Tumbling Chinese stocks have left a key index close to a level that threatens heavy losses for both investors and banks, according to traders.
Since the start of January, the Hang Seng China Enterprises Index (HSCEI) – the reference for a variety of equity-linked structured products, including autocallables – has fallen 12%, from 9,650 points to 8,494 points on January 13. That has already handed losses to investors in around 3% of existing HSCEI-linked autocallables, dealers estimate, and the danger level for the bulk of the products starts at around 8,000. One dealer warns the situation could get "out of control".
Tim Bousser, head of equities and derivatives for Asia-Pacific at Societe Generale Corporate & Investment Banking in Hong Kong, says the bank meticulously reviews its risk exposures.
"At the top level of the bank we are constantly reviewing products including autocallables, as the amount of stock available in the market has increased over the past few years. Firms that have accumulated concentrated risk in these products may see bigger challenges. Firms are assessing their business models, risk matrixes and risk limits," he says.
In September, dealers lost an estimated $300 million as they scrambled to rehedge the products following a 40% drop in the HSCEI.
A large proportion of the Korean structured products market consists of autocallable instruments linked to the worst performance of two or more underlying stocks or indexes, with the HSCEI typically included in the basket. A typical product has a three-year maturity and 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.
The downside barrier, consisting of a sold knock-in put option, is usually set at about 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 until maturity.
With the HSCEI continuing to fall, dealers say knock-in barriers are starting to be reached. "A few autocallables issued in Korea touched the knock-in barrier, but the amount was small and there was no panic selling or big effect for the market. But everybody's a little bit nervous, because as HSCEI drops more we are going to see more autocallables touch knock-in barriers," says Yeonchoo Kim, a trader at securities house Korea Investment & Securities in Seoul.
Dealers estimate about 3% of structures have hit their knock-in points so far, while data from Societe Generale says the bulk of structures will knock in if the index falls below 8,000.
Banks face hedging problems as the HSCEI moves toward the knock-in points. As spot falls, the desks become long vega – the change in an option's price for a change in volatility – because of the put 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 forces them to sell puts to flatten the risk.
When the knock-in points start to be hit, however, the long vega position disappears, forcing banks to buy back volatility – creating huge one-way demand.
At HSCEI levels below 8,500, dealers' exotic books will be "deformed" as their inventory of vega vanishes, says Valery Bloud, head of flow and hedge funds sales for Asia-Pacific at BNP Paribas in Hong Kong: "The supply of volatility would disappear and you would see aggressive one-way volatility buying. At 8,000 it could get out of control. Knock-ins start at 8,500 but the majority are at 8,000–6,000," he says.
Forewarned is forearmed
These pressures were felt in September when the HSCEI was around the 9,000 level, but this time dealers say they are more prepared for a downward move.
"After the sell-off in China last year, some firms anticipated potential further turmoil and kept their vega inventory rather than hedging 100% of exposure on the book," says Bloud.
A trader at a large securities firm in Korea says his firm has taken this approach, buying put options at tenors of three to five months between October and December last year.
"To prepare for a move lower we put on out-of-the-money hedges such as buying put options at below 8,500, so this time it might not be as bad as last year. If the market is up and down like this we can't make a profit as it gets spent on hedging," he says.
Dealers have also put on volatility hedges in case of further HSCEI movements in the coming months, says BNP Paribas' Bloud. He says that on January 7, banks put on a total of $1 billion notional of call spreads on the HSCEI December expiry, with the buy call strikes at around 8,600 and sell put strikes at around 10,200.
"It was probably a trade by banks loading up on skew to hedge their exotics book. That's a very big trade for HSCEI," he says.
Volatility skew measures the difference in implied volatility between out-of-the-money, at-the-money and in-the-money options. During the September bout of volatility, moves in the skew would have led to large profits for those exposed to it via these types of call spreads.
Lee Hyo-seob, a researcher at the Korean Capital Markets Institute, says that if the HSCEI drops another 20%, banks and retail investors face the prospect of real pain.
"The main problem is that HSCEI might fall under 7,000; then many securities firms will have a big hedging loss and retail investors will lose their money, and the same issues will be raised as in September," he says.
In September, Korea's Financial Services Commission required domestic securities houses to temporarily halt sales of some products and the Korea Financial Investment Association (Kofia) – a self-governing body representing the Korean financial industry – agreed on new principles for the issuance of equity-linked securities (ELS). This included a commitment by Korean securities firms to reduce issuance linked to HSCEI, but not totally abandon it.
"FSC and Kofia published guidelines to decrease the total outstanding of HSCEI-linked ELS products to $25 billion outstanding. To meet it, securities firms must decrease ELS issuance, but if the redemption amount increases then they don't need to make reductions," says Lee.
Recent statistics show the product may be losing favour among investors anyway. At the end of June last year there was $40 billion of outstanding products linked to HSCEI, but this has now fallen to $36 billion, according to Lee.