Breaking point?

- 01 Nov 2007 - Risk print v iew

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Breaking point?
/asia-risk/feature/1509956/breaking 01 Nov 2007, Asia Risk

Structured products based on equity, foreign exchange and interest rate underlyings form the backbone of Asia's financial derivatives markets. The contrast between derivatives trading desks in most of Asia's financial centre compared with the world's leading two financial hubs, London and New York, is dramatic. In Asia, most staff are employed to cater to the demands of private and retail bank distributors for structured products - and the risks get laid off via warrants issuance or 'book axe' positions packaged as innovative new instruments, such as variance and correlation swaps that get snapped up by ever-vigilant hedge funds. By contrast, in more mature markets such as the two largest over-the-counter derivatives markets, London and New York, derivatives trading desks see relatively limited - but growing - structured products activity. Typically, trading desks in these jurisdictions focus on institutional client demands - albeit that some of these institutions handle retail money via unit trust or mutual fund investments. So what's the problem? After all, Asia's markets are booming. Hong Kong's Hang Seng Index exceeded a record 31,000 points on October 30; while the Bombay Stock Exchange Sensex Index rose above 20,000 points. Indeed, even the fallout from problems associated with synthetic credit structured products, such as collateralised debt obligations, appear- at least at first sight - to be far less dramatic in Asia than in Europe and the US. But the credit derivatives market, however fast-growing, is relatively new: quantitative analysts are still a long way from effectively modelling credit correlation. And a real solution to this pricing and hedging problem still seems a fair way off. So dealers are not surprised that Europe and the US are facing the brunt of issues linked to over-exuberance in the credit markets.
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Models used for pricing and risk managing equity, interest rate and foreign exchange derivatives positions, however, are far more developed. Teething pains associated with understanding how to model equity skew and correlation are now well established as more robust models were developed and consensus on modelling approaches was achieved. Arguably, it should follow that problems linked to pricing and hedging structures linked to these asset classes should be relatively easy. That said, some parties, such as David Samuel, managing director for equity derivatives at Royal Bank of Scotland in London, believe there are indications that hedging linked to Asian equity structured products exposures is having an impact on underlying equity prices. This breaks one of the assumptions of the BlackScholes options pricing model - that delta hedging activity does not move the price of the underlying. But this can fail when large quantities of stock need to be traded in a finite time period. "Our day-to-day activity can have a cumulative impact on our operating environment due to non-linear feedback mechanisms," says Samuel. "This may also be true of trading activity in structured products on the world financial markets." Samuel says his research indicates that the impact of 'asymmetrical hedging' has been witnessed in other areas of the markets for some time. Indeed efforts by dealers to enhance investor participation in the performance of Europe and US stock markets prior to 1998 led to dealers being substantially short gamma - gamma measures how fast the delta, or change in price of a call option for a one-point move in the underlying security, changes, given a unit change in the underlying. In 1998, the equity markets effectively 'broke' following the near-collapse of Long Term Capital Management and the Russian debt crisis. At that time, dealers offered yield products rather than participation products and this shift to yield eased the pressure in the system. Similar characteristics are now showing themselves in the Asian equity markets, notably Hong Kong, Samuel says. And the increased realised volatility may be an early warning that the structured products market is currently exacerbating market swings and has the future capacity to 'break' equity markets. That might not be too surprising. The amount of structured products transactions done in Asia during the past three years has been phenomenal. Volumes of structured products sold in Asia, excluding Japan, were close to $46 billion last year, according to French bank BNP Paribas. In Hong Kong, the large majority of instruments sold - 82.6%, according to the Hong Kong Securities and Futures Commission's (SFC) Structured Product Investor Survey, published in November last year - are equity-linked. Most large structured products houses say their volumes have more than doubled in the past year. That means the market is probably worth between $90 billion to $135 billion. The types of products on offer, notably in the equity area are 'accumulators' and 'auto-callable daily range accruals'. These instruments are typically shorter-dated structures compared with their European equivalents with maturities of less than three years. These tend to be based on household name underlying stocks - in some markets, such as Hong Kong and Korea, just five stocks represent the majority of structured product underlyings. Accumulators, which are hugely popular in Hong Kong, effectively offer investors the ability to buy shares everyday at a level lower than their current market price so long as the price does not exceed a pre-set barrier. This barrier is typically about 5% above the current price. But if the price falls below the purchase price, the investor has to buy at the purchase price. The bull run witnessed in most Asian equity markets during the past 18 months has led to most accumulators being called well before their expiry. This has made investors increasingly more comfortable to reinvest in the instruments.

