The People's Bank of China's (PBoC) surprise devaluation of the renminbi against the US dollar on August 11, 2015 rattled global markets and left the currency's Hong Kong variant, CNH, with the unwelcome title of the most expensive volatility in the world, on a relative basis, according to one London-based hedge fund manager.
Overnight three-month implied volatility for CNH/USD jumped from 2.2% last July to 6.9% last December as corporates rushed to hedge in anticipation of further deprecation – resulting in a 4.7 percentage point spread between implied and historically realised levels. By comparison, at the time of the trade, the spread between three-month implied versus realised volatility was 2.7% for US dollar and yen currency pair and –0.42% for euro/US dollar.
The hedge fund manager agrees with the consensus that the RMB was heading for further depreciation, but believes it would happen at a slower rate than the market was currently predicting. He also thinks it is possible to profit from other investors' misunderstanding of volatility.
"After the surprise devaluation that happened in August, everybody thought the PBoC was going to weaken the renminbi substantially. Most macro funds don't really pay attention to the costs of the second-order Greeks when they trade volatility. But when you buy an option, you are really getting three separate types of volatility. The difference between implied and realised volatility (gamma), spot volatility correlation (vanna), and volatility of volatility (volga). And in August all three of these were extremely expensive for CNH/USD – much more than any other currencies we looked at," the hedge fund manager says.
"So while we had the same view as the market that CNH was going to devalue in the short term, we didn't want to pay for the most expensive volatility in the planet. How do we short volatility, but go long the devaluation aspect of it?"
The solution was to bet that both realised volatility would be lower than implied volatility, and that spot correlation would be lower than expected, via a volatility knock-out (VKO) with Deutsche Bank. As the name implies this instrument knocks out when the realised volatility hits a pre-determined level, allowing the hedge fund manager to express his view, while saving one-third of the cost compared with a regular option.
VKOs are a common tool in G10 currency trading, but because the renminbi is a controlled currency – trading within a range preset by the central bank – until the PBoC's August 11 intervention volatility hadn't been high enough to warrant structuring a VKO. This same novelty also meant that dealers were not keen to offer VKOs given the uncertainty about the renminbi's direction against the dollar. All except Deutsche Bank.
"A lot of people could price it, but no one really wanted to take the risk," says the hedge fund manager. "Deutsche Bank was the only counterparty that was able to trade as well as price a VKO."
Zhiming Yang, Singapore-based senior trader of renminbi derivatives at Deutsche Bank, says its ability to offer this structure is a result of the bank's sophisticated pricing model and experience of managing VKOs in other currencies. Yang says these factors were particularly valuable given the renminbi's unique status of being halfway between a pegged and a free floating currency, while still possessing many characteristics of an emerging market currency.
"There was experience gained and lessons learnt in managing VKOs in other currencies in the past. From there, we have improved our models and also gained a better understanding on the dynamics of this product, which is a very important part of our ability to offer a CNH VKO to our clients," Yang says.
As a result of the trade Deutsche was left long volatility position – a potentially precarious position were the PBoC to make another surprise devaluation. But, according to Yang, this is where Deutsche's broad book of renminbi business was extremely helpful. Its large-scale activities in both spot and derivatives markets, and counterparties across the corporate and financial institution sectors, meant it had a sufficient two-way flow of risks to offload its volatility exposure, and this closeness to the market enabled the dealer to spot the VKO opportunity quickly.
"There has been demand for protection and speculation for renminbi weakness and a general worry about a sharp devaluation, which have pushed the volatility and surface to extreme levels. Many market participants agree it was overvalued but didn't know how to play it. We spotted the opportunity and packaged it into the VKO idea and it was very popular. We manage to create good liquidity with two-way flows where we match supply of volatilities and surface from VKO and demand by institutions and corporates seeking protection," he says.
The introduction of the VKO was just one example of Deutsche Bank providing innovative structuring in the renminbi market over the last 12 months. When combined with the bank's extensive corporate footprint and its role in developing the market in the Chinese currency, the bank was a clear winner of the RMB house category.
The increasing cost of volatility meant forex structures across the board were more expensive, requiring Deutsche Bank to innovate for its clients to provide the risk management tools they needed at an economic price. One example of this was its USD/CNH cancellable call spread cross-currency swap (CCS). Deutsche Bank introduced a cancel feature into call spreads that could be structured into a CCS, allowing clients to manage their CNH risk more cost-efficiently by adjusting the amount of protection required. The solution protects clients against CNH depreciation, and reduces costs in a market reversal by cancelling the call spread CCS.
A real estate client in Hong Kong used this product after issuing a five-year, high-yield callable bond. "We planned to call the bond at some point, so the cancellable feature in the CCS matches the callable feature in the bond. Also in the beginning of the year, we were uncertain about how CNH would move against USD. So we think the callable feature is more favourable for us."
According to Jerry Li, Greater China head of fixed income and currencies, the callable feature also reduces Deutsche's credit exposure to the client because the credit limit is capped at the option premium before the cancellable date and there is no further credit limit consumption after this.
Another advantage for the real estate company was that it adopted IFRS 9 in March. The new hedge-accounting approach in this iteration of the global accounting standard made the transaction more balance sheet-friendly. Under IFRS 9, the intrinsic value of the option is counted under profit and loss and the time value of the option is counted under other comprehensive income (OCI), whereas time value is counted under profit and loss under IAS 39. The new accounting rule, therefore, smoothes out profit and loss swings arising from the time value of the option.
As a result the client is pleased with all aspects of the transaction including its cost, effectiveness and accounting impact, which he says is typical of his experience with the German firm.
"Deutsche Bank always comes to us with new solutions and they are able to provide price quotes quickly. I always joke that we never take investment bankers for dinner, but we have to take the team from Deutsche Bank for dinner once because we are grateful for their help."
Deutsche Bank also made strides on the underlying side of its RMB business, strengthening FX4CASH, its cross-border forex payment platform. This platform allows clients to use existing local currency accounts to make or receive renminbi payments, with real-time forex conversion for payments of any size. In 2015, CNH notional volumes increased by 290% while onshore CNY volumes went up 81%. The bank also expanded the platform's capability to five new Asian markets including South Korea, Thailand, Indonesia, Malaysia and India.
As China continues to open its market, the bank plays an active part to help its clients gain market access. Since China opened its interbank bond market, Deutsche Bank has actively acquired new central banks and sovereign wealth fund clients and now cover about half of the official-type institutions in the market. While in March, the firm's asset management arm introduced Europe's first ETF designed to capture price differences between dual-listed mainland A-shares and Hong Kong H-shares.
According to Li, this year's innovation is part of pattern whereby the German lender has played a pivotal role in developing the nascent renminbi derivatives market since it began. He says that when offshore renminbi went live in 2010, the bank was the first to trade both forex and cross-currency swaps. "And in the same year, we extended CCS risks to 10 years where nobody was doing more than five years. In 2013, we were one of the first batch of banks to receive a forex option licence onshore in China. This year, we again have some of the first trades in the Street."
The week on Risk.net, September 8-14, 2018Receive this by email