hsi services, a shares vs b shares

Indexing Strategies Asia 2007

Vincent KwanManaging Director

28 November 2007

China China ““AA”” Shares vs. Shares vs. ““HH”” Shares:Shares:Hedging ofHedging of

HH--share and Ashare and A--share Portfoliosshare Portfolios

1

Contents

1. The Risk of Different A-share and H-share Prices

2. Higher Volatility and Jumps in AH Price Differentials – Who Cares?

3. Hedging the Risk, or Arbitraging the Difference

2

Why A share & H share Price Diverge?Why A share & H share Price Diverge?Why A share & H share Price Diverge?

And the Risk of Such a PhenomenonAnd the Risk of Such a PhenomenonAnd the Risk of Such a Phenomenon

3

The A/H Price Anomaly

265.12%3.388.54天津創業環保Tianjin Capital

278.01%18.8049.81江西銅業Jiangxi Copper

250.93%

263.74%

276.15%

305.26%

6.77

8.16

4.40

8.0423.39中國南方航空China South Air

大唐發電

中國國航

北京北辰實業

16.19Datang Power

20.51Air China

11.58Beijing N Star

A shares(CNY)(As at 21 Nov 2007)

H shares(HKD)

A/H Price Ratio

CNY 100 = HKD 104.93

Hang Seng China AH Premium Index: 168.58

4

Possible Reasons for the A/H Price Differential

NOT convertible

HKD

USD

EUR

JPYCNY

Limited Convertibility

Hong Kong

LocalInvestors

IndividualPRC citizens

QDII

Int’lInvestors

QFII

Dom

estic

Inve

stor

s

Mainland China

Company

H shares A shares

5

Can We Accept This As Normal?… For Now

Nationalisation

TWOMARKETS

Hong Kong Mainland China

Internationalisation

ONE COUNTRY

TWOCURRENCIES

TWOPRICES

TWOSYSTEMS

6

Risk of the A/H Price Differential

Further Widening of A-share PremiumLiquidity in China push A-share prices further up

Sudden Narrowing of A-share PremiumPolicy changes lead to price equalisation

Increasing Price Fluctuation & Volatility

A-H Shares Move in Different Directions

Bubble

7

20 August 2007Announced the launch of Tianjin Pilot Program (“Through-train” Scheme)

Risk: Policy Driven

AHPI178.93

- 4.83 p.p.

< Impact >Investors expect to purchase H shares which trading at deep discount relative to A shares

HSI 5.9%

HSCEI 8.7%

AH (H) 8.4%

SSE 50 6.2%

SHCOMP 5.3%

AH (A) 5.5%

18 October 2007Rumor of arbitrage mechanism by swapping A & H shares was being studied by the China Govn’t

AHPI147.00

- 7.59 p.p.

< Impact >HSCEI went up 5% intraday and Valuation gap in dual-listed stocks narrowed

HSI 0.6%

HSCEI 1.0%

AH (H) 1.5%

SSE 50 3.7%

SHCOMP 3.5%

AH (A) 3.4%

5 November 2007Premier Wen Jiao Bao remarked on 3 Nov (Sat) the “Through-train” Scheme will be postponed

AHPI160.44

+ 4.75 p.p.

< Impact >HSI tumbled 5% while HSCEI tumbled 6.4%; SHCOMP tumbled 2.5%

HSI 5.0%

HSCEI 6.4%

AH (H) 5.9%

SSE 50 2.9%

SHCOMP 2.5%

AH (A) 3.3%

8

Risk: Higher Vol & Jumps in Premium Index

0

10

20

30

40

50

60

Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07

HSCEI SHCOMP

80

100

120

140

160

180

200

Jul-07 Aug-07 Sep-07 Oct-07 Nov-07

Risk 1: Increasing Volatility30-day Rolling Hist Annualized Volatility

Risk 2: Jumps in AHPI9 Jul 07 – 21 Nov 07

?

Highest: 183.76(17 Aug 07)

168.58(21 Nov 07)

9

Higher Volatility and Jumps in A/H Price DifferentialHigher Volatility and Jumps in A/H Price DifferentialHigher Volatility and Jumps in A/H Price Differential

Who Cares?Who Cares?Who Cares?

100

1,000

2,000

3,000

4,000

5,000

6,000

Jan-07 Apr-07 Jul-07 Oct-07

AH(A) Index (HKD)AH(H) Index

Impact on "Fungible"

80

100

120

140

160

180

200

Jan-07 Apr-07 Jul-07 Oct-07

HSAHPI

“Fungible” Scheme Operational in ST

Questions:

Would contraction in AHPI lead to a broad-based drop in A shares? Would a significant drop in A-share market drag down HK and H-share market?After the sharp fall, what will be the future direction?

