People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues

This Selected Issues paper for the People’s Republic of China—Hong Kong Special Administrative Region (SAR) reviews the residential property market and implications of an aging population. The fiscal sector impact of price fluctuations is important in Hong Kong SAR with land sales and stamp duties providing an important source of government revenue. The simulations are based on a dynamic general equilibrium system with forward-looking behavior and rational expectations. Hong Kong SAR’s revenue flows are characterized by relatively volatile nontax items.


This Selected Issues paper for the People’s Republic of China—Hong Kong Special Administrative Region (SAR) reviews the residential property market and implications of an aging population. The fiscal sector impact of price fluctuations is important in Hong Kong SAR with land sales and stamp duties providing an important source of government revenue. The simulations are based on a dynamic general equilibrium system with forward-looking behavior and rational expectations. Hong Kong SAR’s revenue flows are characterized by relatively volatile nontax items.

IV. Rapid Growth of Equity and Derivatives Markets in Hong Kong SAR 1 2

A. Introduction

1. Hong Kong SAR’s equity and equity-based derivatives markets have experienced very fast growth of late measured by market capitalization, turnover and issuance. These developments reflect: (i) the recovery of the local economy, including the property sector and bank balance sheets; (ii) the ongoing strong regional growth story and its positive impact on Hong Kong as a financial center; and (iii) the proliferation of increasingly sophisticated derivative products, including those effects stemming from regulatory changes. Hong Kong SAR currently has the second largest equity market in the region (behind Japan) ranked by capitalization and is the most active derivative warrants market in the world.

2. Much, though not all, of this increase in activity has been driven by deepening financial integration with the Mainland. Hong Kong SAR’s equity and derivatives markets are becoming increasingly dominated by claims related to Mainland enterprises. An important element of this trend is IPOs, including from major state banks. This pattern looks set to continue as the Mainland gradually opens its capital account and as Mainland firms seek funding, ownership and expertise from abroad. Hong Kong’s financial markets are, in turn, increasingly dependent on the Mainland—funds raised through the issuance of H shares (Mainland companies incorporated in the Mainland) and red chips (Mainland affiliated companies incorporated outside the Mainland) amounted to more than half of the total funds raised in the local market during the past decade.

3. The ongoing rapid development of local financial markets and increasing financial linkages to the Mainland highlight a number of policy issues. Foremost among these is the need to maintain Hong Kong’s status as a regional financial center—in particular to intermediate between Mainland firms and overseas investors—by ensuring orderly and efficient markets, and by preserving its cutting edge supervisory capabilities. These should be seen against the backdrop of competition from existing and aspiring financial centers in the region. Given the relatively high retail participation in the Hong Kong market, investor education and information dissemination also play important roles in ensuring market integrity. The authorities remain well aware of all of these challenges.

4. This paper provides an overview of the recent growth of Hong Kong’s equity and equity-related derivatives markets: what has happened, to what extent the Mainland has been the driver of change, and what are the main policy implications. Given the breadth of the topic, the coverage is necessarily broad brush and selective; developments in other financial asset classes are left for future research. The remainder of the paper is as follows: Section B looks at recent developments in the markets for equities, futures and options, and derivative warrants and structured notes; Section C discusses the influence of the Mainland on Hong Kong financial markets; and Section D concludes.

B. Recent Market Developments

Equity Markets

5. Hong Kong’s market capitalization, which is approaching $1 trillion, is now the second largest in Asia behind Japan. Compared with the major U.S. exchanges, however, Hong Kong’s capitalization remains modest at only one-fourteenth the level of the NYSE and one-fourth the level of the NASDAQ. That said, compared with the top ten markets, Hong Kong’s capitalization has grown the fastest in the past 15 years. Ranked by turnover, Hong Kong falls to fifth in the Asia region behind Japan, Korea, Australia and Taiwan POC. Since the recent lows of early 2003, market capitalization has risen by 122 percent and daily turnover by 196 percent.

Figure IV. 1.
Figure IV. 1.

Hong Kong SAR: Equity Markets in an International Context

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Note : Figures in the brackets refer to expansion from 1990.Source : World Federation Exchanges.

