HKSI Paper 7: 80 Key Concepts and Study Guide
HKSI Paper 7, Financial Markets, is one of the practical papers of the Licensing Examination for Securities and Futures Intermediaries. It tests your understanding of how financial markets work: the global financial system, Hong Kong's financial architecture, and the equity, debt, foreign exchange and derivatives markets, together with financial risk management and how financial-sector functions fit together. The paper contains 60 multiple-choice questions answered in 90 minutes, and the pass mark is 70 percent. Remember that the pass mark is the score you need, not a statistic about how many candidates succeed.
This guide presents 80 key revision concepts in the official topic order of the Paper 7 syllabus effective from 1 March 2026. As at 14 September 2026, the current Paper 7 study guide is version 3.6, valid for LE sittings from 6 July 2026 onwards; please confirm which version applies to your own exam sitting, because regulatory and market information may change between versions. Each concept gives a short explanation, an explicitly hypothetical example, a common trap, and a self-check question with its answer, so you can revise actively rather than passively.
Exam format: HKSI examination overview . Latest published pass rate: 62.14% (Jul 2026) . A pass rate is a past result for a group of candidates, not your required score.
How to use these 80 concepts
- Work through the topics in syllabus order the first time, because later topics build on earlier ones such as interest rates and pricing concepts. Read each concept's explanation, then cover the screen and try the self-check question before reading the answer.
- For every quantitative concept, redo the hypothetical calculation on paper with your own changed numbers, keeping track of units, signs and each step. If your answer does not match, rework the steps before moving on.
- After your first pass, use the trap notes as a spot-check list. Make flashcards only for concepts whose traps or self-check questions you got wrong, and revisit those cards in your final revision week.
The practice examples are original and hypothetical unless explicitly identified as a published case. The concept count is a revision structure; it does not represent official question frequency or topic weighting.
No matching concepts. Try a shorter search term.
Topic 1: The global financial system
How savings flow to investment worldwide, the role of money, central banks and intermediaries, market structures, prudential regulation and lessons from financial crises.
1. Supply and demand for funds
Interest rates are the price of funds, set where savers' supply of loanable funds meets borrowers' demand for them. Stronger demand for funds or weaker savings tends to push rates up, while abundant savings relative to borrowing demand pushes rates down.
Example. Suppose many hypothetical companies seek bank loans to build factories in the same year while household savings grow slowly. The excess demand for funds would likely push borrowing rates higher until borrowers and savers rebalance.
Watch out. Treating high interest rates as good news for everyone: lenders benefit from higher returns, but existing borrowers face higher funding costs.
Self-check: In a hypothetical economy, corporate borrowing demand surges while household savings stay flat. Which direction do interest rates most likely move, and why?
Answer: Upward: demand for funds rises while supply is unchanged, so the price of funds (the interest rate) rises.
2. Economic sectors and the flow of funds
The economy is usually divided into sectors such as households, businesses, government and the overseas sector. In practice households are often net savers while businesses and governments are often net borrowers, so the financial system channels surplus funds to deficit units through banks, markets and funds.
Example. A hypothetical teacher saves part of her salary in a bank deposit. The bank lends those pooled deposits to a local manufacturer buying machines, moving funds from the household surplus sector to the corporate deficit sector.
Watch out. Assuming every sector is always on the same side: a government may be a net saver in one period and a net borrower in another.
Self-check: A hypothetical household buys a corporate bond issued by a deficit company. Describe the sector roles and the flow of funds.
Answer: The household sector supplies savings; the corporate deficit sector borrows; funds flow indirectly through the debt market from surplus to deficit unit.
3. International capital and investment flows
Funds move across borders when investors seek better returns or diversification, and when businesses invest abroad. Capital inflows can lower local funding costs and support asset prices, while sudden outflows can pressure currencies and markets.
Example. Suppose a hypothetical European pension fund allocates new money to Asian bonds for diversification. The purchase adds demand for local bonds, tending to lower their yields and bring foreign currency into the local market.
Watch out. Assuming cross-border flows are always stabilising: rapid reversals of 'hot money' can destabilise exchange rates and asset prices.
Self-check: In a hypothetical scenario, foreign investors rapidly sell one country's bonds and repatriate proceeds. Name two likely domestic effects.
Answer: Downward pressure on the local currency and rising local bond yields as bond prices fall from the selling.
4. Participants in the global financial system
Key participants include commercial and investment banks, central banks, institutional investors such as insurers and pension and mutual funds, corporations, governments, exchanges, and international organisations that promote financial cooperation and stability. Each plays a distinct role: some intermediate funds, some set policy, and some provide infrastructure. International organisations also differ among themselves: some promote monetary and financial cooperation and policy coordination, some support development finance through lending, and some facilitate trade and set common frameworks and standards, so describe their differing functions rather than treating them as one undifferentiated group.
Example. In a hypothetical cross-border bond issue, an investment bank arranges the deal, institutional investors buy it, the central bank of the issuer's country monitors stability, and a clearing system settles the trades.
Watch out. Mixing up regulators and operators: an exchange typically operates a trading venue, while the regulator supervises conduct and licensing.
Self-check: A hypothetical government issues bonds sold to foreign insurers. Identify the borrower, the investor type and one infrastructure participant needed.
Answer: The government borrows; the insurers are institutional investors; a clearing and settlement system (or exchange/intermediary) is needed to complete transactions.
5. Money and its classification
Money serves as a medium of exchange, a unit of account and a store of value. Monetary aggregates classify money by liquidity: narrow measures cover the most spendable forms, such as currency held by the public and demand deposits, while broader measures add less liquid deposits such as savings and time deposits.
Example. A hypothetical shopkeeper holds cash in the till and a demand deposit for daily payments (narrow money), plus a 12-month time deposit for reserve savings (counted in broader aggregates only).
Watch out. Assuming all deposits count equally in every aggregate: time deposits are less liquid and appear only in broader measures.
Self-check: A hypothetical saver shifts funds from a demand deposit into a fixed time deposit. What happens to narrow and broad monetary aggregates, all else equal?
Answer: Narrow money falls because the demand deposit leaves that measure, while broad money is broadly unchanged since the time deposit is included in the wider measure.
6. The banking system and credit creation
Banks accept deposits and make loans, and because loans are typically redeposited within the system, the banking sector as a whole can support a multiple of the original deposits. This credit creation expands the money supply but depends on banks' willingness to lend, prudential requirements and depositors' confidence.
Example. Suppose a hypothetical customer deposits cash and the bank keeps part in reserve and lends the rest; the borrower spends it, the recipient redeposits it, and the next bank lends on a portion again, so total deposits grow step by step.
Watch out. Assuming one bank alone multiplies deposits: the multiple arises from the banking system as deposits circulate, not from a single institution.
Self-check: In a hypothetical downturn, banks decide to hold much larger reserves and lend less. What happens to credit creation and the money supply?
Answer: Credit creation slows sharply, so growth of deposits and the money supply contracts relative to what it would otherwise have been.
7. Central banks and their typical duties
Central banks typically maintain currency and price stability, act as banker to the government and to banks, manage official reserves, oversee payment systems and influence money market conditions. In Hong Kong the HKMA performs many central-bank functions under the Currency Board system, although commercial note-issuing banks issue most of the banknotes.
Example. Suppose a hypothetical central bank sees inflation pressures. It may tighten money market conditions so borrowing costs rise, cooling demand and easing price pressure, while continuing to lend to banks needing short-term liquidity.
Watch out. Assuming the HKMA prints all Hong Kong banknotes: most are issued by note-issuing banks under the currency arrangement, a common misconception.
Self-check: A hypothetical candidate claims Hong Kong's central bank issues all HKD banknotes. Correct this using the currency arrangement.
Answer: The HKMA performs central-bank functions, but commercial note-issuing banks issue most banknotes under the Currency Board system, so the claim is wrong.
8. Intermediation and its advantages
Intermediation occurs when financial institutions such as banks stand between savers and borrowers. Advantages include pooling many small savings into large loans, transforming short-term deposits into longer-term lending, diversifying and assessing credit risk professionally, and reducing search and monitoring costs for both sides.
Example. A hypothetical bank pools thousands of small deposits and lends a large amount to one infrastructure project. Savers gain safety and liquidity, while the borrower gets size and maturity that no single saver could provide.
Watch out. Confusing intermediated finance with direct finance: in a bond purchase through a broker, the broker only arranges the deal; the investor lends directly to the issuer.
Self-check: A hypothetical saver wants daily access to funds; a company needs a five-year loan. Explain how a bank solves this maturity mismatch.
Answer: Through intermediation: the bank offers the saver a liquid deposit while lending long-term to the company, transforming maturities and pooling risk across many customers.
9. Disintermediation
Disintermediation is the movement of financial activity away from intermediaries toward direct dealings between savers and borrowers, often through capital markets. When strong companies can issue bonds or commercial paper directly to investors more cheaply than borrowing from banks, funding migrates to the market.
Example. Suppose a hypothetical large corporation finds it can issue three-year bonds to institutional investors at a lower cost than its bank loan rate. It repays the bank and borrows directly in the bond market instead.
Watch out. Thinking disintermediation removes all institutions: brokers, dealers and arrangers still facilitate trades; what is bypassed is the lending intermediary role.
Self-check: A hypothetical firm swaps a bank term loan for bonds bought directly by pension funds. Which institutions remain involved and which role disappears?
Answer: Arrangers, dealers and settlement systems remain; the bank's role as lending intermediary disappears, since investors now lend directly to the firm.
