Insupportoftheirprimaryandsecondarymarketrolesrelatingtotheissueofordinarysharesand hybridsecurities,stockexchangesmayprovideamarketforthetradeofspecificequity-basedmanaged productsandderivativeproducts.Theseproductsderivetheirvaluefromthevalueofanunderlying securityorgroupofsecuritieslistedonastockexchange.Theunderlyingsecuritiestradeintheso- calledphysical market,beingthestockexchange.
Equity-based managed products provide investors with the opportunity to gain a diversified exposure to a market, or a market sector, through a single investment product rather than directly purchasing all the individual securities represented in the basket of securities held in the managed product.Forexample,aninvestorisabletobuyanexchangetradedfund(ETF)whichisbasedon 20majorstockslistedontheASXandrepresentingthemainsectorsintheAustralianequitymarket.
Derivative a risk management product that derives its value from an underlying commodity or instrument Physical market a market in which a commodity or financial instrument is issued or traded
LEARNING OBJECTIVE 4.5
Examine the managed product (exchange traded funds, contracts for difference, real estate investment trusts and infrastructure funds) and derivative product (options, warrants and futures contracts) roles of a stock exchange.
ThevalueoftheETFisbasedonthevalueoftheunderlyingsharesheldbythefundandthevalue movesasthemarketvalueoftheunderlyingsharesmoves.
In the case of an equity-related derivative product, the price of the derivative will be directly correlated with the price of the corresponding equity security quoted on the stock exchange. For example,ontheASX,aninvestormaybuyanoptioncontract(derivative)thatprovidestherightto purchase100CrownResortsLimitedsharesatacertainprice,onorbyapredetermineddate.Theprice oftheoptionwillbebasedonthecurrentpriceofCrownonthesharemarket(physicalmarket).The valueoftheoptioncontractwillchangeovertimeasthepriceofthesharechangesonthesharemarket.
The derivative products available through a stock exchange are described asexchange traded contracts.Themainfeatureofanexchange-tradedcontractisthestandardtermsandconditionsofeach contract.Forexample,anexchange-tradedcontractisbasedonastandardproduct,forafixedamount and will mature on a predetermined date. Alternatively,over-the-counter contracts that are available fromotherfinancialinstitutionsandfundmanagersarenotstandardisedacrossamarket,andterms andconditionsarenegotiatedbetweenthewriterandthebuyerofacontract.
Itshouldbenotedthatthetypesofcontractstraded,andthestandardtermsandconditionsof thosecontracts,willvarybetweenstockexchangesindifferentcountries.
Whydostockexchangesofferarangeofmanagedproductsandderivativeproducts?Themanaged productsallowinvestorstoinvestinassetclassesthatotherwisemaybecomplextomanageordifficultto accessdirectly.Forexample,theexchange-tradedcontractsofferedbytheASXgiveindividualinvestors theopportunitytoaccessabroadrangeofinternationalshareswithinasingleproductlistedonthe exchange.Otherproductsprovideaccesstotherealestatemarketsandtheinfrastructuremarkets.
Derivativeproducts,inpart,giveinvestorstheopportunitytomanage,orhedge,ariskexposurein theirinvestmentportfolio.Forexample,aninvestormightbeexposedtotheriskthatsharepricesmay fallinthefuture.Theinvestormightconsiderusingaderivativeproductthatgivestherighttosellthose sharesatafuturedate,butatapricethatissetinthecontracttoday.Inenteringintosuchacontract, theinvestorhashedged,ormanaged,theriskthatthesharepricewillfallinthefuture.
Derivativesalsoenableaninvestortosyntheticallyrestructureaninvestmentportfolio,suchasby buyinganoptionthatgivestherighttobuyorsellacertainstockataspecifiedpriceatapredetermined date.Ifattheexercisedateinthefuturetheinvestorstillwishestobuyorsellthestock,theinvestoris abletoproceedattheknownprice.
Thescopeofmanagedproductsandderivativeproductsquotedonanexchangeislimitedonly bythedepthofthemarket,thesophisticationofmarketparticipants,theregulatoryenvironmentand competition.Inthischapter,webrieflyconsider:
• exchangetradedfunds
• contractsfordifference
• realestateinvestmenttrusts
• infrastructurefunds
• options • warrants • futures.
