Repeated intervention by Hong Kong’s de-facto central bank in the currency market last month to curb HK dollar strength saw Hong Kong Exchanges & Clearing (HKEx, code 388:HK) benefit in a somewhat unexpected way from the resulting surge in interbank liquidity.

More cash in the banking system generally has a positive impact on the HKEx, which operates the Hong Kong stock and futures exchanges, as investors have access to more money they can put to work, meaning more transaction fees.

During the last two weeks of October when the Hong Kong Monetary Authority (HKMA) intervened in the market seven times, call derivative warrants sold on HKEx stock jumped, coinciding with a general rise in the firm's spot share price.

That stands in stark contrast to a year when trading volume in listed warrants on the Hong Kong stock exchange -- which accounts for up to 30% of its cash-market trading volume -- has slumped. Credit Suisse data shows total turnover of warrants from January to October 2012 fell 40% year-on-year.

Cedric Cheung, head of warrants marketing for Hong Kong at JP Morgan, ascribes the two-week surge in HKEx warrants to expectations of improving market sentiment for Hong Kong stocks. “When the market turns more bullish, investors tend to use warrants as one of the first tools they reach out to obtain leverage,” he adds.

Cheung notes the HK warrants market saw more than HK$140 million in inflows on October 24, when the HKMA sold HK dollars to defend the peg with the US dollar for the second time in four days. It was striving to keep the HK dollar within its 7.75 to 7.85 trading band to the US dollar to counterbalance foreign capital inflow.

Some say such inflows were spurred by the third round of quantitative easing (QE3) implemented by the Federal Reserve this September. But not all market-makers see a direct causal link between QE3 and this surge in HKEx warrants.

Ivan Ho, head of warrants and callable bull/bear certificate sales at Credit Suisse, argues that interest in HKEx call warrants is correlated to the underlying share price of HKEx itself, as well as broader external equity market sentiment and the performance of the A-share market.

Market-makers note that HKEx's stock price displays relatively higher beta than other equities – when market turnover goes up, the exchange’s share price shows more upward momentum than other lower-beta stocks. This is reversed in a market with shrinking turnover.

Ho says investors usually buy OTM call warrants – when the strike price is above the current price of the underlying – only when they feel the spot price will have a big upward move. 

“So when market sentiment improves, they are betting the share price of HKEx will also rise significantly due to the stock's high beta,” notes Ho. Rather than buy the stock directly in the cash market, "they feel that OTM call warrants would give them higher effective gearing." Hence they buy warrants in the hope of exercising them to gain exposure of the underlying stock, he says.

The leverage effect of warrants is seen as favoured by retail investors, particularly in Hong Kong, as a way to chase high returns using relatively little capital rather than betting in the cash market directly. 

Yowjie Chien, head of warrants trading and marketing for Asia ex-Japan at JP Morgan, estimates up to 80% of daily warrants turnover is accounted for by high-frequency market-makers or short-term intra-day retail punters, leaving 20% in traded volume to institutional flow.

But he confirms his team has recently seen increased interest from institutional investors in warrants, including from institutions with more than US$1 billion in AUM.

“As the bid/offer size of the warrants market is often bigger than those of their underlying stocks, and that warrant bid/offer spreads are a lot tighter than the underlying cash equities, some hedge fund managers prefer trading warrants to cash equities as they could get bigger exposure on certain names,” says Chien.