derivatives outlook_ change coming in 2012 - more regulations, volatility expected
TRANSCRIPT
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November 25, 2011
Samsung Securities (Korea) www.samsungpop.com
This report has been prepared without anyundue external influence or interference, andaccurately reflects the views of the analyst(s)covering the company or companies herein.
All material presented in this report, unlessspecifically indicated otherwise, is under copyrightto Samsung Securities. None of the material, norits content, nor any copy of it, may be altered inany form or by any means, transmitted, copied, ordistributed to any other party, without the priorexpress written permission of Samsung Securities.This memorandum is based upon informationavailable to the public. While we have taken allreasonable care to ensure its reliability, we do notguarantee that it is accurate or complete. Thismemorandum is not intended to be an offer, or asolicitation of any offer, to buy or sell the securitiesmentioned herein. Samsung Securities shall not be
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DERIVATIVES ISSUE
Change coming in 2012
More regulations, volatility expected
DerivativesOutlook
2011 review: Stock markets rallied in 1H on liquidity injections by developed countries
and a resurfacing of risk appetite, but eurozeone risk led to more volatility. Buffeted by
sovereign risks, the financial markets have found themselves at the mercy of
uncertainties that appear to be more and more political and long-term in nature. As risk
escalated, asset correlation levels increased in 2H11.
A mixed year: With the markets highly volatile, trading volume of Korean equity
futures (index and single-stock) has jumped h-h in 2H, while that of option products
(index options and ELWs) has stagnated or declined. But global products (nighttime
futures and options) have overcome weakness to become established as investment
vehicles permitting real-time tracking of the worlds stock markets. In the equity-linkedsecurities (ELSs) market, average monthly issuances plummeted from KRW3.2t in 1H
to KRW2.5t in 3Q alongside a plunge in the stock market and growing concerns over
financial products in general. The Korean equity-traded fund (ETF) market has
experienced record growth, with more than 100 ETFs listed on the KRX and their net
asset value surpassing KRW10t. Due to a decline in issuances of derivative-linked
securities (DLS), 2H trading of OTC derivatives will likely be flat y-y.
2012 strategy: We anticipate dramatic changes in 2012. A crisis-struck eurozone will
either come together or shatter; the global economy could fall into recession or begin to
gradually recover. Next year will be the first that derivatives, long a symbol of
deregulation, will fall under the numerous regulations agreed to in the wake of the
financial crisis. Given concerns over the global economy and eurozone, we expect the
worlds stock markets to remain highly volatile through 1H. In consideration of volatilityrisk, we advise investors to: 1) implement knock-in put and 100-110% put spread
strategies to limit downside risk; 2) execute a 100-110% call ratio spread strategy to
hedge against upside risk; and 3) include US VIX-tracking ETFs in their portfolios.
More regulations:We anticipate more regulations for OTC derivatives in 2012, aimed
at: 1) curbing speculative investments and protecting investors (eg, through an increase
in the contract multiplier of option products); and 2) preventing incomplete sales and
enhancing information transparency. Regulatory risk will likely lead to declines in the
number of traders and trading volume of on-exchange derivatives products. On a
positive note, however, there should be opportunities in hedge funds, new products, and
revisions to Koreas Commercial Code (KCC). We advise caution when it comes to
Korean hedge funds, which may not be as attractive as advertised due to a slew of
regulations and limited investment targets. To reduce transaction costs, algorithmictrading needs to be applied in order execution of long/short strategies, and investments
in commodity-based options and ETFs need to expand in the pursuit of alpha.
Structural products suitable for hedge funds will need to be developed. Furthermore,
revisions to the KCC and Financial Investment Services and Capital Act (FISCMA)
should allow companies to issue a wider variety of securities, derivative-linked bonds,
and DLSs.
AnalystsGyun [email protected] 2020 7044
Trisha [email protected] 2020 7823
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Derivatives Issue
2
2011 review
Risk on in 1H, risk off in 2H
Stock markets generally rallied in 1H on liquidity injections by developed countries
mainly quantitative easing in the US that boosted liquidity around the world and sparked
inflationand a resurfacing of risk appetite, while some markets remained sluggish
(Europes debt crisis weighed on the PIGS, inflationary pressure on BRICs, and a
tsunami/earthquake disaster on Japan). In 2H, however, only a few frontier countries ( eg,Indonesia and Chile) advanced, as a credit crisis in the eurozone deepened. Southern
European countries have seen stock markets tumble around 30% since end-June, while
the Korean and US markets have pulled back around 10% as Europes debt woe have
escalated into a structural crisis for the global economy.
Equity market returns (1H11) Equity market returns (2H11, through Nov 15)
Source: Bloomberg, Samsung Securities Source: Bloomberg, Samsung Securities
Stock marke ts bullish in 1H, but
faltered in 2H due to Europea n
debt crisis
CONTENTS
2011 review p2
A mixed year p5
2012 strategy p10
More regulations p19
(9.5)
(8.1)
(4.0)
(3.9)
(3.6)
(2.8)
(1.6)
0.1
0.8
2.4
5.0
5.1
6.7
(15.0) (10.0) (5.0) 0.0 5.0 10.0
Greece
India
Japan
Australia
Taiwan
Hong Kong
China
Italy
UK
Korea
US
Spain
Germany
(%)
(42.5)
(24.2)
(20.5)
(19.6)
(13.6)
(13.4)
(13.0)
(10.4)
(10.2)
(8.4)
(7.2)
(6.6)
(4.8)
(50.0) (40.0) (30.0) (20.0) (10.0) 0.0
Greece
Italy
Spain
Germany
Hong Kong
Taiwan
Japan
India
Korea
China
UK
Australia
US
(%)
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Derivatives Issue
3
2008 all over again?
The crisis in Europe this year has been reminiscent of what happened in the US in 2008.
After falling on a crisis confined largely to PIGS countries in 1Q, stock markets stabilized
in 2Q, but have fallen since 3Q as fears of a Greece-to-Italy contagion have elevated
systemic risk. We saw similar movements after the collapses of Bear Stearns and LehmanBrothers and financial-sector bailouts in 2008.
The VKospi also moved similarly in 2011 and 2008, spiking in 1Q08 and 1Q11 to double
its preceding two-month averages, stabilizing for five months, and surging in 3Q08 and
3Q11 to triple the averages of the preceding five months on growing systemic risk.
Financial crisis continued to create market volatility through 1H09, when the VKospi
stood at 39%, more than 40% above its 1H08 average of 27%. Using this as a guide, we
expect the index to remain elevated through 1H12, averaging 30% (vs 18% in 1H11).