DerivativecontractsarediscussedinmuchmoredetailinPart6.
4.5.1 EXCHANGE TRADED FUNDS
Exchange traded funds (ETFs)offeredthroughastockexchangesuchastheASXgenerallyinvestinabasket ofsecuritieslistedontheASX,securitieslistedonaninternationalstockexchange,foreigncurrenciesor commodities.ETFsarepartofaclassofinvestmentscalledexchange traded products (ETPs).
Typically,theETFwillbearegisteredmanagedinvestmentscheme.Investorspurchaseunitsinan ETF.Thefundmanagerofanequity-basedETFseekstotracktheperformanceofabenchmarkstock
Exchange traded contracts standardised financial
contract traded on a formal exchange Over-the-counter
contracts non-standardised contract negotiated between a writer and a buyer
Hedge implement a strategy
that manages or protects against an identified risk exposure
Exchange traded funds (ETFs) units sold in a managed investment scheme that tracks the performance of a specified stock exchange index, foreign currencies or commodities Exchange traded
products (ETPs) group of products that includes ETFs, managed funds and structured products
exchangeindex,suchastheS&P/ASX200,byusingthefundsraisedfromthesaleofunitsintheETF topurchaseasecuritiesportfoliothatreplicatesthespecifiedindex.Forexample,theETFwouldhold allorthemajorityofsharesincludedintheS&P/ASX200index.
ETFs are distinguished from other types of ETPs. While an ETF traditionally tracks the performanceofanindex,othertypesofETPsinvolveactivemanagementstrategies.Active ETFstry tooutperformanindexratherthanmerelytrackingit.ETPsalsoincludestructured products (SPs).
SPsareinstrumentsthatinvolveacompanypromisinganinvestorarateofreturnthatisbasedonthe movementinthepriceofanunderlyingasset,suchasanindex.SPsarequitedifferentinnaturefrom bothETFsandactiveETFs.
BypurchasingunitsintheETFaninvestorgainsaccesstoadiversifiedportfolioofsecurities.The extentofdiversificationwilldependonthebenchmarkindexspecifiedintheETF.Forexample,an ETFthatreplicatestheS&P/ASX200providesexposuretothetop200shareslistedontheASX.The risksinvolvedinETFsincludeexposuretotheupsanddownsintheunderlyingbenchmarkindex.
Shouldaninvestorwishtogainadiversifiedexposuretotheinternationalmarkets,thenanETF suchastheiSharesS&P500givesexposuretotheUSmarkets,whileiSharesS&PEurope350provides exposuretomajorEuropeancorporationslistedonanumberofEuropeanexchanges.ThelistofETFs offeredbyastockexchangewillbefoundontheirwebsite.TherisksinvolvedwithETFsthattrack overseasindicesincludeexposuretothevolatilityofthoseindexesandcurrencyrisksiftheinvestments aredenominatedinaforeigncurrency.
MostETFsareopen-endedfunds;thatis,thenumberofunitsofferedbyafundisnotfixed.For example,ifdemandforunitsinaparticularfundincreases,thefundmanagercanincreasethenumber ofunitsonoffer.ThisensuresthatunitsintheETFtradeatornearthenetassetvalueofthesecurities heldinthefund.
UnitsinanETFareboughtandsoldthroughastockexchangeinexactlythesamewaythatordinary sharesoflistedcorporationsareboughtandsold.TherehasbeenstronggrowthintheETFsector inAustralia.Assetsundermanagementreached$25billionin2018.MostETFsinAustraliainvest inAustralianequitiesandinternationalequities.However,someventureintofixedincomesecurities andcommodities.TheinnovationinthetypesofproductsofferedasETFsorETPsprovidesmore opportunitiesforinvestorsbutalsoraisesconcernsabouthowwellthoseinvestorsunderstandtherisks thatareinvolved.
