Surprise Chinese devaluations may revive bid for FX notes, offer new trade opportunities

By Emma Trincal

New York, Aug. 14 – China’s devaluation of the renminbi twice last week and the ensuing volatility felt in the global markets could create new investment opportunities for structured product investors in all asset classes, including in currencies, the market’s laggard, which sources said could be revived.

Two rounds

“Investors are in a wait-and-see mode. A new policy has been abruptly put in place by the Popular Bank of China. It takes a week or a couple of weeks for investors to digest and for the impact of the devaluation on the markets to settle down,” an FX structurer said.

China’s intervention was sudden and not totally transparent, he noted, which added to the uncertainty.

“The government wants to increase the flexibility of the exchange rate. At the same time, they’re not disclosing everything. They are only introducing a new fixing methodology. It’s no longer pegged to the dollar, but it’s not a free-floating currency yet. They’re just trying to align to the market,” he said.

“Let’s see what happens a couple of weeks from now in terms of pricing.”

China devaluated the renminbi by 2% against the dollar on Tuesday morning. A second devaluation followed on Wednesday. Volatility in all markets rose worldwide as a result.

Volatility

The FX structurer said the devaluations had a broad impact.

“With the surprise devaluations, we’ve seen a spillover of volatility across most markets globally including equities, currencies, commodities, etc.” he said.

Volatility creates opportunities, according to a market participant.

“This move is beneficial to anyone looking to sell premium,” he noted.

“When volatility is higher, you generate more premium to stick inside a note. You can generate yield, or you can use it to provide a hedge.

“It’s usually a positive thing to have volatility when you want to structure a product.”

The FX structurer was more skeptical at least for the short term.

“Volatility is higher, but it has a mixed impact,” he said.

“People are worried, and it takes time for the markets to settle down.

“You may get better terms, but if fear kills the appetite for deals, it’s not going to help.

“Yes, products can get more exciting because you can sell volatility for a higher premium. That’s how investors can take the higher risk. It doesn’t mean they want the risk though. It’s all based on sentiment.”

Quanto

A sellsider on the equity side said the recent currency move coupled with other trends is likely to boost demand for hedges in the equity-linked market.

He pointed to the market fearing a currency war, which, as the reasoning goes, leads other governments to depress their own exchange rates in order to maintain the competitiveness of the goods they export.

“If China devalues, who’s going to be next?” this sellsider said.

“It came as such a shock. ... We’re hearing a lot of investors asking us to remove the currency risk.

“This move didn’t affect just China but all currencies. The need for currency hedging is huge.

“We see a lot of investors who say, I want to be in U.S. dollar. I have exposure to the Euro Stoxx, but I don’t want the risk of the euro.”

Those fears are exacerbated by the unresolved Greek debt crisis, he said, as bailout talks have yet to reassure investors that Greece will not be leaving the euro zone.

“There’s a lot of volatility around the world’s politics. People are now looking at Spain, Portugal and Italy as other possible currency shocks.”

Structurers offer hedges against currency risk through derivatives contracts called “quanto.”

Demand for quanto instruments is rising, he said, going beyond the structured notes space. Several exchange-traded funds have offered such features, which have been popular.

“Some structured notes are quanto. But not all of the notes,” this sellsider said.

“Most notes and most mutual funds are not currency-hedged. It’s expensive to quant it out with the call option, the time premium, the volatility value, etc.

“Yet the demand is there. I think we’ll see more of that.”

Protection wanted

Market turmoil will lead investors in general to ask for more protection.

“The precipitous drop in the Chinese currency has rattled the market, especially on the retail side. At the same time, institutions are coming in. There’s a lot of fear in the market,” the sellsider continued.

“People say, I want to stay invested. I don’t want to miss the run-up. But the question is how much this protection is going to cost me.

“Higher volatility sometimes works against you if you’re trying to buy protection because it becomes more expensive.”

Some stocks were hit particularly hard last week, such as Alibaba Group Holding Ltd., he noted.

Alibaba shares opened down more than 7% on Wednesday. But the notional value of deals tied to this name is only $30 million so far this year, according to data compiled by Prospect News.

Businesses with exposure to China were also vulnerable. The shares of Apple Inc., the underlying of 167 deals this year to date totaling $795 million, dropped 8.5% from Monday’s close to the open on Wednesday.

In general, the unexpected Chinese intervention on its currency revived fears about a slower economic growth in China and worldwide, sources said.

FX momentum

Currency-linked notes are the weak spot of the U.S. structured products market. The current market swings may, however, be good news for this asset class, some said.

With only $297 million priced this year to date in 46 deals, currency-linked notes issuance accounts for 1% of the total U.S. volume, according to Prospect News data.

But the recent monetary intervention in China, coupled with bearish trends worldwide across Chinese equity markets, crude oil, commodities and emerging markets, could offer new trade opportunities, especially with currencies-linked notes, sources predicted.

“We’re seeing an increasing interest in FX inside structured products. It never really interested a lot of people in the U.S. That’s changing,” the market participant said.

China play

As the renminbi is becoming more market-friendly, trades linked to the Chinese currency could be engineered.

“The Chinese currency is one of the top 10 in the world. It’s very liquid. The market is very capable of trading it. There’s no liquidity issue. Nobody is having trouble in clearing,” an FX trader said.

“The 2% move is not that much. It’s not going to wipe out anybody. But it’s just going to bring volatility that gets traders’ attention and make them want to capitalize on higher premiums.

“Before, you really didn’t have much volatility, not enough to get some optionality where you could sell the options.

“While I wouldn’t say that the Chinese currency volatility is extreme, there’s a lot of interest because now it’s actually moving.”

New currency trade ideas should emerge, this FX trader noted.

“There are a lot of global trades, not necessarily China versus U.S dollar. I would think the more interesting deals would be China versus other Asian countries or China versus commodities countries,” he said.

As currencies are getting the attention of a growing number of investors, demand for notes offering FX exposure or hedges should follow, the market participant said.

“It’s part of a large movement across various wrappers. ... It’s only a matter of time before this trend hits different other products including structured products.

“You can always use structured notes in certain situations.

“Currencies lost a lot of interest when volatility was too low. It made no economic sense.

“That’s changed.”

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.