6. Hong Kong equity markets feature a “main board” and a NASDAQ-style Growth Enterprise Market (GEM). The GEM was launched in November 1999 to provide venture companies, in particular those involved in the technology sector, with access to equity market financing. Many GEM-listed companies do not fulfill the profitability and track record requirements to list on the main board. The main board has 915 listed companies as of end-October 2005 (202 for the GEM); market capitalization of $972 billion ($9 billion for the GEM) daily turnover of 2.3 billion shares (11.6 million for the GEM).

7. Hong Kong’s equity market is one of the world’s major fundraising centers. In 2004, IPOs launched in the Hong Kong market raised $12 billion, while total fundraising in the equity market was $36 billion, fourth globally behind the NYSE, Euronext and Spain.3 One-third of total new issuance was related to Mainland enterprises. In the first ten months of 2005, this percentage jumped to over 60 percent, and for IPOs only was nearly 90 percent in light of China Construction Bank’s record $9 ¼ billion issued in October 2005.

8. Mainland enterprises have become increasingly important in Hong Kong’s equity market in terms of market share as well as contribution to growth.4

Figure IV. 2.
Figure IV. 2.

Importance of Mainland Enterprise Shares

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Note : Figures in the chart refer to the overall market growth rate during the period.Source : HKEx.
  • Market shares. The share of Mainland enterprises in total market capitalization, daily turnover and IPOs, has risen sharply so far this decade compared with the late 1990s. Comparing 2001 – November 2005 with the previous five years, the share of Mainland enterprises has risen from about 20 to 30 percent of market capitalization, 30 to 40 percent of average daily turnover, and 70 to 77 percent of IPOs.

  • Developments in the percentage contribution to overall market growth of Mainland enterprises have been even more pronounced than for market shares. Comparing the same five-year periods, the percentage contribution to overall market growth rose from: 46 to 52 percent for market capitalization, 34 to 115 percent for average daily turnover and 75 to 141 percent for IPOs. The higher-than-100-percent contribution suggests a contraction of non-Mainland listed companies in terms of turnover and IPOs.

Exchange Traded Futures and Options5

9. The number of exchange-traded contracts for equity derivatives has also risen sharply in recent years, although amounts remain well below key international and regional markets. The Hong Kong Exchange (HKEx) offers futures and options contracts on various indices as well as on individual stocks; these tend to be traded by professionals using specialized accounts with exchange participants. The number of contracts rose to 20 million in 2004, an increase of 35 percent,6 and has doubled since the Asian financial crisis. Futures comprised 60 percent of the 2004 total. Most futures contracts were index-based (with Hang Seng futures accounting for three-fourths of the total), while over 70 percent of options were based on individual stocks. Fast growth continued into 2005 as the total number of contracts traded in 2004 had been matched as of mid-October.

Figure IV. 3.
Figure IV. 3.

Recent Developments in Exchange-Trade Futures and Options

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Source : HKEx.

10. Pure trading remains the most common reason for transacting futures and options in Hong Kong. Surveys by the HKEx (2005) show that about one-half of all equity derivative transactions were for pure trading, one-third were for hedging and the remainder were for arbitrage, although these vary considerably by product. For example, over one-half of futures contracts were reportedly for pure trading purposes, while only one-third of options were for pure trading and almost one-half were for hedging. The sum of pure trading and hedging as a percentage of the total has been broadly stable (although data on the composition are limited).

Figure IV. 4.
Figure IV. 4.

Ten Fundraising Markets (2004)

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Source : World Federation Exchanges.
Figure IV. 5.
Figure IV. 5.

Transaction Purposes by Products

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Source : HKEx.

11. Hong Kong’s derivatives market has a relatively diverse investor base with a strong local retail presence (Chart 2c). The bulk of trading is divided between three main groups: exchange participants, including their proprietary trades (35 percent); local retail investors (26 percent); and overseas institutional investors (26 percent).7 Over the past five years, the percentage contribution of overseas institutional investors has doubled and has been offset largely by a decline in the contribution of exchange participants. Contributions of these groups by product vary widely: exchange participants account for over three-fourths of stock option volume, while overseas investors account for nearly one-half of index futures volume. The participation of local retail investors is also skewed towards futures trading.

Table IV.1.

Derivative Warrants by Types

(In percent of total)

article image
Source : SFC.

