Warren Buffett once famously remarked that “derivatives are financial weapons of mass destruction.”
That’s true enough in the hands of financial professionals.
But what happens when derivatives are nicely packaged for retail investors – offering an attractive yield based on the performance of individual stock indices, currencies, and even single stocks?
You get the current turmoil in markets from Asia to Europe, and even to America’s shores…
It all starts with the world’s central bankers and their extremely low interest rates. This has led investors to search worldwide for a decent yield.
Add central bankers’ implicit support for stock markets into the mix – and exotic options (derivatives) named autocallables (because they’re “automatically callable”) were created by the financial industry.
Autocallables offer yields higher than most fixed-income investments, usually with a maturity of two to three years. However, the yield is contingent upon a security like a stock index or currency remaining within a set range.
And if the index rises above the set range, it gets even better. The investor would be “knocked out” and get their principal back plus a nice bonus. This feature made autocallables look spectacular, especially with central banks pushing stock markets higher on a sea of liquidity.
Investors ignored the fact that if the index fell below the set range, they would be “knocked in” and lose part of their principal.
The epicenter of this autocallable universe is South Korea. There was a record amount of such instruments issued last year – $63 billion.
But then the stock markets around the world began to go down, and the central banks didn’t immediately ride to the rescue. That forced the Korean brokerage firm creators of these autocallables to hedge their positions. Which usually involves selling futures.
As described by the Financial Times, this forced hedging caused downward pressure in everything from the Hong Kong dollar, to the Euro Stoxx 50 Index, to the Hang Seng China Enterprises Index (HSCEI).
China Stock Market Mess Caused by Korea
Let’s take a look at just one of these trouble spots – the Hang Seng China Enterprises Index. This index consists of Hong Kong-listed shares of large Chinese companies.
The Korea Securities Depository said that there were nearly $40 billion of these autocallables based on the HSCEI still outstanding at the end of 2015. That’s an astounding amount. And these autocallables make up a full 60% of all Korean autocallables.
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Sales were brisk in the first half of 2015, when the HSCEI hit 14,800. An added plus was the fact that the Hong Kong dollar has been pegged to the U.S. dollar for 32 years. So there was no currency risk, either. A “can’t-miss” investment, many Korean retail investors thought…
Until the Chinese market began sinking, that is. The problem is, as the market continued to sink, the hedging from the Korean brokerage firms increased. The index went down even more. That brought on further hedging and selling.
And the hedging continues.
With strike prices concentrated around the 7,800 level, continued hedging will keep pressure on the index. The HSCEI is currently at 8,055. This will no doubt continue until about 7,300 on the index where the last of these autocallables’ strike prices remain.
When the HSCEI does fall below the levels of the strike prices, Korean retail investors will lose part of their principal. Good – and I hope these investors sue their brokers who sold them on an “easy” way to get extra yield.
If I were China, I would be furious at the Korean regulators. Instead of trading on Chinese economic fundamentals, this index trades in line with the prices of Korean brokerage firms. In fact, since April 2015, there has been a 90% correlation.
When Will Investors Learn?
The moral of the story is that some people never learn from history.
Korean investors should’ve been wary of these autocallables. They had many of the same features that blew up previous experiments of derivatives for amateurs in Asia.
One example was so-called accumulators. Across Asia, the product became “affectionately” known as “I’ll kill you later.” Retail investors’ portfolios were devastated. And China’s biggest conglomerate in 2008, CITIC Group Corp. – through its brokerage subsidiary – lost $2 billion on accumulators.
Sadly, the financial industry around the globe continues to sell these types of “can’t-miss” products to unwary investors.
Regulators need to keep a tighter rein on their introduction to unsophisticated investors.
Of course, these products wouldn’t exist if the central banks would stop their low interest rate and currency devaluation policies. So the best way investors can protect themselves is to steer clear.