Since the start of 2015 a number of dealers have been predicting that a big decline in one of the indexes linked to Korean equity-linked securities (ELSs) would cause heavy losses for securities firms that had exponentially expanded their presence in the market – taking market share from international firms and even bringing their hedging in-house.
That moment finally came in early September when the Hang Seng China Enterprises Index (HSCEI), which is composed of H-shares listed on the Hong Kong Stock Exchange (HKEx), plummeted to a low of 9,100 points – a 40% decline from its high of 14,900 in April. The bullish market had turned bear, causing an inevitable fallout for firms rushing to hedge long volatility positions generated by selling autocallable structured products referencing the index.
"It's like musical chairs. Everyone's happy when the market goes up, products knock out and you get new money all the time, but when the music stops some dealers find themselves in real trouble," says John Sung, head of single-stock flow and exotics at UBS in Hong Kong.
As the HSCEI fell throughout September, exotics desks were forced to sell and then buy back increasing amounts of volatility simultaneously across the Street. At the same time, position limits made delta hedging a challenge, while index correlation and foreign exchange issues complicated things further. Korean and international dealers are believed to have lost around $300 million on the move.
"When the China bubble unravelled and HSCEI followed, the sensitivity of managing an autocallable book came back to life. When books are stressed and a dislocation strikes it tends to be brutal in Asia. There was simply too much risk on HSCEI, and both Korean securities houses and foreign dealers suffered significant losses," says the head of equity derivatives at a European bank in Hong Kong.
When books are stressed and a dislocation strikes it tends to be brutal in Asia. There was simply too much risk on HSCEI, and both Korean securities houses and foreign dealers suffered significant losses
International dealers were hit again though, as their portfolios of sold variance swaps referencing the HSCEI left them short variance, which spiked when the index collapsed. The move put them the same way around as autocallable sellers, creating a pricing squeeze.
Korean autocallables have been one of Asia's big success stories. With investors receiving coupons of 8–10% at a time when the Bank of Korea has set benchmark interest rates at 1.5%, retail investors flocked to the product. As a result, the market grew from 492 billion won ($435 million) in 2009 to 94.4 trillion won at the end of June – an increase of nearly 190 times. In total, 20 Korean securities companies issue ELS autocallables, with the five largest accounting for a 70% market share.
A typical three-year autocallable ELS note has two barriers – one on the upside and one on the downside. If the upside barrier is breached the structure knocks out, and investors get their principal back plus a coupon.
On the downside, the barrier consists of a sold knock-in put option, set at around 55% of the initial spot price. If this is triggered, investors' principal is at risk. If the spot stays between these two barriers, investors receive an above-market coupon.
A large proportion of the products were linked to the worst performance of two or more underlying stocks or indexes. The HSCEI has been a particularly popular worst-of reference over the past 18 months as it has a higher volatility than the Korea Composite Stock Price Index (Kospi) 200. Higher volatility means a higher return to investors on the sold knock-in put option embedded in the structure. Worst-of products referencing the HSCEI index accounted for 82% of all Korean autocallable issuance since January, according to data from Societe Generale.
This is all fine for banks in a bull market – the indexes move up, the products knock out and investors buy more. However, trouble in the Korean autocallables market started brewing earlier this year when the China-driven equities rally lifted the HSCEI index, taking it from 12,177 on March 23 to 14,800 on May 26. This incentivised issuers to include the index in the worst-of basket, as a rising index is more likely to knock the product out early.
After hitting its peak, however, the HSCEI started to fall dramatically, hitting 11,131 at the end of July, then 9,741 at the end of August and 9,400 at the end of September. Implied volatility doubled to 50%, while realised volatility moved from 19.4% to more than 35%, causing immediate problems for dealers left long vega – the change in an option's price for a change in volatility – from their autocallable issuances.
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 trigger. This makes them increasingly long vega, forcing them to sell puts to flatten the risk.
A research note by Morgan Stanley from September estimates that the vega outstanding in the market on September 14 was $102 million for autocallables referencing the HSCEI, compared to $78 milllion for the Euro Stoxx 50 and $28 million for the Kospi.