10. Characteristics of an effective financial market
Effective markets need adequate liquidity so positions can be traded quickly, transparent and timely price information, low transaction costs, a strong legal and regulatory framework protecting property rights and enforcing contracts, and fair and orderly trading. These features build confidence and lower the cost of capital.
Example. In a hypothetical comparison, market A has deep order books, published prices and swift enforcement, so issuers raise funds cheaply; illiquid market B with opaque pricing must offer higher returns to attract capital.
Watch out. Equating 'effective' with 'always rising prices': effectiveness concerns the quality and efficiency of the market process, not the direction of prices.
Self-check: A hypothetical market suddenly widens bid-offer spreads and trade information is delayed. Which effectiveness characteristics are damaged, and what is one likely consequence?
Answer: Liquidity and transparency are damaged; investors demand higher returns, raising issuers' cost of capital and deterring participation.
11. Primary versus secondary markets
The primary market is where new securities are issued and the issuer receives the proceeds. The secondary market is where existing securities trade between investors, providing liquidity and continuous price discovery. Secondary-market prices also feed back into primary-market pricing because issuers benchmark new issues against prevailing market prices.
Example. A hypothetical company sells new shares to investors in an IPO, raising cash on the primary market. A week later, an investor sells those shares to another investor on the exchange, with no new money going to the company.
Watch out. Assuming the issuer receives money in every trade: after the initial issue, all secondary-market proceeds go between investors, not to the issuer.
Self-check: In a hypothetical exchange trade of existing shares, why does the secondary market still matter to the issuing company?
Answer: It provides liquidity and price discovery, making the shares more attractive and lowering the cost of any future primary-market fundraising.
12. Exchange-traded versus over-the-counter markets
Exchange-traded markets use a centralised venue with standardised contracts, central counterparty clearing and published prices. OTC markets are decentralised networks where dealers negotiate customised terms directly with counterparties, offering flexibility but typically greater counterparty and transparency risk.
Example. A hypothetical fund buys a standardised index futures contract on an exchange with daily margining. Separately, a company signs a bespoke interest rate swap with its bank over the counter, with terms tailored to its exact loan.
Watch out. Assuming OTC means informal or unregulated: OTC trading is customised and decentralised, but it still operates within regulatory and documentation frameworks.
Self-check: A hypothetical trader wants a contract with non-standard size and maturity. Which market type fits, and what extra risk is typically accepted?
Answer: An OTC market fits, since terms are negotiated; the trader typically accepts greater counterparty credit risk and less price transparency than exchange trading.
13. Prudential regulation and supervision
Prudential regulation aims to keep financial institutions safe and sound so they can withstand shocks, using tools such as capital and liquidity requirements, supervisory review and reporting duties. It protects system stability and depositors or clients of the institution, complementing conduct regulation which focuses on fair treatment in transactions.
Example. Suppose a hypothetical bank must hold a buffer of capital above a supervisory minimum. In a downturn, losses absorb the buffer instead of immediately threatening depositors, and the supervisor can intervene early.
Watch out. Confusing prudential regulation with conduct regulation: prudential rules target institutional soundness; conduct rules target how firms behave toward clients.
Self-check: A hypothetical bank is well capitalised but mis-sells products to customers. Does prudential regulation address the mis-selling, and which branch of regulation does?
Answer: No; prudential rules address solvency and soundness. The mis-selling falls under conduct regulation and supervision of market behaviour.
14. Economic factors, market expectations and lessons from crises
Indicators such as GDP growth, inflation, unemployment and interest rates shape market expectations, and prices move on the gap between expected and actual outcomes. Financial crises share recurring lessons: excessive leverage, asset bubbles, poor risk assessment and weak risk management amplify shocks, and systems are interconnected so problems spread quickly.
Example. Suppose a hypothetical economy is expected to report strong growth. If actual data come in weaker, markets may fall even though the economy is still growing, because reality fell short of expectations.
Watch out. Thinking only bad actual data moves markets: an outcome that disappoints relative to expectations can move prices even when it is objectively decent news.
Self-check: In a hypothetical episode, easy credit fuels a housing bubble that bursts and strains banks. Identify two recurring crisis features illustrated.
Answer: Excessive credit and leverage inflates an asset bubble, and the bursting of that bubble transmits stress to financial institutions through interconnected exposures.
Topic 2: Financial system in Hong Kong
The roles of government bodies and regulators, the HKMA and Exchange Fund, participants such as authorized institutions and brokers, and the economic forces shaping Hong Kong's market.
15. Government agencies and advisory bodies
Government policy bureaus set financial-services policy and sponsor legislation, while advisory bodies provide forums through which the market and public can advise on regulatory and market development. Regulators such as the HKMA and SFC then implement and enforce the framework within their remits.
Example. Suppose a hypothetical new market-development proposal is consulted publicly. An advisory body gathers industry views, the policy bureau formulates the legislative approach, and the relevant regulator later supervises compliance once rules take effect.
Watch out. Assuming advisory bodies make binding rules: they advise; lawmaking sits with government and the legislature, and rule enforcement sits with regulators.
Self-check: In a hypothetical reform, industry representatives submit views that later become enforceable rules. Who advised, who made the rules and who enforces them?
Answer: The advisory body channelled views; government and the legislature made the rules; the relevant regulator enforces them.
16. HKMA, the Currency Board system and the Exchange Fund
The HKMA maintains currency stability under the Linked Exchange Rate System, a currency board arrangement in which the monetary base is backed by foreign currency reserves, so the exchange rate stays within a defined range through automatic interest-rate adjustments. The HKMA also manages the Exchange Fund and regulates authorized institutions.
Example. Suppose the hypothetical HKD weakens to the weak side of its permitted range. The currency board mechanism reduces the monetary base, pushing interbank rates up and making HKD holding more attractive, which stabilises the rate.
Watch out. Thinking the HKMA sets a discretionary interest rate like typical central banks: under the currency board, exchange-rate stability, not discretionary rates, is the anchor.
Self-check: In a hypothetical episode of strong HKD selling pressure, explain the currency board mechanism that restrains the fall.
Answer: Sales of HKD shrink the monetary base because it is fully backed by reserves; interbank rates rise, making HKD more attractive and supporting the rate.
17. The Securities and Futures Commission
The SFC is the independent statutory regulator of Hong Kong's securities and futures markets. Its functions include licensing intermediaries, supervising market conduct and issuers' ongoing disclosure, setting and enforcing rules, and taking enforcement action against misconduct to protect investors and maintain market integrity.
Example. Suppose a hypothetical brokerage mishandles client assets. The SFC can investigate, impose sanctions on the licensed firm and its individuals, and issue guidance so other intermediaries correct similar weaknesses.
Watch out. Assuming the SFC runs the trading venue: exchanges operate markets and perform delegated frontline functions, while the SFC is the statutory regulator overseeing the framework.
Self-check: In a hypothetical case of market manipulation, state which body licenses the trader and which body may take enforcement action.
Answer: The SFC both licenses intermediaries and takes statutory enforcement action against misconduct such as manipulation.
18. MPF Schemes Authority and Insurance Authority
The Mandatory Provident Fund Schemes Authority regulates retirement savings schemes, supervising trustees and protecting MPF scheme members' assets. The Insurance Authority is the independent regulator of insurers, licensing and supervising them and regulating insurance intermediaries, with a focus on policyholder protection and the soundness of the industry.
Example. Suppose a hypothetical employer enrolls staff in an MPF scheme and a separate insurer sells them protection policies. The MPFSA oversees the scheme's trustee, while the IA supervises the insurer and the intermediaries involved.
Watch out. Assuming one super-regulator covers everything: each authority has a distinct remit covering its own products, providers and participants.
Self-check: A hypothetical employee has an MPF account and an insurance policy. Match each product to its regulator and the protected party.
Answer: The MPF scheme is regulated by the MPFSA protecting scheme members; the policy is regulated by the IA protecting policyholders.
19. AFRC, exchanges and self-regulatory bodies
The Accounting and Financial Reporting Council oversees auditors and promotes high-quality financial reporting, supporting market confidence in published accounts. Exchanges and their clearing subsidiaries operate trading, clearing and settlement infrastructure, and perform frontline self-regulatory functions delegated or recognised within the regulatory framework.
Example. Suppose a hypothetical listed company publishes accounts with unusual accounting. The AFRC may scrutinise the auditor's work, while the exchange applies listing-related frontline processes and the SFC pursues disclosure issues as statutory regulator.
Watch out. Assuming exchanges are merely commercial venues: exchange group companies also carry frontline self-regulatory responsibilities for orderly and fair markets.
Self-check: In a hypothetical audit-quality concern over a listed issuer, which body examines the auditor and which body operates the listing venue?
Answer: The AFRC examines auditor and financial-reporting quality; the exchange company operates the listing and trading venue with frontline functions.
20. Authorized institutions: the three-tier banking system
Hong Kong's banking sector comprises three tiers of authorized institutions licensed and supervised by the HKMA: licensed banks, restricted licence banks and deposit-taking companies. Licensed banks may take deposits from the public without restriction, while the other two tiers face limits on the size or term of deposits they may accept, positioning them to serve wholesale or specialised funding needs.
Example. Suppose a hypothetical industrial bank focuses on wholesale business deposits and a finance company on larger, shorter deposits. Each operates under the tier whose deposit-taking permissions match its business model.