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Breaking point? - 01 Nov 2007 - Risk print v iew

Attempts by dealers to wean investors away from accumulators and range accrual trades are having limited success, which is a potential problem. The trading books run by dealers providing large structured products hedges increasingly look 'the same way' in their exposures. They are short gamma and short vega - vega represents the change in price of an option that results from a 1% change in volatility. And most major dealers Asia Risk spoke to during the past several months say they have substantially increased their risk limits related to their profitable structured products businesses. But it's not just that positions tend to be one way. There is also a problem linked to the concentration of these positions. For example, most structured products done in Hong Kong are based on the Hang Seng Index and Hang Seng China Index along with Bank of China, China Mobile, HSBC, PetroChina and Sun Hung Kai Properties. In Korea, most structured products are based on the Kospi 200 index and leading stocks such as Samsung Electronics, Korea Telecom (KT), Korea Electric Power Corporation (Kepco), chip maker Hynix, Hyundai Motors and Posco. Market turbulence since July has resulted in the volatility levels of these stocks rising dramatically. Take the Korean market. Realised daily volatility for Samsung Electronics rose from 24% at the end of May to 32% at the end of November; while the similar figures for Hynix and Hyundai were 28% to 40% and 25% to 36%, respectively. Daily realised volatility for the Kospi 200 index increased from 18% to 32%, over the same period. In Korea, instruments such as 'dual-stock triggers' and 'high-five autocallables' dominate the $20-plus billion market. While increases in volatility do not immediately appear to be a problem - after all, it was a 10 point decline in volatility last year that caused losses for the industry estimated at about $300 million-$400 million (see Asia Risk, November 2006) - the knock-out features may leave dealers over-hedged, and, therefore, they are left short vega and gamma. "When dealers hedge vol risk, they sell it to hedge funds or issue warrants if they have an OTC derivatives licence," says the head of equity derivatives at a large dealer in Hong Kong. "People have not lost a lot of money, but it is annoying," he says. Levels of correlation have risen significantly. The one-month historical correlation between Samsung Electronics and Kepco, for example, stood at 37% at the start of May, fell to 28% by June before rising by July to 52%, up to 60% by August, 81% in September and 86% by October, according to Woori Investment & Securities. When there is high realised correlation, a dealer gets net short gamma. "Take a two stock example," says the head of equity derivatives trading at a large international investment bank. "I have a client trade out there and the pay-off is linked to the least performing of the two. So I owe someone an option on the worst performer of these two. As my hedge, I buy a similar amount of options on name A." This means the trader's model shows he is gamma neutral. So, if A goes up, that is ok - the trader loses money on the overall structure, but makes money on the long gamma position on A. Then if B doesn't move at all, the trader has effectively overhedged. So he would lose money on the client trade but make money on the hedge. "Now let's assume they are highly correlated. So whenever A moves, B moves; now what I see is that I get shorter B and am having to buy B on the way up. So yes, I have gamma on A and it is paying me. But I am losing on B as if I am short an option on B. When realised correlation moves up on a whole raft of names, as it goes up I am getting shorter, and as it goes down, I am getting longer; then I will be in there rebalancing furiously as if I had a short gamma position on those names explicitly. And that can definitely exacerbate volatility in those individual names."
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However, Don MacKenzie, chief risk officer at Kookmin Bank in Seoul, says hedging activity linked to structured products in the country has declined due to problems last year. He says investors have switched to cash equities and fund products. "The volume of ELS (equity linked securities) and EL deposits and related hedging have declined considerably," MacKenzie adds. An official at Korea's financial watchdog, the Financial Supervisory Service, says "testing a hypothesis that (Asia Risk) raised - ie, the size of certain structured products sold in Asia markets reaching a scale where the associated delta hedging could 'break' certain equity markets - needs rigorous statistical work and is difficult to address even with ample empirical work". Some industry professionals say Asia's regulators may not be best equipped in terms of suitable skills, staff and foresight, to properly monitor the situation. "Asia's regulators tend to adopt regulation that is imported from Europe and the US," says one senior derivatives executive. "But structured products are proportionally a bigger issue in Asia, where there is far less institutional activity. So Asian regulators really need to develop their own techniques to ensure the smooth performance of their financial markets, but they may not all have that capability at present." Hong Kong's watchdog, the SFC says it has monitored the development of structured products. SFC chief executive, Martin Wheatley says that while the watchdog does not monitor the outstanding positions banks hold, the SFC "does require they have in place the systems and controls". "And that is something we review every now and then," Wheatley tells Asia Risk. He adds that while Asian regulators may take the lead from international peers on "raw policy issues", such as governance and accounting standards, this is less the case on "tactical issues" as "every market is special and has difference characteristics". Wheatley says one-way positions do cause regulators concern. "That's when you worry about it potentially becoming a destabilising effect - we've seen it over the years many times," says Wheatley. "You end up with these horrendous situations where you have crowded trades and everybody trying to respond to a market change at the same time in the same way. "When a single style with a single strategy becomes predominant, you have higher risk," says Wheatley. "I don't think we are at that stage yet. It is something we are conscious of, but it is very difficult to monitor and work out exactly what the data would be that we would say, 'right, we have got to rein this back in now'." Wheatley argues that the diversity of strategies and types of market participants in Hong Kong acts as a check against that happening. He adds that the warrants market also acts as a natural hedge for structured products manufacturers. And the size of the Hong Kong warrants business has increased substantially. Total main board warrants trading in the third quarter of this year hit HK$1.19 trillion ($153 billion), up 169% compared with the similar quarter in 2006, according to the Hong Kong Exchanges and Clearing. While the SFC will monitor the structured products business moving forwards, Wheatley reckons it is an issue banks will respond to themselves: "It is up to the banks to have in place sensible systems and controls." That seems to be the case in Japan, which is also prone to large market cash moves due to structured products hedging. "A lot of Nikkei hedging happened because of quanto positions," says Jason Sippel, head of equity derivatives trading at JP Morgan in Tokyo, referring to large moves in the equity and foreign exchange markets in mid-August. "Forex is one thing, but most houses will have a position where if dollar/yen dumps, they get longer Nikkei, so they will be selling Nikkei because of FX moves. It is difficult to prove the extent to which that added selling pressure contributes to the Nikkei futures decline." The realised correlation of daily returns between the Nikkei 225 and USD/JPY foreign exchange spot stood at 0 for the full-year 2006. Since July 19, when the equity market turmoil started in Japan, to the end of