VKospi (2008) VKospi (2011)
Source: Bloomberg, Samsung Securities Source: Bloomberg, Samsung Securities
Risks different now and then
In some ways, the markets have responded differently to the liquidity risk of 2008, and
sovereign risk of 2011. The eurozone problems with sourcing funds and dealing with risk
have become highly politicized and will likely take a long time to resolve. The nature of
contagion has differed, with credit ratings at US companies in 2008 steadier than at
European companies in 2011, and CDS premiums on emerging market (EM) and Korean
bonds displaying less sensitivity to issues in the eurozone issues than they did to the
meltdown in America in 2008.
CDS for North America and EU corporate bonds* CDS premiums on EM* and Korea government bonds
Note: * Based on 125 investment-grade corporate bonds
Source: Bloomberg, Samsung Securities
Note: * Based on 15 emerging market nations
Source: Bloomberg, Samsung Securities
2011 reminiscent of 2008
VKospi soars at height of 2008
and 2011 crises
Volatility likely to stay high
through 1H12
Liquidity risk ruled in 2008;
sovereign risk has held sway in
2011
0
10
20
30
40
50
60
70
80
90100
Jan 08 Apr 08 Aug 08 Dec 08
Bankruptcy of Bear Sterns
Bankrupcty of Lehman Brothers
(%)
0
10
20
30
40
50
60
Jan 11 Apr 11 Jul 11 Nov 11
Financialcrisis inSouthern Europe
European credit crisis
(%)
0
50
100
150
200
250
300
Jan 07 Dec 07 Dec 08 Nov 09 Nov 10 Oct 11
iTraxx EU 5-year IG C DX N orth Am erica 5-year IG
(Bps)
0
100
200
300
400
500
600
700
800
900
1,000
Jan 07 Dec 07 Dec 08 Nov 09 Nov 10 Oct 11
CDX EM 5-year IG Korea 5-year CDS
(Bps)
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Derivatives Issue
4
Despite an EU-nation default or other clear display of rising systemic risk, asset market
trends have changed drastically in 2011, with investor preferences quickly switching from
risky assets in 1H to safety in 2H. A weakening US dollar and declines in inflows of
speculative capital created strong demand for gold, silver, and the euro in 1H11, but
growing risk pushed investors toward US treasury bonds and weighed on returns from
risky assets in 2H.
Global asset markets (1H11) Global asset markets (2H11)
Note: Return over end-2010 ~ Jun 2011
Source: Bloomberg, Samsung Securities
Note: Return over end-Jun ~ Nov 15, 2011
Source: Bloomberg, Samsung Securities
Growing risk in financial markets tend to trigger greater correlation among asset prices,
as it becomes more difficult to find alternative safe assets (see the Nov 10, 2011 article in
theWall Street Journal, As Correlations rise, Theres Nowhere to Hide). While
developed market (DM) stocks and treasury bonds were the only assets with correlation
coefficients of more than 0.5 in 1H, stronger correlations than this were seen in DM stocks,
treasury bonds, the euro, and oil prices in 2Hsuggesting that the stock, bond, forex, andcommodity markets were all moving in sync in response to eurozone issues.
Meanwhile, gold showed less correlation with other assets, as investorslooking for a safe
investment and hedge against inflationflocked to the metal.
Asset class correlation (1H11) Asset class correlation (2H11)
Note: Red = correlation of +0.5 or more; blue = correlation of -0.5 or less
Source: Bloomberg, Samsung Securities
Note: Red = correlation of +0.5 or more; blue = correlation of -0.5 or less
Source: Bloomberg, Samsung Securities
S&P 500DAX
Nikkei 225Euro spotYen spotUS treasuryGerman gov. bondJapanese gov. bondWTIGold
S&P500
DAX
Nikkei225
Eurospot
Yenspot
UStreasury
Germangov.
bond
Japanesegov.
bond
WTI
Gold
-0.5-0 0-0.5 0.5-1
S&P 500DAXNikkei 225Euro spotYen spotUS treasuryGerman gov. bondJapanese gov. bondWTIGold
S&P500DAX
Nikkei225
Eurospot
Yenspot
UStreasury
Germangov.
bond
Japanesegov.
bondWTIGold
-0.5-0 0-0.5 0.5-1
Growing risk leads to more pr ice
correlation amon g assets
Gold an exception
Extreme preferen ce for safe
assets seen in 2H
1.3
2.4
4.1
4.4
5.0
6.6
9.2
12.3
0 5 10 15
USD/JPY
Kospi
US 10-year treasury
WTI oil
S&P 500
Gold
EUR/USD
Silver
(%)
(10.2)
(6.4)
(4.8)
0.8
4.1
4.4
18.3
54.5
(40) (20) 0 20 40 60
Kospi
EUR/USD
S&P 500
Silver
WTI oil
USD/JPY
Gold
US 10-year treasury
(%)
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Derivatives Issue
5
A mixed year
Futures trade volume up due to increased volatility
As the markets grew more volatile, futures trading volume jumped from 3Q. The average
daily trading volume of Kospi 200 futures contracts surged from 330,000 in 1H to
380,000 for July-November, while the figure for equity futures soared from 190,000 to
300,000 (the latter received a boost from the banning of shorting in August).
Trading of Kospi 200 options, however, fell steadily, due to rising prices rose, a shortage
of tradable exercise prices, and a drop in equity-linked warrant (ELW) trading volume
due to regulations that ate into hedging demand and participation in Kospi 200 option
trading by securities firms.
Daily average trading volume: Kospi 200 futures vs SSFs Daily average trading volume: Options vs ELWs
Note: As of Nov 15, 2011
Source: KRX, Samsung Securities
Note: As of Nov 15, 2011
Source: KRX, Samsung Securities
Investor breakdown, by product
(%) Retail investors Foreign investors Securities ITCs
Index futures
Jan-Oct 2010 26.2 29.5 41.3 0.8
Jan-Oct 2011 30.5 31.9 33.9 1.0
Index options
Jan-Oct 2010 32.5 31.5 33.1 0.9
Jan-Oct 2011 32.8 37.2 29.1 0.1
Single stock futures
Jan-Oct 2010 70.2 6.2 16.9 0.7
Jan-Oct 2011 64.6 17.3 10.1 0.3
Note: Average over the period observed; among institutional investors, only ITCs are considered
Source: KRX, Samsung Securities
Futures trading volume up in 2H
Option and ELW trading volume
down
CONTENTS
2011 review p2
A mixed year p5
2012 strategy p10
More regulations p19
0
50
100
150
200
250
300
350
400
450
500
Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11
Index futures Index futures
('000 contracts)
0
1
2
3
4
5
6
7
0
2
4
6
8
10
12
14
16
18
20
Oct 10 Dec 10 Feb 11 Apr 11 Jun 11 Aug 11 Oct 11
Index options (LHS) ELW (RHS)
(Mil contracts) (Bil shares)
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Derivatives Issue
8
Koreas exchange-traded fund (ETF) market has had a year of explosive growth in 2011.