Derivative Warrants and Structured Notes 8

12. Following regulatory reforms in the derivatives warrants market in late 2001 and early 2002, the issuance and trading of derivative warrants in Hong Kong has exploded and the market is currently the most active in the world. 9 10 Daily turnover jumped from under $100 million in 2002 to $424 million in the first nine months of 2005, equal to the sum of the German and Italian markets combined (the second and third most active exchanges in the world). This in spite of Hong Kong having only the 9th most number of derivative warrants listed—there are now over 1,000, more than the total number of companies listed on the main board and GEM. Derivative warrants’ share of total market turnover rose from 6 percent in 2002 to 17 percent in the first half of 2005, and now exceeds the share of red chips.

Figure IV. 6.
Figure IV. 6.

Distribution of Trading by Investor Types

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Source : HKEx.
Figure IV. 7.
Figure IV. 7.

International Comparison of Warrants Markets in 2004

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Note: Figures in the brackets refer to the percentage to total shares turnover.Source: World Federation Exchanges.

13. Equity call warrants continue to be the most common type of instrument issued, although the share of index warrants have been rising rapidly. Whereas five years ago plain vanilla (put and call) derivative warrants based on individual stocks comprised over 90 percent of issuance, index warrants currently comprise about one-fifth of the total. Calls continue to outnumber puts, and the gap has been rising since 2003.

14. The equities underlying the derivative warrants are fairly concentrated, and contain a sizeable Mainland component. Derivative warrants are typically issued on large capitalization and high turnover stocks, as well as the main indices. The top 10 underlyings (which include two indices) account for 73 percent of issue size during the first eleven months of 2005. Five of the top ten underlyings represent exposure to Mainland entities. The issuers of derivative warrants were even more concentrated, with the top three banks accounting for nearly one-half of the total amount and the top ten 90 percent.

Table IV. 2a.

Top Ten Underlyings of Derivative Warrants

(January – November 2005)

article image
Sources: HKEx, SFC Research

15. The rapid growth of the equity-linked retail structured note market has been an important complement to the equity derivatives market, again with a strong Mainland component. These structured notes,11 many of which are not listed (and for which data is less plentiful), are yield-enhancing fixed income products that pay out in some underlying stock rather than in currency if the underlying stock price falls below a certain threshold. Structured notes became popular in the period of historically low yields, and tend to be lightly traded instruments with longer tenors than equity derivatives. As with equity derivatives, Mainland stocks are popular underlying assets, comprising three of the top ten. It should be noted that, as in other markets, volatility has been falling in Hong Kong reflecting in part that market forces stemming from hedging activities of structured note issuers have offset the impact on volatility associated with derivative warrants (see Box IV.1).

Table IV. 2b.

Hong Kong SAR: Top Ten Issuers of Derivative Warrants

(January – November 2005)

article image
Sources: HKEx, SFC Research.

C. The Role of the Mainland in Hong Kong’s Recent Financial Market Developments

16. Hong Kong continues to be the main foreign fund raising center for the Mainland. This has been facilitated by geographic, demographic and cultural factors. Fundraising has taken place across a wide spectrum of channels, including foreign direct investment, equity financing, and bank lending. The most important market for intermediation in Hong Kong SAR is the stock market—although, as we have seen, derivatives markets have grown quite rapidly in recent years—which has operated efficiently and has long provided a low-cost source of funds for Mainland enterprises. Reflecting difficulties in the Shanghai and Shenzhen markets, Mainland firms also benefit from having the imprimatur of a Hong Kong listing.

17. Hong Kong serves a role as the premier risk management center for the Mainland. Exchanges in China have resumed warrant trading lately and, to date, there are only seven warrants listed on the two Mainland exchanges. With many Mainland enterprises listed in Hong Kong, equity exposures can be managed through derivatives on Hong Kong listed Mainland stocks and indices, the latest product being the FTSE/Xinhua China 25 index, which commenced to trade on the HKEx in May 2005.12

18. Hong Kong markets provide an efficient channel for foreign investors to gain Mainland exposure. Due to capital controls, foreign investors can achieve only minimal direct participation in the Mainland markets. To capitalize on the increasing interest in China, many foreign institutional and local retail investors view H shares and red chips and their related derivative products as the first choice of investment vehicle. This has resulted in a sharp rise in the share of turnover of Mainland-related equity products over the past decade.

