HONG KONG, June 12 (Reuters) - An increasingly volatile Chinese currency prone to bouts of weakness is breathing fresh life into the yuan derivatives market in Hong Kong as more investors look to hedge currency risks.
Enthusiasm for yuan currency futures, cross currency swaps, deliverable forwards and other hedging instruments is likely to persist as traders expect future movement of the yuan will be harder to predict amid further FX market reform.
The "redback" fell sharply earlier this year and has only recently shown signs of stabilising, marking its most sustained depreciation since the landmark revaluation in 2005. The correction was widely believed to be engineered by the central bank to flush out speculators who saw the yuan as a one-way appreciation bet.
However, in recent sessions the central bank has set a series of surprisingly strong midpoints to guide the yuan higher, fueling speculation it may be putting the currency back on a gradual appreciation path.
Spot yuan gained 0.4 percent so far this week, recovering some of its over 3 percent loss in the first five months, yet the currency is still among the worst performers in Asia.
"More and more clients have started to tap hedging tools this year as the yuan is quite volatile. We see daily trading volume of cross currency swaps more than doubled from last year," said a trader at a U.S. investment bank in Hong Kong.
A cross currency swap (CCS) is a financial instrument that allows participants to exchange both principals and interest payments denominated in two different currencies, which enables investors to reduce FX and rate risks.
There are no accurate data on the turnover of CCS as it is an over-the-counter (OTC) market, but traders estimate daily trading volume is around $500 million and the tenor has been extended to 10 years with longer ones not very active.
The boom in the CCS market has also benefited from the flourishing offshore yuan bond market, where issuance so far this year has already surpassed the total in 2013 due to heavy refinancing pressure.
CCS is frequently used by both "dim sum" bond issuers and investors to swap yuan funds to dollars and vice versa. Usually low CCS rates are favorable to dollar-based investors as they can obtain cheap yuan funds with their dollars.
In a more transparent market which is monitored by the Hong Kong Stock Exchange, turnover of yuan/dollar currency futures has also jumped as investors either hedged more of their yuan exposure or speculated on future movements of the currency.
The total trading volumes of the currency futures that were first launched in September 2012 amounted to 97,832 contracts from January to May, up 92 percent from a year earlier, while peak volume for a single day exceeded 6,000 contracts in March, according to the Hong Kong bourse.
Analysts are still divided on whether the yuan will gain or lose against the dollar for the full year. This uncertainty and two-way volatility marks a watershed from the non-stop and steady appreciation in the past few years and adds to the attractiveness of yuan derivative products.
Pessimism on the yuan persisted although short positions fell to the smallest level since late February as some investors took profits from their dollar long positions to the yuan, a recent Reuters poll showed.
WEEK IN REVIEW:
* Equity index provider MSCI on Tuesday said it will not add China's mainland-based A shares to its benchmark emerging markets index but that the shares will remain on review for a possible move in 2015.
* China Minmetals, a stat-owned enterprise, completed the sale of a 2 billion yuan three-year dim sum bond, which attracted 5.7 billion yuan from 88 orders, according to a term sheet seen by Reuters.
* China has relaxed rules on how asset managers can utilise their quotas for investing in its domestic capital markets, according to a circular from the state market regulator seen by Reuters.
* China Construction Bank (CCB), China's second-largest lender, has been selected to become the first clearing service for renminbi trading in London, the Financial Times reported, citing people close to the decision.
CHART OF THE WEEK:
Yuan has become more volatile as the central bank aims to shake out speculative money and deepens FX market reform: link.reuters.com/rym99v
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(Editing by Kim Coghill)