Yuan's fall raises risk of big losses on offshore products

Fri Feb 28, 2014 12:16am EST

Related Topics

* Estimated $350 bln of structured products sold in past 14 months

* 6.20 yuan per dollar seen as inflection point below which losses multiply

* Regulators looking into impact of yuan fall on FX trades - sources

* Yuan set for biggest weekly loss on record

By Saikat Chatterjee

HONG KONG, Feb 28 (Reuters) - China's weakening of the yuan over the past 10 days has exposed risks created by the rapid growth of offshore derivative products, with holders seen potentially facing billions of dollars of losses if the currency keeps falling.

Bankers say the buyers of these leveraged bets -- and Deutsche Bank estimates $100 billion have been sold this year alone -- have largely been Chinese companies with large dollar receivables, who saw the products as a way to earn some extra income given the seemingly inexorable rise of the yuan.

These products, also known as target-redemption forwards were initially aimed at companies in China wanting to hedge their FX exposure. But they soon morphed into a product that offered regular income as long as the yuan did not weaken sharply.

The danger is that buyers are not hedged against a weaker yuan, and analysts worry that could leave them open to expensive margin calls.

Indeed, banking sources have told Reuters that China's foreign exchange regulator is looking into the possible impact on the yuan's fall on foreign exchange transactions at domestic banks and companies.

The key level, market players say, is 6.20 yuan per dollar in the offshore market, which will trigger requirements for payments. In just over a week, the offshore yuan (CNH) has also fallen by 1.6 percent to six-month lows near 6.13 per dollar, a massive move by its quiet standards.

On Friday, in the onshore market, the spot rate fell to a 10-month low of 6.1806, extending sharp losses from a close of 6.0641 on Feb. 17. The offshore market normally trades at a premium to the onshore market because of the limited availability of the yuan.

Implied volatility on one-month offshore yuan, a gauge of perceived price swings, was just below a record 3.8 vol on Friday, nearly double its level through most of 2013.

"The CNH market is set to be more volatile in the future and higher volatility will likely be the new norm in the backdrop of foreign exchange market reform," said Ju Wang, a senior FX strategist at HSBC in Hong Kong.

China set up an offshore yuan market in Hong Kong in 2010 to promote the use of the yuan in global trade. It has since established yuan trading hubs in Singapore, Taiwan and London.

PIVOTAL LEVEL

Deutsche Bank and Morgan Stanley both estimate that about $350 billion of structured-product trades have been sold since the beginning of 2013.

Morgan Stanley says if the yuan breaks below 6.20 per dollar, holders face potential losses of up to $200 million per month. With average maturities of the structured products around 24 months, total losses could run into billions of dollars.

The yuan has risen against the dollar every year since 2010, and structured products were growing rapidly on expectations of another 2-3 percent appreciation this year.

The yuan's fall -- seen as driven by the central bank wanting more two-way volatility in the market as preparation for more reforms -- has shattered complacency about its direction.

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VIDEO: Wealth Strategies: Yuan fall may creep past China's borders: link.reuters.com/ryw27v

ANALYSIS: Attack on speculators risks backfiring

CHART: CNY and risk reversals link.reuters.com/rad27v

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TWO-WAY BET

Greater yuan volatility increases the risk of holding these products because of their asymmetrical nature.

As long as the yuan stays above a particular level, the holder earns the difference between the market price and the strike price of the product multiplied by the notional value.

Below that level, the holder has to pay out twice the difference multiplied by the notional value to the bank which sold the product. That could raise the risk of some defaults on repayments if losses mount quickly, traders said.

"Breaking a level of 6.20 would really hurt the offshore market," said the head of FX trading at a European Bank in Hong Kong. ($1 = 6.1695 Chinese yuan) (Additional reporting by Michelle Chen; Editing by John Mair)

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