Dealers say peak vega exposure came when the HSCEI hit 10,000. As spot fell towards 9,000, dealers started to lose vega as structures approached their bought knock-in puts. This forced banks to buy back their short vega hedges all at the same time – creating a huge one-way demand for volatility.
"We moved down to peak vega so the Street would have been longer vega from the move lower. Dealers had to re-hedge the book aggressively to keep a flat exposure, which meant buying HSCEI vega by buying downside protection at around the knock-in put level or slightly below, ideally. So the hedge is to buy longer-dated 6,000–7,500 strike puts on HSCEI – but that's not very liquid and also became extremely expensive in the market given the huge outstanding notional size," says a senior exotics trader at one US bank.
In September, this activity caused the price of HSCEI index options to rise by around 1.5 times, according to one trader.
The situation bears some similarities to what happened in the Japanese retail structured products market in 2012, when a build-up of vega led to a short squeeze when spot and volatility shot up over a short period. This time around it is a short squeeze on the downside as spot moved lower and volatility spiked.
Hedging the delta in the products was also a challenge. Usually it can be hedged using index futures, but position limits on the HKEx – which limit trading entities to a maximum of 12,000 contracts or 12,000 positions of delta on a net basis – left some market participants unable to hedge as the HSCEI continued to fall and deltas continued to increase.
"Some Korea securities touched that limit at HKEx. When we hedge ELSs we need to buy more futures when the market goes down, causing problems for those that couldn't," says Yeonchoo Kim, a trader at Korea Investment & Securities (KIS) in Seoul.
To make matters worse, foreign dealers were said to have restricted some Korean securities firms' access to the futures market during this period. Most Korean dealers use a combination of in-house hedging and back-to-back transactions with foreign dealers to manage their risks. Kim says KIS hedges 25% of its risk internally, with the remaining 75% done via international banks.
But during the September volatility, some international dealers were said to have limited swap lines that provide Korean firms with access to the Hong Kong futures market, citing counterparty risk concerns around smaller issuers with low credit ratings.
With large sizes in their go-to hedge unavailable, some Korean houses took a different tack. A trader at one Korean securities firm used call spreads – a pair of at-the-money and out-of-the-money call options – to hedge in a market where volatility had risen dramatically and buying options had become expensive.
"From 10,600 points the HSCEI dropped towards 9,000, so we bought call spreads and increased our position every 100 points down to hedge the delta instead of buying futures," says the trader.
From 10,600 points the HSCEI dropped towards 9,000, so we bought call spreads and increased our position every 100 points down to hedge the delta instead of buying futures
A further risk dealers had to tackle was the correlation between the indexes in the worst-of basket. When the indexes are less correlated, the probability of early knock-out is lower, and the probability of hitting the knock-in put is higher. As the dealer wants the product to knock out, they are therefore short correlation and short cross-gamma – the rate of change of delta in one underlying due to a change in the level of another underlying.
When times were good, correlation between the HSCEI and Euro Stoxx 50 and S&P indexes was low, and trades were printed with correlation at around 55%. However, the Chinese equity crash in June caused all indexes to fall, causing correlation to spike to 80%.
KIS's Kim says this was the most painful aspect of the HSCEI fall for his firm: "We experienced losses because of realised correlation, whereas other houses lost money from delta or vega. We couldn't hedge 100% of the correlation risk. Correlation was low and became much higher," he says.
Kim says that as correlation is hard to hedge, he uses exotic options such as worst-of baskets of options. The firm also issued an ELS product with reverse correlation risk, which referenced the average return of an underlying rather than the worst reference in an underlying basket.
An equities trader at one international bank in Hong Kong says the experience of 2008, when correlation went to one across asset classes, meant they were well aware of the risk. "Global banks experienced the crash and lost money in 2008 and know that correlation risk can't be recycled," he says.
ELS products that reference the HSCEI also contain forex risk. This is because the autocallable products are denominated in won, but the options and futures used to hedge the issuance are denominated in Hong Kong dollars – a situation known as quanto. This puts banks short Hong Kong dollar/won vega and gamma, as dealers do not want the exchange rate to move.
As the HSCEI was the worst-performing index in all baskets, banks' hedging efforts were all focused on reducing the same quantoed forex exposure. This pushed up the price of volatility on the currency pair, even though the Bank of Korea was holding the rate versus the US dollar steady and the Hong Kong dollar is pegged to the US currency.
