Caixin
May 19, 2021 07:48 PM
FINANCE

Snowball Derivatives Offer a Risky Bet on Stock Market Stability

China’s stock markets have been rather tepid in recent months, increasing the popularity of an investment product which is able to offer healthy returns for those willing to bet on stability.

However, the products, which can bring decent returns at best, but crushing losses at worst, have some industry insiders worried.

The so-called snowball (雪球) products are high-risk barrier option (障碍期权) contracts whose value is based on an underlying asset and an ideal payoff is conditional upon the asset’s price remaining within a certain range.

Surging demand

China’s snowball product market has grown rapidly since 2018, the head of the equity derivatives business at a top Chinese brokerage told Caixin. The source said the total value of the snowball products issued by his company jumped to around 10 billion yuan ($1.6 billion) in 2019 from between 2 billion yuan and 3 billion yuan in 2016 and 2017, and then surged to over 50 billion yuan last year.

If interest rates remain low and the stock markets see only slight fluctuation, investment in snowball products may keep growing rapidly, with the largest share grabbed by top brokerages, said the source.

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Most observers expect the A-share market to neither surge nor fall dramatically in the near term. Since falling just under 10% from its peak in mid-February, the benchmark Shanghai Composite Index, a gauge of all stocks traded on the Shanghai Stock Exchange, has been hovering around 3,450 in recent weeks.

Many snowball products issued by major Chinese brokerages are linked to the CSI 500 Index which tracks 500 Chinese mainland-listed small and midsize stocks. It has been relatively stable since around mid-2020. The products usually have a one-year or two-year lifetime with a minimum investment of 1 million yuan.

Bet on stability

A snowball product behaves in different ways. Taking a one-year product linked to the CSI 500 Index as an example, it has monthly observation dates, on which the product will end prematurely if the index has closed above a certain upper threshold, usually set between 3% and 10% higher than its initial reading. In this case, investors will earn a return based on how long they’ve held the product, at an annualized return rate of normally no more than 20%. The longer they hold the product, the bigger the return — like a snowball rolling down a hill.

If the index closes below a lower threshold — usually 20% to 30% down from its initial reading — on any trading day, there will be several possible outcomes when the product matures. If it fails to rebound to the initial reading, the investors will have to bear the losses. If it returns to between the initial reading and the upper threshold, the investor can recover their principal. If it breaches the upper threshold, they can profit based on the same annualized rate of return as above.

The most ideal outcome for investors is that the index fluctuates within the set range, which allows them to hold the contract to expiration to gain the full-year return. However, only 4% of the 121 snowball products linked to the CSI 500 Index over the decade up to 2019 saw this outcome, according to an April report (link in Chinese) by investment bank China International Capital Corp. Ltd. (CICC).

About 71% of the products ended in advance and earned investors a return rate ranging from 1% to 27%, while 25% reported losses ranging from 6% up to 45%, according to the CICC report.

In a word, if investors win their bet that the underlying index won’t drop by as much as 20% in a year or two, they can avoid huge losses or perhaps even earn a handsome return through the snowball.

Unequal design

But if a bet was risk-free it wouldn’t be called a bet.

Investors won’t gain the full profits if the index surges sharply, and still face the prospect of bearing all the losses if it plummets. This ceiling on returns and absence of a corresponding floor on losses to the principal means these products aren’t very investor-friendly, derivatives industry insiders said.

“Investors need to be clearly aware of the risk exposure of this product, which is by no means a fixed-income investment with a stable profit and no loss,” a source close to regulators said.

Some industry insiders have also raised concerns about how these snowball products are designed. The chance to check whether the upper threshold has been breached comes once a month — meaning 12 chances a year for a product to prematurely end and pay out, not to mention some products are designed to remain unchecked in the first three months.

However, the lower threshold is checked every trading day — meaning hundreds of chances every year for investors to possibly lose their opportunity to make a profit.

Contact reporter Luo Meihan (meihanluo@caixin.com) and editor Joshua Dummer (joshuadummer@caixin.com)

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