Watch out. Assuming all licensed deposit-takers are identical: tier determines what deposits may be accepted, so the restricted tiers face constraints licensed banks do not.
Self-check: A hypothetical non-bank company wants to accept unrestricted deposits from the public. Which tier would it need, and who licenses it?
Answer: It would need to become a licensed bank, the only tier authorised to take public deposits without restriction, licensed by the HKMA.
21. Fund houses, brokerage houses and investment banks
Fund houses manage pooled investment portfolios for clients, generating returns according to mandates. Brokerage houses execute securities transactions for clients and may add research and margin services. Investment banks advise on capital raising and corporate transactions and often underwrite and distribute new issues.
Example. In a hypothetical IPO, the investment bank underwrites and distributes the new shares, a brokerage house executes clients' first-day trades, and a fund house decides whether the stock belongs in its managed portfolio.
Watch out. Assuming one institution cannot wear several hats: large groups often house fund management, brokerage and advisory units, each subject to its own regulatory requirements.
Self-check: In a hypothetical scenario, who underwrites new shares, who executes retail orders and who manages pooled client money?
Answer: The investment bank underwrites; the brokerage house executes orders; the fund house manages the pooled portfolios.
22. Financial advisers, private wealth managers and family offices
Financial advisers help retail and mass-affluent clients choose suitable products and plans. Private wealth managers serve high-net-worth clients with tailored portfolios, credit and structuring. Family offices manage the finances of a single wealthy family across investments, succession and governance, an increasingly prominent participant segment in Hong Kong.
Example. Suppose a hypothetical entrepreneur sells her business. A family office may oversee the family's overall wealth and succession, while a private bank manages the investment portfolio and an adviser structures her retirement plan.
Watch out. Treating these labels as interchangeable: the distinction lies in the client served and the breadth of services, not merely in product choice.
Self-check: In a hypothetical scenario, whose needs are served by a family office rather than a retail financial adviser, and why?
Answer: A single wealthy family with complex, consolidated needs such as investments, succession and governance, which go beyond retail product advice.
23. Monetary policy versus fiscal policy
Monetary policy influences the economy through money and credit conditions, typically via interest rates or money supply, and is run by monetary authorities. Fiscal policy works through government spending and taxation to manage demand. In Hong Kong, the Linked Exchange Rate System means currency stability constrains independent monetary action, so fiscal policy carries substantial stabilising weight.
Example. Suppose a hypothetical slowdown hits Hong Kong. The government may raise spending or cut taxes to support demand, while interest rates largely track the currency arrangement rather than a local discretionary decision.
Watch out. Assuming Hong Kong sets interest rates freely to manage the domestic cycle: the currency board arrangement means local rates largely follow the anchor currency's conditions.
Self-check: In a hypothetical downturn, why might Hong Kong rely more on budget measures than on cutting interest rates?
Answer: Because the Linked Exchange Rate System anchors the currency, leaving limited room for discretionary rate cuts, so fiscal policy is the main stabilising lever.
24. Factors affecting the Hong Kong market
Hong Kong's open, externally oriented economy is shaped by Mainland Chinese trade, investment and financial linkages, by US monetary and economic conditions because of the currency link, and by global and regional trends. Regulatory, political and social developments and rapid technology change, including fintech adoption, also reshape participation and competition.
Example. Suppose a hypothetical US rate rise occurs while Mainland demand for Hong Kong services softens. Funding costs rise through the currency link, and lower cross-border activity weighs on trading and listings, showing the two influences compounding.
Watch out. Analysing influences in isolation: the Mainland economy, US conditions and global sentiment interact, and candidates should explain combined rather than single effects.
Self-check: In a hypothetical year of US rate rises, stronger Mainland trade through Hong Kong and rapid fintech growth, outline how these three forces might net out.
Answer: Higher US-linked rates raise funding costs, but stronger Mainland trade supports activity and fintech boosts efficiency; the net effect depends on the relative size of each force.
Topic 3: The equity market
Equity as ownership capital, methods of raising equity finance, pricing approaches, indices, exchanges, and the structure and settlement of Hong Kong's stock market.
25. What equity is and why investors buy it
Equity represents ownership of a company, giving shareholders residual claims on profits and assets after all creditors, typically paid through dividends and price appreciation. Equity financing lets companies raise permanent capital without mandatory repayments, while investors accept higher risk for potentially higher long-run returns than debt offers.
Example. Suppose a hypothetical investor buys 1,000 shares of a listed retailer. If profits grow, she may receive rising dividends and sell at a higher price, but if the retailer fails, she stands last in line behind creditors.
Watch out. Assuming dividends are guaranteed: they are discretionary distributions, unlike contractual coupon payments on debt.
Self-check: In a hypothetical liquidation, a company owes banks and bondholders and has little left. Rank ordinary shareholders and explain the trade-off they accepted.
Answer: Shareholders rank last, after banks and bondholders; they accepted residual risk in exchange for unlimited upside participation in profits.
26. Methods of raising equity finance
Companies raise equity by issuing new shares to new investors, such as through an IPO or a placing, or by offering shares to existing shareholders, such as through a rights issue. Bonus issues, by contrast, convert reserves into share capital without raising cash. Choosing a method turns on how much cash is needed, who should bear dilution and market conditions.
Example. Suppose a hypothetical listed firm needs new cash and wants all shareholders to participate proportionately. A rights issue at a discount lets existing holders subscribe or sell their rights, balancing funding needs against dilution control.
Watch out. Assuming every share issue raises money: a bonus issue increases share capital on paper but raises no new funds for the company.
Self-check: In a hypothetical case, a company wants new cash only from existing shareholders pro rata. Which method fits and why not a bonus issue?
Answer: A rights issue fits, since shareholders pay cash for new shares; a bonus issue raises nothing because shares are issued free from reserves.
27. Initial public offerings
An IPO is a company's first public share offering, converting it into a listed company. The process typically involves preparing a prospectus with prescribed disclosures, marketing the issue to investors, often with underwriters committing to take up unsold shares, and listing on an exchange, after which ongoing disclosure obligations apply.
Example. Suppose a hypothetical technology firm lists. It publishes a prospectus describing its business and risks, institutions indicate demand during marketing, underwriters support the placement, and the shares begin trading with a market-set price.
Watch out. Assuming the listing price is set by the company alone: the price reflects marketing and demand, and once listed, the market reprices it continuously.
Self-check: In a hypothetical IPO that attracts weak demand, explain one economic function of underwriting for the issuer.
Answer: The underwriter takes up unsold shares, giving the issuer assurance of raising the intended funds despite weak demand.
28. Rights issues and the theoretical ex-rights price
A rights issue offers existing shareholders the right to buy new shares, usually at a discount, in proportion to holdings, protecting them from dilution if they act. The theoretical ex-rights price blends the pre-issue price and the subscription price weighted by the number of existing and new shares.
Example. Hypothetically, shares trade at $10 and a rights issue offers one new share at $4 for every two shares already held. TERP = (2 x $10 + 1 x $4) / 3 = $8 per share, ignoring costs and any change in business value. The old shares and the subscription money together determine the theoretical blended price.
Watch out. Computing TERP as a simple average of the two prices: it must be weighted by the existing-to-new share ratio, not averaged equally.
Self-check: Hypothetically, a $6 share makes a 1-for-1 rights issue at $2. Calculate TERP and state whether the company raises cash.
Answer: TERP = (6 + 2) / 2 = $4. Yes, the company raises cash because holders pay the $2 subscription for each new share.
29. Bonus issues and price adjustment
A bonus issue distributes free additional shares to existing holders by capitalising reserves, increasing the number of shares without raising any cash. Because company value is spread over more shares, the market price adjusts downward proportionately, leaving each shareholder's total wealth unchanged in theory.
Example. Suppose a hypothetical 1-for-1 bonus issue on a $10 share. After the issue the theoretical price becomes about $5, and a holder with 100 shares now has 200 shares worth roughly the same $1,000.
Watch out. Believing a bonus issue enriches shareholders: the value split across more shares leaves total holding value unchanged; it signals capitalisation of reserves instead.
Self-check: Hypothetically, a company announces a 1-for-2 bonus issue on a $9 share. What is the indicative adjusted price and has cash been raised?
Answer: Adjusted price = 9 / 1.5 = $6. No cash is raised; reserves were capitalised into share capital only.
30. Methods of equity pricing
Common valuation approaches include dividend-based models, which discount expected future dividends; earnings multiples, which apply a price-to-earnings ratio to profit per share; and net asset value approaches, which value the business from its assets less liabilities. The suitable method depends on the company's payout record, profitability and asset intensity.
Example. Hypothetically, a stable utility pays dependable dividends, so a dividend discount model fits. A fast-growing but asset-light software firm with no dividends may be better compared using an earnings multiple against similar listed peers.
Watch out. Applying one method everywhere: a NAV approach may misprice an asset-light growth firm, while dividend models cannot value non-payers at all.
Self-check: Hypothetically, a mature insurer pays reliable dividends while a start-up earns nothing but owns property. Suggest a sensible valuation method for each.
Answer: Discount the insurer's expected dividends; value the start-up primarily on the net asset value of its property, since earnings multiples lack a positive earnings base.
31. Stock market indices
A stock market index measures the performance of a whole market or a segment, constructed from constituent shares using a weighting method, so movements in larger constituents matter more in capitalisation-weighted indices. Indices serve as performance benchmarks, underlie index funds and derivatives, and summarise market direction for investors.
