Emerging markets derivatives: The central European option
Emerging markets derivatives: Latins learn virtue of credit swaps
For the brave, equity derivative products in south-east Asian emerging markets have been throwing up some exceptional opportunities. Local regulations, such as the inability to short stocks in many markets, have produced some spectacular swings in pricing on either side of notional fair value.
Taiwan has been one of the most prominent markets in this respect, with equity swaps fluctuating widely. Last year, when international investors were chasing the Taiwanese cash market, equity swaps ran up to 300 basis points over Libor.
This year, the rush to lock in some unexpectedly strong gains with hedging strategies and a far less certain equity outlook, have at times pushed equity swaps down as far as 1,300bp below Libor. Even after allowing for a dividend yield of around 2%, one-year equity swaps are still typically trading at around 8% below fair value.
Such variations are not found in the region’s mature markets. The Japanese markets will sometimes deviate, but typically by no more than 20bp30bp from fair value in any quarter. A measure of the potential in Taiwan can be seen from what happened the last time Japan exceeded this, some two years ago. Then, the futures calendar spread ran up to 80bp above fair value and massive arbitrage on the short side saw a lot of traders make big profits.
At current levels, hedging existing Taiwanese equity portfolios becomes uneconomic, but the flip side (taking a synthetic long position) has plenty to offer. “For those looking for exposure to these markets, equity swaps at current levels present a tremendous opportunity,” says Steve Kim, equity derivatives analyst at Merrill Lynch in New York. “So far there hasn’t been much activity on this front from US investors but, if you want to be in Taiwan and the swaps market is trading this cheaply, why not use it? The administrative headaches of dividend accounting have meant that most activity has been in price-return, as opposed to total-return, swaps. Even then, any dispute over the dividend yield component of the swap pales into insignificance against an underpricing of this magnitude.
“This sort of market is best suited to a long-term strategic approach that also makes opportunistic use of this sort of mispricing to boost returns. A longer horizon is needed; trying to look at emerging markets quarter-by-quarter is not appropriate.”
Alastair Cooper, head of equity trading and derivatives at Morgan Stanley in Hong Kong, feels that the pricing fluctuations in Taiwanese equity swaps have been principally driven by the convertible market and the lack of stock lending facilities. “The lack of stock lending means that there is no convertible arbitrage activity,” he says. “Consequently the convertible remains cheap with often a 20% discount to parity, and 30% not unknown. At the moment, they’re off their lows, but it’s been due to that pick-up that people have been able to afford to sell swaps cheaply. They tend to be convertible funds willing to leg the conversion, which takes about three months to complete.”
Another factor has been the activity of hedge funds. “In Taiwan the closed-end funds have been under attack from hedge funds,” says Nigel Beattie, a vice-president at Merrill Lynch in Hong Kong. “A lot of the closed-end funds have been trading at around 20% discount to their net asset value. Under Taiwanese law if they trade at a greater than 20% discount for 20 consecutive trading days, then the shareholders have the right to call an extraordinary general meeting. This allows them to break open the fund [so it becomes open-ended] and realize the full net asset value – so there’s an immediate potential gain of 20% to be had there.”
On average it takes four to five months to complete this process, after which the hedge funds unwind their equity swaps. As the positions are held only for four to five months, the hedge funds are still typically making a net gain of 14%-15% on each trade. The equity swap market has been the preferred route for this type of trade as the exchange-traded alternative, the MSCI stock index future traded on the Singapore International Monetary Exchange, is rather illiquid. It also trades at an even steeper discount to fair value – typically Libor minus 1,500bp-1,600bp on an annual basis.
Lack of appetite
The MSCI future has been a source of interest in its own right, particularly on the short side. It currently trades some 2%-2.5% under fair value per contract with a monthly expiry. A major factor in this has been the lack of any natural appetite on the long side of the market, with the monthly expiry cycle tending to exacerbate the situation. As the futures roll relative pricing between contract months trades around 1% cheap to fair value, it’s possible to capture 13.5% by rolling it 11 times and then capturing the final 2%-2.5%. At the same time it has been a focus of some very limited arbitrage activity with the equity swap market. Liquidity has remained thin, as few players feel comfortable with an unproven entity. Those active in the market remain very much at the mercy of where the spread is at the end of the month.
Wild swings in equity swap pricing haven’t been the sole preserve of Taiwan. The prize must go to Thailand, with a move from Libor minus 600bp to plus 200bp in the space of a day (when a devaluation in the baht was announced). Several other markets in the region are offered at minus 200bp-300bp and Korea hit Libor minus 600bp when it appeared that the economy was in danger of meltdown.
Despite this, the equity swap market has been gaining in liquidity. Earlier in the year, it was impossible to trade $2 million-$3 million in some smaller markets, now $5 million usually presents no problem. There is some evidence that the liquidity is growing from a broader investor base as some plain-vanilla institutions are starting to wake up to the possibilities of a market they would previously have shunned.
