At a time when Korea’s financial regulator is warning of mounting risks in the country’s burgeoning equity structured products market, Hana Financial Investment (HFI) has been rolling out a new product that is not only better yielding but also less demanding for dealers to risk-manage.
The product is an autocallable structure linked to won-denominated versions of the three most popular underlyings: the S&P 500; Euro Stoxx 50; and Hang Seng China Enterprises Index (HSCEI) that its French banking partner Societe Generale launched in December 2018.
The hedged indexes address a long-standing risk management problem facing distributors in the Korean autocall market. Standard autocall products in Korea are typically denominated in won, but are linked to offshore indexes that settle in a range of currencies – this leaves forex risk to manage.
By obtaining a proprietary licence from the three index providers, Societe Generale was able to create foreign exchange-hedged underlyings, denominated in won, which closely track the original indexes. This eliminates the need to manage the embedded forex risk and the associated cost that banks add to their products to compensate for it – known as the quanto adjustment.
“We worked with Societe Generale to distribute this product to the Korean market,” says Sangho Lee. “This kind of foreign exchange inefficiency has been in the equity-linked structures sold in Korea for more than 10 years. With Societe Generale, we thought what can we do to manage this inefficient foreign exchange hedging cost?”
The index works by investing in one of the underlying benchmarks and adds a forex forward, which hedges the currency risk of the benchmark versus won. The index is rehedged on a monthly basis.
The appeal for investors is a boost in yield. Roughly 1% of the upfront value of a typical autocall contract is the embedded quanto buffer, Lee explains. By using forex-hedged indexes instead, dealers can offer a 0.5–1% increase in coupon per annum – a 20% boost in yield – and without taking on any additional risk.
“Since this hedging cost reduces the coupon we can provide, one way to provide a higher coupon with a similar level of risk is to use won foreign exchange hedged indices instead of regular indices,” says Lee.
Since autocall products linked to the new forex indexes were first issued by HFI back in January, investment volumes have been growing rapidly.
Since this hedging cost reduces the coupon we can provide, one way to provide a higher coupon with a similar level of risk is to use won foreign exchange hedged indices instead of regular indices
Sangho Lee, Hana Financial Investment
In the space of just five months, the total market value of autocall products linked to forex-hedged indexes as an underlying asset had grown to $846 million, which represents 8.1% of the entire Korean structured products volume in the period. HFI has by far the largest market share, issuing 87% of the products.
“Through close monitoring of each index and continuously providing numerous educational opportunities for investors in order to promote the market’s understanding on this new underlying asset, Hana Financial Investment has not only been able to retain its strong presence in foreign exchange hedged DLS market [derivatives-linked securities] but also contributed to its market expansion,” says Lee.
The securities house has also been working on improvements to the way in which it manages the exotic risks generated by the issuance of autocallable products.
Historically, Hana Financial Investment has relied on two types of hedging schemes. One is static back-to-back hedging, which transfer gains and losses from the hedging of autocalls to foreign banks. The second is in-house dynamic hedging, where the securities house seeks to limit its exposure to delta, gamma and vega by adjusting their hedges as the underlying changes.
In early 2018, Hana Financial Investment started to take a new approach, which it calls cross-hedging. The cross-hedging scheme sits in the middle of the two traditional approaches to hedging, meaning the bank can take lower risk compared with dynamic hedging, but achieve higher returns than static hedging.
“Through this unique cross-hedging scheme, which is outside the existing framework in terms of risk management strategy in the structured products market, Hana Financial Investment has been able to provide its clients with competitive pricing and payoff structures,” says Lee.
“In fact, approximately 45% of the equity-linked products issued by the in-house trading team as of May 2019 are covered with this cross-hedging strategy and Hana Financial Investment is expanding its in-house hedging and risk management capabilities to apply more cross-hedging ideas.”