More than 100 are ETFs listed on the KRX with a net asset value of over KRW10t, making
Korea one of the most advanced ETF markets in the Asia Pacific region.
ETF trading volume has surged on speculative demand for inverse and leverage ETFs
amid steep market pullbacks in August and pronounced volatility afterward. Theconcentration of trading on these, though, has left other ETF products marginalized.
Securities lending & borrowing (SBL) for ETFs also rose, primarily due to efforts to
minimize tracking error by including Kospi 200 ETFs in inverse/leverage ETFs (rather
than for short selling). The SLB balance for ETFs has risen to KRW500b as the size of
inverse/leverage ETF assets has increased. ETF SBL faces a double taxation issue,
because of the inclusion of ETFs in other ETFs in some cases.
Korean ETFs: NAV and number of products ETFs: Daily average trading volume and SLB
Note: As of Nov 15, 2011
Source: KRX, Samsung Securities
Note: As of Nov 15, 2011
Source: KRX, Samsung Securities
More than 100 ETFs listed on
KRX
Trading volume of
inverse/leverage ETFs sur ges
SLB for ETFs also up
0
200
400
600
800
1,000
1,200
0
20
40
60
80
100
120
Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11
NAV (RHS) No of products (LHS)
(KRWb)(No of products)
0
50
100
150
200
250
300
350
400
450
500
0
20
40
60
80
100
120
Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11
Trading volume (LHS) SLB (RHS)
(KRWb)(Milshares)
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Derivatives Issue
9
OTC trading to contract
Over the counter (OTC) trading tends to track ELS and DLS issuances, as most OTC
derivatives are equity-related. With ELS issuances increasing to more than KRW3t per
month, trading of OTC options and swaps jumped a respective 24% and 100% y-y in 1H11
(from KRW104.9t in 1H10 to KRW130.9t and KRW7t to KRW14t). Interest-rate swaptrading also rose 57% y-y from KRW64t in 1H11 to KRW101t in 1H11, on an increase in
IRS transactions to hedge against interest-rate changes, with bond investments surging
alongside growth in ELS issuances.
Credit-related derivatives trading surged from KRW0.3t in 1H10 to KRW3.5t in 1H11,
mainly for credit-default swaps (CDS) on overseas bonds of domestic companies. Based
on trade balance, CDS selling jumped from KRW2.4t to KRW4.7t, with TRS buying in
1H11 increased by KRW0.2t y-y. Meanwhile, CLN buying increased by KRW1.5t to
KRW2t over the same period.
OTC derivatives: Trading volume trends
Note: 3Q11 data to be released at end-Dec 2011
Source: FSS, Samsung Securities
However, with ELS issuances plunging from 3Q11, we expect OTC trading to contract in
2H11. Global systemic risk is causing credit risks to rise and credit lines to decrease,
limiting room for securities firms to issue ELSs. Securities companies are further limiting
trading in derivatives 3- and 12-month volatility levels spiking due to the plunge in the
stock market, and value at risk (VaR) and hedging costs jumping as a result. We expect
OTC trading by securities firms to increase just 5% from KRW492t in 2010 to KRW515t in
2011. OTC trading in 1H11 totaled KRW286t.
Variance swap term structures
Note: Data at end of each month observed
Source: Bloomberg, Samsung Securities
Trading stimulated by ELS
issuances in 1H11
Credit-related d erivatives trading
up noticeably
OTC trading to contract in 2H11
on decline in ELS issuances and
unfavorable m arket environment
0
20
40
60
80
100
120
140
4Q09 1Q10 2Q10 3Q10 4Q10 1Q11 2Q11
Options Swaps Forwards
(KRWt)
0
10
20
30
40
50
60
Jan 11 Mar 11 Jun 11 Aug 11 Sep 11 Oct 11 Nov 11
1-month 3-month 6-month 12-month 18-month
(%)
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Derivatives Issue
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2012 strategy
Three changes
We anticipate dramatic changes in 2012. A crisis-struck eurozone will either come
together or shatter; the global economy could fall into recession or begin to gradually
recover; and stricter regulations on derivatives will likely lead to more capital-market
risks and increases costs for businesses, or trigger an outflow of funds from financial
markets into real economies.
Developments in Europe will go far toward determining the direction of the global
economy. Moving beyond an intervention by the European Central Bank and an
expansion of the European Financial Stability Facility (EFSF), EU members with
conflicting interests must find a solution. Ailing and crisis-stricken countries need to slash
spending and pursue sweeping reforms that could result in prolonged recessions, while
leading nations (such as Germany and France) need to continue on a path of monetary
expansion to support their weak neighbors and prevent a credit crunch in the eurozone. A
weakening euro will not make things easier. Efforts to prevent the worst and the ensuing
economic fallout are likely to trigger more public displays of discontent in 2012.
A full-blown financial crisis in Europe would impact not only eurozone countries but the
global economy, so a recovery in the latter will hinge on solutions for the former. Austerity
measures will likely lead to reduced exporting to some countries that, combined with
restrictions on domestic consumption aimed at controlling inflation, could delay
recoveries of EM economies. While developed countries could turn to quantitative easing
in response to spreading eurozone risks, such measures would likely create more of
financial burden and inflationary pressure.
In the US, the Dodd-Frank Act, the Volker Rule, and OTC derivatives regulations agreed
upon by the G-20 should be implemented in 2012. Derivatives regulations proposed by
the US and Europe focus on standardizing OTC derivatives, clearing them through a
central clearing counterparty (CCP), limiting leverage, and strengthening supervision. A
tax on financial transactions, if implemented, would also amount to a derivatives
regulation. Such regulations should ultimately weaken the standing of financial capital.
Derivatives, long a symbol of financial innovation amid a period of deregulation in the2000s, are likely to be shunned because of regulatory pressure in 2012, in the aftermath
of the financial crisis.
Eurozone woes: Conflicts of
interest and fear of recession
Global economic recovery to
hinge on solutions to eurozo ne
issues
Derivatives, long a symbo l of
innovation, likely to be shunned
due to heavy r egulation in 2012
Key things to watch: Eurozo ne,
global economy, regulations
CONTENTS
2011 review p2
A mixed year p5
2012 strategy p10
More regulations p19
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Derivatives Issue
11
Shift to high volatility regime
We expect to see a spike in financial market volatility in 2012, at least in 1H12 as investors
try to gauge whether a financial crisis will destroy or solidify the eurozone, and growth in
the global economy continues the slowdown that began in 2H11.