19. Hong Kong’s financial services industry can assist the Mainland in bringing greater sophistication to its market. Hong Kong’s advantages in terms of overseas market networks and level of professional service have made it the main choice for Mainland enterprises venturing abroad. According to the 5th Survey of Mainland Private Enterprises,13 over 47 of respondents consider overseas market expansion as their top development target, while 5 percent say they aim for a listing. The survey also found that a majority of the respondents opt for cooperation with foreign companies in seeking either domestic or overseas market expansion. Among them, 90 percent indicated they prefer Hong Kong companies or use Hong Kong services and 75 percent would choose Hong Kong as the location for listing in future.

D. Supervisory Issues

20. The recent rapid growth in equity and equity-related derivatives trading reflects a healthy deepening of, and confidence in, Hong Kong financial markets. While this paper covered equity and equity-based products, it should be noted that market deepening extends across all three asset classes, as well as other derivative products.14 Although Hong Kong does possess important advantages over other existing and aspiring money centers, recent developments in the local markets can be viewed as a vote of confidence by the investor community. Financial capital is mobile and participants do have a choice as to where intermediation takes place.

21. The growing depth and sophistication of the equities and derivatives markets underscores the importance of continued close supervision to preserve and enhance Hong Kong’s role as a regional financial center. Hong Kong remains at the forefront of financial sector supervision worldwide, and the authorities are mindful of the need to maintain close surveillance over both the “hardware” (infrastructure) as well as the “software” (quality of supervision and regulations), in order to ensure that markets continue to function in an efficient and orderly manner. An important recent example is the SFC’s recent review of the derivatives warrants market (SFC, 2005b) which was prompted by rapid growth and market concerns. Although the review found no systemic issues, it did propose a number of initiatives to strengthen the regulatory regime.15

22. Hong Kong will almost certainly be the most important gateway for external fundraising for Mainland enterprises over the medium term, pointing to the necessity of continued cooperation with Mainland regulators and strengthening financial linkages. Cooperation and coordination with the Mainland’s financial authorities—across the banking, securities and insurance regulators—which have advanced well, will become increasingly important. Increasing access of Mainland firms to Hong Kong’s financial infrastructure will also require continuous upgrading of cross-border linkages between payment, settlement and clearing systems. Progress in these areas will be dictated in large part by the pace of financial liberalization on the Mainland.

23. Given the relatively high retail participation in Hong Kong markets, investor education takes on particular importance. Although the local investor base is relatively sophisticated, retail access to increasingly complex financial instruments opens the possibility that even seasoned investors may not fully appreciate or understand the risks of the product they are buying. A fresh example is the SFC’s recent finding that there is a fairly high level of misunderstandings about such products. While all supervisory bodies in Hong Kong SAR run active public education and information dissemination programs, there is an ongoing need to promote such efforts given the likely widening of the investor base and the likely continual flow of new and more complex financial instruments.

Derivative Warrants, Structured Notes and Volatility1

Some commentators have expressed concern that complex instruments such as derivative warrants add to market volatility. While this may be true for derivative warrants taken in isolation, it is necessary to look across instruments to assess whether there are any offsetting factors in the market. Indeed, in Hong Kong, many banks have in recent years have issued a large number of structured notes, many linked to the same underlying stock or indices as the derivative warrants. The overall impact of these two types of instruments is to lower the volatility of the underlying stocks or indices. The purpose of this box is to present a stylized version of this phenomenon using popular instruments in the Hong Kong market: warrants and equity-linked notes referenced to an underlying stock.

Taken in isolation, call warrants (which give the owner the right to purchase a stock at pre-specified price) can potentially add to market volatility. When the price of the underlying stock is rising, the probability that the warrant will be exercised by the warrant holder increases. Thus, the bank that issued the warrant is more likely to have to purchase shares of the underlying stock in order to fulfill its end of the contract. The effect is to exacerbate the rise in the share price, adding to volatility.

A structured note linked to the same underlying stock has the opposite effect on volatility. These notes, which pay an interest rate above the market rate, have the feature that if the underlying stock falls below a predetermined price, then the holder of the note is paid in stock rather than the currency denomination of the note. Thus, when the price of the underlying stock is rising, the probability that the issuing bank will have to pay out in stock, rather than currency, falls, offsetting the volatility effects of the warrant.


Charts in Box on Volatility

Citation: IMF Staff Country Reports 2006, 051; 10.5089/9781451816945.002.A004

Whether this favorable constellation of factors will persist is an open question. A key issue is the demand for structured notes in a rising interest rate environment. One attraction of these notes is to enhance returns over “plain vanilla” fixed income products, which was particularly important when yields were at or near historic lows. Now that U.S. dollar and Hong Kong dollar short-term interest rates have risen, the demand for such yield enhancing products may decline. On the other hand, new products may emerge with similar volatility characteristics.