4.5.2 CONTRACTS FOR DIFFERENCE
Acontract for difference (CFD)isacontractlistedonastockexchangethatisanagreementbetweena buyerandsellertoexchangethedifferenceinthevalueofaCFD.Thedifferenceinvalueiscalculatedby subtractingthevalueoftheCFDcontractatthestartdatefromthevalueofthecontractattheclosedate.
TheCFDmaybebasedonanominatedsecuritylistedonalocalorinternationalstockexchange, stockexchangeindices,foreigncurrenciesorcommodities.Forexample,aCFDmaybebasedonBHP BillitonLimitedshareslistedontheASX.ThevalueoftheCFDisdirectlycorrelatedwiththevalueof theunderlyingBHPsharesatthestartandclosedatespecifiedintheCFDcontract.
ACFDprovidesahighlevelofleverageforaninvestorasthebuyerofaCFDonlypaysadeposit orinitialmargin;thatis,theinvestordoesnotpaythefullvalueoftheunderlyingshares.Thismeans thataninvestormaybeabletotakeamuchlargerexposuretothemarketinthatmoreoftheunderlying securitycanbeboughtorsoldbecausefullpaymentisnotrequiredtobemadebythepurchaserupon executionoftheCFD.
However,therisksassociatedwithleveragearemuchhigherasthefullgainorlossassociatedwith theunderlyingsecuritywillbemadewhentheCFDisclosedout.Therefore,investorsmustunderstand theupsideandthedownsideriskassociatedwithaleveragedinvestmentsuchasaCFD.
AninvestormayuseaCFDtogolonginarisingmarket,orgoshortinafallingmarket.
Forexample,ifaninvestorbelievesBHPBillitonsharesaregoingtoriseinvalue,theinvestor mighttakealongpositionbybuying1000BHPBillitonCFDat$43.25pershare.Thevalueofthe
Active ETFs a type of ETF that deploys strategies designed to outperform a market index Structured products (SPs)
instruments that promise a rate of return based on the movement in the price of some asset
Contract for difference (CFD) an agreement between a buyer and seller, based on an underlying security, to exchange the difference between the contract start and close values
CFDis$43250,buttheinvestorwouldonlypay,say,a10percentdepositof$4325.00.IfBHPBilliton sharesaretradingat$45.76ontheCFDclosedate,thentheinvestorwouldmake$2510profit.Thisis a58.00percentreturnontheinitialcapitalinvestment.
Ifaninvestorbelievesthatthemarketisgoingtofall,thentheinvestormaydecidetosellaCFD;
thatis,takeashortposition.IftheunderlyingsecurityoftheCFDfalls,thentheinvestorwillmakea profit,butifthesecurityrisesinvalue,theinvestorwillmakealoss.ACFDhasnoexpirydatesothe positionhastobeclosedbyconductingareversetrade.
4.5.3 REAL ESTATE INVESTMENT TRUSTS (REIT)
Areal estate investment trust (REIT)purchasespropertyandholdstheassetswithinatrust.Unitsin theREITmaybelistedonastockexchangeandtradedinthesamewayasordinarysharesinlisted corporations.Becauseinvestorsarebuyingunitsinthelistedtrust,theygainaccesstoadiversifiedreal estateportfoliothatotherwisewouldnotbepossiblefortheaverageinvestor.Forexample,aninvestor maypurchaseunitsworth$5000inaREIT,whereas,withthatsmallamount,theinvestorcouldnot purchasepropertydirectly.
ThetypeofpropertyheldinaREITwillbespecifiedinthefund’strustdeed.Thecategoriesof propertythataREITmaypurchaseinclude:
• industrial—suchaswarehouses,factoriesandindustrialparks
• hotelandleisure—includinghotels,themeparksandcinemacomplexes
• retail—inparticularmajorshoppingcentres
• office—suchasmulti-storeyofficebuildings.
Investors may benefit from both capital gains on the property assets as well as rental income generatedbytheproperties.Also,unitsinalistedREITaremuchmoreliquidthantheunderlying property;thatis,itiseasiertoselltheunitsthanitistoquicklysellthepropertyheldinthetrust.