From the regime-switching perspective, we believe the high volatility regime that haspersisted in 2011 will continue up to 1H12. (We define a period of low average returns and
high volatility as a high volatility regime, and a period of high average returns and low
volatility as a low volatility regime.).
The Kospi 200 was characterized by a high volatility regime from 2H07 to 1H09, a low
volatility regime until 1H11, and a high volatility regime from 2H11. With the last high
volatility regime lasting from 2H07 to 1H09, we expect the current high volatility regime
to continue through 1H12.
Volatility regime switching
Note: 2-phase regime switching model applied; weekly data used
Source: KRX, Samsung Securities
Three-month implied and medium-term historical (60- and 180-day) volatility trends of
the Kospi 200 indicate that volatility levels remain higher h-h in 2H11, with the medium-
term historical volatility continuing to rise. The same patters have been seen in the
implied and historical volatility trends of the Hang Seng Index. While implied volatility in
early 4Q appears to have temporarily stabilized in both Korea and Hong Kong, historical
volatility levels continue to steadily ascend.
We would need to see at least two months of steady stock price trends to argue that
medium-term volatility had switched to a downtrend. It is unlikely that the markets will
remain steady, considering the EU debt that will mature between end-2011 and early
2012, and the growing concerns of a breakup of the eurozone. Consequently, we believe
historical volatility in Korea will remain elevated in 1H12.
Volatility to re main high through
1H12
High volatility regime in 2011
to continue in 2012
Implied volatility and medium -
term historical volatility
continuing upwards
0
50
100
150
200
250
300
0
1
2
Jan 05 Sep 05 May 06 Jan 07 Sep 07 May 08 Jan 09 Sep 09 May 10 Jan 11 Sep 11
Prob. of low volat ilit y (LH S) Prob. of high v olat ilit y (LH S) Kos pi 200 (R HS)
(Pts)(x)
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Kospi 200: Implied and historical volatility Hang Seng: Implied and historical volatility
Source: Bloomberg, Samsung Securities Source: Bloomberg, Samsung Securities
Implied volatility in OTC-traded Kospi 200 options has also risen. The options impliedvolatility remained relatively stable at around 20% until the end of June, before turning
up and averaging 20% by November. From a term-structure basis, at end-November 6-
month and 1-year ATM options had an implied volatility of 30-32%, while the figure for
110% OTM options was 30%. With the OTC market pricing 1H12 volatility at 30%, VKospi
levels will likely stay near 2H11 levels for the time being.
Kospi 200 call option volatility, by expiration and strike Kospi 200 put option volatility, by expiration and strike
Source: Bloomberg, Samsung Securities Source: Bloomberg, Samsung Securities
Meanwhile, US y-y GDP growth and the VIX tend to move in opposite directions, with the
VIX bottoming out during the bull economy of the early 1990s and surging when the dot-
com bubble burst and a bear market emerged in the early 2000s. The VIX set new record
highs during the bear market brought on by the housing market crash of 2008, and has
been rising again in 2011 amid concerns over an economic slowdown.
Similar dynamics have been seen in domestic marketsthe VKospi remaining at low
levels during the bull economy of 2004-2007 and rose as economic growth started to slow
in 2008. This year, with economic growth slowing and Eurozone issues weighing on
markets, it has hit highs unseen since 2009.
We expect volatility to remain high in both US and Korea, with volatility indices
continuing to trend up since 3Q11 and economic growth expected to slow in 2012.
OTC market pricing optionvolatility at 30-32%
Volatility indices r ising on
econom ic uncertainties
Volatility to re main high in 2012
as economic growth slows
0
5
10
15
20
25
3035
40
45
Jan 1 Mar 2 May 1 Jun 30 Aug 29 Oct 28
3-month implied vola tilit y 60-day implied vola ti lit y
180-day implied volatlity
(%)
0
5
10
15
20
25
3035
40
45
Jan 1 Mar 2 May 1 Jun 30 Aug 29 Oct 28
3-month implied vola tili ty 60-day implied vola tilit y
180-day implied volatility
(%)
0
5
10
15
20
25
30
35
40
45
3M 6M 9M 1Y 2Y 3M 6M 9M 1Y 2Y
90% 100% 110% 115%
Jun 2011 Nov 2011
(%)
0
5
10
15
20
25
30
35
40
45
3M 6M 9M 1Y 2Y 3M 6M 9M 1Y 2Y
90% 100% 110% 115%
Jun 2011 Nov 2011
(%)
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US GDP growth vs VIX Korean GDP growth vs VKospi
Source: Bloomberg, Samsung Securities Source: Bloomberg, Samsung Securities
With GDP growth at home and abroad expected to slow in 2012, and economic growthexpected to be lowest in 1H12, volatility should remain high in 1H12.
GDP growth: Consensus forecasts
Country (%) 4Q11 1Q12 2Q12 3Q12
US 2.3 1.7 2.1 2.4
Japan 0.7 1.6 2.3 1.6
EU (0.6) (0.4) (0.5) 1.2
China 8.1 8.0 8.3 8.6
Korea 4.1 3.5 3.8 4.1
Note: GDP forecasts for countries other than Korea obtained from Korea Center for International Finance atend-October; Korean GDP forecasts based on FnGuide consensus as of Nov 15, 2011
Source: KCIF, FnGuide, Samsung Securities
US and Korean volatility indices tend to remain below 30% as long as GDP growth ratesremain positive, and surpass 30% when GDP growth turns negative or goes flat.
Unusually strong GDP growth (above 4% in the US) also tends to bring higher volatility,
indicating that volatility rises when economies overheat.
US GDP growth & VIX distribution Korean GDP growth & VKospi distribution
Note: Quadratic trend line applied; since 1991
Source: Bloomberg, Samsung Securities
Note: Quadratic trend line applied; since 2003
Source: Bloomberg, Samsung Securities
Volatility rises in overheated andslowing economies
0
10
20
30
40
50
60
70
(6)
(4)
(2)
0
2
4
6
1Q91 1Q93 1Q95 1Q97 1Q99 1Q01 1Q03 1Q05 1Q07 1Q09 1Q11
GDP growth y-y (LHS) VIX (RHS)
(%)(%)
0
10
20
30
40
50
60
70
(5)
(4)
(3)
(2)
(1)
0
1
2
3
4
1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11
GDP growth y-y (LHS) VKospi (RHS)
(%) (%)
R = 0.3409
0
10
20
30
40
50
60
70
(6) (4) (2) 0 2 4 6
(VIX)
(GDP growth, y-y)
R = 0.5826
0
10
20
30
40
50
60
70
(6) (4) (2) 0 2 4
(GDP growth, y-y)
(VKospi)
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Investment strategy for 2012
With stock market volatility likely remain high in 1H12, predicting the Kospis direction is
difficult. The eurozone crisis should linger, and worries of an economic slowdown in the
US and China are likely to grow. Consensus forecasts have Korean corporate earnings
falling significantly in 2012. The US and Korea will likely continue with quantitativeeasing to prevent economic growth from slowing, while in Asian countries any success
with anti-inflationary measures should boost consumption and enable economic
recoveries. That said, growth in the global economy appears set to slow in 1H12, due to
lingering economic tightening, reduced consumption, and sluggish growth in China and
other EMs.
