Vanishing hedges hurt HK warrants issuers

Traders suspect big losses after Hang Seng gapped down at start of wild week

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Dealers are thought to have taken heavy losses on Hong Kong-listed equity products when the Hang Seng Index gapped down on Monday – the start of a week of historically wild trading.

Because the HSI opened 4% lower than the previous week’s close, it deprived warrants issuers of a key hedge, forcing them to buy new offsets at inflated prices. The gap down also meant issuers of callable bull contracts were unable to offload their hedges in time to avoid a loss.

“We saw some people going out to hedge their positions in the afternoon session,” says Ivan Ho, head of listed products at Credit Suisse in Hong Kong. “I suspect losses for issuers [on hedges] to be huge because we saw quite a big position in the bull market.”

The HSI opened at 25,134.02 on March 9, down more than 1,000 points or roughly 4% from its closing level of 26,146.67 the previous Friday. The index would go on to close at 25,047, capping its worst single-day selloff since a 5.1% plunge on February 6, 2018.

“The gap down was quite significant and the hedging [of callable bull contracts] was very challenging,” says Dick Chau, director of equity derivatives sales at UBS.

Derivatives warrants are like options contracts, which give investors the right but not the obligation to buy or sell an underlying asset. Like options, these give sellers exposure to non-linear risks. One key risk is vega, the impact of changes in the underlying volatility on the option price. The other is gamma, the rate of change in an option’s delta per one-point move in the price of the underlying.

Issuers typically hedge these risks through a combination of futures, options and so-called accumulators – a product in which the buyer agrees to purchase shares of the underlying security at a predetermined strike price.

When the HSI gapped down at the open, accumulator buyers fell deeply out-of-the-money. Faced with prohibitive margining costs, Credit Suisse’s Ho says a number of investors chose to cut their losses and unwind. This left issuers with less protection and a decision to take about whether to re-hedge.

“If the investor is forced to unwind the position, maybe because they don’t have enough margin, it means the position is not there anymore and they need to source another hedge in the market,” says Ho.

Re-hedging would involve buying a put on the HSI. However, with volatility rising in recent weeks as coronavirus fears rattled the local stock market, and rising significantly on March 9 itself, Martin Wong, head of exchange-traded solutions for Asia-Pacific at BNP Paribas, says this made the cost of hedging expensive.  

“It’s a bit like if you are only going out now to buy a mask or a sanitising liquid – it is going to be expensive,” says Wong.

Mind the gap

Callable bull contracts differ from warrants in that they have a mandatory call mechanism. Bull contracts gain value when spot rises, and the payout is based on a strike price. But if spot moves down and hits the mandatory call price – which is either equal to or above that strike – the product terminates and investors regain part of the principal.

The spread between the call and strike prices has compressed in recent years to lure investors with offers of better returns in a competitive market.

To delta hedge the products, issuers buy the underlying shares of the contract. If spot falls below the call price, they need to sell the shares to unwind the hedge immediately in order to fund the residual value payouts to investors.

But on Monday, issuers did not have time to sell before spot skipped straight through the call and strike prices, meaning the hedges did not cover the payments.

This gap risk can be hedged ahead of time by taking a long gamma position through the purchase of downside put options. This comes with a theta cost, however – the depreciation in value of an option over time – meaning not all issuers would have chosen to fully hedge.

“You have to strike a balance, and that will be different from house to house,” says UBS’s Chau.

With a majority of investors expecting the market to rally on March 9, issuers say the Street’s books were largely weighted to upside warrants and bull contracts.

While the extent to which individual issuers had hedged their positions is unknown, Credit Suisse’s Ho says the speed and magnitude of the selloff may have taken some by surprise.

“Previously we faced coronavirus fears over Chinese New Year and the US-China trade tensions last year, and most of the traders believed that to be the maximum volatility. But on March 9, I think we can say nobody expected those sorts of moves in the oil market,” he says.