficult to quantify. But when looking at which financial products to buy, it is a lot simpler.

A perfect example is the equity-linked deposit. This is a retail product banks pitch as a way for investors to gain more interest on their savings than they can get on a term deposit and such deposits can offer interest of as much as 10 per cent. This of course looks pretty attractive, but the equity-linked deposit is very different from a term deposit.

The way it works is this: the bank will offer you a one-month deposit with an interest rate of something like 10 per cent, linked to an individual stock, for example, China Mobile (SEHK: 0941, announcements, news) . The stock will have a strike price that is at a 5 per cent to 10 per cent discount to its market price.

At the end of the month, if the market price of China Mobile is above the strike price, you get back your deposit plus the high interest.

If the market price is below the strike price, you get the stock plus the interest. The number of shares you get will be based on the strike price and not the market price.

One of the important things to notice in our example (see chart) is that 10 per cent interest sounds like a lot, but the advertised rate will be on an annual basis. Over 30 days, 10 per cent annual interest is only 0.822 per cent (10 per cent multiplied by 30 divided by 365).

So, over the 30 days, the most an investor can expect to make on this product is 0.822 per cent. But then, this might not be too bad given that at current rates you would have to put your money in a term deposit for a bit more than 82 years to make the same amount. However, if the China Mobile stock were to drop 10 per cent over the same 30-day period, the loss that an investor would suffer would be 2.3 per cent, which on an annualised basis would not be a 10 per cent gain, but a 27 per cent loss.

The other thing that is obvious from our example is that if the China Mobile stock price was to rise during the deposit period, the investor does not get the benefit. A 10 per cent rise in the value of China Mobile stock over the deposit period would translate into an annualised return of 122 per cent for a China Mobile stockholder, but would still only represent a 10 per cent annualised return for the equity-linked-deposit holder.

So, in a nutshell, the most an investor who buys an equity-linked deposit stands to make is the interest rate. In return for this, the investor takes equity-market risk on the linked stock.

The only theoretical limit to this risk is the investor's principal.

There is obviously nothing wrong with taking equity-market risk, but investors who do so generally expect equity-market returns.

And that is the mismatch with the equity-linked deposit. The investor forgoes the equity-market return for a fixed-interest rate, but still takes equity-market risk. You will notice that the equity-linked deposit is pretty similar to the currency-linked deposit I wrote about a few months ago. It is exactly the same structure. The only difference is what the deposit is linked to.

The bank could theoretically put together the same structure with any number of underlying assets. Commodities, bonds or gold would do just as well. I imagine that if you really wanted to buy a pork-belly-linked deposit, then there will be someone out there prepared to sell it to you.

So, what's in it for the banks? Sure, if the equity (or whatever) loses money the bank looks like it comes out ahead. But if the underlying asset either stays flat or rises, doesn't the bank end up losing money by paying out such high interest? Well, no. From the bank's point of view, what it is doing is buying a "put" option from you. A put option is a fairly common financial derivative under which one party agrees to sell the other a particular asset at a fixed price at some point in the future, but only if the purchaser exercises the option.

If you sell me a put option for China Mobile shares with a strike price of HK$65, you are agreeing to buy China Mobile shares from me at HK$65 if I want you to.

I don't have to sell you the shares; that's my option. But if I do decide to sell you the shares, then you have to buy them at the pre-agreed price. I can "put" the shares to you.

When you sell this put option to me, you are taking a risk. I won't exercise the put option if the market price of China Mobile is above HK$65. Why would I want to sell China Mobile shares to you at HK$65 if I can sell them on the market for more? But if the market price drops below HK$65, I will certainly sell the shares to you.

Say the market price of China Mobile drops to HK$60. Then when I exercise the put option I will be selling China Mobile shares to you for HK$65 even though I can buy them for HK$60. I will make HK$5 a share. And you will lose HK$5 a share.

If the market price is HK$70 I won't exercise the option and no one will make or lose any money.

So the only person in this example who can make money is me, and the only person who can lose money is you. And you won't take this risk without being compensated for it.

So when you sell me the put option, the sale price, the amount of money I need to pay you to take this risk, will reflect how likely you think it is that you will lose money.

So when you enter into the equity-linked deposit in our example, you are actually selling the bank a China Mobile put option. And the bank pays you for this put option, but it calls that payment "interest". In our example above, the bank pays the investor HK$822 in return for a put option under which the bank has the option to sell you 1,538 China Mobile shares at HK$65 in 30 days.

You take the risk that if China Mobile falls below HK$65 at the end of 30 days, the bank will put the shares to you, and the bank pays you HK$822 in return. I imagine that quite a few investors will be surprised to learn that when they thought they were buying a term deposit with a high interest rate, they were in fact entering a derivative contract with the bank.

Having realised this, the obvious question is, what is this derivative contract really worth? In our example, the bank is buying the option from you for HK$822, or HK$0.53 per share. Is that what it is actually worth?

Calculating the value of stock options is incredibly complicated. Mathematicians work for years to produce option-pricing models with funky names like the "Monte Carlo simulation", the "binomial tree" and probably the best known "Black-Scholes Model".

These kinds of models use concepts such as probability, volatility and time value of money to come up with theoretical prices for derivatives.

Now, I'm no expert on this stuff, but based on my analysis, the option value of our equity-linked deposit or put option is something like HK$2,700, or around HK$1.75 per share. So if the bank could buy it for HK$822, or HK$0.53 per share, it's getting a bargain. If you look at this equity-linked deposit as a put option, then, technically, it would only be a good deal if the interest rate were 33 per cent, not 10 per cent.

The tricky part about this analysis is, as I mentioned, that calculating option values is not simple.

You could try asking the investment adviser at any of the banks around town what the option value is of the equity-linked deposit they are trying to sell you, but you're sure to get a blank look. You can assume, though, that somewhere in the bank, probably surrounded by computer screens in another country, there is a guy who knows exactly what the product's option value is.

Aside from the one or two readers out there who understand the mathematics of options valuation, or those who have a Bloomberg terminal on their desks, your average investor is at a bit of a disadvantage when buying derivatives from a bank.

On one side of the transaction there is a sophisticated financial institution with a team of mathematicians and proprietary models calculating the value of their products in an instant. And on the other there is you.

I mentioned the imbalance between risk and reward of the equity-linked deposit. Well, here is one more imbalance - only the bank knows what it is really worth, and it is selling these things to make money.

Risk doesn't always balance reward

Sunday, June 7, 2009