4.5.4 INFRASTRUCTURE FUNDS
Aninfrastructure fundisamanagedfundthatmaybelistedonastockexchangeandenablesinvestors togainaccesstoinvestmentopportunitiesinlarge-scaleinfrastructureprojectssuchastollroads.
Infrastructureprojectsarenormallymulti-milliondollarprojectsandthereforebeyondtheinvestment capacityoftheaverageinvestor.Theinfrastructurefundacceptsfundsfromalargenumberofinvestorsto createasignificantpooloffunds.Thisenablesthefundmanagertotheninvestinthesetypesofprojects orassets.Returnstoinvestorsmaytaketheformofcapitalgainsandincomegeneratedfromtheproject.
Forexample,atollroadwillgenerateincomefromthetollchargedforvehiclestravellingonthetollroad.
Thecategoriesofinfrastructureassetsheldinafundmightinclude:
• utilities—suchaspowerstations,electricitytransmissionlinesandgaspipelines
• transportandmaterialshandling—includingrailwaylines,airportterminals,portanddockfacilities
• communicationfacilities—suchasbroadcastingandcommunicationtowersandnetworks.
The income earnings from many infrastructure assets are quite predictable as they are often regulated or guaranteed by government. Also, infrastructure projects typically have high barriers to entry(costs,technology,regulation)andthereforelowlevelsofcompetition.
4.5.5 OPTIONS
Anoptioncontractgivesthebuyeroftheoptiontheright,butnottheobligation,tobuy(call option) orsell(put option)aspecifiedsecurityatapredeterminedprice,onorbeforeapredetermineddate.
Real estate investment trust (REIT) managed funds that provide investors with the opportunity to invest in a range of property categories such as industrial, hotels and retail
Infrastructure fund managed fund that
provides investors with the opportunity to invest in infrastructure assets such as toll roads and utilities
Call option gives the buyer the
right, but not the obligation, to buy a specified commodity or financial instrument at a specified price and date
Put option gives the buyer the
right, but not the obligation, to sell a specified commodity or financial instrument at a specified price and date
Thebuyeroftheoptionmustpayapremiumtothewriter,orseller,oftheoption;thatis,thewriterof theoptionissellingarighttotheoptionbuyer.
For example, an investor who holds Santos Limited shares in an investment portfolio might be concernedthatthesharepricewillfallintheneartermbutdoesnotwanttosellthesharesatthistime.
Theinvestormayimplementanoptionsstrategytoprotectagainsttherisk.Theinvestormaydecideto buyaputoption,whichgivestheinvestortherighttosell,say,1000Santossharesatanexercise priceof
$7.00persharewithinthenextthreemonths.Thepremiumpaidtotheoptionwriterisquotedat$0.20 pershare.Assumethatthesharepriceactuallyfallsto$6.00;theoptionbuyerwillthenexercisethe optionandsellthesharesat$7.00,orreceiveacashsettlementfromtheoptionwriter.Theinvestorhas protectedtheinvestmentportfoliototheamountoftheexercisepriceminusthecurrentmarketpriceless thepremiumpaid,multipliedbythenumberofshares;thatis,1000($7.00−$6.00−$0.20)=$800.
Aninterestingfeatureofanoptioncontractisthatiftheinvestordecidesnottoselltheshares, perhapsbecausethepriceinthesharemarkethasactuallyrisen,thereisnoobligationtoproceed.In thiscase,thecosttothebuyeroftheoptionistheinitialpremiumpaidtobuytheoptioncontract.
A stock exchange may quote on a range of different types of option contracts, including stock options, index options, flexible options and low-exercise-price options. To find out more about the variousoptioncontractsofferedontheASX,youcanlookontheinternetatwww.asx.com.au.Option contractsarederivativecontractsandarediscussedingreaterdetailinChapter20.
4.5.6 WARRANTS
Anotherderivativeproductquotedonastockexchangeisthewarrant.Awarrant issuer,suchasabank, must be authorised by the stock exchange to write warrant contracts. The warrant issuer is able to determinethetermsandconditionsthatwillapplytoaspecificwarrantseries,butthewarrantisthen quotedandtradedonthestockexchange.
