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Bucking the trend

/asia-risk/feature/1510115/bucking-trend 01 Jun 2008, Asia Risk

South Korea's equity derivatives market has thrived since its inception in 2002, growing to $25 billion in notional volumes of equity-linked securities (ELS) last year, according to Samsung Securities. And the market has continued to perform well, despite problems in the global credit markets and big jumps in South Korean equity volatility this year. The rise in both implied and realised volatility in the first four months of the year, combined with a double-digit percentage drop in share prices, has led to some failed products, as elsewhere in the region. But it has also driven development of the domestic market's most successful product, the 'high-five'. High-fives are ELSs with a final payout based on the performance of underlying equity - single stocks, baskets of stocks or equity indexes. They are Bermudan-style auto-callable options, with many permutations of knock-in and knock-out features. A conventional high-five structure has two underlying shares - let's call them A and B. The product's standard maturity is three years and it is auto-callable every three months. The auto-call would work if the share price of A or B is greater or equal to 90% of the initial share price. If the note is not called, its final payout is determined by the worst of A or B's closing price at maturity. They represent more than 50% of the equity derivatives market, estimate market participants. However, market turbulence has resulted in the re-engineering of high-five structures. For example, high-five ELSs issued in 2007 with a peak initial price level had a very low chance of early termination following the South Korean stock market plunge this year - the Korea Composite Stock Price Index (Kospi) lost 16% of its value in the first three months of 2008. But some newly developed high-five structures also captured a lot of upside potential during the bout of

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market volatility, say market participants. "The volatility in the equity markets from the end of 2007 to March this year gave us many opportunities," says Wonjae Chang, head of equity trading at Samsung Securities in Seoul. High equity volatility encouraged the development of variance high-five structures. As hedging financial institutions become more experienced at handling multiple risks, securities companies have offered high-five structures with "extraordinarily" higher coupon rates, says Ki Hyun Cha, head of equity derivatives trading at Woori Investment and Securities in Seoul. Products with coupon rates higher than 20% a year have become a popular retail product. In addition, issues offering a closer at-the-money (ATM) daily early-termination barrier - for example 102% of the ATM - are now selling well, say dealers. Changing face But the country's equity derivatives market now faces new challenges, as the products that were developed for volatile equity markets began to lose their investor appeal as volatility stabilised in April and May. That's because the step-down feature of the high-five is less effective when volatility is low. In the step-down structure, there is a step down for every observation set. While daily volumes rose from January, reaching a peak in April, activity has fallen since, says Jay Hwang, vice-president of equity derivatives at Citi in Seoul. "It fits with the Korean client," says Hwang. "Most Korean clients like to have profits from the stock market, but are not so aggressive. The step-down structure provides the buyer with the interest payment, which is around 5-6% in Korea, while the autocall provides the possibility of earning more than 15%. Yet when market volatility is declining, the autocall structure does not work and the price of the autocall becomes more expensive." Others make similar points. Seon-Kyu Lee, head of equity derivatives sales at Woori Investment and Securities in Seoul, says: "Recently issued high-five ELSs have a more conservative character, emphasising stability, which reduces the coupon rate of ELSs (over time)." Under the knock-in conditions, which set the criteria for the opening principal-loss option, current ELSs are set at a lower level of 50-60% compared with 60-70% in 2007. Dealers are also extending the possibility of early termination, says Lee. That is, the knock-out conditions - or the level at which the product expires - decreases based on the time elapsed, such as from 85% to 70% in 5% increments every six months. Playing volatility A high proportion of the South Korean equity derivatives market caters to retail investors, according to Macquarie Securities. These equity-linked warrants (ELWs) are often structured to allow dealers to shed some of the risk concentration exposures generated by structures developed for private banks. "There are new products coming out of the ELW market for the retail market, such as Nikkei 225 and HSI (Hang Seng Index) underlying ELWs," says Ross Gregory, head of the equity markets group for South Korea at Macquarie Securities in Seoul. Macquarie Securities also plans to introduce exotic and investment-syle ELWs later this year. But institutional investors - notably hedge funds - are also active in the market and help dealers hedge their positions by taking on volatility and correlation exposures. In the past three years, the use of variance swaps and correlation swaps in the wholesale market has increased. Hedge funds benefit by conducting these trades with structured product providers that want to lay off their concentrated risk exposures to hedge funds. And
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South Korea is seen as attractive due to the depth of its equity options market. Market participants says hedge funds have been active in conducting dispersion trades in the country, which has helped to keep volatility levels down at manageable levels. Another important development is the launch of single-stock futures on May 6 on the Korea Exchange (KRX). The exchange launched a total of 15 products, with a daily average of 9,452 contracts traded from May 6-13. Single-stock futures should help deepen the structured product market, as they provide dealers with another cheap hedging option. In the first week of trading, Kookmin Bank was the most active warrant future traded, which was the result of hedging activity linked to ELW issuance by several securities dealers, say market participants. The market participant breakdown is 50% local individual investors, 25% local institutional investors and 25% foreign investors, says KRX. And single-stock futures are trading in close correlation with their respective underlying stocks and ELWs, says Yoonbae Kim, deputy manager of KRX's futures market division. "They are showing quite high coefficients," he adds. Dealers say they are watching the new futures and waiting for major market-makers to supply more liquidity. The entry of market-makers late in May has already resulted in a sharp increase in the daily average traded volume, which rose to 13,820 contracts in late May. While a liquid warrant futures market would reduce hedging transaction costs across the board, it is likely that KRX single-stock futures will benefit South Korean domestic issuers the most, as they typically receive higher internal funding rates than their foreign counterparts, says WIS' Cha. Regulatory developments Meanwhile, a number of structural and regulatory developments in South Korean financial markets are expected to continue to propel the domestic equity derivatives market, including a change to the pensions market. The country's pension industry, which conventionally invests in the fixed-income markets, is being incentivised to increase its exposure to the equity markets in the low interest rate environment of 4-5%. South Korea adopted a new retirement fund system in 2007 similar to US defined-contribution plans, where employees can choose from a variety of investment options, including direct investment in equity funds. The five-year defined-benefit contribution programme is forecast to reach a value of $100 billion. At present, the retail market is responsible for around 65% of activity in the South Korean equity derivatives market. Meanwhile, in May, volatility was returning to the equity markets and the Kospi hit a five-month high - both seemingly positive for South Korea's high-five structures and the multitude of new derivatives instruments under development. Print | Close Incisive Media Investments Limited 2012, Published by Incisive Financial Publishing Limited, Haymarket House, 28-29 Haymarket, London SW1Y 4RX, are companies registered in England and Wales with company registration numbers 04252091 & 04252093

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