Example. Suppose a hypothetical capitalisation-weighted index includes one giant bank and many small firms. If the bank's shares jump 10 percent while the small firms are flat, the index rises noticeably because of the bank's large weight.
Watch out. Assuming an index tracks the average share equally: in capitalisation-weighted indices, the biggest companies dominate index moves.
Self-check: In a hypothetical index, two large constituents fall while dozens of small constituents rise slightly. Which direction does a capitalisation-weighted index most likely move?
Answer: Likely downward, because the heavy weighting of the two large falling constituents outweighs the small gains of many lighter constituents.
32. The stock exchange, and bull versus bear markets
A stock exchange provides the organised venue, rules and surveillance for fair, orderly and efficient trading of listed securities. A bull market describes a sustained period of rising prices and optimism, while a bear market describes a sustained decline and pessimism; the terms describe broad, persistent trends rather than single-day moves.
Example. Suppose a hypothetical market rises around 20 percent over many months on strong earnings, then falls persistently for an extended period as recession fears build. Commentators would describe a bull phase followed by a bear phase.
Watch out. Labelling any sharp daily move a bull or bear market: the terms require sustained directional trends, not short-term volatility.
Self-check: In a hypothetical week, prices fall 3 percent then rebound 2 percent. Should this be called the start of a bear market?
Answer: No; a bear market implies a sustained, broad decline, whereas these are short-term fluctuations within an overall trend.
33. Privatisation of government-owned companies
Privatisation transfers government-owned enterprises to private ownership, often by listing shares publicly. Governments pursue it to raise revenue, improve commercial efficiency and discipline through market oversight, and to deepen the local equity market, while retaining, in some cases, strategic or golden-share interests in sensitive businesses.
Example. Suppose a hypothetically state-owned electricity utility is listed. The government sells a stake to the public, the utility gains market-based scrutiny of its costs, and retail investors gain a new defensive stock.
Watch out. Assuming privatisation always transfers full control: governments sometimes keep special rights or significant shareholdings in privatised strategic entities.
Self-check: In a hypothetical listing of a state-owned port operator, give two motives for the government and one way the market gains.
Answer: Motives: raising revenue and improving commercial efficiency through market discipline; the market gains a new listed instrument deepening the equity market.
34. Structure and development of the Hong Kong equity market
Hong Kong's stock market developed from several brokerage exchanges into a unified market with international and Mainland connections. SEHK operates the Main Board and GEM, with different admission and continuing requirements. Compare the issuer's eligibility, financing needs and investor base; a company's age or industry alone does not determine its listing venue.
Example. Hypothetically, a growing business compares Main Board and GEM entry requirements before deciding where to apply. It must establish eligibility under the relevant rules instead of assuming that every smaller company qualifies for GEM.
Watch out. Assuming all listed companies face identical admission standards: the boards are deliberately tiered to suit companies of different size, maturity and risk profiles.
Self-check: Can you choose a company's listing board solely because it is young or small?
Answer: No. Consider the separate admission requirements and the company's circumstances. Age and size alone do not establish eligibility for either board.
35. Types of equity securities and market participants
Ordinary shares carry voting rights and residual claims; preference shares typically offer fixed dividend priority and rank ahead of ordinary shares on distributions, often with limited or no voting rights; equity-linked instruments such as warrants give rights over shares. Participants include retail investors, institutional investors, listed issuers, brokers and market makers.
Example. Suppose a hypothetical company issues preference shares paying a fixed dividend and ordinary shares. In a weak year it may pay preference dividends first, while ordinary holders receive nothing yet keep their votes.
Watch out. Assuming preference shareholders control the company: their priority on distributions usually comes with reduced or absent voting rights compared with ordinary shareholders.
Self-check: In a hypothetical year with limited profit, who is paid first and who retains voting control: preference or ordinary shareholders?
Answer: Preference shareholders are paid their fixed dividend first; ordinary shareholders generally retain voting control despite being last in distributions.
36. Trading and settlement of Hong Kong equities
Investors trade through brokers on the exchange's automated system, and settlement of listed securities occurs through the central clearing and depository system, with trades generally settled two business days after trade date on a T+2 cycle. Centralised settlement nets obligations and holds securities in electronic form, reducing risk and paperwork.
Example. Suppose a hypothetical investor buys shares on Monday. The trade matches instantly on the exchange system, and settlement moves shares and money through the central depository by Wednesday, the second business day after the trade.
Watch out. Confusing trade date with settlement date: ownership and cash transfer on settlement day, not the day the trade was executed.
Self-check: Hypothetically, shares trade on Thursday. On which calendar day does T+2 settlement fall, assuming no holidays?
Answer: Count two business days after Thursday: Friday is T+1 and Monday is T+2, so settlement occurs on Monday.
Topic 4: The debt market
Debt concepts and bond categories, time value of money and bond pricing calculations, interest rate measures, credit ratings, the yield curve, repos and Hong Kong's debt market.
37. What debt is and how it differs from equity
Debt is borrowed money that the issuer must repay with interest under a contractual schedule; debt holders are creditors, not owners. Debt securities such as bonds specify principal, coupon and maturity, and holders rank ahead of shareholders if the issuer is wound up, but they do not share in the issuer's profits beyond agreed interest.
Example. Suppose a hypothetical company issues a five-year bond and also has ordinary shares. Bondholders receive fixed coupons and principal at maturity regardless of profits, while shareholders receive nothing fixed but own the residual business.
Watch out. Assuming higher risk always means equity: for the investor, debt usually carries lower risk than the same issuer's equity but lower potential upside.
Self-check: In a hypothetical wind-up, rank the claims of bondholders, ordinary shareholders and unsecured bank lenders, briefly justifying the order.
Answer: Generally secured and priority creditors first, then unsecured lenders and bondholders as creditors, with ordinary shareholders last, because debt is contractual and equity is residual.
38. Characteristics of debt securities
Key characteristics include par (face) value, the coupon rate and payment frequency, maturity date, redemption terms and the issuer's identity and covenants. These features determine the cash flows the investor receives and how sensitive the bond's price is to changes in market interest rates.
Example. Suppose a hypothetical bond has $100,000 par, a 5 percent annual coupon and 10-year maturity. The investor expects $5,000 each year plus $100,000 at year 10, whatever happens to market rates meanwhile.
Watch out. Confusing coupon rate with yield: the coupon is fixed at issue against par, while the yield reflects the current price and market conditions.
Self-check: Hypothetically, a bond's price falls below par after issue. Does its coupon rate change, and what adjusts instead?
Answer: No; the coupon stays fixed. The market yield adjusts because the fixed cash flows are now being bought at the lower price.
39. Advantages of investing in debt securities
Debt offers predictable contractual income, repayment of principal at maturity if the issuer does not default, and generally higher standing than equity in insolvency. It diversifies an equity-heavy portfolio because bond prices respond more to interest rate and credit conditions than to shareholder profit expectations.
Example. Suppose a hypothetical retiree holds only shares with fluctuating dividends. Shifting part into investment-grade bonds gives fixed coupons that fund living costs and reduces exposure to equity price swings.
Watch out. Assuming bonds are risk-free: default risk, interest rate risk and inflation risk all still apply, varying with issuer and maturity.
Self-check: In a hypothetical rising-rate environment, name one advantage a bondholder retains and one risk that grows.
Answer: The contractual coupons and promised principal remain; the risk grows that the bond's market price falls as yields rise if sold before maturity.
40. Nominal, real and effective interest rates
The nominal rate is the stated rate before inflation; the real rate adjusts for inflation to show purchasing-power growth, approximately nominal minus inflation or exactly (1 + nominal) / (1 + inflation) - 1. The effective rate is different again: it annualises compounding so that rates with different compounding frequencies can be compared.
Example. Hypothetically, a deposit pays 6 percent nominal with inflation at 2 percent. Real rate = 1.06 / 1.02 - 1 = 0.0392, about 3.92 percent. Separately, its effective annual rate depends on how often interest compounds.
Watch out. Using 'real' and 'effective' interchangeably: real adjusts for inflation, effective adjusts for compounding frequency; they answer different questions.
Self-check: Hypothetically, a bond yields 8 percent when inflation is 3 percent. Compute the exact real rate with units.
Answer: Real rate = 1.08 / 1.03 - 1 = 0.04854, i.e. about 4.85 percent per year of purchasing-power growth.
41. Calculating the effective annual rate
The effective annual rate converts a nominal rate with intra-year compounding into one annual compounding rate: EAR = (1 + nominal / m)^m - 1, where m is the number of compounding periods per year. More frequent compounding at the same nominal rate always produces a higher effective rate.
Example. Hypothetically, a product pays 12 percent nominal compounded monthly. EAR = (1 + 0.12/12)^12 - 1 = (1.01)^12 - 1 = 0.1268, i.e. about 12.68 percent, higher than 12 percent because interest earns interest monthly.
Watch out. Quoting the nominal rate as if it were the true annual cost or return: with monthly compounding, the effective rate exceeds the nominal rate.
Self-check: Hypothetically, two accounts both pay 10 percent nominal, one compounded semi-annually and one quarterly. Which has the higher EAR, and why?
Answer: The quarterly one: EAR = (1 + 0.10/4)^4 - 1 = 10.38 percent versus (1 + 0.05)^2 - 1 = 10.25 percent, since more frequent compounding earns interest on interest sooner.