Warrantissuersarerequiredbytheexchangetomakeamarket;thatis,theymustquotebothbuy andsellpricesontheirwarrantseries.Callandputwarrantsarequoted;acallwarrantholderwill benefitfromanupwardpricemovementintheunderlyingphysicalmarketsharepriceorindex,whilea putwarrantholderwillbenefitfromadownwardmovementinprices.
Anequity-basedcallwarrantgivesthewarrantholdertherighttobuytheunderlyingsecurityata particularprice,onorbeforeapredetermineddate.Similarly,aputwarrantgivestherighttosell.
Instalmentwarrantsareoftenattractivetoinvestorsastheygivethewarrantholdertherighttobuy theunderlyingsharesbypaymentofanumberofperiodicinstalments,butstillbeentitledtoreceive anydividendpaymentsandfrankingcredits.GenerallythereareonlytwoinstalmentsonASXquoted instalmentwarrants:aninitialpartpaymentandanoptionalfinalpayment.
Astockexchangemaylistanumberofdifferenttypesofwarrantcontracts.(Arangeofwarrant contractsisdiscussedinChapter20.)Youcanobtainfurtherinformationonwarrantcontractsoffered ontheASXatwww.asx.com.au.Similarly,othernation-stateexchangesalsoprovidedetailsoftheir particularcontractsontheirwebsites.
4.5.7 FUTURES CONTRACTS
Anothertypeofderivativeproductthatmaybequotedonastockexchangeisthefuturescontract.
A futures contract is a contract between two parties to either buy or sell a specified commodity or financialinstrumentattheexpirydateofthecontract.Thevalueofthecontractatcommencement,and attheexpirydate,willrelatetothepriceoftheunderlyingphysicalmarketpriceateachofthosedates.
Settlementofthecontractwillbespecifiedinthecontract,andmaybebydeliveryoftheunderlying security, such as a share, or by payment of a cash equivalent. The underlying security of a futures contractmaybeaparticularshareofalistedcompanyorastock-marketindex.Stock-marketindicesare discussedinChapter6.FuturescontractsarediscussedindetailinChapters18and19.
Exercise price the price specified in an options contract at which the option buyer can buy or sell
Warrant
a financial instrument that conveys a right in the form of an option Warrant issuer a third party, such as a bank, authorised by a stock exchange to write warrant contracts
Notallstockexchangesofferalltheaboveproducts.Stockexchangeswilloffermanagedproducts andderivativeproductsonlyifthereissufficientdemandandliquidityforaparticularproduct.Also,in somecountriestheregulatormayrestrictthetypesofproductsoffered.InAustralia,theASXprovides alltheaboveproducts.
R EFLECTION POINTS
• Stock exchanges may list a range of managed products and derivative products. These standardised products are known as exchange-traded contracts.
• Exchange traded funds (ETFs) usually invest in a basket of securities listed on the local or international exchanges, foreign currencies or commodities. ETFs provide access to a diversified portfolio of securities. ETFs are just one type of exchange traded product (ETP).
Other ETPs include active ETFs and structured products (SPs).
• A contract for difference (CFD) is an agreement to exchange the net difference in value between the start date and the close date of a CFD. The CFD is based on a specified security.
Only a deposit is paid initially, therefore the CFD is highly leveraged (increased risk).
• A real estate investment trust (REIT) issues units in the trust in order to raise funds to purchase property, including industrial, hotels and leisure, retail and office. Assets generate rental income and (hopefully) capital gains.
• Infrastructure funds enable investors to gain access to large-scale infrastructure projects, such as utilities, transport, materials handling and communications facilities.
• An option contract gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) a specified security at a predetermined price and date. The writer of the option receives a premium payment from the option buyer.
• An equity warrant gives the holder the right to buy (or sell) the underlying security at a specified price on or before a nominated date. Stock exchanges list a wide range of warrant contracts.
• A futures contract is an agreement between two parties to buy (or sell) a specified commodity or financial security at a specified date in the future. The value of the futures contract moves as the price of the underlying asset in the physical market moves. Settlement may be for delivery of the asset or cash.