South Korea, Where Speculators Short EU Stocks, HK$

♠ Posted by Emmanuel in , at 2/05/2016 12:26:00 PM
Beware the Seoul speculator whose derivatives trading causes disorder elsewhere in the world.
There's an interesting illustration of financial globalization in how derivatives trading in South Korea (of all places) is apparently helping drive down not only European stock indices but even the Hong Kong dollar. Despite being removed from where the action is--Seoul is not usually regarded as a front-line financial center--the consequences of Korean derivatives trading has magnified movements in offshore markets. The knock-on effects are evident when markets are especially turbulent--as they have been as of late:
Korea hosts the largest and most liquid market in the world for options on single stocks — bigger than the US, even, according to bankers — and retail interest in derivatives does not stop there. In what looks like the latest example of a “butterfly effect” in global markets, last year Korean investors bought record amounts of so-called “autocallables” — a structured product offering an attractive yield. About $40bn are outstanding. 
The distinguishing feature of these structured products is that they tend to magnify volatility when the indices or underlying securities they are based on fall below a level known as the "knock-in" level which makes the derivatives (and therefore mark-to-market losses) active. When this happens, investors write put options--to sell at a certain price in expectation they may decrease--to hedge against future losses. All this activity introduces additional volatility:
Since these autocallables are two- or three-year deals, and most were sold last year, the final reckoning over who has lost what is some way off. The area of interest for now is their effect on other markets. The products in essence sell volatility. They work by offering investors a “worst of” basket of two or three reference securities — typically indices.

The sales pitch is that investors get a yield on top of their capital if the reference securities stay within a specified range. If they rally above it, investors are “knocked out” and get their money back with a bonus. If it falls below a specified point — usually between 40 and 50 per cent of the level, when the product was sold — they are “knocked in” and lose some capital.
Holders can be made whole if the index recovers all lost ground before the autocallable ends — hence it being difficult to gauge losses at this point. However, the nearer an index falls to that strike price, the more product sellers have to hedge, which they do via selling futures. This is what is weighing on the HSCEI, which was a popular inclusion in the first half of last year because of China’s soaring markets. But it is now down 46 per cent from its May 2015 peak — putting it right in the zone where issuer hedging will be at its highest.
To illustrate, consider the Hong Kong dollar. As speculative rumors swirled on breaking its 32-year-old peg to the US dollar, Koreans were forced to follow suit lest this become another source of losses:
Hong Kong indices are even more popular in Korean products because of the 32-year unchanged link between the Hong Kong dollar and its US counterpart. So imagine the fear among Korean sellers of autocallables last month on seeing the Hong Kong currency suddenly spike higher after Chinese authorities quashed speculative shorts in the offshore renminbi market. The result was additional weakening pressure on the Hong Kong dollar as Korean groups rushed to hedge.  
Who'd have thought the Koreans were introducing more volatility into global finance?