Who will be Harmed if A shares Fall?

Domestic Mainland InvestorsQFII Holders

Who will Suffer if H Shares Surge?

Foreign investors Under-weighted/Sold H sharesForeign investors Shorting H shares

Premium Index

AH (A) Index vs AH (H) Index

IndicativeProjection

IndicativeProjection

110

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Jan-07 Apr-07 Jul-07 Oct-07

AH(A) Index (HKD)AH(H) Index

Nothing on the "Fungible"

80

100

120

140

160

180

200

Jan-07 Apr-07 Jul-07 Oct-07

HSAHPI

What if this is NOT happening in ST?

Nobody could predict themovement in AHPI becauseof:

DifferentSentimentGovernment Policy

Premium Index

AH (A) Index vs AH (H) Index

IndicativeProjection

IndicativeProjection

12

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

-10.0% -5.0% 0.0% 5.0% 10.0%

Daily Return Rate of AH(A)

Dai

ly R

etur

n R

ate

of A

H(H

)

From launch day to current

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

-10.0% -5.0% 0.0% 5.0% 10.0%

Daily Return Rate of AH(A)

Dai

ly R

etur

n R

ate

of A

H(H

)

From base day to launch day

AH (A) Index and AH (H) Index

Back-testing Data(4 Jan 06 – 6 Jul 07)

Real-time Data(9 Jul 07 – 21 Nov 07)

Period 3Jan06 to 6Jul07 9Jul07-21Nov07Correlation 0.3654 0.5886

Trading day*Move in the different direction 135 (38.68%) 26 (28.57%)Move in the same direction 214 (61.32%) 65 (71.43%)Total 349 91*Days when either A-shares or H-shares are traded.

13

R(AHA)-R(AHH)

-10.00-8.00-6.00-4.00-2.00

-2.004.006.008.00

10.00

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07

AH (A) and AH (H) Indexes – Relative Movement

ReturnAH(A) – ReturnAH(H)Back-testing Period

(3 Jan 2006 – 6 Jul 2007)Live Period

(9 Jul – 21 Nov 2007)

Average: 1.68 p.p.# of Trading Days: 181

Average: - 1.60 p.p.# of Trading Days: 168

Outperformance

Underperformance

Average: 1.85 p.p.# of Trading Days: 53

Average: - 1.90 p.p.# of Trading Days: 38

14-15.00

-10.00

-5.00

-

5.00

10.00

15.00

Jan-06 A pr-06 Ju l-06 O ct-06 Jan-07 Apr-07 Ju l-07 O ct-07

Dai

ly P

oint

Cha

nge

9 /7 /20

80

100

120

140

160

180

200

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07

HSAHPI

Hang Seng China AH Premium Index (“AHPI”)

Premium Index

AHPI Daily Point Change

Period I (Back-testing)(3 Jan 2006 – 6 Jul 2007)

Period II (Live)(9 Jul – 21 Nov 2007)

Period I Period II

Maximum 10.46 8.89 Minimum -9.55 -8.83 Average of absolute changes 1.93 3.04

No. of days premium increase 188 56No. of days premium decrease 195 41No. of days unchanged 1 0

Average of premium increase 2.08 2.95 Average of premium decrease -1.80 -3.17

15

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07

AH(H) IndexHSCEI (rebased)

AH (H) vs HSCEI

×= 246# Annualised Volatility Standard Deviation of [ln (Price t)-ln (Price t-1)]

From 3 Jan 2006 to 21 Nov 2007

Correlation: 89.07%

% Change

1 month 3 months 6 months 1 yearSince 3 Jan 06

AH(H) Index 2624.06 -18.61 25.72 41.89 89.17 162.41 29.55HSCEI 15993.50 -18.91 29.94 46.92 92.11 195.47 29.48

Index Index Level # Annualised Volatility (%)

16

500

1,500

2,500

3,500

4,500

5,500

6,500

Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07

AH(A) IndexSSE50 (rebased)

AH (A) vs SSE 50

×= 246# Annualised Volatility Standard Deviation of [ln (Price t)-ln (Price t-1)]

From 3 Jan 2006 to 21 Nov 2007

Correlation: 90.11%

% Change

1 month 3 months 6 months 1 yearSince 3 Jan 06

AH(A) Index 4242.28 -7.32 19.35 57.45 174.90 321.17 32.21SSE50 4064.78 -9.56 4.13 41.92 195.27 400.22 29.75