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Breaking point? - 01 Nov 2007 - Risk print v iew

October, it rose to 64%. Meanwhile, implied correlation stands at more than 70%. "The reason is simple: when markets are calm, emerging markets rally and leveraged investors borrow in yen and Swiss francs to invest in risky assets," says Sippel. Once markets take a downturn, that leverage is unwound and investors buy yen and francs. "The cost to a quanto book is significant," Sippel adds. Pure equity structured products sold in Japan also have an effect on the country's underlying cash equity market. The most popular stock underlyings include the mega banks, Mizuho, MUFG and SMBC, along with car manufacturer Toyota, electronics company Canon and teleco NTT Docomo. The three most popular index underlyings are the Nikkei 225, Topix and Topix Core 30. One popular product in Japan is an 'equity gain knockout', which is a high coupon structure where when the Nikkei 225 index fixes high, the investor gets paid a high coupon and the structure is redeemed early. But when the Nikkei 225 goes down, the investor receives a low coupon and the structure becomes a five-year bond, which in turn has an embedded put option. "So when volatility becomes very illiquid, and you know that from a structural position when spot moves down you get shorter volatility as vol goes up, 'what do people do?'" asks Sippel. "They wind up selling spot on the way down." This appears to be what happened in mid-August. The Nikkei 225 fell 2.19% on August 15, by 1.99% to close at 16,148.49 points on August 16. On August 17, it plunged 5.42% closing at 15,273.68. This market move may represent a salutary example of the potential magnifier effects caused by structured products. Print | Close Incisive Media Investments Limited 2012, Published by Incisive Financial Publishing Limited, Haymarket House, 28-29 Haymarket, London SW1Y 4RX, are companies registered in England and Wales with company registration numbers 04252091 & 04252093

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