42. Categorising bonds
Bonds are commonly categorised by issuer, such as government, quasi-government or corporate; by credit quality, from high-grade to speculative; and by coupon structure, such as fixed, floating or zero coupon. Maturity bands and currency also matter. Classification determines risk profile, liquidity and typical investors.
Example. Suppose a hypothetical investor compares a government bond with a start-up's high-yield corporate bond. The categories signal different default risk, liquidity and coupon levels, guiding whether the instrument suits her mandate.
Watch out. Assuming the label alone sets risk: a short senior corporate bond may be safer than a long-dated instrument from a weaker sovereign, so inspect the features.
Self-check: In a hypothetical portfolio, sort these by issuer category: a utility's note, a treasury bill, a development bank bond.
Answer: Treasury bill: central government; utility's note: corporate issuer; development bank bond: quasi-government/ supranational-type issuer.
43. Time value of money
A dollar today is worth more than a dollar later because it can earn interest meanwhile, so future cash flows are discounted back using a rate reflecting opportunity cost and risk. Present value equals the future cash flow divided by (1 + r)^n, where r is the periodic rate and n the number of periods.
Example. Hypothetically, $110,000 arrives in one year at a 10 percent rate. PV = 110,000 / 1.10 = $100,000, meaning $100,000 today grows to the same $110,000, so the two amounts are equivalent at that rate.
Watch out. Adding cash flows from different dates directly: sums must first be discounted (or compounded) to a common date before comparison.
Self-check: Hypothetically, which is worth more at 5 percent per year: $10,000 today or $10,800 in one year?
Answer: $10,800 in one year: PV = 10,800 / 1.05 = $10,285.71, which exceeds $10,000 today.
44. Pricing zero coupon bonds
A zero coupon bond pays only its par value at maturity, so its price is simply the discounted par value: Price = Par / (1 + r)^n. Because the entire return comes from buying below par, zeros are more sensitive to interest rate changes than coupon bonds of the same maturity.
Example. Hypothetically, a zero with $100,000 par, three years to maturity and a 5 percent market yield prices at 100,000 / (1.05)^3 = 100,000 / 1.157625 = $86,383.76. The discount of $13,616.24 is the total interest earned.
Watch out. Assuming the investor receives interim cash: a zero pays nothing until maturity, so price movements are the only source of return before then.
Self-check: Hypothetically, a two-year zero with $50,000 par and a 4 percent yield: compute the price with steps.
Answer: Price = 50,000 / (1.04)^2 = 50,000 / 1.0816 = $46,227.81, the discounted value of the single maturity payment.
45. Pricing coupon bonds
A coupon bond's price is the present value of all coupons plus the discounted par value: Price = sum of C / (1 + r)^t for each period plus Par / (1 + r)^n. If the market yield equals the coupon rate the bond prices at par; above it, the bond prices at a discount; below it, at a premium.
Example. Hypothetically, a two-year annual-pay bond: par $1,000, coupon 6 percent, market yield 5 percent. Price = 60/1.05 + 1060/(1.05)^2 = 57.14 + 961.45 = $1,018.59, a premium because the coupon exceeds the yield.
Watch out. Forgetting to add the discounted par value, or discounting coupons with the coupon rate: discounting must use the market yield throughout.
Self-check: Hypothetically, a bond with an 8 percent coupon trades when market yields are 8 percent. State its price relative to par and justify.
Answer: It prices at par, since the fixed coupons exactly compensate investors at the market yield, so the present value of cash flows equals the par value.
46. Credit ratings and rating agencies
Credit rating agencies assess the likelihood that an issuer will meet its debt obligations, assigning letter-grade ratings that summarise default risk. Higher-grade ratings, broadly described as investment grade, usually mean lower borrowing costs, while lower grades indicate speculative credit and higher required yields. Ratings can be revised, and downgrades typically push prices down.
Example. Suppose a hypothetical corporate bond is downgraded from a strong investment-grade level to a speculative level. Some mandate-constrained investors must sell, the bond's price falls, and its yield rises to compensate new buyers.
Watch out. Treating ratings as guarantees or real-time truth: they are opinions about creditworthiness as at the rating date and can lag rapidly changing conditions.
Self-check: In a hypothetical downgrade, explain the likely direction of the bond's yield and price, and why.
Answer: Yield rises and price falls: the same cash flows now carry higher perceived default risk, so investors demand greater compensation, which the price must adjust to deliver.
47. The inverse relationship between yield and price
Bond prices and yields move inversely: when market yields rise, existing fixed coupons are worth less and prices fall; when yields fall, prices rise. Longer-maturity and lower-coupon bonds experience larger price swings for a given yield change because their cash flows are received further in the future.
Example. Hypothetically, rates rise by one percentage point. A 20-year low-coupon bond's price drops far more than a one-year bond's, because the 20-year cash flows are discounted at the higher rate over many more periods.
Watch out. Assuming a price fall means the issuer is failing: rate-driven price declines reflect market yields, not necessarily any change in the issuer's creditworthiness.
Self-check: Hypothetically, market yields fall. State what happens to an existing fixed-coupon bond's price, and which bond gains more: a 2-year or a 15-year of the same credit?
Answer: The price rises; the 15-year bond gains more because its longer-dated cash flows are discounted at the now-lower rate over more periods, amplifying the price increase.
48. The yield curve: normal, inverted and flat
The yield curve plots yields of similar-quality bonds across maturities. A normal curve slopes upward, reflecting higher compensation for longer maturities; an inverted curve slopes downward, often signaling expectations of weaker growth or coming rate cuts; a flat curve shows little difference between short and long yields.
Example. Suppose a hypothetical market shows one-year yields above ten-year yields. That inverted shape may indicate investors expect the central bank to cut rates as activity slows, even though current short rates are high.
Watch out. Memorising shapes without meaning: each shape encodes market expectations about future rates and growth, which is what exam scenarios test.
Self-check: In a hypothetical market, three-month yields equal ten-year yields after short rates fell. Name the curve shape and one interpretation.
Answer: A flat curve; one interpretation is market uncertainty or an expectation that rates will stay broadly unchanged across maturities.
49. Repurchase agreements (repos)
In a repo, one party sells securities to another with an agreement to repurchase them later at a set price, effectively a collateralised short-term borrowing. The seller obtains funding cheaply because the buyer holds collateral, and the difference between sale and repurchase prices implies the repo interest rate. Repos are widely used for liquidity management and by monetary authorities in market operations.
Example. Hypothetically, a dealer needs cash overnight. It sells government bonds to a fund for $10,000,000 and agrees to buy them back tomorrow for $10,001,500; the $1,500 difference is the overnight repo interest.
Watch out. Mistaking a repo for an outright sale: legal title transfers temporarily, but the transaction is economically a secured loan repaid at the agreed price.
Self-check: In a hypothetical repo of $5,000,000 of bonds sold at $5,000,000 and repurchased at $5,000,600 after one month, what does the $600 represent?
Answer: The collateralised interest cost of the one-month borrowing: the repo rate applied to the $5,000,000 cash advanced against the bonds.
50. The Hong Kong debt market: structure and settlement
Hong Kong's debt market includes Exchange Fund instruments and other government paper, a deep private-sector CD and corporate bond segment, and substantial foreign issuer participation. The central moneymarkets unit provides book-entry clearing and settlement for Exchange Fund paper, while the debt securities settlement infrastructure supports efficient custody and transfer for other debt instruments.
Example. Suppose a hypothetical bank wants to hold short-term government paper for liquidity. It buys Exchange Fund bills, which settle electronically through the central moneymarkets unit and can be used as high-quality collateral.
Watch out. Assuming all Hong Kong debt settles through equity-style systems: government moneymarket instruments use dedicated book-entry settlement tailored to wholesale debt trading.
Self-check: In a hypothetical trade, a fund buys Exchange Fund notes and later corporate bonds in Hong Kong. Describe the settlement distinction.
Answer: Exchange Fund notes settle by book entry through the central moneymarkets unit; the corporate bonds use the general debt securities settlement and custody arrangements.
Topic 5: The foreign exchange and derivatives markets
Exchange rates and regimes, cross and forward rate calculations, derivatives and their functions, the main derivative categories, and Hong Kong's derivatives market.
51. The foreign exchange market: terms and structure
The FX market is where one currency is exchanged for another, quoted as a rate expressing how much of one currency buys a unit of the other. It is a global, largely OTC market operating continuously across time zones, with dealers quoting bid (buy) and ask (sell) prices and profiting partly from the spread.
Example. Suppose a hypothetical dealer quotes USD against HKD at bid 7.7980 and ask 7.8020. A client buying USD from the dealer pays 7.8020 HKD per USD, while a client selling USD receives 7.7980 HKD per USD.
Watch out. Applying the wrong side of the quote: the dealer buys at the bid and sells at the ask, so clients always transact on the side that favours the dealer.
Self-check: Hypothetically, a quote shows bid 1.2050 and ask 1.2070 for EUR against USD. At which side does a client sell EUR to the dealer?
Answer: At the bid, 1.2050 USD per EUR, because the dealer buys the base currency at its bid price.
52. Exchange rate regimes
Exchange rate regimes range from freely floating rates set by market forces, to managed floats with occasional intervention, to fixed or pegged arrangements. Under Hong Kong's Linked Exchange Rate System, a currency board design keeps HKD within a defined band around the US dollar link, with the monetary base fully backed by reserves.
Example. Suppose a hypothetical country lets supply and demand set its currency value with no target. Contrast a pegged neighbour that buys or sells reserves whenever its currency hits the edge of its agreed band.
