You have probably heard stories about investors suffering massive losses from investing in stock or foreign currency accumulators. Investors should be aware that although accumulators, or products of a similar nature, by whatever names they are called, appear to be associated with attractive returns under certain circumstances, they are actually high risk investment products with embedded derivatives.
Investors may find accumulators attractive as the products generally allow them to buy (or “accumulate”) an agreed number of contract units of the underlying asset, such as a stock or a foreign currency, at a “discount” to the prevailing market price of the underlying asset (i.e. strike price) at the date of the contract. This is because accumulators involve a series of options. The “discount” in fact comes from the premium the investor receives from selling the options to the counterparty of the accumulator contract and, as a result, the investor is obliged to purchase (from the counterparty) an agreed amount of the underlying asset at the strike price. Therefore, the more options sold, the larger the “discount” but the risks also rise accordingly for the investor.
Investors make a gain on the trading days within the contract period when the market price is above the strike price. Nevertheless, the upside is usually capped, for example, by a knock-out clause which provides that if the market price of the underlying asset is at or above the knock-out price, the accumulator contract will be terminated (i.e. the investor will cease to accumulate any further underlying asset from the knock-out date).1 This effectively means that investors have taken the view that the price of the underlying assets will move within the defined range between the strike price and knock-out price. During periods of high market volatility, such as the recent market situation, this fundamental assumption may be unrealistic and investors need to exercise extra caution at such times.
Also, despite their apparent attractiveness, accumulators are in fact associated with significant investment risks. Among others, the investor is bound by the contract to take up the daily contract units of the underlying asset (at the strike price) when the market acts against the investor, i.e. when the market price falls below the strike price (this is the risk associated with selling put options). The downside risk is magnified when the contract includes a “multiplier” condition (i.e. the investor is obliged to take up multiple times of the daily contract units of the underlying asset when the market turns against the investor). In these circumstances, the investor will suffer even greater losses. In the extreme case where the price of the underlying asset falls to a very low level or even zero, the investor would find that he or she is still bound by the contract to purchase the underlying asset at the strike price. Furthermore, the longer the contract period, the larger the number of contract units of the underlying asset an investor is obliged to purchase during the whole contract period, and thus the riskier the product.
A similar product called “decumulators” also involves the investor writing a call option to the counterparty, but the mechanism works in the opposite direction to accumulators. In the case of decumulators, the investors agree to sell a fixed number of underlying assets on a regular basis at the strike price. As the price of the underlying assets may rise higher and higher, the downside risk is theoretically unlimited and the risk to the investor can be a bottomless pit.
Therefore, investors should understand the features and risks associated with accumulators thoroughly, and ensure they have the ability to honour all contracts, taking into account the “multiplier” effect (if applicable), before deciding to invest in these products. Some may invest in accumulators with the intention of hedging against their exposure to the relevant underlying assets. However, they should be aware that accumulators with knock-out clauses or other features to cap the upside may not serve their intended hedging purpose. They should also note that if the maximum exposure associated with the accumulator contracts are materially larger than their positions or inflows/outflows in the underlying assets, they will be over exposed instead of hedged. More importantly, investors should not treat accumulators as a hedging tool for decumulators or vice versa.
As many banks offer credit facilities for their customers to invest in accumulators, the ability to transact on a margin basis can magnify the investor’s potential gain, but at the same time magnify the potential loss. Investors who plan to enter into accumulator transactions on a margin basis should note the additional risks associated with leveraged trading. In particular, they need to be prepared to pay interest for the margin facility and to meet margin calls, which require them to make top-up payments to cover the estimated full mark-to-market losses for the remaining period of the contract. The margin calculation is basically linked to the market value of the accumulators, the market value of the investor’s asset portfolio pledged with the bank and the margin level designated by the bank. All these factors can turn against the investor in poor market conditions, and the top-up payment can be substantial, in such circumstances.
In addition, in poor market conditions, investors may have to meet margin calls at short notice while their ability to make top-up payments may be much worse than during normal times, due to the significant fall in the market values of other financial assets. Investors should bear in mind that banks usually reserve absolute discretion to raise the margin level and this can add further liquidity pressure on the investors. When the investors fail to meet the margin calls, they will be forced to close out the contract and bear the costs and losses. In adverse market conditions, the investors may not be able to terminate the accumulator contracts early to cut losses, and even if the bank consents to the customers’ request for early termination, the investors are likely to incur unexpectedly high exit costs and losses.
Given the inherent risks of accumulators as mentioned in the above paragraphs, the HKMA issued a circular in December 2010 to all authorized institutions (AIs) reminding them to adopt a cautious approach when selling accumulators. In particular, AIs were reminded to ensure the suitability of a recommendation to or solicitation of a customer in respect of accumulators. AIs were asked to sell accumulators only to investors who could fully understand the structure and risks, had the risk appetite for acquiring the underlying assets with leverage, and had the ability to withstand the potential financial loss. The HKMA said that, as a general principle, it expected that AIs should only sell such products (in whatever names they are called) to professional investors as defined in Part 1 of Schedule 1 to the Securities and Futures Ordinance (e.g. institutional investors or individuals having a portfolio of not less than HK$8 million).
Investors need to play their part and should not hesitate to raise questions to the intermediary selling them the product to ensure that they thoroughly understand the risks and features of the products (including the potential loss and conditions for meeting margin calls) in which they intend to invest. This can also be done by obtaining copies of relevant product documents in their preferred language and reading the documents carefully. As a rule of thumb, before entering into any investment transactions, investors should always understand the worst-case scenario, and the maximum cost and exposure they potentially face. This will enable them to decide whether they are ready and have sufficient net worth to bear the investment risks and absorb the potential loss, which can be very substantial, in return for the chance of making a profit. Always remember, do not invest if you don’t understand the product.
Executive Director (Banking Conduct)
28 September 2011
1 Some products limit the upside by capping the maximum gain, for example, for each observation period (i.e. potential gain for each observation period is capped that there will be no incremental gain for that observation period if the market price of the underlying asset increases beyond a pre-defined price), or on an aggregated basis (i.e. the accumulator contract will be terminated if the investor’s gain from the contract aggregates to a pre-defined amount).