With seemingly little chance of the eurozone crisis being resolved in the near term,
investors need to prepare for a stock market downturn. We recommend they apply a 95%
knock-in put option to defend against tail risk and be able to roll over investments into
short-term (less than three months) ones when necessary. If they want to reduce costs
and prepare for a bear market, a 90-100% put spread would be appropriate.
Constructing a portfolio around safe assets should be beneficial, but investors need to
consider the possibility of a solution to the eurozone crisis emerging or the US economy
recovering. Instead of reducing risk-asset exposure, we recommend using options to
hedge against the risk of both an unexpected downturn and upturn in the markets. We
recommend a 100-110% call ratio spread (for upside risk) and a butterfly strategy (for
range trading). Peak profit for the former can be set either at the Aug 2011 level (when the
eurozone crisis broke out) or the 2011 high (115% OTM).
Tail risk: Long knock-in put options Bear market: Put spread position
Note: Based on long 95% knock-in put with implied volatility of 29%, remainingdays to maturity of 180 days, interest rate of 3.55%, and dividend of 1.49%
Source: Bloomberg, Samsung Securities
Note: Based on long ATM put with implied volatility of 29% and short 10% OTMput with implied volatility of 34%, remaining days to maturity of 90 days,interest rate of 3.55%, and dividend of 1.49%
Source: Bloomberg, Samsung Securities
Prom ising strategies for
increased volatility for 1H12
Knock-in put option or 100%-
110% put spread strategy
100-110% call ratio spread
recommended for upside risk,
butterfly strategy for range
trading
(20)
(10)
0
10
20
30
40
50
60
70
160 170 180 190 200 210 220 230 240 250 260 270
Now After 3 months Expiry
(Pts)
(10)
(5)
0
5
10
15
20
180 190 200 210 220 230 240 250 260 270 280 290
Now After 2 months Expiry
(Pts)
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Equity derivatives market in 2012
The index-futures basis generally moves in sync with the stock market, trending up
during the 2004-2007 stock market boom and widening gradually since 2009. (A
mismatch occurred in 2008, when the basis hit a post-2000 peak while the stock market
fluctuated markedly.)
Index-futures basis trends, by year Index-futures basis magnitude (average basis / Kospi 200)
Note: Based on average market basis
Source: KRX, Samsung Securities
Source: Bloomberg, Samsung Securities
We doubt the basis will continue to widen in 2012, although it could briefly, depending on
market movements. Taking advantage of unusual price gaps, Korean hedge funds are
likely to aggressively utilize arbitrage opportunities between futures and options/ETFs.
Korean hedge funds are likely to use single stock futures (SSF) as a proxy for underlying
stocks to go short while implementing long/short strategies, and may feel it prudent to
have a certain amount of SSFs for some stocks in case short selling is banned again.
Disparity ratios (the difference between futures theoretical and market prices) of many of
the 25 listed SSFs remain in negative territorymeaning SSFs are undervalued relative to
and could be sold below theoretical prices. Investors should recognize the possibility of
losing amounts on SSFs commensurate with such disparity ratios.
2011 price and disparity ratio of major single stock futuresName Average price
(KRW)Daily average trading volume
(contract)Average basis
(KRW)Basis / futures price
(%)Average disparity ratio
(%)
Samsung Electronics 880,056 2,407 2,523 0.29 (0.10)
Hyundai Motor 212,113 8,340 468 0.22 (0.21)
Hynix Semiconductor 26,406 99,363 90 0.34 (0.09)
Woori Financial Group 13,093 28,274 51 0.39 (0.06)
Kia Motors 68,906 19,920 225 0.33 (0.10)
Daewoo Securities 18,503 14,627 41 0.22 (0.19)
Note: Based on nearest-expiration futures over Jan 3Nov 15, 2011
Source: KRX, Samsung Securities
Index-futures basis generally
moves in tandem with stock
market
Basis likely to fluctuate in 2012
Hedge funds to u tilize SSFs often
Negative SSF d isparity ratios bad
for sellers
(3)
(2)
(1)
0
1
2
3
4
2003 2004 2005 2006 2007 2008 2009 2010 2011
Max Mean Min
(Pts)
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
2003 2004 2005 2006 2007 2008 2009 2010 2011
(%)
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Only one stock this year has had a derivatives-liquidity ratio (DLR, or futures trading
volume (x10)/stock trading volume) exceed 10%. We advise considering the DLR,
intraday trading volume, and disparity ratios collectively when using SSFs for long/short
strategies.
SSFs: Average daily DLRs (2011)SSF DLR* (%) SSF DLR (%)
SK Innovation 10.25 Samsung C&T 3.23
Hynix Semiconductor 9.81 Korean Air 3.13
Woori Financial Group 8.62 Doosan Infracore 3.12
Hyundai Motor 8.61 Kepco 2.81
SK Telecom 8.04 Posco 2.60
Daewoo Securities 7.09 E Mart 2.40
Hyundai Heavy Industies 6.99 LG Display 2.39
Samsung Electronics 6.55 NHN 2.34
Kia Motors 6.27 Hana Financial Group 2.30
KT 5.82 Shinhan Financial Group 2.06
GS E&C 4.97 KB Financial Group 1.88
Hyundai Steel 3.99 KT&G 1.73
LG Electronics 3.51
Note: Data over Jan 3Nov 15, 2011 observed; * DLR = futures trading volume (x10) / stock trading volume
Source: KRX, Samsung Securities
DLRs low
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More regulations
Era of regulations
There have been some policy contradictions in the domestic derivatives market in 2011
on-exchange derivatives have been increasingly regulated, but investment banks less so.
Regulations began to increase after the stock market plunged on Nov 11, 2010, as a
massive unwinding of positions revealed growing settlement risk arising from poor risk
management. Authorities have looked to mitigate settlement risk, reduced the severity ofmarket shocks (through program trading rules designed to lessen long-short imbalances
and the resultant market volatility during closing auctions), and set futures/option
positions limits for institutional investors at a maximum of 10,000 contracts per day
(based on net-position delta).