Much of the distortion in the Thai equity swap market was caused by official restrictions on the baht, which prevented onshore banks from supplying the currency to those offshore. Offshore banks were obliged to borrow among themselves, which created extraordinary demand and wild discrepancies between onshore and offshore short-term interest rates. On one particular day, onshore overnight rates were less than 10%, while those offshore hit 1,200%. Another anomaly was an effective two-tier foreign exchange market, as the relative inability of those offshore to buy (as well as borrow) baht caused an artificial squeeze that rallied the currency. While the situation lasted (some three weeks), the best way for those offshore to raise baht was to sell existing stock positions to raise cash and use equity swaps to maintain market exposure, if required.
Other equity swap markets in the region remain ultra-sensitive to supply and demand. With the current speculation on the peso, trying to find serious buyers for the Philippines is something of a lost cause – with any offers firmly in negative territory. Under such circumstances normal valuation techniques based on dividends are clearly irrelevant. Such activity as there has been has focused on a few single stock trades. The popular trade has been in playing the “B” share premium against the “A”. The “B” shares, to which overseas investors have access, traditionally trade at a significant premium to the local-investor-only “A”. At times the premium can reach 65% or more. Various strategies, such as local swap products, have been designed to allow offshore participants to capture “A” share performance without having to pay the “B” share premium.
Consequently the premium has been trending gradually lower over the past two to three months. On the back of this, there has been some pressure on the authorities to reduce the premium in some way and eventually to make the shares fully fungible.
Bullish activity
Despite Thailand’s recent dismal performance, most investors’ derivatives activity has been bullish. “The demand has been for leveraged upside positions,” says Dennis McNell, a director at ING Barings in Hong Kong. “Most international investors have been bottom-picking all the way down. Call warrants, barriers and call spreads have all been in demand – particularly in the banking sector, which contains most of the highest cap Thai issues. Though interest in call warrants has abated a little in the last month or so, it’s interesting to note that many fund managers are bringing out Thailand recovery funds. If the market starts to pick up, I think the OTC call warrant market will become very active.”
Thailand has been an area of considerable interest for international investors, but also a source of frustration for the dealer community. “Clearly with the speculation over baht devaluation, and then the devaluation itself, we have seen a lot of interest from people looking to buy optionality in Thailand, both in baht terms and crossed into US dollars,” says Cooper at Morgan Stanley. “However, the Thai authorities have been clamping down hard on funding and currency hedging. They have stopped stock loan activity as well, which makes it effectively impossible for dealers to operate on anything other than a matched bargain basis. The trouble is that all the business is going one way.”
Corporate listed warrants have remained very popular with local investors in Thailand and consequently trade at high premiums. The warrants market in the region should receive a further boost in the near future with the announcement by the Taiwanese Stock Exchange of a listed warrant market. OTC products have remained relatively simple, as hedging optionality in the region is extremely difficult.
Only in Hong Kong is there any meaningful two-way option flow, typically in six- and 12-month index options. Trying, for example, to trade Taiwanese index volatility is something of a non-starter, as asking for a quote in the inter-dealer broker market won’t even elicit a two-way price. Under those circumstances there is little incentive to design more complex products, for which there is limited demand.
One possible OTC growth area is in funding-type products. “We are seeing – and I think will continue to see – Asia being the laboratory for a whole series of new structures based on funding,” says Jonathan Fox, managing director of Credit Suisse Financial Products in Hong Kong. “If you look at Asian corporations, they typically have high capital requirements. Their access to the bond markets is still less than perfect, despite the efforts of US bulge-bracket firms to get Asian names recognized on a worldwide basis. As a result, we’re seeing a lot of people looking at OTC equity derivatives as part of fund-raising transactions.”
Hong Kong’s reinvention of itself as an emerging market should have a big effect on new derivative business there, helped by the influx of high growth, capital hungry, mainland stocks. Earlier in the year, volatility was exceptionally cheap on both the index and single stocks, but the last month has seen a sharp spike upwards.
This has slightly softened recently in the three-month time-frame, but the six-month-to-a-year range is still well bid. “The area of interest at the moment, where there is a lot of activity, is in the red chips where the cash volume has moved,” says Cooper. “The rise in volatility has not been driven by panic hedging against the new administration, but simply by genuine activity in the underlying red chips.”
These levels of activity are also driving the development of new exchange-traded products. The Hong Kong Futures Exchange has recently announced the introduction of a futures contract on a basket of 32 of the red chips, and (in conjunction with the Hong Kong Stock Exchange) the first two red chip single stock options.
While this all appears most encouraging, there remains the question of the likely impact on the market (and volatilities) should China indulge in another bout of war games in the Taiwan Straits. That’s one thing with a major market index composed of stable and established companies, but quite another when they all have P/Es of 75.