This box is based on Securities and Futures Commission (2005a).


  • Hong Kong Exchanges and Clearing Limited (2005), Derivatives Market Transaction Survey 2004/05, December.

  • Hong Kong Monetary Authority (2005), Results of the 2004 Survey on Credit Derivatives and Asset Securitization Activity, Quarterly Bulletin No. 43, June.

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  • Lee, Joseph and Chang Veronica (2005), A Survey on the Retail Structured Notes Market in Hong Kong, Securities and Futures Commission Quarterly Bulletin, Autumn.

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  • Lee, Joseph and Poon Joanna (2004), The Listing of Mainland Companies on HKEx and the Implications for Hong Kong, Securities and Futures Commission Research Paper No. 17, September.

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  • Lee, Joseph and Yuhong Yan (2004a), Profile of the Derivative Warrants Market in Hong Kong, Securities and Futures Commission Research Paper No. 13, March.

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  • Lee, Joseph and Yuhong Yan (2004b), Profile of the Stock Options Market in Hong Kong, Securities and Futures Commission Research Paper No. 15, June.

  • Securities and Futures Commission (2005a), An Overview of the Derivative Warrants Market in Hong Kong, unpublished.

  • Securities and Futures Commission (2005b), A Healthy Market for Informed Investors—A Report on the Derivatives Warrants Market in Hong Kong, November. Available on the Internet:

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Prepared by Paul Gruenwald (Resident Representative) and Cynthia Leung (Economist) of the Hong Kong SAR sub-office.


The relatively narrow focus of this paper reflects the recent rapid growth in the relevant instruments, the authorities’ high level of interest in the topic, and space constraints.


Non-IPO activity includes rights issues, warrants exercised, share options, placing activities and consideration issues.


Hong Kong reportedly accounts for about 70 percent of Mainland-based companies’ share turnover outside of the Mainland; New York and London account for most of the rest.


This section is based on Hong Kong Exchanges and Clearing Limited (2005). The survey covers transactions during July 2004 – June 2005 in the main futures and options products, which represents 99 percent of the turnover volume in the HKEx derivatives market.


This amount includes all exchange-traded contacts, of which 0.3 percent were HIBOR futures and a miniscule amount were Exchange Fund note futures.


In 2004/05, UK, US and non-UK European investors (institutional and retail combined) each accounted for roughly one-quarter of the overseas total.


Box 1 describes in detail some of the derivative products with a particular focus on warrants and structured notes both which have grown in trading volumes in recent years. Warrants are stock option-like derivatives that are issued by individual investment banks, securities houses or their afiliates to attract retail investors, who are interested in taking leveraged bets, through lower transactions costs. Like a warrant, a structured note is backed by stocks. But unlike warrants, the holder receives at maturity either the principal amount in cash or the underlying stock if the price of that stock falls below the predetermined price. This requires the issuer to hedge by selling the underlying stock when the price increases (and the chance of delivering the underlying stock decreases) and buying when the price falls (when the issuer is more likely to deliver the stock). Indeed, banks find it attractive to issue both warrants and structured notes to “automatically” hedge against stock price changes.


These changes removed the placement requirement to issue derivative warrants before a listing, and introduced a requirement for warrant issuers to appoint a liquidity provider (Lee, 2004a). The dramatic rise in turnover is less well understood and is a topic for future research.


In contrast to stock options, derivative warrants are pitched to retail investors (contract sizes are small) and can be traded like regular stocks using normal investment accounts. Derivatives warrants are also attractive due to their lack of position limits.


According to the SFC’s survey, equity-linked notes account for about 60 percent of total retail structural note issues.


This is increasingly true for other asset classes as well: as of November 2005, retail investors can trade RMB non-deliverable forward contracts over the counter.


A special “study group” comprising the Propaganda Division of the CPC Central Committee, the All-China Federation of Industry and Commerce, and the All-China Society of Private Economic Research.


For example, a description of the recent fast growth in credit derivatives and asset securitization, see Hong Kong Monetary Authority (2005).


The proposals seek to improve market integrity and conduct (for example through tightening liquidity provider provisions, and banning rebates and other potentially distortionary incentive schemes) and bolster investor education.

People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues
Author: International Monetary Fund