New ELW regulations were also put in place in Oct 2010 (measures to monitors liquidity
providers [LPs]) and May 2011 (larger base deposit and more efficient pricing).
Guidelines to raise public awareness about the importance of fairness in direct market
access and pre-order risk checking were also announced.
We expect more of the same in 2012. Regulators have proposed raising the contract
multiplier of option products from KRW100,000 to KRW200,000-250,000, a measure
that would: 1) drive out small investorsas the value of one tick would climb by
KRW5,000-25,000, or 0.01-0.05pts; and 2) reduce option trading volume from
professional traders who manage delta position using futures, because the delta ratio of
futures and option products would become 1:1 (vs 1:0.2 now).
The measure would also likely reduce ITM stock liquidity, boosting transactions of only
deep OTM stocks. It can also dampen pricing efficiency and futures-option arbitrage
trading, while the negative impact on retailers (key players in Kospi 200 options, along
with foreign investors and securities firms would likely trigger a disproportionate increase
in foreign dominance of the market.
Some academics are arguing that the distribution channel for DLSs should be expanded
to improve price transparency and information dissemination, and prevent sales
involving conflicts of interests or that are incomplete. They say excessive commission
rates and issuances/sales of DLSs make it unreasonably difficult for investors to selectproducts. In Europe, the authorities plan to standardize the investment performance, risk,
commissions, and guaranteed returns of packaged retail investment products (PRIPs) to
allow investors to easily compare different products.
Standardization and the establishment of integrated information systems could benefit
investors, but considering the nature of DLSs, we believe firms need to be able to set
different estimates for funding rates and market conditions, and thus commission rates.
Rather than promote product development, standardized information may risk more
price competition in DLS market that is already highly competitive. All in all, the
standardization should weigh on financial investment firms and eventually damage
investors.
Regulations enacted after stock
mar ket plunged on Nov 11, 2010
More regulations for ELWs
Controversy over raising contract
multiplier of option products
Rise in multiplier wou ld hurt
price efficiency
DLS regulations being considered
Further DLS regulations would
benefit investor s little
CONTENTS
2011 review p2
A mixed year p5
2012 strategy p10
More regulations p19
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Regulations have been implemented to ensure OTC derivatives market transparency and
prevent systemic risk. The G20 has agreed that all standardized OTC derivative contracts
must be cleared through a CCP. In establishing an advanced financial market
infrastructure, the KRX plans to establish a CCP by 2H12. The success of the institution
will likely depend on the degree of use by banks, which account for most domestic OTC
derivatives deals (in the form of interest-rate swaps). Banks may not be put off by theadditional costs incurred in using a CCP, particularly if CCP-cleared contracts make up a
miniscule proportion of the OTC derivatives market. Some countries, like Hong Kong, are
proposing to phase in CCPs depending on the growth phase of each financial market in
question. Much debate will likely ensue before a consensus on expanding financial
infrastructure is established.
Tighter regulations of on-exchange derivatives could hurt the overall derivatives market,
given the immaturity of Koreas OTC derivatives market (compared to those of developed
countries) and the limited use of OTC derivatives by domestic institutional investors.
Regulations are likely to reduce liquidity and raise transaction costs for on-exchange
derivatives, preventing them from serving as an efficient hedging tool in issuing ELSs and
DLSs, and impeding the development of financial products.
We expect a tax on financial transactions, now being discussed in the developed world, to
be debated in Korea in 2012 under the guise of a derivatives-transaction tax. Taxation of
on-exchange derivatives has been discussed for several years, but not been implemented
due to questions over market protection, the possibility of an outflow of national wealth,
and the legitimacy of taxing inherently zero-sum derivatives. As discussions on the issue
pick up overseas, however, Korea could begin to tax equity-related derivatives, which are
considered to have relatively little ramifications on the real economy.
Led by the Dodd-Frank Act in the US and the European Securities and Market Authority
(ESMA), tightening regulations will likely hold back growth in the global derivatives
market. Domestically, regulations will likely tighten in an effort to restrict speculation in
on-exchange derivatives and better protect investors. For the most part, overseas
regulations are aimed at minimizing systemic risk, while domestic regulations are focusedmore on individual product risk and are likely to reduce the number of participants and
trading volume.
CCP may hur t OTC derivatives
mar ket by incurr ing additional
cost
Regulations of on-exchange
derivatives may deter growth of
OTC der ivatives
Financial- or der ivatives-
transaction taxes being seriously
considered
Overseas regulations focus on
preventing systemic risk,
dome stic regulations on
individual product risk
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Hedge funds comingwith many regulations and restrictions
Onshore hedge funds will be introduced in Korea in 2012 under a slew of regulations,
including: 1) minimum assets-under-management requirementseg, KRW10t for asset
management firms; 2) minimum investment requirementsie, retail investors with over
KRW500m or qualified investors; and 3) restrictions on fund managementeg, leverageand limit on the use of derivatives. Regulators focus seems to be systemic risk monitoring
and investor protection.
In accordance with the FISCMA, only prime brokers will be allowed to provided a full
range of serviceseg, SBL, margin lending, commissions, settlement and custody, and
capital introductionto hedge funds, while financial investment companies lacking a
prime brokerage license will be allowed to serve as execution brokers. In other words, the
authorities should be able to indirectly regulate hedge funds by limiting the business
scope of prime brokers and receiving updates on their activities.
Korean hedge funds will likely invest more in Korean assets (than overseas ones) and in
stocks (not bonds), because: 1) bond arbitrage in Korea is difficult because few firms have
the credit lines needed to engage in it; 2) issuances and trading volume of credit bonds are
limited; and 3) arbitrage using foreign stocks is so limited that Korean prime brokers will
likely be forced to limit long/short strategies to Korean stocks. Forex transactions will
continue to be strictly regulated, and commodity investing remains in its infancy due to a
lack of research and systems designed to carry out direct investments in overseas futures.
In a nutshell, limits on investment strategies and assets for hedge funds are likely to make
the devices less attractive than many hope.
To overcome such issues, most hedge funds are likely to adopt similar approaches (such
as factor-model or pair-trading) in implementing long/short equity strategies. When the
same strategies are applied to a group of limited assets, order-execution factorsspeed,
cost, stop-lossesare likely to prove important.
We expect transaction cost analysis (TCA) and algorithmic trading strategy to be essential
to minimizing transaction costs. Long/short trading profitability depends on the directionand sustainability of share pricesthough returns can be affected by the impact of
position building and liquidation. Transaction costs are actually the key determinant in
statistical arbitrage or pair trading. When the size of an order of a stock used for a long or
short strategy exceeds a certain percentage of hourly trading, volume-weighted average
price (VWAP) is crucial. Brokers with algorithmic trading systems to minimize market
impact and TCA services should play a crucial role in enhancing hedge fund returns.