Watch out. Assuming a peg removes all pressure: pegs convert exchange-rate pressure into interest-rate and reserve movements, as the currency board mechanism shows.
Self-check: In a hypothetical speculative attack on a currency peg, where does the pressure reappear if the peg holds?
Answer: In domestic interest rates and reserve levels: defending the rate requires monetary adjustment, since the exchange rate itself is fixed.
53. Participants in the FX market
Main participants include commercial and investment banks that quote two-way prices as market makers, central banks managing reserves and currency stability, corporates exchanging currencies for trade and investment, institutional investors and fund managers taking positions or hedging, and FX brokers matching flows.
Example. Hypothetically, an exporter receives US dollars and sells them for local currency, its bank quotes the two-way price, the central bank observes the flow for stability reasons, and an investment fund separately buys the dollar for a portfolio position.
Watch out. Assuming all participants aim to profit from FX movements: corporates and central banks typically transact for business or policy purposes, not speculation.
Self-check: In a hypothetical flow, who quotes prices, who hedges trade exposure and who intervenes for currency stability?
Answer: Banks quote two-way prices; the corporate hedges its trade exposure; the central bank acts for currency and reserve stability.
54. Cross rates
A cross rate is the exchange rate between two currencies derived through a common third currency, usually the US dollar, when no direct quote exists. Multiply or divide the two published rates so the common currency cancels, checking units so the result is expressed in the desired currency pair.
Example. Hypothetically, USD/JPY = 150.00 (JPY per USD) and USD/CHF = 0.9000 (CHF per USD). JPY per CHF = 150.00 / 0.9000 = 166.67. So one CHF buys about 166.67 JPY at these hypothetical rates.
Watch out. Multiplying when division is needed: always write the units out so the common currency cancels; wrong direction gives a nonsensical rate.
Self-check: Hypothetically, GBP/USD = 1.2500 and USD/HKD = 7.8000. Compute the HKD per GBP cross rate with steps.
Answer: 1 GBP = 1.2500 USD, and 1 USD = 7.8000 HKD, so 1 GBP = 1.2500 x 7.8000 = 9.7500 HKD.
55. Forward rates and forward premium or discount
A forward rate is agreed today for exchange at a future date, differing from spot to reflect interest rate differences between the currencies. The forward premium or discount measures the percentage deviation of the forward from spot: (forward - spot) / spot. A positive result means the base currency trades at a forward premium; negative means a discount.
Example. Hypothetically, spot USD/HKD = 7.8000 and the one-year forward = 7.9000. Premium = (7.9000 - 7.8000) / 7.8000 = +0.01282, so USD trades at about a 1.28 percent forward premium against HKD at these hypothetical rates.
Watch out. Mixing up which currency is at the premium: the sign applies to the base currency of the quote, so state the currency pair clearly in the answer.
Self-check: Hypothetically, spot EUR/USD = 1.1000 and the six-month forward = 1.0945. Calculate the premium or discount, with sign, for EUR.
Answer: (1.0945 - 1.1000) / 1.1000 = -0.005, so EUR trades at about a 0.5 percent forward discount against USD.
56. What derivatives are
A derivative is a financial contract whose value is derived from an underlying asset, rate or index, such as shares, bonds, currencies, commodities or market benchmarks. The derivative itself involves an agreement about future outcomes on the underlying, so parties can gain exposure to it without necessarily owning it.
Example. Suppose a hypothetical contract pays the difference if the Hang Seng-type index ends above an agreed level. Its value moves with the index, though the buyer owns none of the constituent shares.
Watch out. Assuming derivatives require ownership of the underlying: exposure is contractual, which is exactly why small capital can carry large underlying exposure.
Self-check: In a hypothetical scenario, a farmer agrees today to sell wheat at a fixed price at harvest. Why is this agreement a derivative?
Answer: Its value is derived from the underlying wheat price; the contract fixes future terms on an underlying asset without immediate delivery.
57. Functions of derivatives
Derivatives let users hedge, transferring unwanted price risk to those willing to bear it; speculate, taking directional positions with less capital than the underlying; and arbitrage, exploiting price differences between related markets, which helps keep prices consistent. They also contribute to price discovery by aggregating expectations.
Example. Hypothetically, an airline fearing higher fuel costs buys derivatives paying off if fuel rises, while a speculator takes the other side expecting prices to fall. The airline's risk is transferred and the market's collective price view is refined.
Watch out. Assuming derivatives are inherently risky instruments: their risk depends on use; the same contract can be a prudent hedge for one party and a leveraged bet for another.
Self-check: In a hypothetical trade, a fund buys index futures fully offsetting its shareholdings. Which function is performed, and who bears the transferred risk?
Answer: Hedging; the counterparty taking the opposite position bears the market risk the fund transferred away.
58. Forwards versus futures
Both are agreements to transact at a set price on a future date. Forwards are OTC, customised and settled at maturity, exposing each party to the other's counterparty risk. Futures are exchange-traded, standardised, margined daily and guaranteed by a clearing house, which substantially reduces counterparty risk.
Example. Hypothetically, a chocolate maker needs exactly 37 tonnes of cocoa delivered to a specific port in seven months; a bespoke forward fits. A fund wanting simple index exposure trades standardised futures with daily margin flows instead.
Watch out. Assuming futures are risk-free: counterparty risk is largely addressed by clearing and margin, but market risk remains fully present.
Self-check: In a hypothetical comparison, why might a corporate accept forward counterparty risk instead of using futures?
Answer: Because the forward can be tailored in size, timing and delivery to match its exact commercial exposure, which standardised futures cannot.
59. Options: calls, puts and asymmetric payoffs
An option gives the buyer the right, but not the obligation, to buy (call) or sell (put) an underlying at a strike price by or at expiry, for a premium paid upfront. The buyer's loss is capped at the premium while upside can be large; the seller collects the premium but bears potentially large adverse moves.
Example. Hypothetically, an investor pays a $5 premium for a call with a $100 strike. If the share ends at $120, the option payoff is $20 and net profit is $20 - $5 = $15 per share. At $90, the option expires worthless and the loss is the $5 premium, ignoring fees.
Watch out. Assuming buyers must exercise: the option can lapse worthless, which is the defining right-not-obligation feature separating options from forwards and futures.
Self-check: Hypothetically, a put is struck at $50 with a $3 premium and the underlying ends at $44. Compute the buyer's net result.
Answer: Intrinsic payoff = 50 - 44 = $6; net result = 6 - 3 = $3 profit per unit, since the right to sell at $50 exceeds the market price.
60. Swaps
A swap is an agreement to exchange streams of future cash flows according to agreed terms, most commonly exchanging fixed for floating interest payments on a notional principal. Swaps are typically OTC contracts used to transform the nature of existing exposures, such as converting fixed-rate borrowing into floating-rate cost.
Example. Hypothetically, a company pays fixed 4 percent on a $10 million loan but prefers floating. It enters a swap paying a floating reference rate and receiving 4 percent fixed on the same notional, converting its net cost to floating.
Watch out. Assuming notional principal changes hands: usually only the interest differences are exchanged, not the notional amount itself.
Self-check: In a hypothetical plain interest-rate swap, assume a one-year accrual period, $20 million notional, a 3.5% floating rate and a 4% fixed rate. Who makes the net payment, and how much?
Answer: The fixed-rate payer pays the fixed-rate receiver, who is the floating-rate payer. Net payment = (4% - 3.5%) x $20,000,000 x 1 year = $100,000. The notional principal is not exchanged in this assumed interest-rate swap.
61. Structure and products of the Hong Kong derivatives market
Hong Kong's exchange-traded derivatives trade on the futures exchange within the exchange group, alongside OTC activity negotiated between institutions. Key listed product types include stock index futures and options, single-stock futures and options, and other financial and commodity derivative contracts, cleared through the group's clearing infrastructure.
Example. Suppose a hypothetical fund wants to hedge a portfolio of Hong Kong shares. It can sell index futures on the exchange for broad exposure, or buy put options on individual stocks for targeted downside protection.
Watch out. Assuming every derivative traded in Hong Kong is exchange-traded: bespoke OTC contracts between professional counterparties form an important parallel segment.
Self-check: In a hypothetical scenario, distinguish who would use index futures versus single-stock options for hedging a Hong Kong portfolio.
Answer: Index futures hedge overall market exposure; single-stock options hedge downside risk in specific individual holdings.
62. Derivatives participants, trading and settlement
Derivatives participants include hedgers reducing risk, speculators accepting risk for profit and arbitrageurs aligning prices across markets; exchanges, brokers and clearing houses supply the infrastructure. Exchange-traded positions are margined daily with gains and losses settled through the clearing house, creating an orderly cycle of variation margin and position reporting.
Example. Hypothetically, a hedger's futures position loses value on a given day. The clearing house collects variation margin from her account and pays it to counterparties whose positions gained, keeping cumulative exposures covered daily.
Watch out. Assuming profits or losses are only realised at expiry: daily margining moves cash every day, so funding liquidity matters even for positions held to settlement.
Self-check: In a hypothetical day, a speculator's long futures position gains. Describe the settlement mechanics and role of the clearing house.
Answer: The clearing house credits variation margin to the speculator's account, funded by counterparties whose positions lost, guaranteeing performance and settling gains daily.
Topic 6: Financial risk management
The nature of risk and return, major financial risk types, the risk management process, systems and techniques used in Hong Kong, and lessons from past failures.
