What Is Accumulator And How Does It Function Finance Essay

In 2007, accumulator or decumulator was really famous in USA and Hong Kong among every private banks. Private banks’ clients had made much benefits every day at that time. But that good time would not last forever, in the recent bear stock market, these buyers are incurring huge losses each day with these accumulator contracts during the bull year. And the mass media has given a appropriate and interesting nickname of “I kill you later” to accumulator.

What are these accumulator contracts and how it functions actually?

If you have learnt what is option, they contain of one long in-the-money call option, and two short out-of-the-money options.

Accumulators( also called share forward accumulators) are financial derivative products sold by an issuer/seller to the investors/the buyers that require the issuer to sell stock shares of some underlying security at a predetermined strike price, settled periodically. This product let the buyer accumulate holdings in the underlying security over the term of the contract.

The basic idea of an accumulator contract is that the investors speculate a company will trade between a certain price range( the range between the strike price and the knock out price) within the contract period and the seller bets that stock will fall below the strike price.

Then the stock accumulator let investors accumulate stocks at a discount rate to the stock market. If you were to buy an accumulator today on HSBC or other stocks, it means that you could start to buy shares in these companies at about a 25 per cent discount rate(can higher or lower) to their market price.

Purchasing stocks at a discount to the stock market sounds really attractive, but there is a little more to it. The first catch is that an accumulator is not a one-off transaction. It lasts a year and you have to commit at least US$1 million generally, and you have to accumulate the stock regularly.

The next catch is that when you buy the accumulator, the price you pay for the stock is already fixed. So that the stock price you pay from the first day to the last day will be the same, no matter what the stock’s market price is. For example, themarket price of the stock on day one is HK$80, you will pay at a discount like HK$60. But if the price on the last day, or any other day over that one year, is HK$70, you will still pay HK$60 and only can get a around 14 per cent discount, not 25 per cent.

Of course there are catches. It would be very costly to long a series of call options. In order to make the transaction cheaper, the call option is a knock-out option because it is cheaper. A knock-out option limits the upside point you can get. For example, if the knock-out value is HK$ 90 and one day the stock price is above HK$90, the whole contract will be over and you will not be able to get any more shares in the future.

On the other hand, in order to make the accumulator cheaper, the investor are selling two put options to subsidize the cost of the knock-out call. When shorting a put option, the investor gets shares at a higher price when the stock price is under the strike price. For example, the put strike price in the above HSBC accumulator is $91: when the current stock price is $89, the investor will be required to receive a certain number of shares at $91. The investor is losing $2 per share he receives. And to make the matter worse, since you are shorting two puts for each call, you will be receiving twice the number of shares at $91. With the stock market fell down more than 60% in 2007-2008, we can see that there are a lot of private banking clients who are receiving lots of shares every day at a price much higher than the current price.

A decumulator functions the opposite way of an accumulator. The investors long a put option and shorts two call options.

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Case of Derivative loss:

CITIC Pacific (267) has suffered a big losses due to their foreign currency target redemption forward contracts. They have bought so many foreign currency target redemption forward contracts and daily accrual (accumulator) contracts for AUD and EUR. These contracts was working so good in the first half of a year, but things start to turn bad with the big and sudden drop in AUD and EUR in the exchange market.

CITIC Pacific has exposures to currencies such as AUD and EUR because of their mining projects in Australia. On the other hand, they have bought contracts with notional values that are a lot higher than what they need. A hedging tool, that was supposedly useful for the company to hedge risk, but it also can be a speculation tool. CITIC Pacific has suffered a loss of HKD 807 million on these contracts from 1 July to 17 October 2008, and they think that they will continue to loss money on these contracts until 2010 because not all contracts can be terminated or unwound. At the same time, they are planning a provisional loss of HKD 15.5 billion for these contracts.

In fact, buying these accumulator contracts, investors have got limited profits but unlimited loss. Investors have to consider your potential returns and potential risks seriously before you invest in the accumulator contracts, otherwise accumulator will be really “I kill you later”.