It will be equally important for hedge funds to find new investment targets. Applying a
similar investment strategy to a limited investment universe generally results in less alpha
creation due to competition. Hedge funds are likely to view commodity futures as their
best investment target, utilizing managed-futures or commodity trading advisor (CTA)
strategies to exploit the low correlation of process movements among commodities and
between them and traditional assets.
Given the difficulties of understanding the characteristics of single products and market
participants, we believe hedge funds will first have to focus on commodity index futures
or ETFs and then expand into single product futures. Commodity indices should come
first, given their diversity (eg, S&P GSCI, DJ-UBS CI, Deutsche Bank CI, and Rogers
International CI) and differences in composition portion and rebalancing cycles.
Kore an hedge funds to be
introduced with regulatory focus
placed on systemic risk and
investor protection
Authorities to indirectly regulate
hedge funds by supervising prime
brokers
Small scope of investment targets
and dearth of investment
strategies could reduce
attractiveness of hedge fun ds
Speed and cost cutting key to
long/short strategies
Algorithmic trading strategy
essential for orde r execution
Alpha creation w ill require
Korea n hedge funds to enter
commodity market
Comm odity index futures or ETFs
likely to be good option s initially
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More than 80% of CTA strategies are based on systemic approaches and combine
fundamental and technical analysis. Hedge funds and prime brokers will need to develop
investment models and hire research talent to conduct commodity-correlation analysis,
engage in single product system trading, and evaluate supply-demand dynamics. To
execute CTA strategies, Korean hedge funds will need execution brokers for overseas
commodity futures markets and back-office support. Ofthe worlds top-10 CTA programs,more than 70% take a systemic approach that simultaneously invests in multiple products.
Best performing CTAs (2010)
Rank CTA Program 2010 return (%)
1 Global Ag 86.29
2 Global Investment Management 79.96
- GIM High Frequency
3 Blue Fin Capital 70.91
- Compact Omega
4 Tactical Investment Management 68.92
- Institutional Commercial
5 AIS Futures Management 66.30
- 3X-6X
6 24FX Management 63.15
7 Hawksbill Capital Management 57.56
- Global Diversified
8 Commodity Futures Services 55.93
- IPATS
9 Friedberg Commodity Management 52.33
- Currency
10 Clarke Capital Management 52.19
- Jupiter
Note: Return based on individual fund under investment company
Source: Barclays, Samsung Securities
Best performing CTAs (Sep 2011)
Rank CTA Program Sep return (%) YTD return (%)
1 Friedberg Commodity Management 41.14 2.12
Currency
2 Pere Trading Group 38.46 37.43
Pere Trading Program
3 B eechdale Capital Management 29.79 (2.44)
Gamma Traders
4 Di Tomasso Group 22.79 1.85
Equilibrium Trading
5 Lakshmi Capital Management 15.86 86.39
Global Macro
6 Qbasis Fund Management 15.41 (5.74)
Qbasis Futures Fund
7 Currency Insight 13.17 0.98
Diversified Systematic
8 Hamer Trading 12.96 33.25
Diversified Systematic
9 LJM Partners 12.58 (13.10)
LJM Fund.
10 Cambridge Strategy Asset Management 12.51 9.21
Asian Markets Alpha
Note: Return based on individual fund under investment companySource: Barclays, Samsung Securities
Hedge funds and prime brokers will also have to give much thought on how to use
collateral. Hedge funds will be able to use initial assets as collateral for leverage and for
signing derivatives contracts with prime brokers. The latter can engage in SBL and
rehypothecation (when borrowing from other financial institutions).
Prime brokers can create extra profit through collateral-backed repo transactions (like
they did in the US prior to the 2008 financial crisis), while hedge funds can increase
leverage through repetitive transactions of cash borrowing and bond purchasing, repo
selling, and bond purchasing and repo selling. In the process of a repo-based leverage
expansion, however, collateral values can rise or fall, triggering deleveragingmaking the
question of how to use collateral an important one.
Investment model, research pool,
and back-office system n eed to be
put in place
How to u se collateral a key issue
Rehypothecation warrants
attention
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Using repos to create leverage
Note: NRI, Suggestion for improvement of Repo and SLB, 2011
Source: KSD, Samsung Securities
To hedge against risk and diversify profit sources, hedge funds will likely tap into a variety
of derivatives, but from an overall perspective we expect their derivatives investments to
be limited, as only asset management firm are authorized to operate them. That said, as
hedge funds grow larger, how they utilize cash assets should become more essential and
investing in DLSs or structured products (vs deposits, such as commercial paper) more
effective.
Securitized derivatives and structural products in which hedge funds can invest (eg,
dispersion or variance swap products, or credit derivatives index-based products) will
need to be developed.
Cash borrowing &
bond purchasing
Repo selling
100 cash
Bond purchasing &
repo selling
100 cash &
bond purchasing
Repo selling &
100 cash
Bond purchasing 300 &
repo selling 300
Hedge funds expected to invest in
DLSs or structured products
Development of securitized
derivatives and structural
products necessary
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Product development needs to continue
We now expect VKospi futures to be introduced in 2012 (vs our previous forecast of 2H11).
Given the increasing awareness of the VKospis usefulness in predicting market
movements, VKospi derivatives need to be introduced, to enable investors to hedge
against stock portfolio volatility and price risks.Trading volume of VIX futures (with a contract multiplier of USD1,000), listed on the
CBOE Futures Exchange, touched a yearly high in August as the US market nosedived on
European issues. The VIX averaged more than 35% for the month and peaked at 48%.
Trading of VIX futures soared on: 1) demand to hedge against volatility-driven losses; and
2) speculative demand betting on the direction of volatility.
VIX and S&P 500: Returns since 2008 VIX futures: Monthly trading volume (2011)
Note: Weekly data used
Source: Bloomberg, Samsung Securities
Source: CBOE, Bloomberg, Samsung Securities
VKospi futures, if introduced, would help hedge against volatility risk in equity portfolios.Just as the VKospi reflects stock market instability, risk reversal (RR) reflects the volatility
of the KRW/USD rate. Given the high correlation between the VKospi and RR (61% based
on post-2010 daily data), VKospi futures could also be used to indirectly hedge against an
upheaval in the forex market.
