What links a European benchmark equity index, the Hong Kong dollar and a group of blue-chip Chinese stocks? Apart from the early-year pain shared by investors in all three, Seoul may not be the first answer that springs to mind. But it appears South Korea’s outsized derivatives market, dominated by retail investors, has a lot to answer for.
Korea hosts the largest and most liquid market in the world for options on single stocks — bigger than the US, even, according to bankers — and retail interest in derivatives does not stop there. In what looks like the latest example of a “butterfly effect” in global markets, last year Korean investors bought record amounts of so-called “autocallables” — a structured product offering an attractive yield. About $40bn are outstanding.
This year stock market losses have forced the sellers of those deals to hedge their exposure — that has damped volatility for Euro Stoxx-linked products, pressured the tightly-pegged Hong Kong dollar and crushed the Hang Seng China Enterprises Index. On Wednesday for example, the sliding oil price prompted a weakening of stocks across Asia. While in mainland China benchmark indices closed 0.4 per cent lower, the HSCEI — consisting of many of the same stocks — dropped 2.5 per cent.
Autocallables contain features that have blown up previous products, from “target redemption forwards” — once dubbed kill-you-later-accumulators — to “knock-in-knock-out”, or Kiko, deals. Asian investors have reason to know: the former blew a $2bn hole in the balance sheet of Citic, China’s foremost conglomerate in 2008. And Kikos caused such problems for Korean companies that had wrongly hedged the South Korean won that regulators in 2009 had to stress test banks to gauge the depth of the issue.
Since these autocallables are two- or three-year deals, and most were sold last year, the final reckoning over who has lost what is some way off. The area of interest for now is their effect on other markets.
The products in essence sell volatility. They work by offering investors a “worst of” basket of two or three reference securities — typically indices. The sales pitch is that investors get a yield on top of their capital if the reference securities stay within a specified range. If they rally above it, investors are “knocked out” and get their money back with a bonus. If it falls below a specified point — usually between 40 and 50 per cent of the level, when the product was sold — they are “knocked in” and lose some capital.
Holders can be made whole if the index recovers all lost ground before the autocallable ends — hence it being difficult to gauge losses at this point. However, the nearer an index falls to that strike price, the more product sellers have to hedge, which they do via selling futures. This is what is weighing on the HSCEI, which was a popular inclusion in the first half of last year because of China’s soaring markets. But it is now down 46 per cent from its May 2015 peak — putting it right in the zone where issuer hedging will be at its highest.
Hong Kong indices are even more popular in Korean products because of the 32-year unchanged link between the Hong Kong dollar and its US counterpart. So imagine the fear among Korean sellers of autocallables last month on seeing the Hong Kong currency suddenly spike higher after Chinese authorities quashed speculative shorts in the offshore renminbi market. The result was additional weakening pressure on the Hong Kong dollar as Korean groups rushed to hedge.
“The bottom line remains that investors should be aware of this additional market dynamic that could drive Hong Kong dollar volatility, forwards and swaps higher,” says William Chan, head of Asia-Pacific equity derivatives research at Bank of America Merrill Lynch.
Before the financial crisis, most autocallables would have referenced South Korea’s benchmark Kospi Composite. But as the autocallables market grew and volatility in Korea stayed low, issuers had to look elsewhere. The Euro Stoxx 600 is down about 20 per cent from last year’s peak. In the current febrile environment, that could be enough to see Korean issuers wanting to hedge early — reportedly suppressing volatility in two- and three-year options.
Korea’s derivatives habit does not yet look big enough to cause systemic stresses. But as an example of the unexpected and little-explored links between markets, it should be watched closely.
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