As Hong Kong dollar/won options are not liquid, though, some looked to use a US dollar proxy given the Hong Kong dollar peg: "There are Hong Kong dollar/won forex options but the spread is very wide, making it hard to trade, so we used won/US dollar options. We bought US dollar gamma through strangles or straddles – a combination of puts and calls," says KIS's Kim.
With so many moving parts, losses were almost inevitable. According to the Morgan Stanley note, NH Investment & Securities – formerly Woori Securities – was the worst-hit securities house, nursing losses of around 20 billion won, compared with 17 billion won for KIS and 15 billion won for Samsung Securities. International dealers were not immune, though. Estimations from five market sources put their cumulative losses at around $150 million.
Just as damaging for international banks was the impact the moves in HSCEI spot and volatility had on variance swaps referencing the index. Variance swaps 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.
Variance swaps are used as part of a strategy known as the relative value volatility trade, which has long been popular in Asia. In this strategy, institutions such as pension funds and insurance companies typically go long Asian volatility – using the HSCEI, Nikkei or Kospi indexes – while shorting US or European volatility using the S&P 500 or Euro Stoxx 50. The idea makes sense; in a crisis period, the lower liquidity in Asian markets tends to force volatility to overreact versus S&P volatility, for example.
In calmer times the trade works well for bank exotics desks active in the autocallable market. They are long vega from issuing the ELS autocallables and offset this by being short variance. As long as spot and volatility do not move to extremes, the book is balanced.
For buyers of the variance swap, the product hadn't performed well due to the global low-volatility environment. But when the HSCEI started to fall, one-year implied variance moved from 27 to 45 points, causing pain for dealers and hedge funds who were short variance. According to a trader at one European buy-side firm, if a bank had gone short a $10 million vega variance position at 27, unwinding at 45 would have realised a $250 million loss.
Soeren Grooss, Copenhagen-based portfolio manager at pension fund PKA – a seller of variance swaps during market stress – says dealers should theoretically be able to buy a strip of index options as a hedge for sold variance swaps, but the scarcity of HSCEI options made this difficult.
"Usually this would mean selling variance swaps and buying back a very broad portfolio of options such as out-of-the-money 20% strike puts. But since it is not possible to get hold of such a strip of options there is a basis risk between the hedge and the variance, which will yield a loss in a stressed market where the variance is more explosive," says Grooss.
The scarcity was exacerbated by the fact that dealers trying to hedge their variance swaps were scrambling for the same instruments as those covering their autocallable risks. Selling variance swaps gives dealers a short position in volga, which is the change in vega for a change in volatility – in other words volatility of volatility. To flatten this they need to buy index puts at the same time as Korean and international dealers were buying back the same options to cover their autocallable vega exposures.
This scarcity also had a knock-on effect on the price of skew – the difference in implied volatility between out-of-the-money put options and out-of-the-money calls. While Risk.net reported in June that skew on HSCEI options was at a record low due to the bullish sentiment at the time, the index's subsequent collapse led to a 3% rise over a matter of weeks, which the US bank's senior exotics trader described as "a huge move".
"As we approached knock-ins and people ran out of vanilla hedges for variance swaps, leaving them very exposed, we saw the biggest repricing of skew for many years. While skew wasn't as high as 2008, the speed it moved was the fastest for 10 years," he says.
While markets have calmed down since September, a trader at one European buy-side firm says the HSCEI event was a "permanent implied volatility shock" in the Korean autocallable market that could prove to be a seminal moment. It has already had an effect – in September, issuance of HSCEI-linked products was at its lowest level since June 2014, at $14.8 million in terms of vega compared with $46.3 million in July.
Combined with the activities of Korean markets regulator the Financial Services Commission, which is believed to have privately asked domestic securities houses to halt new issuance of HSCEI-linked autocallables, the buy-side trader suggests the market may simply not return to its heyday.
Correction, November 3, 2015: Due to an error in Morgan Stanley’s research note, the original version of this article wrongly attributed loss figures of 90 billion won to NH Investment & Securities, and 20 billion won to each of KIS and Samsung Securities. Morgan Stanley has now corrected its note.
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