VKospi and Kospi: Returns since 2008 VKospi and risk reversal
Note: Weekly data used
Source: KRX, Samsung Securities
Note: Difference between call and put options with 25% delta
Source: KRX, Samsung Securities
VKospi futures to be introduced
in 2012
Trading volume of VIX futures
soars amid European crisis
VKospi inversely related withKospi, bu t positively related w ith
RR
y = -3.0354x + 0.6088R = 0.56
(50)
(40)
(30)
(20)
(10)
0
10
20
30
40
50
(20) (15) (10) (5) 0 5 10 15 20
(VIX)
(S&P 500)
0
5
10
15
20
25
30
35
40
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
2,000
Jan 11 Mar 11 May 11 Jul 11 Sep 11
Trading volume (LHS) VIX (RHS)
('000 contracts) (%)
y = -2.1973x + 0.7472R = 0.3959
(50)
(40)
(30)
(20)
(10)
0
10
20
30
40
50
(20) (15) (10) (5) 0 5 10 15 20
(VKospi)
(Kospi)
0
2
4
6
8
10
12
0
10
20
30
40
50
60
Jan 10 Aug 10 Mar 11 Oct 11
VKospi (LHS) Risk Reversal (RHS)
(%) (%)
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The VKospi is calculated by building a 30-day imaginary option using nearest- and next-
to-nearest-month options. While nearest-month options are often fairly priced in the
market, next-to-nearest-month options tend to be overvalued or undervalued due to low
liquiditythey account for less than 2% of Kospi 200 option trade volume. As their low
liquidity limits the ability to replicate the VKospi, and the VKospi lags market-implied
volatility during rollover periods (four days before expiry), arbitrage between VKospifutures and replicated futures is difficult.
VKospi futures can serve as a useful tool to hedge against or speculate on volatility. But
arbitrage trading between VKospi futures and replicated positions will not be possible as
long as next-to-nearest-month options are traded thin. Only when it enables arbitrage
trading as well as speculative/hedge trading can the VKospi successfully take root.
We expect options on ETFs to be introduced along with VKospi futures. In US exchanges
like the CBOE, ISE, AMEX, and PHLX, ETF options are being increasingly traded, with
trade volume of ETF options jumping to 70% of the level of single stock option (SSO)
trade volume this year, from 50% last year. SSOs make up the lion's share of the US
option market.
We see a greater need for options on sector or commodity ETFs than index ETFs, given
the presence of Kospi 200 options. Listing of sector ETF options could stimulate trading
of SSOs not traded at all now, by creating demand for arbitrage or correlation trading
between sector ETFs and sector ETF options, or between sector ETFs and constituent
SSOs. It could also encourage arbitrage trading between single stock ELWs and sector
ETF options as well as hedge trading. This, in turn, would encourage institutional
investors to participate in the ELW market, which speculators currently dominate.
To help the sector ETF option market take off (and avoid the path of SSOs), market
makers should be designated, bloc trading allowed, and FLEX options introduced. These
tools should also be applied to SSOs to revive the SSO market.
Daily average trading volume of CBOE ETF options 2011 trading volume of US-listed options (Jan~Oct)
Source: CBOE, OCC, Samsung Securities Source: OCC, Samsung Securities
Underlying assets for SSFs should also broaden from the current 25 stocks, as hedge
funds will want to make use of long/short strategies. SSFs should be available for at least
all Kospi 50 constituents in 2012. For reference, 1,470 SSFs (including ETF futures) were
listed on the US stock exchange as of November.
Liquidity of next-to-nearest-
month op tions crucial to active
trade of VKospi futures
ETF options should be
introduced-in US, trade volum e of
ETF options amou nts to 70% that
of SSOs
Listing of sector ETF optio ns to
stimulate trading of SSOs and
enable arbitrage trading w ith
single stock ELW s
Bloc trading should be allowed to
help sector ETF option marke t
take off
Underlying assets for SSFs should
broaden as hedge funds are
launched
0
500,000
1,000,000
1,500,000
2,000,000
2,500,000
Jan 10 May 10 Sep 10 Jan 11 May 11 Sep 11
(Shares)
2,101
290
1,508
1,939
245
1,022
0
500
1,000
1,500
2,000
2,500
Equity Index ETF
2011 2010
(Mil. shares)
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Revisions to the Commercial Code and FISCMA to allow micro-unit derivatives
Revisions to the Korean Commercial Code and the FISCMA will allow companies to issue
a wider variety of securities to secure funds or manage voting rights. The KCC revisions
will go into effect in Apr 2012; the FISCMA revisions took effect in Sep 2011.
After the revisions take effect, companies will be able to issue classes stocks offeringdividend payments based on different rules from common shares (eg, dividends fixed to
KRW1,000 per share or based on an adjustable-rate for certain preferred stocks), shares
with voting rights different than those of common shares, and redeemable shares and
convertible stocks. Mandatory and reverse convertibles will allow companies to issue
preferred equity redemption cumulative stocks (PERCS) or dividend enhanced
convertible securities (DECS), which gained popularity in the US in the 2000s.
PERCS offer higher dividends than common shares, are subject to conversion at maturity,
with caps set on the number of common shares into which they can be converted. DECS
offer additional OTM call options on PERCS, allowing the shares to be converted to
common shares only when share prices exceed conversion prices (OTM levels) at
maturity. However, without a cap placed on conversion rules, DECS holders can profit
from the rise in share prices. Companies tend to partner up with the corporate finance
division of investment banks to issue PERCS and DECS. As a result of the revision,
securities firms will be able to expand past conventional roles of issuing common shares
ie, conducting IPOs and rights offerings.
Meanwhile, the FISCMA revision allows the issue of independent warrants such as call
options on newly issued shares. Instead of opting to conduct the pricing (setting the
exercise price and issue price) of the call options by itself, we expect individual companies
to turn to investment banks for the issue of independent warrants.
We expect the issue of independent warrants and the increase in variety of preferred
shares to help spark stronger OTC trading. As the role of investment banks expands from
the simple issue of shares to active book management, we expect the firms to increasingly
turn to OTC options markets to hedge against risks, leading to more OTC trading volume.
Companies will also be allowed to issue a wider variety of bonds, such as dividend-
participating bonds, bonds exchangeable into stocks or other securities, as well as
derivative-linked bonds (DLBs). Financial products that have the characteristics of a bond
but had been categorized as DLSs will be re-categorized as DLBs. While only securities
firms with OTC licenses had been allowed to issue DLSs in the past, banks will be allowed
to issue DLBs after the revision. In effect, regulatory changes will intensify competition
between banks and investment banks and increase financing options for companies.
KCC and FISCMA re visions to
allow new classes of shares
Companies to turn to investment
banks for the issue of class stocks
FISCMA revision to allow
issuance of independent warrants
Increased variety to spark
stronger trading in OTC markets
Regulatory changes to spark
competition between banks and
investment banks
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November 25, 2011
Derivatives Issue
27
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