63. What risk is, and risk versus expected return
Financial risk is the possibility that actual outcomes differ unfavourably from expectations, including losing money or failing to meet objectives. Investors generally require higher expected returns to accept higher risk, so risk and expected return are positively related; the discipline lies in pricing that trade-off rather than avoiding risk blindly.
Example. Hypothetically, a government bill offers a low return with minimal default risk, while a start-up bond offers a much higher yield partly as compensation for possible default. The extra return is payment for bearing extra risk.
Watch out. Equating high return with skill: sustained above-market returns usually signal above-market risk being taken somewhere in the portfolio.
Self-check: In a hypothetical choice, fund A returns 4 percent with minimal risk, fund B returns 9 percent with high volatility. Explain the relationship candidates should identify.
Answer: B's higher expected return compensates for its higher risk; the choice depends on the investor's risk tolerance and objectives, not on return alone.
64. Fundamental risk management techniques
Core techniques are: avoid the risk by not undertaking the activity; reduce it through controls and diversification; transfer it to another party, for example by hedging or insurance; and accept (retain) it where the cost of managing exceeds the benefit, ideally with monitoring and limits. Choice depends on cost, materiality and the entity's capacity to bear loss.
Example. Hypothetically, a broker avoids some risks by not offering certain products, reduces operational risk with system controls, transfers market risk using futures, and accepts small residual risks within set limits.
Watch out. Assuming transfer eliminates risk entirely: hedging shifts market risk but can introduce counterparty, basis and liquidity risks in its place.
Self-check: In a hypothetical firm, exiting a volatile business line entirely names which technique, and which technique suits a small residual exposure?
Answer: Exiting is risk avoidance; a small residual exposure is best accepted (retained) with monitoring and limits.
65. Credit risk and settlement risk
Credit risk is the risk that a counterparty fails to meet contractual obligations, such as a bond issuer defaulting. Settlement risk is the specific risk that you pay your side of a trade but do not receive the other side, arising from timing differences in settling the two legs, particularly across time zones in FX deals.
Example. Hypothetically, a bank pays yen to a counterparty in Tokyo in the morning and expects dollars back later in the New York day. If the counterparty fails in between, the bank has paid but received nothing, a classic settlement risk scenario.
Watch out. Merging the two risks: credit risk covers any failure to perform; settlement risk concerns the dangerous window when one leg is paid before the other.
Self-check: In a hypothetical FX trade settled leg-by-leg across time zones, name the specific risk and one way its impact is reduced.
Answer: Settlement risk (principal risk); it is reduced by mechanisms such as payment-versus-payment settlement linking both legs so neither pays without receiving.
66. Market risk and basis risk
Market risk is exposure to losses from movements in market prices such as interest rates, exchange rates and equity prices. Basis risk arises when a hedge instrument does not move perfectly with the exposure being hedged, so even a well-sized hedge leaves residual risk from the imperfect correlation between the two.
Example. Hypothetically, a fund hedges a portfolio of smaller shares by selling index futures. If the index falls 5 percent but the portfolio falls 7 percent, the extra 2 percent loss is unhedged basis risk from imperfect correlation.
Watch out. Assuming a hedge in place means no market risk remains: an imperfect hedge still leaves both basis risk and any mismatch in size or timing.
Self-check: In a hypothetical oil hedge using a related but different product's futures, what residual risk remains if prices diverge, and what is it called?
Answer: The residual loss from the price gap between the hedge instrument and the exposure remains; it is basis risk.
67. Liquidity risk
Liquidity risk has two faces: funding liquidity risk, the inability to meet cash obligations as they fall due; and market liquidity risk, the inability to sell an asset quickly without a large price discount. Both can turn otherwise sound positions into losses when cash needs and market depth fail to align.
Example. Hypothetically, a fund holds sound long-term bonds but faces client redemptions this week. If the bond market is thin, it must sell at a deep discount, converting a funding shortfall into realised losses.
Watch out. Assuming high-quality assets eliminate liquidity risk: even sound assets can be hard to sell quickly in stressed markets without accepting significant price cuts.
Self-check: In a hypothetical stress, distinguish the two liquidity risks facing an investment firm with redemptions due and illiquid holdings.
Answer: Funding liquidity risk: insufficient cash to pay redemptions on time; market liquidity risk: disposing of assets quickly only at large price discounts.
68. Operational risk
Operational risk is the risk of loss from inadequate or failed internal processes, people and systems, or from external events, spanning fraud, errors, system outages and business disruption. It is distinct from deliberate market or credit taking, and is managed through controls, segregation of duties, technology resilience and contingency planning.
Example. Hypothetically, a trading error enters a wrong order size, a rogue employee conceals losses, or a data-centre outage blocks client orders on a busy day. Each is an operational loss event, not a market movement.
Watch out. Filing every problem under 'operational' automatically: the distinguishing feature is failed processes, people, systems or external events, not price or credit moves.
Self-check: In a hypothetical scenario, classify these: a typo causing an over-order of shares; a bond issuer default; a fire shutting the office.
Answer: The typo is operational (process/people error); the default is credit risk; the fire is operational via external events.
69. Other financial risks: legal, systemic and country risk
Beyond the core categories, firms face legal risk from unenforceable contracts or litigation; regulatory risk from changing rules; country risk from political or economic instability in a counterparty's jurisdiction; and systemic risk, where failure of one institution or market spreads through interconnections to destabilise the whole system.
Example. Hypothetically, a bank lends across borders and the borrower's country imposes foreign exchange restrictions, blocking repayment. Separately, one large dealer's failure could freeze lending to many others, illustrating systemic transmission.
Watch out. Overlooking systemic risk in firm-level analysis: risk assessment must consider interconnections, since one participant's distress can become everyone's problem.
Self-check: In a hypothetical chain where one bank's default triggers losses at its trading partners, name the risk and the feature that spreads it.
Answer: Systemic risk; interconnected exposures and shared market channels transmit distress from one institution to others across the system.
70. The risk management process: identifying and measuring risk
Risk management follows a cycle: identify exposures across products, operations and markets; measure them using tools such as sensitivity analysis, scenario analysis and stress testing; then manage and monitor. Measurement matters because unmeasured risk cannot be limited, priced or reported, and because aggregation reveals concentrations invisible position by position.
Example. Hypothetically, a treasury desk identifies exposures to interest rates and counterparty default, measures how much value moves for a one-point rate rise, and stress tests a hypothetical sharp rate spike to size potential losses before setting limits.
Watch out. Jumping straight to hedging without measuring: without quantification, the firm cannot know how much to hedge or whether the hedge worked.
Self-check: In a hypothetical portfolio, why must risk be measured before it is managed, in one or two sentences?
Answer: Because management decisions such as limits, hedging size and capital allocation require quantified exposures; unmeasured risk can neither be priced, controlled nor monitored for effectiveness.
71. Managing and monitoring risk: limits and control
Managing risk involves applying techniques such as diversification, hedging, collateral and position limits, with authority segregated from risk taking. Monitoring means ongoing measurement against limits, independent reporting and escalation when breaches occur, closing the loop so the process adapts as markets and exposures change.
Example. Hypothetically, a firm sets a limit per issuer and per market, an independent risk unit produces daily reports, and a breach triggers mandatory reduction and escalation to management rather than discretionary tolerance.
Watch out. Treating limits as sufficient on their own: unmonitored or unenforced limits provide false comfort; monitoring and escalation make them effective.
Self-check: In a hypothetical breach of a counterparty limit, describe the correct sequence of monitoring actions.
Answer: Report the breach through independent risk reporting, escalate to management, reduce or hedge the exposure as required, and review why the limit was exceeded.
72. Risk management systems and practices in Hong Kong
Hong Kong's financial institutions operate risk management frameworks covering governance, measurement, limits and reporting, supported by regulatory requirements for capital adequacy, liquidity and internal controls under the relevant supervisors. Exchanges and clearing houses operate margining, default management and surveillance systems, embedding risk control into market infrastructure.
Example. Hypothetically, a licensed intermediary maintains governance oversight of risk, documented systems and controls, and sufficient financial resources under its regulator's requirements, while its exchange trades are margined daily by the clearing house.
Watch out. Assuming risk management belongs only to regulators: regulatory requirements set a floor, but firms own the design and operation of their own risk frameworks.
Self-check: In a hypothetical overview question, name three layers where Hong Kong risk management operates.
Answer: Within firms (governance, limits, controls), under supervisory requirements (capital, liquidity), and in market infrastructure (clearing, margining and surveillance).
73. Lessons from the past and the future of risk management
Past crises teach that risks migrate, models fail under stress, leverage magnifies losses and interconnection spreads shocks, so robust governance, conservative buffers, stress testing and independent challenge are essential. Regulators have responded with stronger capital, liquidity, reporting and infrastructure requirements, and risk management increasingly emphasises forward-looking scenario analysis. In Hong Kong, the Government manages systemic financial risk through its monetary authority and market infrastructure: the HKMA supervises authorized institutions and requires sound capital and liquidity; the Currency Board arrangement and Exchange Fund back currency stability and prudent reserve management; and reliable payment, clearing and settlement infrastructure is maintained for the financial system. Each initiative maps to a risk type: capital and liquidity requirements address credit and liquidity risk, the currency board and reserve management address currency and systemic risk, and robust settlement infrastructure addresses settlement and systemic risk.
Example. Hypothetically, a firm relying only on historical data misses a new product's hidden concentration risk; a stress test assuming correlated failures would have exposed it, illustrating why lessons from crises shape today's practice.
