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Yuan depreciation ends "free lunch" offered by structured products
September 1, 2015 / 8:17 AM / 2 years ago

Yuan depreciation ends "free lunch" offered by structured products

HONG KONG, Sept 1 (Reuters) - The yuan’s depreciation last month has greatly dampened the appetite for yuan structured products, as investors who bet on the currency’s appreciation using these products face hefty losses.

Thankfully for them, the yuan has shown signs of stabilising, but if it returns to lows of 6.6 per dollar and beyond almost all investors holding these derivative contracts will be liable to burgeoning monthly payments to their bank counter-parties.

Many banks have revised down their forecasts for the onshore yuan’s performance, with some expecting it to fall to 6.6 per dollar by the end of this year and 6.8 by 2016. The onshore yuan traded at 6.3673 per dollar on Tuesday, compared to the offshore yuan at 6.4140.

Some analysts doubt whether the yuan structured products pose any systemic risk, but there is potential for the negative effects to spill in other areas such as cross currency swap (CCS) and dim sum bond markets in Hong Kong.

These structured products, including Targeted Accrual Redemption Note (TARN) and Targeted Redemption Forward (TRF), have been prevalent among foreign investors since late 2012 thanks to steady gains the yuan made against the U.S. dollar.

Companies relied on them to hedge currency risk initially, but as the yuan mostly had kept its strength against the dollar, they gradually increased leverage ratios to make easy money.

“The yuan had a virtual peg to the U.S. dollar since 2009 which made it a popular investment currency. However, the free lunch is over,” said Andrew Fung, head of global banking and markets at Hang Seng Bank.

“There’s no appetite for yuan structured products now as the fundamental, namely stable FX and interest rate differentials, to invest in yuan products have disappeared,” said Fung.

The People’s Bank of China (PBOC) surprised the market by sharply weakening its currency by nearly 2 percent on Aug. 11, sending both onshore and offshore yuan FX rate into a tailspin.

The offshore spot CNH tumbled 5.8 percent to as low as 6.6 per dollar a day after the PBOC move, weaker than knockout rate agreed in many structured contracts in the yuan market as nobody had expected such a big devaluation.

“All structured products that use carry trade have been affected by the yuan depreciation,”a trader at an American bank in Hong Kong.

“And, the biggest shock is to TARN products as investors have become out of the money now,” he added, meaning investors were having to make monthly payments to the banks.

In the TARN market where traders estimate the size is around $35 billion, banks offer investors steady cash flows as long as CNH spot is stronger than the knockout rate. If the CNH rate is weaker, however, investors have to pay banks until their contract terminates.

Tenors of TARN products are usually one to two years, which means investors that entered into these contracts last year around 6.2-6.3 per dollar are set to suffer big losses, especially if they borrowed the funds to speculate, traders say.

In Taiwan, estimated unrealised loss for two popular derivatives - targeted redemption forward (TRF) and discrete knock out (DKO) - was put at about $1.5-1.6 billion, local Economic Daily News cited an official from the Financial Supervisory Commission (FSC) as saying. (Editing by Simon Cameron-Moore)

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