Need to know

• Reinvestment in Korean autocallables has surged as products that were invested in before the 2015 China crash knock out.
• The structured products have performed well for investors in the current low-yield environment, despite taking longer than expected to knock out.
• The growth has come despite a regulatory clampdown on autocallables after the stock market crash.
• Banks have updated their offerings to clients to avoid repeating the hedging losses they incurred in 2015.
• The products now have a greater variety of underlyings – previously there was a heavy reliance on baskets that contained the Hang Seng China Enterprises Index.
• Some structures also include extra barriers across observation periods to increase the likelihood of a knock-out even in a falling market.

Two years on from China's Black Monday stock market crash in September 2015, which caused millions of dollars of hedging losses in dealers’ Korean structured products books, autocallables are experiencing a resurgence.

Banks say they have learned the lessons of the downturn. The products now come with more diversified underlyings to mimimise hedge overcrowding, as well as additional barriers that allow them to knock out during periods when markets are falling.

The changes focus on tweaking structures – in particular, on aligning underlyings to the risk appetite of investors,” says Chang Sik Cin, head of Korea structured sales at UBS in Hong Kong.

The situation in China in 2015 was unique, and I think it became clear that these products were very concentrated and reminded investors, the regulator and dealers that, in light of the concentration of the product and its underlyings, there was a need to diversify,” he says.

Pre-crash, the most popular products were tied to the same basket of equity indexes, with the worst performer – typically the Hang Seng China Enterprises Index (HSCEI), which is composed of H-shares listed on the Hong Kong Stock Exchange – used as the payout reference. The products had a tenor of three years, but once the reference index hit an upside barrier they knocked out and investors received an enhanced coupon in addition to their principal, which they often reinvested in the same product.

If the underlying breached a downside barrier, usually set at around 55% of the spot price, investors faced losses. If spot remained between these two barriers, investors received an above-market coupon but had to wait longer to get their principal back. With the HSCEI plunging 40% between April and September 2015, the products fell a long way below their knock-out barriers, meaning the flow of reinvestment dried up.

But with the HSCEI climbing back from a low of 7,505 points in February 2016 to 11,507 as of October 31 this year, the knock-out barriers embedded in the old products have now been breached. This has seen a return of reinvestment flows. Dealers say issuance is back to around $6 billion a month – a level similar to before the crash. “A lot of the volumes we did in 2015 are recalling, so all this money is being reinvested in these structured products,” says an international bank’s head of cross-asset distribution sales for Korea. Things are a little different this time, however. Regulators are now paying a lot more attention than they were before the 2015 downturn. Korean supervisors, for instance, have placed caps on local firms’ exposures, while banks’ internal management are also applying more stringent limits on the products. Autocallables have also been adjusted to include a more varied set of indexes in the worst-of basket, which minimises the risk that banks will all rush to hedge the same exposures simultaneously – something that created an estimated$300 million of losses for them in 2015. New structures also allow products to knock out even if the indexes fall.

But while the products are different, the risk-recycling methods are more or less the same. Banks are looking to sell some of the volatility exposure they get from selling the products direct to end-users such as hedge funds or pension funds, and hedging residual volatility and other second-order exposures directly in the market.

Prior to the crash, around $6 billion worth of autocallables were being sold to retail investors in Korea each month. The products tended to be tied to a worst-of basket, which included two or more underlying indexes. The HSCEI was popular because of its higher volatility, which allowed the products to give a higher payout due to the increased value of the investor’s sold knock-in put option that forms the downside barrier. With investors receiving coupons of 8–10% at a time when the Bank of Korea set benchmark interest rates at 1.5%, retail investors leaped on board. Korean securities houses that sold the autocallables hedged a large portion with international dealers, doing the rest of the hedging in house themselves. Selling the products gives issuers a range of complex exposures – primarily to volatility, or vega. The desks are long vega because of the embedded option sold by the retail investors to issuers. From the bank's perspective, as the reference price moves lower it becomes less likely that the product will knock out early, and more likely that the bought put option will be triggered. This makes them increasingly long vega, forcing them to sell puts to flatten the risk. When the HSCEI fell from a high of 14,900 in April 2015 towards 9,000 in September of that year, banks all had to buy back vega at the same time. This gave rise to a huge one-way demand for volatility that pushed the price of an HSCEI option up by 1.5 times, according to one trader at the time, and resulted in losses for a number of firms. Dealers also faced problems hedging their delta risk due to position limits on the Hong Kong Stock Exchange. You need to hedge delta, but sometimes this is difficult because you are constrained by futures position limits that are imposed by the exchange. If you are in the position where you need to buy or sell more than that position limit, you are in difficult spot,” says John Sung, head of single-stock derivatives trading at UBS. The HSCEI crash had an impact on other indexes, including the Euro Stoxx 50 and the S&P 500, which caused correlation to rise and resulted in further losses. Also, given the autocallables were denominated in won and the hedges were denominated in Hong Kong dollars, rising volatility on the foreign exchange options hedges caused even more problems. New guidelines In November 2015, lingering concerns about the concentration of autocallables referencing the HSCEI prompted Korea’s Financial Supervisory Service (FSS) – an arm of the Financial Services Commission that supervises financial institutions – to issue guidance on the products. The regulator suggested that domestic securities houses find a way to mitigate the build-up of risks in their books. In response, a group of firms developed self-agreed guidelines that allowed investors to reinvest – up to a cap – in new structures issued by the banks. If the structures were not redeemed, no more would be issued in order to maintain the volume levels at the time. Following the crash, however, the FSS took a more forceful approach and issued mandatory reinvestment limits on the HSCEI, using different caps that depended on the level of the index (table A). These limits remain in place for domestic securities houses until the HSCEI reaches 11,000 and the remaining balance of HSCEI-linked products falls below 25 trillion won ($22.4 billion), or the end of 2017, when most crash-era products mature.

For those firms, the post-2015 period was the first time the products had remained on their books for longer than a year. “They were accustomed to markets where levels were going up, meaning they weren’t really carrying risk for too long – a maximum of one year. This is the first year where they are carrying risk [for longer]. A lot of their models say this product only lasts a maximum of one year, so… after that they were actually paying to keep positions in the books,” says the head of cross-asset sales at a European bank.

The international bank’s head of cross-asset distribution sales says that in addition to the regulatory restrictions, securities houses also placed strict internal limits on their own exposures. Direct exposure, where hedging is managed in house, is now often capped at 30%, with the remainder hedged back-to-back with foreign banks.

The houses are also limiting the size of their books, with some firms capping this at around 50–60% of their peak exposure.

It is not only banks that the regulators are trying to protect. “From the Korean regulator’s perspective, because this is a mass-retail product, this is an issue with people’s money, so it is something they are very passionate about controlling in some way,” says a trader at another international bank.

Chinese regulators were also understood to have been concerned about the volume of investment in the HSCEI and the potentially negative impact it could have on the equity markets in Hong Kong.

Saving graces

While banks felt pain during the 2015 crash, autocallable investors got off lightly by comparison. The fall in the HSCEI wasn't severe enough to trigger the downside knock-in puts, so investors didn’t suffer losses. The products' expected duration increased, however, meaning principal was locked up for longer.

Reinvestment flows stagnated as a result. Monthly investment flows fell from $6 billion in 2015 to$1.5 billion in early 2016, before stabilising around $3 billion for the remainder of the year. The products from 2015 had an HSCEI knock-in level of around 10,000, which was crossed in February this year. Since then, reinvestment – which represents around 60% of volumes, according to one international bank’s head of cross-asset distribution sales for Korea – has returned, and around$6 billion notional is again being issued each month.

What keeps the structures so popular, despite the crash, is the hunt for yield in the region. Low volatility throughout the year has left investors hungry for increased returns and they see the products as attractive and stable. Investors currently expect an annual yield of around 3%, with returns two or three times the current savings rate.

So although investors from 2015 had their money locked up for longer than expected, the above-market coupon they receive from the products means they are still seen as a canny investment.

"I think, for the investors, realised performance of these products in the last 15 years or so was very good in aggregate" says UBS’s Sung. “If you are focusing solely on absolute return, the longer the product survives before it gets called means that you have got the best out of it, and I think time after time that has been a proven strategy for investors,” he adds.

The head of cross-asset sales at the European bank says products knocking out now will benefit from the higher volatility that was locked in when they were struck: “At that time [in 2015], volatility was much higher, so if they were to trade the same structures now they would probably get yields of 4–5%. Then they were getting 6.5–7%, so they locked in when vols were high and now they are getting a full two years’ worth of investment.”

But reinvestment has not fully returned to where it was. One dealer estimates reinvestment after a knock-out is hovering at around 70%, compared with around 90% previously. As a result, the outstanding balance has shrunk slightly despite the rise in issuance (figure 1).

Market participants say the FSS’s caps are not to blame, because they only start to bite if the HSCEI is falling. If anything, says Sung, the caps have been a positive thing for the industry: “I think the regulators had a very positive impact on the market, which was not immediately obvious to outside observers. In short, its efforts to contain further growth and maintain discipline probably helped avoid bigger disasters.

Diversification benefits

The new autocallables that investors are buying differ from the old versions in some crucial respects.

Banks are now issuing products that include a wider range of indexes in their worst-of baskets to lower the risk that everyone will try to use the same hedges simultaneously. Two or more indexes are still used as underlyings but the HSCEI no longer comes as standard. The most popular combinations include the S&P 500, the Euro Stoxx 50 and an Asia-Pacific index such as the Kospi, the Nikkei 225 or the HSCEI.

Issuers have also developed a so-called lizard autocallable, which allows investors to make a return even when the underlying stocks decline. It features additional barriers across observation periods and offers the prospect of a higher coupon if all conditions are satisfied, although investors must forego around 1% of yield per year in order to access this modification.

“In new production, we are seeing around 35–40% of Street volumes on this new feature,” says the first international bank’s head of cross-asset distribution sales. “In a very bad market, it wouldn’t be a déjà vu of 2015 because a lot of the positions would knock out. In that respect, the market has become more efficient and guarantees that turnover continues,” he adds.

UBS's Cin is similarly upbeat: “We constantly seek to diversify both underlyings and structures. The products are proving more stable and, although the coupon is lower than it was previously, they are better than other structures.”

Although the market rally and more diversified products have reduced the risk on trading books, hedging tactics are still largely the same.

Foreign dealers have tried to encourage their hedge fund and pension fund clients to take on more risk-recycling trades directly, which reduces the amount of hedging they need to do in the vanilla options market. Such clients would often go long Asian volatility and short US or European volatility using variance swaps. These involve one leg paying an amount based on the variance of the price changes of the underlying product, and the other paying an amount based on the strike at the deal's inception.

The long Asian volatility exposure that international banks get from the variance swaps can offset the short vega position obtained from selling the autocallables – meaning they don’t have to rely as much on hedging in the regular options markets.

The head of equity structuring at the first international bank says corridor variance swaps on the Nikkei and the S&P 500, in which the payout is made only if variance remains between certain barriers, are popular with investors. The main guys [buying the risk] would be all of the institutional investors that are willing to take the downside,” he says.

But a portfolio manager at one European pension fund says it has been engaging in less risk-recycling-driven variance swap trades this year, as low volatility means sufficient returns are not available.

Sung says the recent HSCEI rally has seen the amount of vega risk fade, meaning risk recycling is less difficult than in the past: “Because of the low level of volatility recycling the implied volatility isn’t much of a concern a lot of the time. The difficulty comes from the quick and big change of risk on the books, and the correlation risks and sharp market movements.”

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact [email protected] or view our subscription options here: http://subscriptions.risk.net/subscribe

Regulation

Pension funds foresaw margin meltdown (a decade ago)

Years of warnings went largely unheeded. Questions may now spread to post-crisis clearing and margining project