Watch out. Assuming compliance equals safety: meeting minimum requirements does not guarantee resilience; culture, governance and independent challenge determine real effectiveness.
Self-check: In a hypothetical post-crisis review, state two design lessons candidates should draw for risk systems.
Answer: Build buffers and stress testing that survive model failure, and control leverage and interconnected exposures so shocks cannot cascade unchecked.
Topic 7: Applications in the financial sector
Corporate finance, asset management and financial advising: what each function is, why it matters, what its professionals do, and how the functions interdepend.
74. What corporate finance is and why it matters
Corporate finance concerns how companies raise capital, structure their funding between debt and equity, and evaluate and execute major transactions such as acquisitions and listings. It matters because sound corporate finance decisions determine a company's cost of capital, growth capacity and ultimately shareholder value.
Example. Suppose a hypothetical manufacturer weighs a bond issue against new shares to fund a factory. Corporate finance analysis compares cost, control and risk of each route to choose the structure that maximises value.
Watch out. Reducing corporate finance to paperwork: the substance is strategic choice of capital structure and transactions, not merely filing documents.
Self-check: In a hypothetical expansion, why would a company care whether it funds with debt or equity?
Answer: Because the choice affects its cost of capital, control and dilution, repayment obligations and financial risk, all of which shape shareholder value.
75. The work of corporate finance professionals
Corporate finance professionals advise on IPOs and other capital raising, mergers and acquisitions, valuations, restructuring and fairness opinions. Their work combines financial analysis and modelling, due diligence, transaction structuring, marketing to investors, and navigating listing and regulatory requirements on behalf of corporate clients.
Example. Hypothetically, on a listing project the adviser builds a valuation model, coordinates accountants and lawyers in due diligence, drafts offering documents with the company, and markets the deal to institutional investors.
Watch out. Assuming the adviser makes the company's decisions: professionals advise and execute; the board and shareholders make the ultimate decisions.
Self-check: In a hypothetical acquisition, list three tasks a corporate finance adviser performs for the buyer.
Answer: Valuing the target, coordinating due diligence, and structuring and negotiating the transaction terms (including financing).
76. What asset management is and why it matters
Asset management is the professional management of investments on behalf of clients according to agreed objectives, through funds and segregated portfolios. It matters because it channels household and institutional savings into productive investments, offers diversification and expertise unavailable to many individual investors, and provides the capital that markets need to function.
Example. Hypothetically, a fund pools savings from thousands of individuals and invests across dozens of bonds and shares, giving each saver diversification and professional monitoring that none could achieve alone.
Watch out. Assuming asset managers promise returns: they manage portfolios against mandates and risk parameters; investment outcomes always remain subject to market risk.
Self-check: In a hypothetical economy, describe one channel through which asset managers support the financial system.
Answer: They pool household and institutional savings and invest them in equities and bonds, supplying capital to companies and governments and liquidity to markets.
77. The work of asset management professionals
Portfolio managers construct and run portfolios to mandates, making allocation and security selection decisions; analysts research companies and markets to support those decisions; risk and compliance staff monitor exposures and rule adherence; and client-facing staff report performance and maintain investor relationships.
Example. Hypothetically, an analyst recommends a bond after researching the issuer, the portfolio manager sizes the position within mandate limits, the risk team checks concentration, and client reporting later explains the contribution to performance.
Watch out. Assuming the portfolio manager works alone: investment decisions sit inside a control chain of research, risk, compliance and reporting functions.
Self-check: In a hypothetical fund, who researches the issuer, who decides the position size and who checks mandate compliance?
Answer: The analyst researches; the portfolio manager decides and sizes the position; the risk and compliance functions verify mandate and limit adherence.
78. What financial advising is and why it matters
Financial advising helps individuals and businesses define goals and match products, savings and risk decisions to their circumstances. It matters because most clients lack the time or expertise to navigate complex markets alone, and good advice improves suitability, helping clients avoid products that do not fit their needs and risk tolerance.
Example. Hypothetically, a young couple with a mortgage and a newborn needs protection, education savings and liquidity. An adviser maps these goals to a plan rather than recommending whatever product offers the highest commission.
Watch out. Confusing advice with selling: proper advising starts from the client's circumstances and objectives; the product follows the analysis, not the reverse.
Self-check: In a hypothetical first meeting, what should an adviser establish before recommending any product?
Answer: The client's financial situation, objectives, investment horizon and risk tolerance, so the recommendation is suitable rather than product-driven.
79. The work of financial advisers
Financial advisers gather and analyse client information, prepare financial plans covering savings, protection, retirement and investment needs, recommend suitable products, and conduct periodic reviews as circumstances change. They must explain risks and costs clearly and keep proper records so recommendations remain defensible and aligned to client needs.
Example. Hypothetically, an adviser assesses a client's family obligations, recommends insurance and a balanced fund matched to her moderate risk tolerance, then schedules annual reviews to adjust the plan after a job change.
Watch out. Assuming advice ends at the sale: ongoing review and updating are part of the adviser's role, since client circumstances and markets change.
Self-check: In a hypothetical scenario, a client's income doubles two years after advice is given. What should the adviser's work involve next?
Answer: A periodic review of circumstances and goals, revising the plan and recommendations so they remain suitable to the new situation.
80. Interdependence of financial functions: an illustration
Corporate finance, asset management and financial advising are distinct yet interdependent: corporate finance brings new investments to market, asset managers supply capital and professional demand, and financial advisers connect suitable products to end clients. A single transaction typically flows through all three functions, each relying on the others for the market to work.
Example. Hypothetically, a company lists shares with corporate finance advice; asset managers analyse and buy the shares for their funds; advisers then recommend suitable allocations to individual clients. Value created at each stage depends on all the others.
Watch out. Studying the three functions in isolation: scenarios may trace a single transaction across functions, so practise describing the linkages, not just the definitions.
Self-check: In a hypothetical IPO, describe how each of the three functions participates and how they depend on one another.
Answer: Corporate finance advisers structure and launch the listing; asset managers provide institutional demand and capital; financial advisers channel suitable allocations to individuals, each function relying on the others for the deal to complete.
Turn your revision into a study plan
Adjust the pace to your starting knowledge and examination date. These are suggested revision stages, not an official preparation timetable.
| Stage | What to do |
|---|---|
| Stage 1 – Build the foundations (Topics 1 and 2) | Work through concepts 1 to 24, drawing one diagram of the flow of funds and one diagram of Hong Kong's regulators and participants. For the HKMA and Currency Board concept, write the stabilisation mechanism in your own words; for monetary versus fiscal policy, note why the linked exchange rate constrains rate policy. |
| Stage 2 – Master the markets (Topics 3, 4 and 5) | Study concepts 25 to 62, then hand-calculate every quantitative example twice: TERP, bonus issue price, real and effective rates, zero and coupon bond pricing, cross rates and forward premium or discount. Change the inputs, keep tracking units and signs, and re-derive the yield-price relationship and the three yield curve shapes from memory. |
| Stage 3 – Apply and integrate (Topics 6 and 7) | Study concepts 63 to 80 by pairing each risk type with a fresh hypothetical scenario of your own, then practise one end-to-end illustration linking corporate finance, asset management and financial advising. Aim to differentiate credit, settlement, basis, liquidity and operational risk without notes. |
| Stage 4 – Consolidate and simulate | Re-attempt all 80 self-check questions, listing every trap you missed. Rework wrong-answer concepts and flashcard their distinctions. Finish with timed 60-question practice sets to match the exam's pace of roughly 90 seconds per question, and confirm your exam sitting uses study guide version 3.6 before your final week. |
Questions candidates ask
What is the format of the HKSI Paper 7 exam?
Paper 7 has 60 multiple-choice questions to be completed in 90 minutes. The pass mark is 70 percent, which is the score you need to pass; it is not the same as the pass rate, which describes how many candidates pass overall.
Which study guide version should I use?
As at 14 September 2026, Paper 7's current study guide is version 3.6, valid for LE sittings from 6 July 2026 onwards; version 3.5 applied only to sittings up to and including 5 July 2026. Always confirm the version applicable to your own sitting on the HKSI Institute website, because exam questions are based on the latest current published study guide.
Do I need to memorise every formula in the debt and FX topics?
You need working fluency rather than rote memorisation. Practise bond pricing, real and effective rates, TERP, cross rates and forward premium or discount until you can set out the formula, substitute hypothetical numbers, keep the units and signs straight, and interpret the result, since transfer questions change the scenario rather than repeat the textbook example.
Are the examples in this guide real exam questions?
No. Every example here is an original, explicitly hypothetical illustration written for revision. The HKSI Institute has not authorised any third-party revision tools, and this guide does not contain actual questions; it teaches the distinctions and applications you need to answer questions yourself.
Should I study the topics in the order given here?
For your first pass, yes: this guide follows the official topic order, and later material such as derivatives and risk management assumes the interest rate and pricing foundations built earlier. On revision passes you can jump to weaker topics, but your first read-through should be sequential so each concept lands on prepared ground.
Official sources and further reading
- HKSI Paper 7 syllabus and learning outcomes (PDF)
- HKSI current study guide versions and effective dates
- HKSI examination format and study resources
These independent revision notes explain the public syllabus through original examples. They do not reproduce the official study guide or examination questions. Use the official study guide valid for your examination date for the full examinable detail. HKSIDataBase is an independent provider and is not endorsed by the HKSI Institute.