SG offers won hedged indexes for Korean autocall clients

Local currency benchmarks cut forex hedging cost for clients and boost yields, bank says

south-korean-won

Korean retail structured product dealers have always faced a currency risk problem: the products are denominated in won, but are linked to baskets of offshore indexes that settle in a range of currencies. Societe Generale believes it has found a way to sidestep this risk and possibly boost yields, in a bid to tempt back investors left jittery about recent stock market falls.

The French bank, in partnership with three index administrators, launched won-denominated versions of the three most popular underlyings in December: the S&P 500, Euro Stoxx 50 and Hang Seng China Enterprises Index (HSCEI).

“Investors are used to funds that are foreign exchange hedged as it preserves their performance when investing in foreign currency,” says Jung-Jin Yoon, head of cross-asset distribution sales for Asia-Pacific ex-Japan at Societe Generale Corporate & Investment Banking. “When there are big currency movements there is profit to be preserved. We are only taking the idea and applying it on an index.”

The indexes are the underlying for the popular autocallable structured products market, which pays investors a competitive coupon linked to the worst-performing benchmark in the basket. Products typically have a three-year maturity and an upside and a downside barrier. Investors get their principal back and a sizeable coupon if the upside barrier is breached. Their principal is at risk if the lower barrier is crossed.

However, sliding equity markets have dented autocallable issuance. Monthly volumes of Korean products peaked last May at almost $8 billion but dropped to as low as $2.5 billion in December as stock markets tumbled by more than 10% in the last three months of 2018, as measured by the MSCI World Index. This stopped the products from knocking out, extending duration and affecting investors’ ability to reinvest. Issuance volumes have recovered since the start of the year.

Standard autocallable products sold in South Korea are denominated in won, but the options and futures that dealers use to hedge the issuance are denominated in the home currency of the index such as the US dollar for S&P 500 or Hong Kong dollars for HSCEI. This leaves banks with forex risk to manage. Dealers that issue autocallables are short the foreign currency/won vega and gamma – the exposure to movements in volatility, and the rate of change of sensitivity to moves in the underlying, respectively – as they do not want the exchange rate to move. Dealers struggled to hedge this risk in HSCEI-linked Korean autocallables during the 2015 China Black Monday episode.

To take on this risk, dealers charge investors for smoothing currency gyrations, which is referred to as the quanto adjustment, and this is about 1% of the upfront value of a typical autocall contract. By using forex-hedged indexes instead, dealers can offer a 0.5% to 1% increase in coupon per annum, or a 20% boost in yield.

Yoon says: “We have optimised our systematic hedge of quanto forex risks, thereby achieving cost savings.” SG claims it returns these savings to investors in the form of yield pick-up.

SG has partnered with S&P Dow Jones Indices, Stoxx and Hang Seng Indexes, the three index providers that oversee the most popular underlying benchmarks for autocallables.  Products referencing all three indexes make up a third of total issuance, while baskets featuring either one or two of the indexes made up a further third of issuance.

The hedged index is an attempt by SG to insulate the largest structured products market in the region from issuance downturns caused by falling stock markets, as seen in 2015 and 2018. To revive investor appetite after those routs, banks altered payouts and built in protection to assuage investors’ fears, such as the so called lizard structure. Lizards are products that include additional barriers across observation periods, usually at about 70–75% of the initial spot level at the end of the first year, allowing the products to knock out early even if spot declines.

In 2017, Natixis offered an index especially built for autocall investors, which is thought to have contributed to the French bank booking large losses on its structured products business late last year.

Protective features like those found in lizards come at a cost of a lower coupon, but Yoon says investors could offset this by using the new indexes.

SG has offered autocallable securities referencing the hedged indexes to wealthy investors through Korean securities house, Hana Financial Investment. The product has attracted about $200 million in investment so far, or about 2.5% of the $8.2 billion in volumes across the Street in the first two months of the year, the bank says.

We now have the same risks as before but without the forex quanto risk

Jung-Jin Yoon, SG CIB

The hedged index works by investing in one of the underlying benchmarks and adds a forex forward to it, which hedges the currency risk of the benchmark versus won. The index is rehedged on a monthly basis.

“The forex forward is put in place monthly and the notional on which the forex forward is based is reset at the start of each month,” Yoon says. “As a result, the index level is hedged at the start of the month, but the additional intra-month performance will not be.”

This means the gains or losses on the index during the month can be affected by currency moves until the position is re-hedged at the end of the period. But Yoon points out that the effect is likely to be minor. For example, if the index went from $100 to $105 but the forex rate fell 2%, there would only be a 10 cent loss in value.

Under the structure, Societe Generale will continue to have vega and index correlation risk and the bank will otherwise hedge the structures as usual.

“In a traditional autocall, hedge providers have vega, correlation and forex risk,” Yoon says. “Forex risk has always been a concern. So we now have the same risks as before but without the forex quanto risk which during difficult markets can be a significant risk factor.”

Editing by Alex Krohn

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