Index Index Level # Annualised Volatility (%)

17

Hedging the RiskHedging the RiskHedging the Risk

or Arbitraging the Differenceor Arbitraging the Differenceor Arbitraging the Difference

18

Hang Seng China AH Index Series

Hang Seng China AHPremium Index

恒生AH股溢價指數

Hang Seng China AH(A) Index

恒生AH股A指數

Hang Seng China AH(H) Index

恒生AH股H指數

Hang Seng China AH(A+H) Index

恒生AH股A+H指數

Hang Seng China AH Index Series恒生AH指數系列

USD

CNY HKD

Same constituents for these 4 indexes

19

Hang Seng China AH Premium Index (“AHPI”)

Objectives

To provide market with a simple and easy-to-use barometer to gauge such a premium (or discount)

Measurement

To measure the “average” price premium or discount of A shares over H shares, weighted by freefloat market cap

20

AHPI - Calculation Methodology

Formula

Index = x 100Valuation of constituents based on A-share priceValuation of constituents based on H-share price

= x 100Freefloat number of shares (A+H) x H-share priceFreefloat number of shares (A+H) x A-share price

100

Premium Index

A shares at a discount A shares at a premium

21

Hang Seng China AH Price Indexes

Hang Seng China AH(A) Index

恒生AH股A指数

Hang Seng China AH(H) Index

恒生AH股H指数

Hang Seng China AH(A+H) Index

恒生AH股A+H指数

Same constituents, same weightingsShow purely price effect

USD

CNY HKD

22

Freefloat market cap weighted index

15% capping on individual company’s weighting in the A+H Index

AH Price Indexes - Calculation Methodology

Synchronised weightings from A+H Index to A Index and H Indexevery month

23

AH (A) Index / AH (H) Index – Illustration

100.0Total

39.3Others

8.9Company E

9.6Company D

12.5Company C

14.7Company B

15.0Company A

AH (A+H) Index

% Weighting in

Monthly Rebalance

Index weightings will be synchronise every month:

To reflect purely price effect

Similar to measuring prices of the same basket of products in different countries

100.0

39.3

8.9

9.6

12.5

14.7

15.0

AH (A) Index

% Weighting in

100.0

39.3

8.9

9.6

12.5

14.7

15.0

AH (H) Index

% Weighting in

24

The Dynamics of the AH market

A shares Price

H shares Price

H Share Company Return

Red-chip Return

Index Futures?

Global Market

Sentiment, Liquidity

QDII

Individual Investors

Insurance Company

Invest Companies

25

Profit Opportunity

100

120

140

160

180

2007 2008 2009 2010 2011 2012

A / HPrice Ratio (%)

100

120

140

160

180

A / HPrice Ratio (%)

1 Year3 Year5 Year

Annualised Rtn:9.86%

Annualised Rtn:16.96%

Annualised Rtn:60.00%

Current A-share Premium at about 60%

If the A/H price differential is to diminish and return to the par level, an investor might be able to make profit at a return rate:

26

Hedging Strategy (I)

168.58200100

Directional Bet

(21 Nov 2007)

A shares Underperformance

AHPI will fall

A shares Outperformance

AHPI will rise

27

Hedging Strategy (II)

Non-Directional Play

(21 Nov 2007)168.58AHPI

263.74 Air China

265.12 Tianjin Capital

276.15 Beijing N Star

278.01 Jiangxi Copper

305.26 China South Air

A/H Price Ratio (%)AH Index Constituents

116.53 Anhui Conch

126.37 CM Bank

136.28 Bankcomm

141.00 Tsingtao Brew

141.86 Jiangsu Express

A shares Underperform

for High A/H Price Ratio

A shares Outperform for Low A/H Price

Ratio

28

The AH Products

Can any products be structured using the indexes to meet market demand?

Can market demand be created?Identifying investors who want to long AHPI as well as those who want to short

29

The Challenges

Any strategy needs to be played across two markets

A-share market is not a totally free market for foreign investors

A-share market cannot be shorted, for nowWill A-share Index Futures be launched soon?

30

The Opportunity

Can a strategy be formed to play just in the H-share market?

e.g. just H shares of the AH Index constituents according to the AH Price Ratio

Can a Mainland partner be found who can play freely (at least on the long side) in the A-share market?

31

HSI Services Limited

http://www.hsi.com.hk

(852) 2877-0704Contact No:

22/F, Hang Seng Bank Headquarters,83 Des Voeux Road Central, CentralHong Kong

Address:

info@hsi.com.hkE-mail: